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Group- F

In The Name Of Almighty

Group Member
No.
01 02 03

ID

Name

120203030 Md. Rafiqul Islam 120203031 Subrata Deb Sajib 120203032

04
05

120203033
120203034 Ripon Das

TOPIC

How a Firm Established Capital Structure ?

Outline
Meaning of Capital Structure Leverage and Capital Structure ModiglianiMiller theory
> Without Tax > With Tax

How companies establish their capital structure?

Capital Structure
The combination of a company's long-term debt, specific short-term debt, common equity, and preferred equity; the capital structure is the firm's various sources of funds used to finance its overall operations and growth. Debt comes in the form of bond issues or long-term notes payable, whereas equity is classified as common stock, preferred stock, or retained earnings. Short-term debt such as working capital requirements also is considered part of the capital structure

Leverage and Capital Structure

Leverage means use of fixed cost source of funds. Generally, it refers to use of debt in the capital structure of the firm How much leverage should be there in a firm?
a higher debt ratio can enhance the rate of return on equity capital during good economic times a higher debt ratio also increases the riskiness of the firms earnings stream

Capital structure decision involves a trade off between risk and return to maximize market price per share

MM Version One: Without Tax (1958)

Changes in capital structure do not affect firm value when financial markets are perfect. Only market imperfections (taxes, etc.) allow for leverage to affect firm value.
MM perfect market assumptions:
No taxes. No brokerage costs. No bankruptcy costs. Investors can borrow at the same rate as corporations. All investors have the same information as management about the firms future investment opportunities. EBIT is not affected by the use of debt.

Proposition I:
levered firm value = unlevered firm value. VL = VU = (EBIT/WACC) = EBIT/ksU
where: ksU = cost of equity for an unlevered firm.

Firm value is independent of leverage.

Proposition II:
ksL = ksU + Risk premium = ksU +(ksU - kd)(D/S)
where: ksU = cost of equity for an unlevered firm, ksL= cost of equity for a levered firm, D = market value of firms debt, S = market value of firms equity, kd = cost of risk-free debt. As a firm increases its use of debt, its cost of equity

also increases; but its WACC remains constant.

MM Version Two: with Corporate Taxes

Because interest is a tax-deductible expense for corporations, a levered firm should be more valuable than an unlevered firm (assuming that this difference in capital structure is the only difference).

Proposition I:
VL = VU + TD
where: T = firms tax rate, D = value of debt.

Proposition II:
ksL = ksU + (ksU - kd)(1-T)(D/S)
where: S = value of equity.

How Firms Establish Capital Structure?

Most corporations have low debt-asset ratios Changes in Financial Leverage affect Firm Value There are differences in the Capital Structures of Different Industries Most companies have a target debt ratio Target debt ratio is dependent on taxes, types of assets, uncertainty of operating income, and pecking order and financial slack.

Thank You