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% 0 20 40 50 60 70
Ke% 20 22 24 30 40 50
Kd% 6 6 6 6.5 7 8
K0% 20 18.8 16.8 18.25 20.02 20.6

V000 500 532 595 548 495 485

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
capital structure.
Indifference Analysis
The indifference point, often called as a breakeven point, is highly
important in financial planning because, at EBIT amounts in excess of
the EBIT indifference level, the more heavily levered financing plan will
generate a higher EPS. On the other hand, at EBIT amounts below the
EBIT indifference points the financing plan involving less leverage will
generate a higher EPS.

Example: Dhaka Builders Ltd., is planning an expansion program. It

requires 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 carrying 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.) Plan 2 (tk.)

Equity Share Capital 15,00,000 10,00,000
10% Preference Share Capital 5,00,000 2,00,000
9% debentures - 8,00,000
Total 20,00,000 20,00,000
Number of Equity Shares 15,000 10,000

Let, at X level of EBIT, the EPS under both the plans will be the same.
X (1 t ) pd X (1 0.5) 50,000
EPS under 1st plan: =
N1 15,000
( X I )(1 T ) Pd
X 72,000(1 0.5) 20,000
EPS under 2nd plan: =
N2 10,000
 Indifference Analysis
Now, equalizing both the EPS, we will get:

X (1 0.5) 50,000 X 72,000(1 0.5) 20,000

> =
15,000 10,000
0.5 X 50,000 0.5 X 36,000 20,000
> =
15,000 10,000
0.5 X 50,000 0.5 X 56,000
> =
3 2
> 1.5X- 1,68,000 = X-1,00,000

> X = tk. 1,36,000

 Financial Distress
Costs of Financial Distress: Costs arising from bankruptcy or distorted
business 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
financial trouble
As the company borrow more, you increase the probability of bankruptcy
and hence the expected bankruptcy costs
Market Value of a firm = all Equity Financed + PV Tax Shield - PV
Costs of Financial Distress
 Financial Distress
Maximum value of firm
Costs of
financial distress
Market Value of The Firm

PV of interest
tax shields
Value o f levered firm

Value of
unlevered
firm

Optimal amount
of debt
Debt
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
rather 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
offer 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 in
dividends.
If the net income is negative, the payout ratio cannot be
computed.

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

dividend policy first use the cash flow to full fill necessary capital
expenditures and the remaining amount available (the residual) is
paid out to shareholders.
Taxes and Dividend Policy
In US, shareholders are taxed twice.

Operating Income 100.00

Corporate tax at 35% 35.00
After Tax income (paid as div) 65.00
Income tax paid by investors at 15.0% 9.75
Cash to Shareholder 55.25

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

tax 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