Capital Structure Theories

A firm’s earnings before interest and tax are the same whether it is funded by owners or by lenders. Does the mix of funding change what the firm is worth? Two early theories give opposite answers.

The firm. It earns an EBIT of ₹6,00,000. It can raise ₹20,00,000 of debt at 10%, with interest of ₹2,00,000 a year.

Debt lowers Ko from 15% to 12.9% and raises the value of the firm by about ₹6.7 lakh. Carried to its end, the theory says a firm should be funded wholly by debt.

In the NOI view, cheap debt is offset by a rising cost of equity: shareholders see more risk and ask for more, from 12% to 13.3%. Debt up, Ke up, Ko constant, value constant.

The logic of the NI theory, in order. Ke and Kd are assumed constant. Debt is cheaper than equity, so more leverage reduces the overall cost of capital. A lower cost of capital raises the value of the firm. So value is maximised by using as much debt as possible.

Don’t treat the NI and NOI theories as findings. They are assumptions about how investors behave. The NI theory assumes shareholders do not mind extra risk from debt; the NOI theory assumes they mind it exactly enough to cancel the saving. Neither is proved, and the next theory tests both.

Where it breaks. No real firm borrows 100% of its capital, so the NI conclusion fails: lenders raise their rates and shareholders ask more. The NOI view ignores tax and the cost of financial distress. Real firms lie in between, which led to the traditional (intermediate) view.

For exams. Remember: NI: debt up, WACC down, value up. NOI: debt up, Ke up, Ko constant, value constant. V = EBIT ÷ Ko under NOI.

NI: more debt, more value. NOI: more debt, same value.

The NOI theory says the mix does not matter, but gives only an assumption. In 1958 Modigliani and Miller proved it, under strict conditions, by showing that if a firm’s value did depend on its debt, traders could make a risk-free profit.

Proposition II, checked. Take the NOI firm: Ko = 12%, Kd = 10%, debt ₹20,00,000 and equity ₹30,00,000, so D/E = 0.67.

It matches the 13.3% found from the earnings. The extra return that shareholders ask is exactly the compensation for the risk that debt adds, so the overall cost stays at 12%.

Homemade leverage. Suppose an investor wants the return of a levered share but only unlevered shares exist. With ₹1,00,000 of her own, she borrows ₹66,667 at 10% and buys ₹1,66,667 of the unlevered firm, a 3.33% stake. Her share of the earnings is 3.33% of ₹6,00,000, or ₹20,000. After interest of ₹6,667, she keeps ₹13,333 on ₹1,00,000, a return of 13.3%. That is exactly the cost of equity of the levered firm.

Because investors can create leverage for themselves, they will not pay extra for a firm that does it for them. This is the leverage irrelevance argument: financing mix does not affect value, WACC stays constant at every debt-equity ratio, and value depends on earnings and asset risk.

The tax shield. At a 25% tax rate and ₹20,00,000 of permanent debt, the shield is 25% × ₹20,00,000 = ₹5,00,000. The levered firm is worth ₹50,00,000 + ₹5,00,000 = ₹55,00,000.

Don’t read M–M as saying debt is harmless. M–M says that in a world with no taxes, no bankruptcy costs and no information gaps, the mix does not matter. It is a benchmark that shows what must be added to explain real behaviour: taxes, distress costs and agency costs.

Where it breaks. People cannot borrow as cheaply as large firms, and markets are not frictionless. Bankruptcy costs money, and a firm near distress loses customers and suppliers. The tax-shield model, taken alone, would also call for nearly 100% debt, which is not seen in practice.

For exams. State both propositions, the formula for Ke, the effect of tax, and what homemade leverage means.

Without taxes: irrelevant. With taxes: debt gives a shield.

In practice, real firms are neither all-debt nor all-equity. Textbooks offer four reasons for the mix that firms choose, and each says something true about how managers behave.

Trade-off. Debt gives a tax shield, but the more a firm borrows the greater the chance and cost of distress: lost customers, forced asset sales and lawyers’ fees. The best mix is where one more rupee of debt adds as much cost as benefit.

Pecking order. A new share issue signals to outsiders that managers think the shares are overpriced, so it lowers the price. Retained earnings avoid that signal, and debt sends a milder one. This explains why profitable firms often carry little debt: they do not need to borrow.

Agency costs. Managers may waste free cash. Fixed interest takes cash out of their hands, and so can improve discipline. But lenders then add covenants and monitoring, and shareholders of a heavily indebted firm may take extra risks at the lenders’ expense.

Market timing. A firm that sells shares when prices are high, and buys them back when low, ends up with a mix that reflects the history of the market. The theory explains why debt-equity ratios drift over time, rather than settling at a target.

Don’t treat these as rival answers. They answer different questions. Trade-off and agency theories give a target ratio. Pecking order and market timing describe the order and timing of choices. A firm may follow a target ratio loosely while using the pecking order day to day.

Where it breaks. None of them predicts every firm. Pecking order fits large firms better than small ones, and trade-off has trouble explaining why some profitable firms use so little debt. Market timing is hard to separate from luck.

For exams. Know the central idea and the cue for each of the seven theories (these four, with NI, NOI and M–M), and the order of the pecking order.

Trade off the shield, peck from inside, discipline with debt, time the market.