MM hypothesis with corporate tax. â Miller's hypothesis with corporate and personal taxes. ..... This is because a profitable form can avail benefits of tax shelter.
Capital Structure and Firm Value
By Dr. Jagdish Raj Saini
OVERVIEW • What should be the proportions of equity and debt in the capital structure of the firm? or • How much leverage should a firm employ? • What is the relationship between capital structure and firm value? or • What is the relationship between capital structure and firm value?
Capital Structure Theories: – – – – – – –
3
Net income (NI) approach. Net operating income (NOI) approach. Traditional approach MM hypothesis without corporate tax. MM hypothesis with corporate tax. Miller’s hypothesis with corporate and personal taxes. Trade-off theory: costs and benefits of leverage.
Assumptions Assumptions made towards examining the relation between capital structure and cost of capital:
There is no income tax, corporate or personal. Firm pursues with 100% dividend payout ratio. Investors have identical subjective probability distributions of operating income for each firm. Operating income remains constant over time.
A firm can change its financing mix instantaneously without incurring transaction costs.
Assumptions Cost of debt (rD ) =
I D
=
Annual interest charges Market value of debt
Cost of equity (rE ) =
E D
=
Equity earnings Market value of equity
Overall capitalization rate (rA) = rA =
E D
D rD ( D+E
Operating income = Market value of the Firm ) +
E rE ( ) D+E
V =D + E Market Value of firm = Market Value of Debt + Market Value of Equity
Net Income Approach (NIA) Assumptions: There are no taxes and transaction costs. The cost of debt is less than the cost of equity. Shareholders perceive no financial risk arising from the use of debt.
• As per this approach, the cost of debt rD and the cost of equity rE remains unchanged when D/E varies. rA= rD(
D D+E
) + rE(
E ) D+E
• According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.
NET INCOME APPROACH According to this approach, rD and rE remain unchanged when D/E varies. The constancy of rD and rE with respect to D/E means that rA declines as D/E increases.
As D/E increases rD which is lower than rE receives a higher weight in the calculation of rA.
Net Income Approach (NIA) • Two firms A & B similar in all aspects except the degree of leverage report the following financials: Item Operating income Debt interest Equity earnings Cost of equity Cost of debt Market value of equity Market value of debt
Total value of firm
Firm A
Firm B
10,000
10,000
0
3,000
10,000
7,000
10%
10%
6%
6%
1,00,000
70,000
0
50,000
1,00,000
1,20,000
rA for firm A = 0.06 x (0/1,00,000) + 0.10 x (1,00,000/1,00,000) = 10% rA for firm B = 0.06 x (50,000/1,20,000) + 0.10 x (70,000/1,20,000) = 8.3%
Net Income Approach (NIA) • Value of the firm under NI approach. re = 10 %
re = 10 % Replaces equity by 5% ₹ 300,000 debt
Zero debt Net operating Income (NOI) Interest (I) Net Income (NI) Market Value of Equity (E) = NI/rE Market Value of debt (D) = I/rD
Market Value of the firm (V) = D + E or NOI/rA Debt to total Value (D/D+E) WACC or rA = rD (
D ) D+E
E ) D+E
+rE (
re = 10 % Replaces equity by 5% ₹ 900,000 debt
100,000 0 100,000 100,000/.10 = 1000,000
100,000 15,000 85,000 85000/.10 = 850,000
100,000 45,000 55,000 55000/.10 = 550,000
0
15000/.05 = 300,000
45000/.05 = 900,000
1,000,000
1,150,000
1,450,000
0.00 0.10
0.261 0.087
0.62 0.081
Therefore, as a firm increases debt proportion in the capital structure, the WACC decreases and market value of the firm increases.
Net Operating Income Approach (NOIA) • The overall capitalization rate (rA) and the cost of debt (rD) remains constant for all degrees of leverage. rA=
D rD( D+E
)+
E r E( D+E
)
• Given this, cost of equity can be expressed as D E
rE = rA + (rA – rD) ( ) • Underlying premises of this approach are: Market capitalizes the firm as a whole at a discount rate which is independent of the firm’s debt-equity ratio. Division between debt and equity becomes irrelevant. An increase in use of debt of funds which are cheaper is offset by an increase in the equity capitalization rate. It results because equity investors seek higher compensation as they are exposed to greater risk on account of enhanced degree of leverage. Thus, they raise rE as the degree of leverage increases.
