CAPITAL STRUCTURE

• Different kinds of theories have been

propounded by different authors to explain
the relationship between capital structure,
cost of capital and value of the firm.

• The main contributors to the theories are

Durand, Ezra, Solomon, Modigliani and Miller.
Does Debt Policy Matter?

Chapter 17
 Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.
• Value of a firm depends upon earnings of a firm and its cost of
capital (i.e. WACC).
• Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
• Value of firm is derived by capitalizing the earnings by its cost of
capital (WACC).
Value of Firm = Earnings / WACC
• Thus, value of a firm varies due to changes in the earnings of a
company or its cost of capital, or both.
• Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders’ earnings.
 CAPITAL STRUCTURE THEORIES

• Net income approach (NI)

• Net operating income approach(NOI)
• The traditional approach
• Modigliani and Miller approach(M-M)
 Capital Structure Theories
ASSUMPTIONS :

• Firms use only two sources of funds – equity & debt.

• No change in investment decisions of the firm, i.e. no change in
total assets.
• 100 % dividend payout ratio, i.e. no retained earnings.
• Business risk of firm is not affected by the financing mix.
• No corporate or personal taxation.
• Investors expect future profitability of the firm.
 Capital Structure Theories –
Net Income Approach (NI)
• According to this approach, a firm can minimize the
weighted average cost of capital and increase the
value of the firm as well as market price of equity
shares by using debt financing to the maximum
possible extent.

• The theory propounds that a company can increase

its value and decrease the over all cost of capital by
increasing the proportion of debt in the capital
structure.
 Capital Structure Theories –
Net Income Approach (NI)
• As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
• Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.

• Thus, as per NI approach, a firm will have maximum value at

a point where WACC is minimum, i.e. when the firm is
almost debt-financed.
 Capital Structure Theories –
Net Income Approach (NI)
As the proportion
Cost
of debt (Kd) in
capital structure
ke, ko ke
increases, the
kd
ko
kd WACC (Ko)reduces.

Debt
 Capital Structure Theories –
Net Income Approach (NI)
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10% Kd = 6%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000

Ke 10% 10% 10%

Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)

Value of Debt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%

(EBIT / Value) * 100
 Capital Structure Theories –
Net Operating Income (NOI)
• Net Operating Income (NOI) approach is the exact opposite of
the Net Income (NI) approach.
• As per NOI approach, value of a firm is not dependent upon its
capital structure.
Assumptions –
• WACC is always constant, and it depends on the business
risk.
• Value of the firm is calculated using the overall cost of
capital i.e. the WACC only.
• The cost of debt (Kd) is constant.
• Corporate income taxes do not exist.
 Capital Structure Theories –
Net Operating Income (NOI)

NOI propositions (i.e. school of thought) :

• The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
• Increase in shareholders’ risk causes the equity
capitalization rate to increase, i.e. higher cost of equity (K e)
• A higher cost of equity (Ke) nullifies the advantages gained
due to cheaper cost of debt (Kd )
• In other words, the finance mix is irrelevant and does not
affect the value of the firm.
 Capital Structure Theories –
Net Operating Income (NOI)
• Cost of capital (Ko)
Cost is constant.
ke
• As the proportion
of debt increases,
ko

kd
(Ke) increases.
• No effect on total
Debt
cost of capital
(WACC)
 Capital Structure Theories –
Net Operating Income (NOI)
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
EBIT 200,000 200,000 200,000

WACC (Ko) 10% 10% 10%

Value of the firm 2,000,000 2,000,000 2,000,000

Value of Debt @ 6 % 300,000 400,000 500,000

Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000

Interest @ 6 % 18,000 24,000 30,000

EBT (EBIT - interest) 182,000 176,000 170,000

Hence, Cost of Equity (Ke)

EBT/ Value of Equity 10.71% 11.00% 11.33%
 Capital Structure Theories –
Traditional Approach
• The NI approach and NOI approach hold extreme views
on the relationship between capital structure, cost of
capital and the value of a firm.
• Traditional approach (‘intermediate approach’) is a
compromise between these two extreme approaches.
• Traditional approach confirms the existence of an
optimal capital structure; where WACC is minimum and
value is the firm is maximum.
• As per this approach, a best possible mix of debt and
equity will maximize the value of the firm.
 Capital Structure Theories –
Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually. This
phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk
(financial risk) and hence Ke increases. Kd also rises due to
higher debt, WACC increases & value of firm decreases.
 Capital Structure Theories –
Traditional Approach

