Transcript
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CAPITAL STRUCTURE
&
FIRM VALUE
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Outline
Assumptions and Definitions
Net Income Approach
Net Operating Income Approach Traditional Position
Modigliani and Miller Position
Taxation and Capital Structure
Tradeoff Theory
Signaling Theory
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Objective of Capital Structure
Judicious use of different long-term sources
of financing such that overall cost of capitalof the firm does not increase and remains
minimum and constant, thereby maximizing
value of the firm.
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Factors Affecting Capital Structure
1. Leverage
2. Cost of Capital
3. Cash Flow Projections of the firm
4. Size of Company5. Dilution of Control
6. Floatation Cost
7. Lenders Attitude
8. Management Attitude
9. Sales Stability
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ASSUMPTIONS
To examine the relationship between capital structure and
cost of capital, the following simplifying assumptions are
commonly made:
1. No income tax
2. 100 percent dividend payout
3. Identical subjective probability distributions ofoperating income
4. No growth /decline in operating income5. A firm can change its capital structure
instantaneously
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IA nnu al in teres t charges
rD = =
D M ark et va lu e o f d eb t
P Equi ty earn ings
rE = =
E M arket va lue o f equi ty
O O p erat in g i n com e
rA = =
V M arket va lue o f the f i rm
D ErA = rD + rE
D + E D + E
W h a t h a p p en s to rD , rE, and rA w hen f inancia l leverage , D /E, changes?
FOCUS OF ANALYSIS
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NET INCOME APPROACH
According to this approach, rD and rE remain unchanged when D/Evaries. The constancy ofrDand rEwith respect to D/Emeans that rA declines as D/Eincreases.
Rates of
return
rA
rE
rD
D/E
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NET OPERATING INCOME APPROACH
According to this approach the overall capitalization rate (rA) and the cost of debt (rD) remain
constant for all degrees of leverage. Hence
rE= rA + (rA rD) (D/E)
Rates ofreturn
rA
rE
rD
D/E
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MODIGLIANI AND MILLER (MM) POSITION
Assumptions
1. Perfect Capital Market
2. Rational Investors and Managers
3. Homogenous Expectations
4. Equivalent Risk Classes
5. Absence of Taxation
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MM
PROPOSITION I
Firms value is determined by its real assets and not by its
financing methods. Thus capital structure is irrelevant .
Value of unlevered firm = value of levered firm
In perfect market both investments give same return
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MM
PROPOSITION II
Expected rate of return on equity of a levered firm (withdebt) increases in proportion to debt-equity ratio.
At high debt levels the risk of the firm increases. Hence any
combination of D/E is as good as another.
The expected return on equity is equal to the expected rate
of return on assets, plus a premium. The premium is equal
to the debt-equity ratio times the difference between the
expected return on assets and the expected return on debt
rE= rA + (rA rD) (D/E)
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CRITICISMS OF MM THEORY
Real World is characterized by various imperfections
1. Firms and investors pay taxes
2. Bankruptcy costs can be high
3. Agency costs exist
4. Managers tend to prefer a certain sequence of financing
5. Informational asymmetry exists
6. Personal and corporate leverage are not perfectsubstitutes
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Factors Affecting Optimal Capital
Structure of A firm
Favourable Financial Leverage : Rise in cost of
equity with rise in debt is not too fast, it is
moderate.
Income Tax Leverage : The interest payment is
tax deductible
Interest Tax Shield =Interest x tax rate
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Contd..
Market Conditions : Investors reaction to
change in capital structure
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Impact of Corporate Taxes
When taxes are applicable to corporate income, debt financing is
advantageous as interest on debt is a tax-deductible expense.
In general
O ( 1 - tC)
V = + tCD
r
where V = value of the firmO = operating income
tC
= corporate tax rate
r = capitalisation rate applicable to the unlevered firm
D = market value of debt
It means:
Value of levered firm = Value of unlevered firm + Gain from leverage
VL
= VU
+ tCD
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COST OF FINANCIAL DISTRESS
A high level of debt may lead to financial distress that
entails certain costs:
Direct Costs
Delay in liquidation may diminish asset value
Distress sale fetches lower price
Legal and administrative costs are high
Indirect Costs
Managers become myopic
Stakeholders dilute their commitment
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AGENCY COSTS
There is an agency relationship between the
shareholders and creditors of firms that have
substantial amounts of debt. Hence lenders impose
restrictive covenants and monitor the behaviour of the
firm.
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TRADE OFF MODEL
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Contd..
Value of the levered firm = Value of unlevered
firm + tax advantage of debt PV of expected
costs of financial distress PV of agency costs
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Corporate Financing Behaviour
Power companies, refineries use more debt as
their assets are tangible and safe. Software
companies borrow less because their assets
are mostly intangible and somewhat risky.
Theory does not answer why Highly profitable
companies like HLL, Colgate Palmolive use very
little debt
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SIGNALING THEORY
(Why profitable companies use little debt)
Noting the inconsistency between trade-off theory and
the pecking order of financing, Myers proposed a new
theory, called the signaling, or asymmetric information,
theory of capital structure.
A critical premise of the trade-off theory is that all
parties have the same information and homogeneousexpectations. Myers argued that there is asymmetric
information and divergent expectations which explains
the pecking order of financing observed in practice.
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PECKING ORDER OF FINANCING
There is a pecking order of financing which goes as
follows:
Internal finance (retained earnings)
Debt finance
External equity finance
Given the pecking order of financing, there is no well-
defined target debt-equity ratio, as there are two kindsof equity, internal and external. While the internal
equity is at the top of the pecking order, the external
equity is at the bottom.
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