The long-term source of finance, which a company may use for investments, may be broadly classified into two types. They are debt capital and equity capital. The financial manager must determine the proportion of debt and equity and financial leverage. Understanding the relationship between financial leverage and cost of capital is extremely important for taking capital structure decisions. Theoretically, the value of a firm can be maximised when the cost of capital in minimised. That capital structure, where the cost of capital is minimum, is known as an optimum capital structure. The existence of optimum capital structure is not accepted by all. There exist extreme views. The first viewpoint strongly supports the argument that the financing or debt-equity mix has a major impact on the shareholder’s wealth. The second, however, is of the opinion that, capital structure is irrelevant.
There are four major theories explaining the relationship between capital structure, the cost of capital and valuation of the firm.
1. Net Income approach (NI)
2. Net Operating Income approach ( NOI)
3. Traditional approach
4. Modigliani-Miller approach
Net Income Approach (NI)
According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. As a result, the average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weighting in the calculation of the cost of capital.
This approach has been suggested by David Durand. According to this approach, capital structure decision is relevant to the valuation of the firm. According to the theory, it is possible to change the cost of capital by changing the debt-equity mix. In other words, a change in the capital structure causes a change in the overall of capital as well as the value of the firm.
The formula to calculate the average cost of capital is as follows:
Ko = Kd (B/ (B+S)) + Ke (S/(B+S))
Ko is the average cost of capital
Kd is the cost of debt
B is the market value of debt
S is the market value of equity
Ke is the cost of equity
The NI approach is based on the following assumptions:
1. The use of debt does not change the risk of investors and therefore, the cost of debt (Kd) and cost of equity (Ke) remains the same irrespective of the degree of leverage.
2. The cost of debt is less than the cost of equity.
3. The corporate income tax does not exist.
According to the theory, cost of debt is assumed to be less than the cost of equity. Therefore, when the financial leverage is increased (proportion of debt in the total capital), the overall cost of capital will decline and the value of the firm will increase.
The implications of the 3 assumptions of NI approach is that, as the degree of leverage increases, the proportion of a cheaper source of funds ( debt) in the capital structure increases. As a result, the weighted average cost of capital tends to decline to lead to an increase in the total level of the firm. Thus, even if the cost of debt and cost of equity remains same regardless of leverage, increased use of low-cost debt will result in the decline of the overall cost of capital and thereby, maximise the value of the firm.
So the overall cost of capital will be minimum when the proportion of debt in the capital structure is maximum. Hence, optimum structure exists when the firm employs 100% debt or maximum debt in the capital structure.
The NI approach may be compared to a dishonest trader who wants to sell 10 litres of milk @ Rs. 15 per litre. He can add water and pure milk to prepare the 10 litres of milk. If the cost of 1 litre of water is Re. 1, and cost of 1 litre of pure milk is Rs.10, he can maximise his profit or minimise his cost per litre of milk by adding more and more of low-cost water. For example: if he purchases only pure milk, his cost will be Rs. 10×10 = Rs. 100. If he adds 5 litres of water to 5 litres of milk, the cost of 10 litres would be 1×5+10×5=(Rs. 5.5/litre). Here, pure milk is compared to equity, which is a costly source, and water is compared to debt, which is a cheaper source.
Net Operating Income Approach
This theory is also given by David Durand. This is just the opposite to NI approach. According to NOI approach, the capital structure decision is irrelevant and there is nothing like optimum capital structure. All the capital structures are optimum.
According to this theory, the market value of the firm is not affected by the capital structure changes. The market value of the firm is found by capitalising (dividing) the net operating income by the overall cost of capital, which is constant. The market value of the firm is obtained by using the following formula.
V= NOI/Ko =(V =B + S)
The overall cost of capital depends on the business risks of the firm, which is assumed to be constant. NOI depends on the investments made by the company and not on the capital structure decisions. So, if NOI and Ko are constant, the value of the firm must remain same regardless of leverage.