• Cost of capital (Ko) is

Cost
reduces initially. ke

• At a point, it settles
ko
• But after this point,
(Ko) increases, due kd

to increase in the
cost of equity. (Ke) Debt
 WACC Traditional View
• The traditionalists say that
borrowing at first increases rE
more slowly than MM predicts,
but rE shoots up with higher
levels of debt. Using the right
amount of debt can minimize the
Weighted Average Cost of
Capital. This graph also shows
that the WACC remains constant
as leverage increases and is
consistent with MM Proposition
I.

I discussed more about this concept in the following

slides)
 Capital Structure Theories –
Traditional Approach
EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC

Particulars Presently case I case II

Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
 Capital Structure Theories –
Modigliani – Miller Model (M-M)
• MM approach supports the NOI approach, i.e. the capital structure
(debt-equity mix) has no effect on value of a firm.
Assumptions –
• Capital markets are perfect and investors are free to buy, sell, &
switch between securities. Securities are infinitely divisible.
• Investors can borrow without restrictions at par with the firms.
• Investors are rational & informed of risk-return of all securities
• No corporate income tax, and no transaction costs.
• 100 % dividend payout ratio, i.e. no profits retention
 Capital Structure Theories –
Modigliani – Miller Model (MM)

MM Model proposition in brief –

• Value of a firm is independent of the capital structure.
• Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate
(i.e. WACC).
• Value of Firm = Mkt. Value of Equity + Mkt. Value of
Debt
= Expected EBIT
Expected WACC
 M-M Approach: Two Propositions without
Taxes
• Proposition 1: with the assumptions of ‘no
taxes’, the capital structure does not influence
the valuation of a firm. In other words,
leveraging the company does not increase the
market value of the company. It also suggests
that debt holders in the company and equity
share holders have the same priority i.e.
earnings are split equally amongst them.
VU=VL
 M-M Approach: Two Propositions without
Taxes
• Proposition 2: it says that financial leverage in
direct proportion to the cost of equity. With
increase in debt component, the equity
shareholders expect a higher return, thereby
increasing the cost of equity. A key distinction
here is that proposition 2 assumes that debt
share holders have upper-hand as far as claim
on earnings is concerned. Thus, the cost of
debt reduces.
 M-M Approach: Two Propositions without
Taxes
In other words:
The expected rate of return on the common stock
of a levered firm increases in proportion to the
debt-equity ratio (D/E), expressed in market values;
The rate of increase depends on the spread
between RA, the expected rate of return on a
portfolio of all the firm’s securities, and RD, the
expected return on the debt.
Note that RE=RA if the firm has no debt.
 M-M Approach: Two Propositions without
Taxes
• When the firm was unlevered, equity investors
demand a return of RA.
• When the firm is levered, they require a
premium of (RA-RD)D/E to compensate for the
extra risk.
 M-M Approach: Two Propositions without
Taxes
• Return on equity increases linearly with
leverage (debt-equity ratio):

• This is MM’s Proposition II.

Derivation of the above formula is available in

your text book chapter 17.
M-M Approach: Two Propositions without
Taxes
M-M Approach: Two Propositions without
Taxes
 MM proposition I and II
• MM’s proposition I says that financial leverage
has no effect on shareholders’ wealth.

• MM’s proposition II says that the rate of

return they can expect to receive on their
shares increases as the firm’s debt-equity ratio
increases.
 Formulae
NO TAXES
TAXES

UNLEVERED UNLEVERED
• VU = NET INCOME/KO • VU = NET INCOME*(1-T)/KO

• Ke=Ko

LEVERED LEVERED
VU=VL VL=VU + [Debt (TAX)]
Ke=Net income/E or S
(this part I discussed in detail in the
following slides)
 Introducing Taxes into the MM Theory

