Presentation on

Corporate Finance
Presented By:
Md. Bashir Uddin Sikder
ID NO- 51326050
Dept. Of Banking and
Insurance
University Of Dhaka.

Presented TO:
Mr. Hasibul Alam
Chowdhury
Assistant Professor
Dept. Of Banking and
Insurance.
University Of Dhaka.

TOPICS:

Chapter-16: Capital Structure

(Basic Concepts)
&
Chapter-17: Capital Structure
(Limits to the use of debt).

Capital Structure (Basic Concepts).

1) Maximizing firm value vs Maximizing
Stockholder Interest
Changes in capital structure benefits the
stockholders if and only the value of the firm
increase. Conversely, these changes hurt
the stockholders if and only if the value of
the firm decreases. Managers should choose
capital structure that has the highest firm
value because this capital structure will be
most beneficial to the firms stockholders.

2) Financial Leverage and Firm Value:

Here we want to determine that optimal capital structure.

In the above figure, the solid line represents the case of no leverage. The line
begins at the origin, indicating that EPS would be zero if EBI was zero. The
EPS rises in tandem with a rise in EBI. The dotted line represents the case of
$4000 of debt. Here EPS is negative if EBI is Zero. This follows because $400
of interest must be paid regardless of the firms profits. Here the slope of the
dotted line is higher than the slope of the solid line. This occurs because the
levered firm has fewer shares of stock outstanding than the unlevered firm.
Therefore any increase in EBI leads to a greater rise in EPS for the levered
firm because the earnings increase is distributed over fewer shares of stock.

3.
Modigliani and Miller (MM): Proposition
II:
This implies that the expected rate of return on
equity is positively related to the firms debt-equity
ratio. This makes intuitive sense because the risk of
equity rises with leverage. MM proposition II (no
taxes) is expressed by the following equation:
Rs=R0 + (R0-RB)
Here,
Rs is the cost of equity
RB is the cost of debt
R0 is the cost capital for all-equity firm
is the debt-equity ratio.

The weighted Average Cost of Capital (R WACC) &

corporate Taxes:

Theweighted average cost of capital (WACC)is the

rate that a company is expected to pay on average to all
its security holders to finance its assets. A higher debt-toequity ratio leads to a higher required return on equity,
because of the higher risk involved for equity-holders in a
company with debt. The formula is derived from the
theory of weighted average cost of capital (WACC).
RWACC= RS+ RB (1-tc)
Where, VL=(S+B)
tc is the corporate tax
In the no taxes case, RWACC is not affected by leverage.
However, because debt is tax advantage relative to
equity, it can be shown that RWACC declines with leverage
in a world with corporate taxes.

 Summary
of
Modigliani
Miller

propositions with corporate taxes:

MM implies that the capital structure decision
is a matter of indifference, whereas the decision
appears to be a weighty one in the real world. To
achieve real-world applicability, we must
considered corporate taxes. Expected return on
levered equity can be expressed as under:
Rs=R0 + (R0-RB) (1-tc)
Here value is positively related to leverage.
This result implies that firms should have a
capital structure almost entirely composed of
debt. Because real-world firms select more
moderate levels of debt.

Capital Structure (limits the use of debt)

1) Financial Distress Costs:

Cost of financial distress indicates when a firm has debt of capital

structure it has an obligation of Principle and Interest payments, if this
obligation are not met then the firm may face financial distress which
may lead to Bankruptcy. The more debt a company takes on, the
more it risks being unable to meet its financial obligations to creditors.
A highly leveraged firm is more vulnerable to a decrease in
profitability. Therefore, a highly levered firm has a higher risk of
bankruptcy.
Indirect costs of Financial Distress
Impaired ability to conduct business
Impaired services
Loss of trust
Direct Costs of Financial Distress
Lawyers fee
Administrative & accounting fee
Expert witnesses fee.

Agency cost:

Agency cost means that shareholders and business

managers may not necessarily agree on the actions that
are best for the business firm and that there is an inherent
cost to that disagreement.

(i) Selfish Investment Strategy:

Selfish strategy 1: Incentive to take large risks-Selfish
Stockholders Accept Negative NPV Project with Large Risks.
Selfish strategy 2: Incentive toward underinvestmentSelfish Stockholders Forego Positive NPV Project.
Selfish strategy 3: Milking the property-Increase
perquisites to shareholders and/or management

2). Can Costs of Debt Be

Reduced?
Each of the costs of financial distress we have
mentioned is substantial in its own right. The sum of
them may well affect debt financing severely. Thus,
managers have an incentive to reduce these costs.

(a) Protective Covenants:

A part of anindentureor loan agreement that limits
certain actions acompany may take during theterm
of the loanto protect thelendersinterests.
Protective covenants can be classified into two types:
(i) Negative covenant
(ii) Positive covenant

3) Signaling:
Financing decision by managers that provide
signaling effect to investors that suggest
increase the value of firm. For example; debt
signaling, concerning exchange offers. Firms
often change their debt levels through
exchange offers, of which there are two types.
The first type of offer allows stockholders to
exchange some of their stock for debt,
thereby increasing leverage.
The second type allows bondholders to
exchange some of their debt for stock,
decreasing leverage.

4. The Pecking-Order Theory:

The pecking-order theory implies that

managers prefer internal to external

financing. If external financing is required,
managers tend to choose the safest
securities, such as debt. The pecking order
theories of capital structure is the most
influential theories of corporate leverage.
It explains the inverse relationship
between profitability and debt ratio.

(a)Rules of the Pecking Order:

Rule 1: Use internal financing first.
Rule 2: Issue debt next, equity last.
(b) Implications:
The pecking-order Theory is at odds with the tradeoff theory:
There is no target D/E ratio.
Profitable firms use less debt.
Companies like financial flexibility

Thank You