Optimal Capital Structure of A Firm

• Group 5
Where is Capital Structuring
Requirement ?
Optimal Capital Structure of A Firm
Capital Structure: A firm's mix of
financing is known as its capital
structure.

Strategies vary - many firms rely solely

on equity finance; typical examples
include those in the technology sector.

Other firms, such as banking and utility

firms, typically adopt some form of
debt financing.
Concept of Leverage
“Give me a lever long enough
and a place to stand, and I will
move the world."
-Archimedes
 Concept of Leverage
• Leverage (or gearing) is the ratio of loan
capital plus bank and other borrowings to
capital employed (the funds that are used to
operate the business).

A firm that makes use of debt finance is referred to as a levered

firm; the purpose of debt financing is to amplify the impact of
changes in operating income on the returns received by
stockholders.
Optimum Leverage Level –
Traditional View
Net Operating Income Approach

Net operating income is a firm's income after deducting for

operating expenses, but before deducting for income taxes and
interest.
The Theory of Modigliani-Miller (MM)

Cutting pizza into 16

pieces rather than the
normal 8 will not satisfy
more hunger for a baseball
star Yoggi Berra .
Obviously the number and
shape of the pieces didn't
affect the size of the pizza
 Modigliani-Miller (MM) Theory
Assuming perfect capital markets (i.e., no taxes or
transaction costs), Modigliani-Miller (or MM as they are
usually referred to) theorized that

• Arbitrage between debt and equity method of

financing is short lived and cannot be capitalised.
Taxation effect on Capital Structure
Dividend payments or retained earnings, neither of which is
deductible by the corporation for tax purposes .
The interest on debt capital, however, is an allowable deduction for
tax purposes and so the cost of debt capital and the cost of share
capital are not properly comparable.
Financial Distress
• Financial distress occurs when a firm's
promises to creditors are not honoured
or are honoured with great difficulty.
Financial distress is costly and can, in
some instances, lead to bankruptcy.
• Beyond a certain level of leverage, the
cost of borrowing will start to rise sharply
• Firms that borrow excessively find that
the cost of equity shoots up faster than
MM would predict.
• High borrowing carries an additional risk
- the risk of default - which, though
negligible at low levels of debt, can
become considerable as the proportion
of debt financing rises
Capital Structure Practical Use

Buss. Plus
Coach
1St Class Class
Class
Class

Exit Gateway Path

Analogy to Asset Classes

Loans Bond Preferred Common

Equity Stock

Debt to Equity Ratio

Capital Structure in Financial Distress

Coach

1st
Class

Analogy to Asset Classes

Loans Bond Preferred Common

Equity Stock
Gm Motors - Financial Distress
Summary for Optimal Capital Structure
THANK YOU