NET OPERATING INCOME APPROACH According to this approach the overall capitalisation rate (rA) and the cost of debt (rD) remain constant for all degrees of leverage. Hence rE = rA + (rA – rD) (D/E)
Net Operating Income Approach (NOIA) • Two firms A & B similar in all aspects except the degree of leverage report the following financials: Item Operating income
Firm A
Firm B
10,000
10,000
15%
15%
66,667
66,667
1,000
3,000
10%
10%
Market value of debt(D) = I/rD
10,000
30,000
Market value of equity (E) = NI/rE
56,667
36,667
0.176
0.818
Overall capitalization rate Total market value (NOI/rA ) Debt interest Debt capitalization rate
D/E
rE for firm A = (10,000 – 1,000)/56,667 = 15.9% or rE for firm A = 15 + (15-10) 0.176 = 15.9% rE for firm B = (10,000 – 3,000)/36,667 = 19.1% or rE for firm B = 15 + (15-10) 0.818 = 19.1%
Traditional Approach (TA) •
The chief assertions of the traditional approach are: Cost of debt rD remains majorly constant up to a certain level of leverage but rises thereafter at an increasing rate. Cost of equity rE remains more or less constant or rises gradually up to a certain level of leverage and rises sharply thereafter. Average cost of capital (rA) as a result of such behavior of rD and rE Decreases up to a certain point Remains unchanged for moderate increases in leverage thereafter Rises beyond a certain point
Optimal Capital Structure: Initially the cost of capital for the firm will fall as cheaper debt replaces expensive equity. Even though the cost of equity rises with increased debt the advantages of debt would outweigh the increased cost of equity equity. Beyond a certain level of leverage the cost of equity starts rising disproportionately, more than offsetting the advantage of debt, raising the overall cost of capital for the firm. Since cost of capital falls initially and then starts rising there exists a point where cost of capital would be least. This point of least cost of capital would maximise the value of the firm and is the optimal capital structure of the firm and is the optimal capital structure.
Traditional Approach (TA)
TA suggests that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. Below optimal point
MC of Debt < MC of Equity
At the optimal point
MC of Debt = MC of Equity
Beyond optimal point
MC of Debt > MC of Equity
MC: Marginal Cost
The traditional theory on the relationship between capital structure and the firm value has three stages: • First stage: Increasing value • Second stage: Optimum value • Third stage: Declining value
Traditional Approach (TA) re = 10 %
re = 10.56 %
re = 12.5 %
Zero debt (₹ in cr.)
Replaces equity by 6% ₹ 300 cr. debt (₹ in cr.)
Replaces equity by 7% ₹ 600 cr. debt (₹ in cr.)
150
150
150
0
18
42
150
132
108
150/.10 = 1500
132/.1056 = 1250
108/.125 = 864
0
18/.06 = 300
42/.07 = 600
Market Value of the firm (V) = D + E or NOI/rA
1,500
1,550
1,464
Debt to total Value (D/D+E)
0.00
0.194
0.410
0.10
0.0970
0.1030
Net operating Income (NOI) Interest (I) Net Income (NI)
Market Value of Equity (E) = NI/rE Market Value of debt (D) = I/rD
WACC or rA = rD (
D ) D+E
E ) D+E
+rE (
Modigliani & Miller Approach (MM) Assumptions: Perfect capital market
Securities are indefinitely divisible. Investors are free to buy/sell securities. Investors can borrow on the same terms and conditions as firms can. There are no transaction costs. Information is perfect, that is, each investor has the same information which is readily available to him without cost. Investors are rational and behave accordingly.
Homogenous expectations Equivalent risk classes Absence of tax The dividend payout ratio is 100 per cent.
Modigliani & Miller Approach (MM) Proposition-1 (without taxes): The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure. V = D + E = O/r V = Market value of the firm, D = Market value of debt, E = Market value of equity O = Expected operating income, r = Discount rate applicable to the risk class to which the firm belongs.
Value of levered firm = Value on unlevered firm • Proposition – 1 is identical to net operating income approach. MM invoked an arbitrage argument to prove this proposition.
