Capital Structure

 Division of capital into debt and equity

 Reduce cost of capital while maintaining the

optimal capital structure
 Net Income approach
 Net Operating Income approach
 Traditional view

 MM hypothesis
 Part I
 Part II
 Net Income approach
 Assumptions:
 No taxes
 Kd less than ke
 kd and ke remain unchanged even as DE varies
Statement of NI Approach
 As DE increases ,cost of capital decreases.
This is because the proportion of debt,
which is a cheaper source of fund,
increases in the capital structure .
 So value of firm goes up with increased
debt.
 ra = rd(D/(D+E)) + re (E/(D+E))

 Vf = MV Debt+MV equity
 MV Debt =int/kd
 MV equity=equity earnings/Ke
 Y axis = rates of return
 X axis = DE


 Re

 ra
 rd

 Net Operating Income approach
 Assumptions
 ra and rd remain constant for all levels of debt
 Cost of equity varies and can be expressed as
re= ra +(ra-rd)(D/E)
 Market capitalizes firm as a whole; so
division between debt and equity is irrelevant
 Statement of NOI Approach
 The increase in the cheaper source of funds(debt) is
offset by the higher premium paid to equity shareholders
for their higher risk.So as debt increases ,re
increases,but rd is constant.But since the firm is
capitalized as a whole,ra remains constant.

 NOI states that the market value of a firm depends only

on its net operating income and business risk. Leverage
does not influence market value of the firm and hence
does not influence the overall cost of capital of the firm.
Traditional view

 Cost of debt remains constant upto a point

and rises thereafter at an increasing rate
 Cost of equity remains constant upto a
point and rises thereafter gradually and
then sharply.
 WACC decreases upto a point ,remains
unchanged threrafter upto a point and
rises sharply thereafter.


 At optimal capital structure,me=md
 Beyond optimal point,md>me
 Before optimal point md<me

 Md=marginal cost of debt

 Me= marginal cost of equity
 Miller Modigliani hypothesis
 Perfect Capital Markets
 Securities are infinitely divisible
 Rational investors
 Homogenous expectations of EBIT by investors
for a certain level of risk
 No taxes
 Personal and corporate leverage can be
substituted
 Statement of MM 1
Modigliani and Miller (1958) show that
financing decisions don’t matter in perfect
capital markets.
Firms cannot change the total value of their
securities by splitting cash flows into two
different streams, ie, debt and equity .Firm
value is determined by real assets and not by
capital structure split up between debt and
equity.
 Value of firm = OI/r
 OI=Operating Income

 r= discount rate or overall cost of capital

applicable to debt-free firm in the same risk
class

 Identical to NOI approach.

Proved by the arbitrage
argument
MM Hypothesis II-Assumptions
 Perfect Capital Markets
 Securities are infinitely divisible
 Rational investors
 Homogenous expectations of EBIT by
investors for a certain level of risk
 No taxes
 MM-II Statement
 An increase in financial leverage increases the
EPS but not the share price.This is because the
increase in expected EPS is offset by a
corresponding increase in the return for equity
shareholders.
 Hence expected return on equity or
 ROCE =ROA+D/E(RNOA-rd)
 MM II-Contd
 Rd is independent of DE and increases linearly
with DE
 As debt crosses a threshold limit,rate of default
increases and rd increases
 But at this point re decreases.
 This is because at higher levels of debt (beyond
a threshold) a part of the business risk is borne
by lenders too.
 Hence risk is shifted from shareholders to
debentureholders
 MM -Prop I vs II
 Prop 1-Financial leverage (debt equity split up)
has no effect on the wealth of shareholders and
value of firm.

 Prop II-ROCE expected by equity shareholders

increases with higher financial leverage because
equity investors are exposed to more risk with
higher leverage.
 Criticisms of MM
 Existence of taxes at corporate and personal level
 Bankruptcy costs of firms
 Agency costs: conflict of interest between managers
and shareholders
 Managers pecking order(preference for retained
earnings, debt and then equity)
 Informational asymmetry between managers and
investors
 Personal and corporate leverage: not substitutes
 Corporate Taxes
 Value of firm(levered or unlevered
without taxes) =OI/r

 Value of unlevered firm(with taxes)

=OI(1-t)/r

 Value of levered firm(with taxes) =

 OI(1-t)/r+D*tc
Pecking order theory
 Managers use internal finance
 Second preference is given to debt. They issue
secured debt first and then issue unsecured debt
 As a last resort, they issue equity shares
 Trade off Theory
 Costs of Financial Distress
 Agency Costs
 Costs of Financial Distress
 Direct costs
 When a firm is unable to meet its obligations,results in
financial distress
 Delay in asset liquidation due to disagreement between
creditors and shareholders
 Selling under distress-less than MP
 High legal and admn costs

 Indirect costs
 Myopic managers
 Reduced commitment to the firm
Agency Costs
Approaches to establishing a
capital structure
 EBIT EPS Analysis
 Valuation Approach
 Cash Flow Approach
 EBIT EPS Analysis :
 EPS and Financial risk
 Operating conditions and business risk
 Cash Flow Approach
 Debt service coverage ratio
 Debt capacity
 Operating,non operating and financial
cash flows
Dividend policy
 Dividend relevance
 Walter’s model
 Gordon’s model

 Dividend irrelevance
 MM Hypothesis
Walter’s model
 Internal Financing
 Constant r and k
 100% payout or retention
 Constant EPS and Dividend
 Infinite time
 Growth firm;r>k

 Normal firm; r=k

 Declining firms; r<k

 P =( DIV +(r/k)(EPS-DIV))/k
Crticism
 Constant r
 Constant k
 No external financing
 Gordon’s Model
 All equity firm
 No external financing
 Constant retrun
 Constant k
 Perpetual earnings
 No taxes
 Constant retention
 k>g
 P0 = Div 1/(k-g)
 Where Div 1 = EPS(1-b)
 g = br
MM Hypothesis(Dividend irrelevance)

 The firm has cash to pay dividends

 The firm does not have cash for
dividends, and issues new shares to
finance dividend payments
 The firm does not pay dividends but the
shareholder needs cash.
 The firm has cash to pay dividends :
 The shareholders gain cash dividends and lose
their claim on (reduced) assets
 The firm does not have cash for dividends, and issues
new shares to finance dividend payments :
 Old shareholders: Suffer capital loss, since the value of their
claim on assets reduce.
 Gain cash in the form of dividends

 New shareholders:
 Pay for shares less dividends(and get assets)
 The firm does not pay dividends but the
shareholder needs cash.

 Shareholder sells a part of his shares

 Perfect markets
 No taxes
 Investment policy is fixed
 No risk ;r=k
 r = (Dividends +capital gain)/share price
 (DIV+P1-P0)/P0
 When the firm issues new shares(say m)
 ,then the value of the firm is

 nP0 = (nDiv1+(n+m)P1-Mp1)/(1+k)