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Finance

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

Legal requirement and law


Condition of the market
Outside availability of fund
and cost of debt capital
Investors sentiment

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:

Net Income Approach (NI)


Net Operating Income Approach (NOI)
Traditional Approach (TA)
Modigliani and Miller Approach (MM)

NET INCOME APPROACH


Ko goes on reducing with increase in Kd
Hence, an ideal capital structure with minimum Ko.

NET OPERATING INCOME


APPROACH
E
D
Ko
Ke
VF
Kd

NOI theory
100
50
0
50
30%
30%
30%
50%
100
100
10%
10%

20
80
30%
110%
100
10%

Ke goes on increasing where as


debt capital goes decreasing.
VF remain constant
Equity earnings/market value of
equity

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

What Is Dividend Policy ??


Dividend policy determines the division of earnings
between payments to shareholders and retained
earnings- Weston and Bringham
Dividend Policies involve the decisions, whether To retain earnings for capital investment and other
purposes; or
To distribute earnings in the form of dividend among
shareholders; or
To retain some earning and to distribute remaining
earnings to shareholders.

Factors Affecting Dividend Policy


Legal Restrictions
Magnitude and trend of earnings
Desire and type of Shareholders
Nature of Industry
Age of the company
Future Financial Requirements
Taxation Policy
Stage of Business cycle
Regularity
Requirements of Institutional Investors

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

Formula Of Walters Model


P

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

Normal Firm (r = k):


r = 15% k = 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

Declining Firm (r < k):


r = 10% k = 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

Effect Of Dividend Policy On Value Of


Share
Case

If Dividend Payout ratio


Increases

If Dividend Payout Ration


decreases

1. In case of Growing firm


i.e. where r > k

Market Value of Share


decreases

Market Value of a share


increases

2. In case of Declining firm


i.e. where r < k

Market Value of Share


increases

Market Value of share


decreases

3. In case of normal firm


i.e. where r = k

No change in value of
Share

No change in value of
Share

Criticisms Of Walters Model


No External Financing
Firms internal rate of return does not always
remain constant. In fact, r decreases as more and
more investment in made.
Firms cost of capital does not always remain
constant. In fact, k changes directly with the firms
risk.

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)

Formula Of Gordons Model


P

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

Normal Firm (r = k):


r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 =
(0.75) 4
= Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 =
(0.50) 4
= Rs. 26.67
0.15- (0.5)(0.15)

Declining Firm (r < k):


r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 =
(0.75) 4
= Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 =
(0.50) 4
= Rs. 20
0.15- (0.5)(0.10)

Modigliani & Millers Model

Depends on

Depends on

Modigliani And Millers Approach


Assumption
Capital Markets are Perfect and people are Rational
No taxes
Floating Costs are nil
Investment opportunities and future profits of firms are
known with certainty (This assumption was dropped later)
Investment and Dividend Decisions are independent

Formula Of M-Ms Approach


Po

1
( D1+P1 )
(1 + p)

Where,

Po = Market price per share at time 0,


D1 = Dividend per share at time 1,
P1 = Market price of share at time 1

Criticism Of M-M
Model

No perfect Capital Market


Existence of Transaction Cost
Existence of Floatation Cost
Lack of Relevant Information
Differential rates of Taxes
No fixed investment Policy
Investors desire to obtain current income

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.

THANK YOU

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