Capital Structure

• the proportion of debt, preference and equity capitals in the total

financing of the firm’s assets.

• to maximize the value of the equity shares of the firm.

• E.g. A company has eq. shares of Rs 1,00,000 , preference shares of

Rs1,00,000, Debentures 1,00,000 & Retained Earnings Rs50,000
Optimum Capital Structure
An ideal relationship between debt and equity securities, resulting in
maximising the value of the company’s equity shares in the stock exchange
and minimising the average cost of capital

Features:
1. Profitability
2. Solvency
3. Flexibility
4. Conservatism
5. Control
6. simplicity
 Determinants of capital structure

• Financial leverage • Purpose of financing

• Corporate taxes • Floatation costs
• Control • Period of finance
• Size of the company • Provision for Future
• Legal Requirements • Stock Market condition
Theories on Capital Structure
Assumptions
• There are only two sources of funds used by a firm: perpetual riskless debt
and ordinary shares.
• There are no corporate taxes.
• The dividend-payout ratio is 100.
• The total assets are given and do not change.
• The total financing remains constant.
• The operating profits (EBIT) are not expected to grow.
• All investors are assumed to have the same subjective probability
distribution of the future expected EBIT for a given firm.
• Business risk is constant over time and is assumed to be independent of its
capital structure and financial risk.
NET INCOME (NI) APPROACH- David Durand
”The capital structure decision is relevant to the valuation of the firm”
• a change in the financial leverage will automatically lead to a corresponding
change in the overall cost of capital as well as the total value of the firm.
• if the financial leverage increases, the weighted average cost of capital
decreases and the value of the firm and the market price of the equity shares
increases.

• Assumptions of NI approach:
There are no taxes
The cost of debt is less than the cost of equity.
The use of debt does not change the risk perception of the investors
NET OPERATING INCOME APPROACH (NOI)
This approach suggests that the capital structure decision of a firm is
irrelevant and that any change in the leverage or debt will not result in a
change in the total value of the firm as well as the market price of its shares.
This approach also says that the overall cost of capital is independent of the
degree of leverage.
Assumptions
• The value of the firm is obtained by capitalizing NOI by the Ko which
depends on the business risk. If business risk is constant, ko is also constant.
• The cost of equity changes with change in degree of leverage.
• Cost of debt remains same regardless of leverage.
• There are no corporate taxes
Modigliani Miller approach
According to this approach the cost of capital and the value of the firm remains
unaffected by the changes in capital structure in the absence of taxes
The weighted average cost of capital or overall cost of capital does not change with
the change in debt to equity in the capital structure of the firm

• Assumptions
 Capital markets are perfect
 Securities are infinitely divisible
 Transactions in securities are cost less
 Information is freely available and investors are well informed
 Investors are rational and behave rationally
 There are no corporate taxes
MM hypothesis under corporate taxes:
In the year 1963, Modigliani and Miller have indentified that with the
introduction of corporate taxes in the computation process, the value
of the firm increases and overall cost of capital decrease with the use
of leverage in the capital structure. This is mainly because of the tax
benefit enjoyed by the firm’s on the interest payments.
Traditional Approach-Ezra Solomon
• According to this theory a proper and right combination of debt and
equity will always lead to market value enhancement of the firm. This
approach accepts that the equity shareholders perceive financial risk
and expect premiums for the risks undertaken. This theory also states
that after a level of debt in the capital structure, the cost of equity
capital increases.
• But it does not support the concept that value of firm continuously
increase with the increase in leverage. It resembles NOI approach, as
this theory also argues that the cost of equity changes with the
changes in the leverage. It also argues that the cost of debt also
increases with increase in leverage.
Dividend Policy Decisions
• Dividends:Portion of a firm's net earnings which are paid out to the
shareholders
• Dividend Policy: determines what portion of profits will be distributed
as dividend to shareholders & what portion will be retained in the
business to finance long-term growth.

• Dividend policy theories or dividend models

Walter’s relevant approach
 Gordon’s relevant approach
Modigliani Miller or M-M hypothesis
Walter’s relevant approach
• According to Walter dividend decisions are relevant and affect the value of
the firm.
𝐸−𝐷
𝐷+𝑅( )
𝐾
P=
𝐾

• According to his theory if return is greater than cost of capital such firms
are termed as growth firms and the optimum dividend payout would be
zero(R>k)

• If the return is lesser than cost of capital such firms are called as declining
firms and the optimum dividend payout is 100 percent (R<K)

• If the return of the company is equal to cost of capital such firms are called
as normal firms. There is no optimum dividend payout and the value of
firm share will not change with the change in dividend rate(R=K)
• Assumptions
The investments of the firms are financed through retained earnings
The internal rate of return and cost of capital is constant
Earnings and dividends do not change
The firm has very long life
The firm's business risk does not change with additional investment
• Criticisms
The assumption that investments are financed through retained
earnings is not true in real world situation
The rate of return will remain constant does not hold good
The assumption that cost of capital remain constant does not hold good
Gordon’s relevant approach –(M.J.Gordon)
• It suggest that dividends are relevant and dividend decisions of the
firm affects its value

• It indicates that dividend and retention ratio are relevant variables

which have impact on value of the firm
𝑬(𝟏−𝒃)
P=
𝑲−𝒃𝑹
• Assumptions
The firm uses only equity capital
For expansion the farm resorts to retained earnings and not external Finance
Internal rate of return and cost of capital will remain constant
There are no taxes on corporate income
The firm has perpetual life
The retention ratio once decided is constant

• Criticisms
The assumption that internal rate of return will remain constant does not hold
good
The assumption that cost of equity remain constant is unrealistic
The assumption that firm uses only equity capital is wrong
The assumption that there are no corporate taxes is wrong
The share price cannot be calculated if the dividend payout ratio is zero
Bird-in-hand Argument (Dividend &Uncertainty)
-Gordon
• According to Walter, dividend Policy will not affect the Price of the
share when r=k. But Gordon argues that dividend policy affects the
Price of the shares even when r=k.

The crux of the Gordon’s argument is based on the following 2

assumptions:
Investors are Risk Averters,
They consider distant dividend as less certain than near dividends
• The investors are rational. Accordingly they want to avoid risk.
• The payment of dividend now completely removes any chance of risk.
• If the firm retains the earnings, the investors can expect to get a dividend in the
future.
• The future dividend is uncertain both with respect to the amount as well as the
timing.
• Though the firm is having ample investment opportunities, by the time it
reinvests its profits and earns returns anything may happen.
• New competitors may enter into the market, the Government policy towards
business might change or the tastes & preferences of the customers might
change
• Rational investors prefer current dividends to the future dividends
• This behavior of the investors is described as Bird-in-hand argument.
• A Bird –in hand is worth two in the bush.
• What is available today is more important than what may be available in the
future
Modigliani Miller hypothesis -1958

According to this model the price of the shares of the firm is

determined by its earning potential it and investment policy and not by
pattern of income distribution
P1= P0(1+KE)-D
• P0 = Price at the beginning
• KE = Cost of Equity
• D= Dividend per share
• Assumptions
There is perfect capital market
Investors behave rationally
Information is freely available to them and no transaction cost
No taxes on corporate income
Firm has fixed investment policy
Risk does not exist
Forecasting ability

• Criticism
Assumption that taxes do not exist is wrong
Assumption that there is no flotation cost is unrealistic