Arbitrage Process: • Two firms U and L, similar in all respects except in their capital structure. Firm U 150,000 0 150,000 0.15 1,000,000 0 1,000,000 0.15
Operating Income (EBIT) Interest Net Income or Equity Earnings Cost of Equity Market Value of Equity Cost of debt Market value of debt Market Value of the firm Average CoC (WACC)
Firm L 150,000 60,000 90,000 0.16 562,500 0.12 500,000 1,062,500 0.1412
Let Suppose, an investor owns 10% equity in firm L, he would do well to: • Sell his equity in firm L for ₹ 56,250. • Borrow 50,000, an amount equal to 10% of L’s debt, at an interest rate of 12%. • Buy 10% of firm U’s equity for ₹ 100,000. • His investment is ₹ 100,000, leaving him with a surplus amount of ₹ 6,250. Yet his income remains the same: Old income from investment in L
New income from investment in U
10% of equity income
9,000
15000
12% interest on Loan
-
(6,000)
9000
9000
Arbitrage Process • Suppose two identical firms, except for their capital structures, have different market values. In this situation, arbitrage (or switching) will take place to enable investors to engage in the personal or homemade leverage as against the corporate leverage, to restore equilibrium in the market. • On the basis of the arbitrage process, MM conclude that the market value of a firm is not affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does not help in creating any wealth for shareholders. Hence one capital structure is as much desirable (or undesirable) as the other. 19
Modigliani & Miller Position (MM) Proposition-2 (without taxes): •
Value of the firm depends on the expected net operating income and opportunity cost of capital (rA or ko).
•
In the absence of corporate taxes, the firm’s capital structure (financial leverage) does not affect its net operating income.
•
The opportunity cost of capital, depends on firm’s operating risk. Since, financial leverage does not affect the firm’s operating risk, therefore, it does not affect opportunity cost of capital.
•
Financial leverage causes two opposing effects: it increases the shareholders’ return but it also increases their financial risk. Shareholders will increase the required rate of return (i.e., the cost of equity) on their investment to compensate for the financial risk. The higher the financial risk, the higher the shareholders’ required rate of return or the cost of equity.
•
The cost of equity for a levered firm should be higher than the opportunity cost of capital, ko; that is, the levered firm’s ke > ko. It should be equal to constant ka, plus a financial risk premium.
Modigliani & Miller Position (MM) Proposition-2 (without taxes): An increase in financial leverage increases the expected earnings per share but not the share price. The change in the expected EPS is offset by a corresponding change in the return required by the shareholders. rE = rA + (rA – rD) (D/E) The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt.
Modigliani & Miller Position (MM) Proposition-2 (without taxes): UnLevered Firm
Levered Firm Debt/equity = 50:50
Ko = Ke
Ko = kd + Ke
= 15%
= 10% (.50) + 20% (.50) = 15%
Expected return on equity: rE = rA + (rA – rD) (D/E) = 15% + (15% - 10%) (.5/.5) = 20% Risk premium for equity: = (rA – rD) (D/E) = (15% - 10%) (.5/.5) = 5%
The cost of equity for a levered firm should be higher than the opportunity cost of capital, ko; that is, the levered firm’s ke > ko , 20% > 15%
Modigliani & Miller Position (MM) Proposition-2 (without taxes) under Extreme Leverage:
• The excessive use of debt increases the risk of default. Hence, in practice, the cost of debt (rD or kd) will increase with high level of financial leverage. • To compensate for this, the rate of increase in rE or ke decreases and may even turn down eventually. • This happens because as the D/E ratio increases beyond the threshold level, a portion of the firm’s business risk is borne by the suppliers of debt capital. • As the firm borrows more, more of its business risk is shifted from shareholders to creditors.
Criticism of the MM Hypothesis • Lending and borrowing rates discrepancy • Non-substitutability of personal and corporate leverages • Transaction costs
• Institutional restrictions • Existence of corporate tax 24
RELEVANCE OF CAPITAL STRUCTURE: THE MM HYPOTHESIS UNDER CORPORATE TAXES • MM show that the value of the firm will increase with debt due to the deductibility of interest charges for tax computation, and the value of the levered firm will be higher than of the unlevered firm. Value of levered firm = Value of unlevered firm + Gain from leverage i.e. PV of Tax Shield VL
=
VU 𝑂(1−𝑡𝑐) r
V = where
V O tC r D
= = = = =
+
tC D +
tC D
value of the firm operating income corporate tax rate capitalisation rate applicable to the unlevered firm market value of debt
Example: Debt Advantage: Interest Tax Shields Suppose two firms L and U are identical in all respects except that firm L is levered and firm U is unlevered. Firm U is an all-equity financed firm while firm L employs equity and Rs 5,000 debt at 10 per cent rate of interest. Both firms have an expected earning before interest and taxes (or net operating income) of Rs 2,500, pay corporate tax at 50 per cent and distribute 100 per cent earnings as dividends to shareholders.
