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Capital Structure Diagrams

corporate finance (Sheffield Hallam University)

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Net Income Approach – M&M I

 Ke increases due to financial risk (bankruptcy risk having been eliminated

by perfect markets)
 Kd is flat as it is unaffected by financial risk
 As debt replaces equity the increased cost of existing equity is cancelled
out by the cheaper cost of debt finance
 The implications are that there is no optimal capital structure

Market Imperfection Theory – M&M II

 The value of the company increases with debt due to the rising tax shield.
 Beyond a certain point bankruptcy risk eats into the tax shield benefits.
 The optimal capital structure is where the marginal benefit of the tax shield
of extra debt is exactly cancelled out by the increased bankruptcy risk.
 The implications are that an optimal capital structure does exist.

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Cost of equity curve (ke):

- Rises with increased gearing due to the increasing level of financial risk being
face by shareholders.
- Curve rises at a steeper rate at high gearing levels due to the risk of
bankruptcy threatening the value of shareholders investments.
Cost of debt curve (kd):
- Will rise only at high levels of gearing, where bankruptcy risk threatens the
value of debt holder’s investments.
- A company finance entirely by equity will be located at point A.
WACC
- The companies WACC will fall initially due to the benefit of the cheaper debt
finance outweighing any increase in the cost of the company’s remaining
equity finance.
- Hence, the company’s WACC will fall to B, to give an optimal cap structure
represented by point X.

 Miller and
Modigliani’s views
do not apply to the
real world as their
assumptions are
unrealistic.
 That implies that
an optimal capital
structure does
exist, i.e. along the
lines of both the
Traditional
Approach and the
Market Imperfections View.

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 The next issue is whether there is one 'magic mix' as implied by the U
shaped curves of the theories.
 If this is true it will be difficult for companies to locate their OCS and then
maintain the structure given the 'lumpy' nature of finance.
 A more realistic position would be a range of optimal capital structures as
indicated by the diagram below:

 This would make it easier for a company to locate and stay at its optimal
capital structure.
 Companies can look at the gearing ratios and interest cover of similar
companies to see if they are 'in line' with them.

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