When taxes are introduced (specifically, the tax

deductibility of interest by the firm), the value of
the firm is enhanced by the tax shield provided
by this interest deduction.
The tax shield:
– Lowers the cost of debt.
– Lowers the WACC as more debt is used.
– Increases the value of the firm by tD (that is,
marginal tax rate times debt)
Introducing Taxes into the MM Theory
How much should a Corporation
Borrow?
Chapter 18
 M-M and Taxes
• Debt financing has one important advantage
under the corporate income tax system in
many countries.
• The interest that the company is a tax-
deductible expense.
• Thus the return to bondholders escapes
taxation at the corporate level.
 M-M and Taxes
Income Statement of the Income statement of the
Firm U Firm L

Earnings before interest $1000 $1000

and taxes

Interest paid to 0 80
bondholders

Pretax Income 1,000 920

Tax @35% 350 322
Net income to stockholders $650 $598
Total income to both 0+650=$650 80+598=$678
bondholders and stock
holders

Interest tax shield $0 $28

(0.35*interest)
 M-M and Taxes
• Simple income statement for firm U, which
has no debt and firm L, which has borrowed
$1000 at 8%.
• L’s tax bill is $28 less than U’s.
• This is the tax shield provided by the debt of L.
• The total income that L can payout to its
bondholders and stockholders increases by
that amount.
 M-M and Taxes
• Tax shields can be valuable assets.
• Suppose that the debt of L is fixed and
permanent. (that is, the company commits to
refinance its present debt obligations when
they mature to keep rolling over its debt
obligations indefinitely).
• Then L can look forward to a permanent
stream of cash flows of $28 per year.
 M-M and Taxes
• The tax shields depend only on the corporate tax rate
and on the ability of L to earn enough to cover interest
payments.
• The corporate tax rate has been pretty stable. And the
ability of L to earn its interest payments must be
reasonably sure; otherwise it could not have borrowed at
8%.
• There fore we should discount the interest tax shields
with its interest rate.
• PV (tax shield) = 28/0.08=$350
• In effect the government assumes 35% of the $1000 debt
obligation of L
 M-M and Taxes

• Under these assumptions, the present value

of the tax shield is independent of the return
on the debt RD.
• It equals to the corporate tax rate Tc times the
amount borrowed D:
M-M and Taxes
 M-M and Taxes
• We have just developed a version of MM’s
proposition 1 as corrected by them to reflect
corporate taxes. The new proposition is

In case of permanent debt:

Value of the firm =

• value if all-equity financed + TcD
 Case let
– You own all equity of Space Babies Diaper Co.
– Company has no debt
– Company has annual cash flow of $900,000 before
interest and taxes
– Corporate tax rate is 35%
– You have the option to exchange 1/2 of your
equity position for 5% bonds with face value of
$2,000,000
– Should you do this and why?
 Case let contd..
($ 1,000 s) All Equity 1/2 Debt Total Cash Flow
EBIT 900 900 All equity = 585*
Interest pmt 0 100 1/2 debt = 620**
Pretax income 900 800
Taxes @ 35% 315 280 (520 + 100)
Net cash flow 585 520

With 50% debt, the net cash flow to the equity is $585 (in thousands). There is a
reduction in taxes by $35 (in thousands). Total cash flow to the holder of equity and
debt is $620 (in thousands). $35 (in thousands) is the tax saving through interest
expense deduction.
*The total cash flow with all equity is $585,000. (Income available to Stock holders)
** The total cash flow with 50% debt is $620,000. (Income available to debt holders
plus income to stock holders)
 Case let contd..
• Tax benefit = 100,000 x (.35) = $35,000
• PV of $35,000 in perpetuity = 35,000/.05 =
$700,000
• PV tax shield = $2,000,000 x .35 = $700,000
Tax benefit per year is $35 (in thousands).
Assuming that this benefit will occur through
perpetuity, the present value of the tax shield is
35/0.05 = $700 (in thousands). The same result is
obtained by using the formula (D)(Tc) =
(2,000,000)(0.35) = $700,000.
 Case let contd..

Value of the Firm

All-equity value = 585/.05 = 11,700

PV tax shield = 700

Firm value of ½ debt = $12,400

(11700+700=12,400)
 Case let contd..
Value of the Firm:

• The increase in the value of the firm due to

the debt is the present value of the tax shield.