26
• Total income after corporate tax is Rs 1,250 for the unlevered firm U and Rs 1,500 for the levered firm L. • Thus, the levered firm L’s investors are ahead of the unlevered firm U’s investors by Rs 250. • You may also note that the tax liability of the levered firm L is Rs 250 less than the tax liability of the unlevered firm U. • For firm L the tax savings has occurred on account of payment of interest to debt holders. • Hence, this amount is the interest tax shield or tax advantage of debt of firm L: 0.5 × (0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus,
Interest tax shield = Corporate Tax Rate x interest = t𝐶𝑟𝐷𝐷
PV of interest Tax shield =
Corporate Tax Rate x interest Cost of debt
=
t𝐶𝑟𝐷𝐷 rD
*Interest tax shield is used for calculating total income of the levered firm. *Present Value (PV) is used for calculating the market value of the levered firm.
= t𝐶𝐷
Implications of the MM Hypothesis with Corporate Taxes • The MM’s “tax-corrected” view suggests that, because of the tax deductibility of interest charges, a firm can increase its value with leverage. Thus, the optimum capital structure is reached when the firm employs almost 100 per cent debt. • In practice, firms do not employ large amounts of debt, nor are lenders ready to lend beyond certain limits, which they decide.
Why do companies not employ extreme level of debt in practice? • First, we need to consider the impact of both corporate and personal taxes for corporate borrowing. Personal income tax may offset the advantage of the interest tax shield. • Second, borrowing may involve extra costs (in addition to contractual interest cost)—costs of financial distress—that may also offset the advantage of the interest shield. 28
FINANCIAL LEVERAGE AND CORPORATE AND PERSONAL TAXES • Companies everywhere pay corporate tax on their earnings. Hence, the earnings available to investors are reduced by the corporate tax. • Further, investors are required to pay personal taxes on the income earned by them. • Therefore, from investors’ point of view, the effect of taxes will include both corporate and personal taxes. • A firm should thus aim at minimizing the total taxes (both corporate and personal) to investors while deciding about borrowing.
How do personal income taxes change investors’ return and value? It depends on the corporate tax rate and the difference in the personal income tax rates of investors. 29
Limits to Borrowings •
The attractiveness of borrowing depends on: corporate tax rate, personal tax rate on interest income and personal tax rate on equity income.
•
The advantage of borrowing reduces :(See Excel File) When corporate tax rate decreases, or when the personal tax rate on interest income increases, or when the personal tax rate on equity income decreases.
•
When will a firm stop borrowing?
•
A firm will stop borrowing when (1 – Tpd) becomes equal to (1 – Tpe) (1 – T). Thus, the net tax advantage of debt or the interest tax shield after personal taxes is given by the following:
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Int. income after personal taxes = KdD (1-Tpd)
=
Equity income after personal taxes (for levered firm) =
Interest Income – Personal tax on int. inc. KdD
–
KdDTpd
(Net operating Income – KdD) (1 – Corporate tax rate) x (1 – Personal tax rate) (O-KdD) (1−Tc) (1−Tpe)
Equity income after personal taxes (for Unlevered firm) =
Net operating Income (1 – Corporate tax rate) x (1 – Personal tax rate) O (1−Tc) (1−Tpe)
Net tax advantage of debt in %
Net tax advantage of debt in Amount
(when, Kpd = Kpe)
Tc (1-Tp)
KdD x Tc (1-Tp)
(when, Kpd ≠ Kpe )
(1-Tpd) – (1-T) x (1-Tpe)
KdD x
PV of interest tax shield
(when, Kpd = Kpe)
KdD x Tc (1 − Tp) Kd (1 − Tpd)
(when, Kpd ≠ Kpe )
KdD x [(1 − Tpd) – (1 − Tc) x (1 − Tpe)] Kd (1 − Tpd)
[(1-Tpd) – (1-T) x (1-Tpe)] PV of interest tax shield
= TcD
=TcDKd
[1 -
(1−Tc) (1−Tpe) (1−Tpd)
]
Value of Levered Firm: Corporate & Personal Taxes Levered firm income After = Unlevered firm income after taxes + Net taxes (when, Kpd = Kpe) tax advantage of debt = O (1 – Tc) (1 – Tp) + KdD x Tc (1-Tp)
Kpd = personal tax on debt or interest income. Kpe = personal tax on equity income. O = Operating Income. Tc = Corporation tax rate. KdD = Interest Income Tp = Personal tax rate, when then, Kpd = Kpe = Tp
Trade-off Theory: Costs & Benefits of Leverage Financial Distress: • Financial distress arises when a firm is not able to meet its obligations to debtholders. • For a given level of debt, financial distress occurs because of the business (operating) risk . With higher business risk, the probability of financial distress becomes greater. Determinants of business risk are: – Operating leverage (fixed and variable costs) – Cyclical variations – Intensity of competition – Price fluctuations – Firm size and diversification – Stages in the industry life cycle 33
Trade-off Theory: Costs & Benefits of Leverage Costs of Financial Distress: Direct Costs: Financial distress may ultimately force a company to insolvency. Direct costs of financial distress include costs of insolvency. Delay in liquidation may diminish asset value. Distress sale fetches lower price. Legal and administrative costs are high. Indirect Costs: Financial distress, with or without insolvency, also has many indirect costs. These costs relate to the actions of employees, managers, customers, suppliers and shareholders. Managers become myopic. Stakeholders dilute their commitment.
