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Capital Structure
Capital Structure
This is concerned with the question as
to whether there is an optimal capital
mix of debt and capital which a
company should try to achieve.
There are three major theories:
Net Income (NI) approach
Traditional view
Assumptions:
b) The company pays out all its earnings as
dividends
c) The leverage of the company can be
changed immediately
by issuing debt to purchase shares,
or by issuing shares to repurchase debt
d) The earnings of the company are expected
to remain constant in perpetuity
and all investors share the same expectations
e) Business risk is also constant, regardless of
how the company invests its funds
f) Taxation, for the time being, is ignored
Traditional View
a) As the level of leverage increase, the cost of
debt remains unchanged up to a certain level.
Beyond this level the cost of debt will
increase
b) The cost of equity rises as the level of leverage
increases and financial risk increases.
There is a non-linear relationship between
the cost of equity and leverage
c) The WACC does not remain constant
falls initially as the proportion of debt capital
increases
Then begins to increase as the rising cost of
equity becomes significant
Traditional View
d) The optimum level of leverage is where
the company WACC is minimized.
Modigliani-Miller (MM) View
Assumptions of MM view
b) A perfect capital market exists in which
investors have the same information
Upon which they act rationally
To arrive to the same expectations about
future earnings and risks
c) There are no taxes or transaction costs
d) Debt is risk-free and freely available at
the same cost to investors and
companies alike.
Modigliani-Miller (MM) View
In 1958 Modigliani and Miller proposed
MM Proposition I
The total market value of a company, in the
absence of tax will be determined by two
factors
3. Total earnings of the company
4. The level of operating risk attached to
those earnings
(The total market value would be computed
by discounting the total earnings at a rate
that is appropriate to the level of operating
risk. The WACC)
Thus the capital structure has no effect on the
Modigliani-Miller (MM) view
MM justified their approach by the use
of arbitrage.
MM Proposition II
3. The cost of debt remains unchanged
as the level of leverage increases
4. The cost of equity rises in such a
way as to keep the WACC constant.
Graphical MM view
WACC(rA) =
Market imperfection
re = rA + (rA –rd) (Vd/Ve)
MM demonstrates that in the world with
corporate taxes
re = ru + (ru –rd) (Vd/Ve)x (1-T)
This results indicates a positive
relationship between the expected return
on equity and debt equity ratio
It implies that the rA decreases as the
amount of debt increases
Market Imperfections
1. Bankruptcy costs
One assumption of MM theory is perfect
capital market
But in reality, at higher levels of
leverage there is an increasing risk of
the company being unable to meet its
interest payment and being declared
bankrupt
At these higher levels of leverage the
bankruptcy risk means that required
rate of return will be higher.
Market Imperfections
2. Agency Costs
At Higher levels of leverage, there are
leverage
they may reach a point where there are not
enough profits from which to obtain all
available tax benefits
Bankruptcy and agency costs will rise, but
benefits of tax shield will not rise
sufficiently.
So market imperfections undermine the
tax advantage of debt finance.
Optimal Capital Structure
Financial distress costs are insignificant
for a firm with little or no debt.
so if an unlevered firm adds a small
amount of debt
It benefits from the tax shield on debt
Without incurring significant costs of
financial distress
As a firm uses more and more debt
The tax savings are eventually offset by the
higher likelihood of financial distress
Optimal Capital Structure
The point where these two factors offset
each other is where the firm value is
maximized.
STATIC THEORY OF CAPITAL STRCUTURE
A Firm uses debt financing up to the point