• Firm value = value of an equivalent all-equity

firm + PV of tax shield.
 Costs of Financial Distress
• Financial distress occurs when promises to
creditors are broken or honored with
difficulty.
• Sometimes financial distress leads to
bankruptcy.
• Sometimes it only means skating on thin ice.
 Costs of Financial Distress
• Financial distress is costly.
• Investors know that levered firms may fall into
financial distress, and they worry about it.
• That worry is reflected in the current market
value of the levered firm’s securities.
• Thus, the value of the firm can be broken
down into three parts.
 Costs of Financial Distress
• Value of firm
= value if all-equity financed
+ PV(tax shield)
- PV(costs of financial distress)
 Costs of Financial Distress – Firm Value
• Firm value is true if all-equity-financed plus PV
tax shield minus PV costs of financial distress
 Costs of Financial Distress – Firm Value
• The graph illustrates the way to understand the true
value of a firm.
• PV (tax-shield) initially increases as the firm borrows
more.
• At moderate debt levels the probability of financial
distress is trivial, and so PV (cost of financial distress) is
small and tax advantages dominate.
• But at some point the probability of financial distress
increases rapidly with additional borrowings; the costs
of distress begin to take a substantial bite out of the
firm value.
Costs of Financial Distress – Firm Value
• Also, if the firm can’t be sure of profiting from
the corporate tax shield, the tax advantage of
additional debt is likely to dwindle and
eventually disappear.
• The theoretical optimum is reached when the
present value of tax savings due to further
borrowings is just offset by increases the
present value of costs of distress.
• This is called the trade-off theory of capital
structure.
 Costs of Financial Distress

Maximum value of firm

Costs of
financial distress
Market Value of the Firm

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount Debt

of debt
 Costs of Financial Distress
• The trade-off between the tax benefits and the
costs of distress determines optimal capital
structure.
• PV(tax shield) initially increases as a firm borrows
more. PV(cost of financial distress) is small and the
value of the firm increases with more borrowing.
• At higher levels of debt, PV(cost of financial
distress) dominates and the firm value diminishes.
• The manager should choose the debt ratio that
maximizes the firm value.
The trade-off theory of Capital Structure
• The trade-off theory balances the tax advantages
of borrowings against costs of financial distress.
• Corporations are supposed to pick a target capital
structure that maximizes firm value.
• Firms with safe, tangible assets and plenty of
taxable income to shield ought to have high
targets.
• Unprofitable companies with risky, intangible
assets ought to rely more on equity financing.
The trade-off theory of Capital Structure

• This theory of capital structure successfully

explains many industry differences in capital
structure, but it does not explain why the most
profitable firms within an industry generally
have most conservative capital structures.
• Under the trade-off theory, high profitability
should mean high debt capacity and a strong
tax incentive to use that capacity.
 Case
• The present value of interest tax shield is often
written as TcD, where D is the amount of debt
and Tc is the marginal corporate tax rate.
Under what assumptions is this present value
correct?
 answer
• The calculation assumes that the tax rate is
fixed, that debt is fixed and perpetual, and
that investors’ personal tax rates on interest
and equity income are the same.
 Case
Book value and market value balance sheets of
the United Frypan Company (UF)
Book
Net working capital $20 Debt $40
Long term-assets $80 Equity $60
Market
Net working capital $20 Debt $40
Long term-assets $140 Equity $120
 Case
Assume that MM’s theory holds with taxes.
There is no growth, and the $40 debt is
expected to be permanent. Assume a 40% tax
rate.
a)How much of the firm's value is accounted
for by the debt-generated tax shield?
b)How much better off will UF’s shareholders
be if the firm borrows $20 more and uses it to
repurchase stock?
 Solution
a) PV tax shield = tax rate x debt = TcD = 0.40 x
$40 = $16.

b) The tax advantage can be found by

multiplying the amount borrowed by the tax
rate: Tc x 20 = $8
 Case
• Compute the present value of interest tax
shields generated by these three debt issues.
Consider corporate taxes only. The marginal tax
rate is Tc= 0.35.
a) A $1,000, one –year loan at 8%
b) A five-year loan of $1000 at 8%. Assume no
principal is repaid until maturity
c) A $1000 perpetuity at 7%
 Solution

PV(tax shield) = TC D = $350.

