CAPITAL STRUCTURE & DIVIDEND THEORIES

Traditional Theory of Capital Structure

There is an optimal capital structure that minimises cost of capital
So, the cost of capital is dependent of capital structure
If a firm has a low level of gearing, borrowing additional debt will not
incur additional risk
A cheap debt reduces cost of capital
At one point, additional debt increases the cost of equity and debt capital.
The advantages of debt are wipe-out by the rise in the cost of capital
.

Traditional Theory of Capital Structure

Traditional View:

Traditional Theory: Example

G%

20

40

50

60

70

Ke%
Kd%
K0%

20

22

24

30

40

50

6.5

20

18.8

16.8

18.25

20.02

V000

500

532

548

495

595

20.6

485

Modigliani & Miller ( M & M) Theory

The relative proportions of debt , equity and other securities that a firm
has outstanding.
Modigliani & Miller:
When there are no taxes and capital markets function well, it makes no
difference whether the firm borrows or individual shareholders borrow.
Therefore the market value of a company does not depend on its capit
al structure.

Indifference Analysis
The indifference point, often called as a breakeven point, is highly impo
rtant in financial planning because, at EBIT amounts in excess of the E
BIT indifference level, the more heavily levered financing plan will gene
rate a higher EPS. On the other hand, at EBIT amounts below the EBIT
indifference points the financing plan involving less leverage will genera
te a higher EPS.
Example: Dhaka Builders Ltd., is planning an expansion program. It re
quires Tk. 20 lakhs of external financing for which it is considering two
alternatives. The first alternative calls for issuing 15,000 equity shares
of tk. 100 each and 5,000 10% Preference Shares of tk. 100 each; the
second alternative requires 10,000 equity shares of tk.100 each, 2,000
10% Preference Shares of tk. 100 each and tk. 8,00,000 Debentures c
arrying 9% interest. The company is in the tax bracket of 50%. You are
required to calculate the indifference point for the plans and verify your
answer by calculating the EPS.

Indifference Analysis
Capital Structure :
Plan 1 (tk.)
15,00,000
5,00,000
20,00,000
15,000

Equity Share Capital

10% Preference Share Capital
9% debentures
Total
Number of Equity Shares

Plan 2 (tk.)
10,00,000
2,00,000
8,00,000
20,00,000
10,000

Let, at X level of EBIT, the EPS under both the plans will be the same.
EPS under 1st plan:

X (1 t ) pd
=
N1

EPS under 2 plan:

( X I )(1 T ) Pd
N2

nd

X (1 0.5) 50,000
15,000

X 72,000 (1 0.5) 20,000

10,000

Indifference Analysis
Now, equalizing both the EPS, we will get:
>
>
>

X (1 0.5) 50,000
15,000

0.5 X 50,000
15,000
0.5 X 50,000
3
> 1.5X- 1,68,000

=
=
=
=

> X =

X 72,000 (1 0.5) 20,000

10,000

0.5 X 36,000 20,000

10,000
0.5 X 56,000
2

X-1,00,000
tk. 1,36,000

Financial Distress
Costs of Financial Distress: Costs arising from bankruptcy or distorted bu
siness decisions before bankruptcy.
The cost of going bankrupt:
Direct costs: Legal and other deadweight costs
Indirect costs: Costs arising because people perceive you to be in finan
cial trouble
As the company borrow more, you increase the probability of bankruptcy
and hence the expected bankruptcy costs
Market Value = all Equity Financed + PV Tax Shield - PV Costs of Fi

nancial Distress

Financial Distress

Market Value of The Firm

Maximum value of firm

Costs of
financial distress
PV of interest
tax shields

Value of
unlevered
firm
Optimal amount
of debt
Debt

Value f levered firm

o

Financial choices
Trade-off Theory - Theory that capital structure is based on a trade-off
between the benefits and costs of debt.

Pecking Order Theory - Theory stating that firms prefer to issue debt r
ather than equity if internal fund is insuffieient.

Dividend
Dividend is the cash/stock/buyback paid to shareholders.
Dividend policy raises a number questions, namely :
Why do companies pay dividends
When do companies pay dividends
What is the process of paying dividends
How do companies pay dividends
Dividend Payment Procedure

Types of Dividends
Cash Dividend.
Stock dividend: Bonus Share, New share
Share Repurchase: Buy shares on the market, tender off
er to shareholders.
Dividend Facts:
Dividends are sticky.
Dividends tend to follow earnings.
Dividends are different across countries.

Measures of Dividend
Dividend Payout = Dividends/ Net Income
Measures the percentage of earnings that the company pays i
n dividends.
If the net income is negative, the payout ratio cannot be comput
ed.
Dividend Yield = Dividends per share/ Stock price
Measures the return that an investor can make from dividends
alone.
Becomes part of the expected return on the investment

Dividend Theories
1)

Modigliani and Miller: Dividend does not effect value.

2)

Rightists: Dividends increase value.

3)

Leftists: Dividends decrease value

4)

Middle of the roaders: Leftist theory with some reality throw in.

5)

Residual Dividend Policy: Companies that use the residual dividen

d policy first use the cash flow to full fill necessary capital expendit
ures and the remaining amount available (the residual) is paid out t
o shareholders.

Taxes and Dividend Policy

In US, shareholders are taxed twice.

Operating Income
Corporate tax at 35%
After Tax income (paid as div)
Income tax paid by investors at 15.0%
Cash to Shareholder

100.00
35.00
65.00
9.75
55.25

Under imputed tax systems, such as that in Australia, Shareholders receive a ta

x credit for the corporate tax the firm pays.
Rate of Income Tax
15%
30%
47%
Operating Income
100
100
100
Corporate Tax (30%)
30
30
30
After Tax Income
70
70
70