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8/7/2019 Finance Slide

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INTRODUCTIONINTRODUCTION

The compositions of long term financing i.e. equity andThe compositions of long term financing i.e. equity anddebt capital is known as capital structure.debt capital is known as capital structure.

There are various views regarding whether or not the valueThere are various views regarding whether or not the valueof firm increases with the leverage.of firm increases with the leverage.

Traditionalist argue that the capital structure is relevantTraditionalist argue that the capital structure is relevantfactor for the valuation of the firm.factor for the valuation of the firm.

Modigliani and Miller on the other hand argue that in theModigliani and Miller on the other hand argue that in theperfect capital market ,capital structure does not affect theperfect capital market ,capital structure does not affect the

value of the firm.value of the firm.


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COMMONCOMMON ASSUMPTIONSASSUMPTIONS

Firm employ only 2 type ofFirm employ only 2 type of capital:debtcapital:debt and equityand equity

The firm total assets remain constant.The firm total assets remain constant.

The dividend payout ratio is 100 percent.The dividend payout ratio is 100 percent.

There are no personal and corporate income tax.There are no personal and corporate income tax.

The net operating income (EBIT) is not expected to growThe net operating income (EBIT) is not expected to growor decline over timeor decline over time


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NETNET INCOME APPROACHINCOME APPROACH

According to this approach, the cost debt capital andAccording to this approach, the cost debt capital andequity capital remain unchanged when leverage ratioequity capital remain unchanged when leverage ratio

varies.varies.


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AssumptionsAssumptions

Change in leverage doesn't change the risk position/Change in leverage doesn't change the risk position/risk perception of the investors, as the result the cost ofrisk perception of the investors, as the result the cost ofequity and cost of the debt remain constant withequity and cost of the debt remain constant withchanges in the leverage.changes in the leverage.

Cost of the debt is less than the cost of capital.Cost of the debt is less than the cost of capital.

Overall cost of capital decreases as leverage increases.Overall cost of capital decreases as leverage increases.


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KeKe

Percentage costPercentage cost

of debt, equityof debt, equity

and capitaland capital

KoKo

KdKd

leverageleverage


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NETNET OPERATING INCOMEOPERATING INCOME

APPROACHAPPROACH

Net operating income is capitalized at an overallNet operating income is capitalized at an overallcapitalization rate to obtain the total market value ofcapitalization rate to obtain the total market value ofthe firm.the firm.


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The market uses an overall capitalization rate toThe market uses an overall capitalization rate tocapitalize the net operating income .capitalize the net operating income .

Overall capitalization rate depend on the business risk.Overall capitalization rate depend on the business risk.

Debt capitalization rate remain constant.Debt capitalization rate remain constant.

The use of less costly debtThe use of less costly debt fundfund increasesincreases, the risk of, the risk ofthe shareholders.the shareholders.

Market value of the firm is the residual value.Market value of the firm is the residual value.


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KeKe

Percentage costPercentage cost

of debt, equityof debt, equity

and equityand equity

KoKo

KdKd

LeverageLeverage


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TRADITIONALTRADITIONAL APPROACHAPPROACH The traditional capital structure theory which is takenThe traditional capital structure theory which is taken

as the middle ground position is also known as theas the middle ground position is also known as theintermediate approach.intermediate approach.

According to the traditionalist view up to someAccording to the traditionalist view up to somemoderate amount of leverage risk , doesn't increasesmoderate amount of leverage risk , doesn't increasesnoticeably on either the debt or equity. So the debt andnoticeably on either the debt or equity. So the debt andthe equity remain constant. Beyond this threshold debtthe equity remain constant. Beyond this threshold debtratio, both debt and equity cost begins to rise sharply,ratio, both debt and equity cost begins to rise sharply,and this increases more than offset the advantage ofand this increases more than offset the advantage ofcheaper debt.cheaper debt.


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The cost of debt capital remains more or less constantThe cost of debt capital remains more or less constantup to certain degree of leverage but rises then after atup to certain degree of leverage but rises then after atan increasing rate.an increasing rate.

The cost of equity capital remains more or less constantThe cost of equity capital remains more or less constantor rises only gradually up to the certain degree ofor rises only gradually up to the certain degree ofleverage and rises sharply thereafter.leverage and rises sharply thereafter.


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KeKe

Cost of capitalCost of capital

(percent)(percent) KoKo

KdKd

LeverageLeverage


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MODIGLIANIMODIGLIANI -- MILLERMILLER MODELMODEL

Identical with net operating income approach.Identical with net operating income approach.

Argue that, in the absence of taxes, a firm's marketArgue that, in the absence of taxes, a firm's marketvalue and the cost of capital remain invariant to thevalue and the cost of capital remain invariant to thecapital structure changes.capital structure changes.


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AssumptionsAssumptions Perfect capital market.Perfect capital market.

Firms can be grouped into equivalent risk classes.Firms can be grouped into equivalent risk classes.

All present and prospective investors have identicalAll present and prospective investors have identicalestimates of each firm's future EBIT.estimates of each firm's future EBIT.

No taxes.No taxes.


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CORPORATE TAXCORPORATE TAX

Relax the assumptionRelax the assumption -- absence of corporate taxes.absence of corporate taxes.

The advantage of debt in a world of corporate taxes isThe advantage of debt in a world of corporate taxes isthat interest payments are taxthat interest payments are tax eductibleeductible..

Consequently, total amount of payments available forConsequently, total amount of payments available forboth debt holders and stockholders is greater if debt isboth debt holders and stockholders is greater if debt is

employed.employed.


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EFFECT OF BANKRUPTCY COST EFFECT OF BANKRUPTCY COST Another important factor affecting capital structureAnother important factor affecting capital structure

decisions is the presence of bankruptcy costs.decisions is the presence of bankruptcy costs.

Larger the amount of debt, higher would be theLarger the amount of debt, higher would be thebankruptcy costs.bankruptcy costs.

Gain from tax shield on debt is offset by financialGain from tax shield on debt is offset by financial

distress cost.distress cost.

Optimal capital structure exists that just balances theOptimal capital structure exists that just balances theadditional gain from leverage against financial distressadditional gain from leverage against financial distress

cost.cost.


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PECKING ORDER OF FINANCINGPECKING ORDER OF FINANCING

Gordon DonaldsonGordon Donaldson (Corporate debt capacity(Corporate debt capacityJournal of FinanceJournal of Finance, July 1984), followed by, July 1984), followed byStewart MyersStewart Myers (Capital Structure Puzzles(Capital Structure PuzzlesJournalJournalof Financeof Finance, July 1984) suggest that management, July 1984) suggest that managementfollows a preference ordering when it comes tofollows a preference ordering when it comes tofinancing:financing:

1.1. Internal financing:Internal financing: No floatation costs. If noNo floatation costs. If noretained earnings, external financing is preferred.retained earnings, external financing is preferred.

2.2. Straight debt:Straight debt: Float. costs are less. Good news.Float. costs are less. Good news.

3.3. Preferred stockPreferred stock


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4.4. Hybrid securities (Convertibles)Hybrid securities (Convertibles)5.5. Straight equity:Straight equity: Float. costs are high. BadFloat. costs are high. Bad

news.news.

Pecking order story is mainly a behavioralPecking order story is mainly a behavioralexplanation of why certain firms finance theexplanation of why certain firms finance the

way they do.way they do.

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