Trade-off Theory: Costs & Benefits of Leverage Agency Costs: • In practice, there may exist a conflict of interest among shareholders, debt holders and management. These conflicts give rise to agency problems, which involve agency costs. • Agency costs have their influence on a firm’s capital structure. – Shareholders–Debt-holders conflict – Shareholders–Managers conflict – Monitoring and agency costs Effect of Financial distress and agency costs:
Value of the levered firm = Value of the levered firm + Tax advantage of debt i.e. PV of tax shield - PV of financial distress
35
Shareholders–Debt-holders Conflict: Agency Cost of Debt • There is an agency relationship between the shareholders and creditors of firms that have substantial amounts of debt. • Managers acting in the interest of shareholders tend to invest in highly risky and volatile projects that increase the wealth of shareholders (Upside potential) at the expense of creditors (downside risk). • Hence, to protect their interests lenders impose restrictive covenants which may hamper the operational flexibility of the firm. • Firm has to be monitored to ensure that covenants are being adhered to and the cost of monitoring are passed on to shareholders in the form of higher debt costs. • The loss in efficiency on account of restrictions on operational freedom plus the cost of monitoring represent agency costs associated with debt.
Agency Benefit of Debt: • Prevent managers to invest/over-invest in their favourite projects or negative NPV projects. • Check empire-building tendencies of managers.
TRADEOFF MODEL
Value of the firm
Value of the firm considering the tax advantage of debt
Financial distress costs and agency costs Value of the firm considering the tax advantage and financial distress and agency costs Value of the unlevered firm
D/E
TRADEOFF THEORY • According to the tradeoff theory, every firm has an optimal debt-equity ratio that maximizes its value.
• The optimal debt-equity ratio of a profitable firm that has stable, tangible assets would be higher than the optimal debt-equity ratio of an unprofitable firm with risky, intangible assets.
• This is because a profitable form can avail benefits of tax shelter associated with debt. • Further, when assets are stable and tangible financial distress costs and
agency costs tend to be lower. • The tradeoff theory, however, cannot explain why some profitable companies (like HUL and Colgate Palmolive India Ltd.) depend so little on debt. This was explained by another theory known as signaling theory.
SIGNALING/PECKING ORDER THEORY • The “pecking order” theory is based on the assertion that managers have more information about their firms than investors. This disparity of information is referred to as asymmetric information. • The manner in which managers raise capital gives a signal of their belief in their firm’s prospects to investors. • This also implies that firms always use internal finance when available, and choose debt over new issue of equity when external financing is required. • Managers issue debt when they are positive about the firms future prospects (expect steady cash flows) and will issue equity when they are unsure. Equity issue indicates that the current share price is overvalued. • Managers avoid signaling adverse information about their companies by using internal finance.
39
SIGNALING/PECKING ORDER THEORY Internal finance is cheaper as: No transaction costs (issue costs) are incurred when the earnings are retained. No taxes are paid on retained earnings.
Thus, the pecking order theory implies that managers raise finance in the following order: 1. Managers always prefer to use internal finance. 2. When they do not have internal finance, they prefer issuing debt. They first issue secured debt and then unsecured debt followed by hybrid securities such as convertible debentures. 3. As a last resort, managers issue shares to raise finances. The pecking order theory is able to explain the negative inverse relationship between profitability and debt ratio within an industry. However, it does not fully explain the capital structure differences between industries. 40
Practical Considerations in Determining Capital Structure 1. 2. 3. 4. 5. 6. 7. 8. 9.
41
Assets Growth Opportunities Debt and Non-debt Tax Shields Financial Flexibility: Loan Covenants, Financial Slack Control Marketability and Timing Issue Costs Capacity of Raising Funds. Tax Rate.
References: • Prasanna Chandra, Financial Management – Theory & Practice 9th Ed, McGraw Hill Education (ISBN: 978-00-7107-840-5). • I.M. Pandey, Financial Management 11th Ed, Vikas Publishing