 Case
Assuming a world of no taxes, the WACC of a
firm is 15% with the capital structure of debt to
equity ratio of 1:3. the cost of borrowing is 9%.
Find the cost of equity of the firm. What will be
its WACC if the firm mobilizes further debt so as
to have the debt equity ratio of 1:1? Will the
cost of equity remain same as before?
 Solution
• The
  cost of equity can be arrived at from Equation
Rd)D/E (see slide no 31)
= 15+(15-9)1/3 = 17%
The WACC will remain same for the firm as per the
MM prepositions with the change in the debt equity
structure. However, the cost of equity will be 21%
Rd)D/E
= 15+(15-9)1/1 = 21%
 Solution contd..
• We
  may verify that the WACC of the firm
remains same irrespective of level of debt
using Equation
r
r (debt equity ratio 1:1)

= 15%
 Case
A firm is financed entirely by equity capital with
expected rate of return of 15%. It has EBIT of
INR 450 lakh. The corporate tax stands at
33.33%. As a financing option and considering
the capital structure the firm is expecting to
borrow INR 900 lakh at an attractive rate of 8%
and retire equity by an equivalent amount. Find
out the following:
 Case Contd..
• The market value of the firm when it is financed
entirely by equity
• The market value of the firm after it borrows from
the market
• What benefits do the equity shareholders draw
from this borrowing
• What is the cost of equity capital after borrowing
• Find market value of equity using answer to above
question
Assume perpetual income and debt.
 Solution
When the firm is financed entirely by equity:
Market value of the firm =

VU = NET INCOME*(1-T)/KO (slide no 29)

= EBIT *(1-T)/r = 450*(1-1/3)/0.15 = 2000 lakh

 Solution contd..
When the firm replaces equity with debt worth
INR 900 lakhs, the value of the firm increases by
the amount of tax shield enjoyed on the interest
paid on debt. For perennial debt the value of the
tax shield is given by - (see slide no 39,40)
 Solution contd..
PV tax shield = tax rate x debt = TcD = 1/3 x 900 =
300 lakh
The total value of the firm would increase by 300
lakh from the earlier position of all equity financing.
Hence, the value of the firm after availing debt
would be: (see slide no 39,40)
Value of the firm =
• value if all-equity financed + TcD
= 2000 + 300 = 2300 lakhs
 Solution contd..
What benefits do the equity shareholders draw from
this borrowing
Value of equity = value of the firm – value of debt
= 2300-900 = 1400 lakhs
The equity shareholders of the firm gain by amount of
tax shield. The value of equity should have reduced to
1100 lakhs from 2000 after borrowing 900 lakhs.
Instead, the value of remaining equity increases by
300 lakhs – the amount of tax shield. The benefit of
tax shield accrues to the equity shareholders.
 Solution contd..
•What
  is the cost of equity capital after borrowing
Rd)D (1-T)/E (see slide no 31)
15+(15-8)*900(1-1/3)/1400 = 18%
The cost of capital of the firm after debt
r
r
13.04%
 Solution contd..
•Using
  cost of equity arrived (i.e., 18%) we may
find the value of equity in the levered firm from:

= 1400 lakh
 Solution contd..
Changing the Capital Structure
Assume that the unlevered firm had 10 lakh
shares outstanding prior to the issue of debt.
With the issuance of the debt how many shares
will be purchased and what shall be the market
price of the shares?
 Solution contd..
• Value of the unlevered firm = Rs. 2000 lakh
• No. Of shares outstanding = 10 lakh
• Market price before the issue of debt = 200
per share
When the issue of debt is announced. The
market value of the firm rises by amount of tax
shield and the entire benefit of the tax shield
The Pecking Order of Financing Choices

• Trade-Off Theory
– Theory that capital structure is based on trade-off
between tax savings and distress costs of debt

• Pecking-Order Theory
– Theory stating firms prefer to issue debt over
equity if internal finances are insufficient
The Pecking Order of Financing Choices

• These are two theories that try to reconcile

theory and practice.
• A firm’s capital structure decision is a trade-
off between interest tax shields and the costs
of financial distress.
• Pecking-order theory states that firms prefer
to issue debt to rather than equity if internally
generated funds are insufficient.
 Pecking order theory
• Pecking order theory has been developed as
an alternative to traditional theory.