The market capitalises the value of the firm as a whole. Thus, the split between debt and equity is not important. The value of the firm is obtained by capitalising NOI by the Ko, which depends on the business risks. If business risks are constant, Ko is also constant.
The use of debt increases the risks of shareholders, So, Ke increases with the leverage and eats completely the advantage of low-cost debt.
1. The cost of debt remains same regardless of leverage.
2. Corporate income tax does not exist.
The critical assumptions of this approach are that Ko remains same regardless of the degree of leverage. The market capitalises the value of the firm as a whole and the split between debt and equity is unimportant. The benefits from the increase in the use of cost debt are completely offset (neutralised) by the increases in the cost of equity. So even if the leverage is increased, the overall cost of capital remains at the same level. When the company increases the leverage, the firm becomes riskier and equity shareholders penalise the firm by demanding higher and higher rate of returns. So, Ke is the function of the debt equity ratio. Since overall cost of the capital structure remains static according to the theory.
Traditional or Intermediate Approach or WACC Approach
This approach is midway between the NI and the NOI approach. The main propositions of this approach are:
The cost of debt remains almost constant up to a certain degree of leverage but rises thereafter, at an increasing rate. The cost of equity remains more or less constant or rises gradually up to a certain degree of leverage and rises sharply thereafter. The cost of capital due to, the behaviour of the cost of debt and cost of equity, decreases up to a certain point and remains more or less constant for moderate increases in leverage, thereafter, rises beyond that level at an increasing rate.
In other words, NI approach and NOI approach represents two polar cases. The traditional or the intermediate approach is a midway between these two approaches because it partly takes the features of both the approaches.
According to the theory, the value of the firm can be increased or cost of capital can be reduced by a judicious mix of debt and equity capital. This approach states that cost of capital is a function of leverage. So the cost of capital decreases up to a certain degree of leveraged then it remains at the same level for certain degrees of leverage and thereafter it rises sharply with the leverage. So optimum capital structure exists when the cost of capital is minimum or value of the firm is maximum.
The manner in which cost of capital reacts to the changes in the capital structure can be divided into three stages.
1. In the first stage, the cost of equity remains constant or rises slightly with the debt. But when it increases, it does not increase fast enough to offset the advantage of low-cost debt. The cost of debt also remains same or rises slightly with the leverage. As the cost of debt is less than the cost of equity, increased use of debt reduces the cost capital during the 1st stage.
2. Once the firm has reached the certain degree of leverage, increased use of debt does not result in the fall in the overall cost of capital. This is due to the fact that, benefits of low-cost debt are offset by the increase in the cost of equity. Within this range, the cost of capital will be minimum or value of the firm will be maximum.
3. Beyond a certain point, use of debt has an unfavourable effect on the cost of capital and value of the firm. This happens because the firm would become riskier to the investors and hence they would penalise the firm by demanding a higher return. Here, advantages of using low-cost debt are less than the disadvantages of the higher cost of equity. So the overall cost of capital increases with leverage and value of the firm decreases.
Thus, the cost of capital decreases with leverage reaches one minimum point and thereafter, increases with the leverage.
Modigliani-Miller Approach (MM)
MM theory relating to the relationship between the cost of capital and valuation is similar to the NOI approach. According to this approach, the value of the firm is independent of its capital structure. However, there is a basic difference between the two. The NOI approach is purely a definitional term, defining the concept without behavioural justification. MM approach provides analytically sound, logically consistent, behavioural justification in favour of the theory and considers any other theories of Capital structure as incorrect.
Capital markets are perfect. This means,
1. Investors are free to buy and sell securities.
2. Investors can borrow and lend money on the same terms on which a firm can borrow and lend.
3. There are no transaction costs.
4. They behave rationally.
5. Firms can be classified into homogeneous risk categories. All the firms within the same class will have the same degree
of business risks.
6. All the investors have the same expectations from a firm’s NOI with which to evaluate the value of the firm.
7. Dividends Payout ratio is 100% and there are no retained earnings.
8. There are no corporate income taxes. This assumption is removed later.