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Capital
Structure
&
Dividend Policy
CAPITAL STRUCTURE
Definition
The capital structure is how a firm finances its overall
operations and growth by using different sources of
funds.
Capital structure of a business enterprise is related to the longterm financial requirements of the business enterprise
It determined by the long-term debt and equity capital used by
the business enterprise.
the capital structure of a business enterprise should be ideal,
according to the requirement of the business enterprise.
2
DETERMINANTS OF
CAPITAL STRUCTURE:
Size of the Business Enterprise
Nature of the Business Organisation
Retaining Control of the Business Enterprise
Period of Finance
The Purpose of Financing
Money Market Conditions
Elasticity of Capital Structure
FACTORS INFLUENCING TO
CAPITAL STRUCTURE
EXTERNAL FACTOR
INFLUENCE
INTERNAL FACTOR
INFLUENCE
Nature of income
Size of the comp
Minimum cost
Maximum return to equity
Advantages of Debt:
Interest is tax deductible (lowers the effective cost of debt)
Debt-holders are limited to a fixed return so stockholders do not have to
share profits if the business does exceptionally well
Debt holders do not have voting rights
Disadvantages of Debt:
Higher debt ratios lead to greater risk and higher required interest rates (to
compensate for the additional risk)
Advantages Equity:
Fixed Costs Unchanged
Collateral-Free Financing
Long-Term Financing
Disadvantages of Equity:
Investor Expectations
Business Form Requirements
Financial Returns Distribution
THEORIES OF CAPITAL
STRUCTURE
Capital Structure Decision:
NOI theory
100
50
0
50
30%
30%
30%
50%
100
100
10%
10%
20
80
30%
110%
100
10%
TRADITIONAL APPROACH
Before optimal: Kd<Ke
At the optimal: Kd=Ke
After optimal: Kd>Ke
MODIGLIANI AND
MILLER APPROACH
No Ideal Capital structure whether we put full equity or debt
Value is based on market. (EBIT/VF)
Assumption:
Perfect capital market
Rational investor and manager
Homogeneous expectations
Absence of taxes
WALTERS MODEL
Prof. James E Walter argued that in the long-run the share prices
reflect only the present value of expected dividends. Retentions
influence stock price only through their effect on future
dividends. Walter has formulated this and used the dividend to
optimize the wealth of the equity shareholders.
Assumptions of Walters Model:
Internal Financing
constant Return in Cost of Capital
100% payout or Retention
Constant EPS and DPS
Infinite time
D + r (E-D)
k
k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firms investment or Internal Rate of
Return
k = Cost of Equity Capital
Illustration :
Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
No change in value of
Share
No change in value of
Share
GORDONS MODEL
According to Prof. Gordon, Dividend Policy almost always
affects the value of the firm. He Showed how dividend
policy can be used to maximize the wealth of the
shareholders.
The main proposition of the model is that the value of a
share reflects the value of the future dividends accruing to
that share. Hence, the dividend payment and its growth are
relevant in valuation of shares.
The model holds that the shares market price is equal to
the sum of shares discounted future dividend payment.
Assumptions:
All equity firm
No external Financing
Constant Returns
Constant Cost of Capital
Perpetual Earnings
No taxes
Constant Retention
Cost of Capital is greater then growth rate (k>br=g)
E (1 b)
K - br
Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
Illustration :
Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 =
(0.75) 4
= Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 =
(0.50) 4
0.15- (0.5)(0.20)
= Rs. 40
Depends on
Depends on
1
( D1+P1 )
(1 + p)
Where,
Criticism Of M-M
Model
TRADITIONAL APPROACH
This theory regards dividend decision merely as a part of financing
decision because
The earnings available may be retained in the business for reinvestment
Or if the funds are not required in the business they may be
distributed as dividends.
Thus the decision to pay the dividends or retain the earnings may be
taken as a residual decision
This theory assumes that the investors do not differentiate between
dividends and retentions by the firm
Thus, a firm should retain the earnings if it has profitable
investment opportunities otherwise it should pay than as dividends.
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