Theories on Capital Structure - Net Income Approach, MM Approach

[Theories on Capital Structure, Net Income Approach, Net operating Income Approach, Traditional Approach, Modigliani and Miller Approach (MM Approach)]

Various theories on Capital Structure

A firm's objective should be directed towards the maximisation of the firm's value; the capital structure or leverage decisions are to be examined from the view point of their impact on the value of the firm. If the value of the firm can be affected by capital structure or financing decision, a firm would like to have a capital structure that maximises the market value of the firm. There are broadly 4 approaches in the regard, which analyses relationship between leverage, cost of capital and the value of the firm in different ways, under the following assumptions:

1)      There are only 2 sources of funds viz. debt and equity.

2)      The total assets of the firm are given and the degree of leverage can be altered by selling debt to repurchase shares or selling shares to retire debt.

3)      There are no retained earnings implying that entire profits are distributed among shareholders.

4)      The operating profit of firm is given and expected to grow.

5)      The business risk is assumed to be constant and is not affected by the financing mix decision.

6)      There are no corporate or personal taxes.

7)      The investors have the same subjective probability distribution of expected earnings.

The approaches are as below:

1) Net Income Approach (NI Approach): 

The approach is suggested by Durand. According to it, a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words, if the degree of financial leverage increases, the weighted average cost of capital would decline with every increase in the debt content in total funds employed, while the value of the firm will increase. Reverse would happen in a converse situation. It is based on the following assumptions:

i) There are no corporate taxes.

ii) The cost of debt is less than cost of equity or equity capitalisation rate.

iii) The use of debt content does not change the risk perception of investors as a result of both the Kd (Debt capitalisation rate) and Ke (equity capitalisation rate) remains constant.

The value of the firm on the basis of Net Income Approach may be ascertained as follows: V = S + D

Where,

V = Value of the firm

S = Market value of equity (S = NI/Ke)

D = Market value of debt

NI = Earnings available for equity shareholders

Ke = Equity Capitalisation rate

Under, NI approach, the value of a firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimising cost of capital. Overall cost of capital = EBIT/Value of the firm

2) Net Operating Income Approach (NOI): 

This approach is also suggested by Durand, according to it, the market value of the firm is not affected by the capital structure changes. The market value of the firm is ascertained by capitalising the net  operating income at the overall cost of capital, which is constant. The market value of the firm is determined as:

V = EBIT/Overall cost of capital

Where,

V = Market value of the firm

EBIT = Earnings before interest and tax

S = V – D Where,

S = Value of equity

D = Market value of debt

V = Market value of firm

It is based on the following assumptions:

i) The overall cost of capital remains constant for all degree of debt equity mix.

ii) The market capitalises value of the firm as a whole. Thus, the split between debt and equity is not important.

iii) The use of less costly debt funds increases the risk of shareholders. This causes the equity capialisation rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalisation rate.

iv) There are no corporate taxes.

v) The cost of debt is constant.

Under, NOI approach since overall cost of capital is constant, thus, there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal.

3) Traditional Approach: 

The traditional approach, also called an intermediate approach as it takes a midway between NI approach, that the value of the firm can be increased by increasing financial leverage and NOI approach, that the value of the firm is constant irrespective of the degree of financial leverage. According to this approach the firm should strive to reach the optimal capital structure and its total valuation through a judicious use of debt and equity in capital structure. At the optimal capital structure, the overall cost of capital will be minimum and the value of the firm is maximum. It further states, that the value of the firm increases with financial leverage upto a certain point. Beyond this, the increase in financial leverage will increase cost of equity, the overall cost of capital may still reduce. However, if financial leverage increases beyond an acceptable limit, the risk of debt investor may also increase, consequently cost of debt also starts increasing. The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase. Thus, as per the traditional approach the cost of capital is a function of financial leverage and the value of firm can be affected by the judicious mix of debt and equity in capital structure. The increase of financial leverage upto a point favourably affects the value of the firm. At this point, the capital structure is optimal & the overall cost of capital will be the least.

4) Modigliani and Miller Approach (MM Approach): 

According to this approach, the total cost of capital of particular firm is independent of its method and level of financing. Modigliani and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital. They argued, in support of their approach, that as per the traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, is determined from the level of shareholder's expectations. That is if, shareholders expect a particular rate of return, say  15 % from a particular company, they do not take into account the debt equity ratio and they expect 15 % as they find that it covers the particular risk which this company entails. Thus, the shareholders would now, expect a higher rate of return from the shares of the company. Thus, each change in the debt equity mix is automatically set-off by a change in the expectations of the shareholders from the equity share capital. Modigliani and Miller, thus, argue that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital is equal to the capitalisation rate of pure equity stream of its class of risk. Thus, financial leverage has no impact on share market prices nor on the cost of capital.

Assumptions:

i) The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities.

a)      They are well-informed about the risk-return on all type of securities.

b)      There are no transaction costs. 

c)       They behave rationally.

d)      They can borrow without restrictions on the same terms as the firms do.

ii) The firms can be classified into 'homogenous risk class'. They belong to this class, if their expected earnings have identical risk characteristics.

iii) All investors have the same expectations from a firms' EBIT that is necessary to evaluate the value of a firm.

iv) The dividend payment ratio is 100 %. i.e. there are no retained earnings.

v) There are no corporate taxes, but, this assumption has been removed.

Modigliani and Miller agree that while companies in different industries face different risks resulting in their earnings being capitalised at different rates, it is not possible for these companies to affect their market values, and thus, their overall capitalisation rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in company's capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate leverage.