• It states that firms will prefer retained

earnings to any other source of finance, and
then will choose debt, and last of all equity.
 Pecking order theory
The order of preference will be:

• Retained earnings
• Straight debt
• Convertible debt
• Preference shares
• Equity shares
 Reasons for the following pecking order

• It is easier to use retained earnings than go to

the trouble of obtaining external finance and
have to live up to the demands of external
finance providers
• There are no issue costs if retained earnings
are used, and issue costs of debt are lower
than those of equity
 Reasons for the following pecking order

• Investors prefer securities, that is debt with its

guaranteed income and priority on liquidation.
• Some managers believe that debt issues have
a better signalling effect than equity issues
because the market believes that manages are
better informed about shares’ true worth than
the market itself is.
Reasons for the following pecking order
• Their view is the market will interpret debt
issues as a sign of confidence, that businesses
are confident of making sufficient profits to fulfil
their obligations on debt and that they believe
that the shares are undervalued.
• By contrast the market will interpret equity
issues as a measure of last resort, that managers
believe that equity is currently overvalued and
hence are trying to achieve high proceeds whilst
they can.
Reasons for the following pecking order

• However an issue of debt may imply a similar

lack of confidence to an issue of equity.
• Managers may issue debt when they believe
that the cost of debt is low due to the market
underestimating the risk of default and hence
undervaluing the risk premium in the cost of
debt. If the market recognizes this lack of
confidence, it is likely to respond by raising the
cost of debt.
Reasons for the following pecking order

• The main consequence in this situation will to

be reinforce a preference for using retained
earnings first.
• However debt (particularly less risky, secured
debt) will be the next source as the market
feels more confident about valuing it than
more risky debt or equity.
 Consequences of pecking order theory
• Business will try to match investment opportunities
with internal finance, provided this does not mean
excessive changes in dividend payout ratios.
• If it is not possible to match investment
opportunities with internal finance, surplus
internal funds will be invested; if there is a
deficiency of internal funds, external finance will
be issued in the pecking order, starting with
straight debt.
 Consequences of pecking order theory

• Establishing an ideal debt-equity mix will be

problematic, since internal equity funds will be
the first source of finance that businesses
choose, and external equity funds the last.
Limitations of pecking order theory
• It fails to take into account taxation, financial
distress, agency costs or how the investment
opportunities that are available may influence
the choice of finance.
• Pecking order theory is an explanation of what
businesses actually do, rather than what they
should do.
Limitations of pecking order theory
• Studies suggest that the businesses that are
most likely to follow pecking order theory are
those that are operating profitably in markets
where growth prospects are poor.
• There will thus be limited opportunities to
invest funds, and these businesses will be
content to rely on retained earnings for the
limited resources that they need.
 Capital Structure Theories –
Arbitrage Process – Home made Leverage
MM Model proposition –
• As per MM, identical firms (except capital structure) will
have the same level of earnings.
• As per MM approach, if market values of identical firms
are different, ‘arbitrage process’ will take place.
• In this process, investors will switch their securities
between identical firms (from levered firms to un-
levered firms) and receive the same returns from both
firms.
 HOME MADE LEVERAGE
Levered Firm
• Value of levered firm = Rs. 110,000
• Equity Rs. 60,000 + Debt Rs. 50,000
• Kd = 6 % , EBIT = Rs. 10,000,
• Investor holds 10 % share capital

Un-Levered Firm
• Value of un-levered firm = Rs. 100,000 (all
equity)
• EBIT = Rs. 10,000 and investor holds 10 % share
capital
 HOME MADE LEVERAGE
Return from Levered Firm:
Investment  10%  110, 000  50 , 000   10%  60, 000   6 , 000

10, 000   6%  50, 000  

Return  10%    1, 000  300  700
Alternate Strategy:
1. Sell shares in L: 10%  60,000  6,000
2. Borrow (personal leverage): 10%  50,000  5,000
3. Buy shares in U : 10%  100,000  10,000
Return from Alternate Strategy:
Investment  10,000
Return  10%  10,000  1,000
Less: Interest on personal borrowing  6%  5,000  300
Net return  1,000  300  700
Cash available  11,000  10,000  1,000