capital structure , goals and significance of capital structure , target capital structure , does capital structure matter , modigliani and miller theory

1. Capital Structure Theory

2. Capital Structure Theory
Learning Objectives:
• To help the perceiving concept of capital structure and
financial structure, pointing out their main differences;
• To help realizing the goal and significance of capital
structure;
• To assist knowing the features, assumptions and criticisms
of the various capital structure theories developed so far .
• To assist understanding the implications of the capital
structure theories.
• To understand the main factors affecting the capital
structure of a firm
• To grasp the meaning and features of an optimal capital
structure;
• To learn the technique of determining optimal capital

3. Capital…..????
• The term Capital has several meanings and it is used
in many business contexts. In general, capital is
accumulated assets or ownership. More specifically,
• 1. Finance: Wealth in the form of money or assets,
taken as a sign of the financial strength of an
individual, organization, or nation, and assumed to be
available for development or investment.
• 2. Accounting: Money invested in a business to
generate income.
• 3. Economics: Factors of production that are used to
create goods or services and are not themselves in
the process.

4. Capital Structure
• In a narrow sense, the authors of financial
management define capital structure as
the relative proportion of the long-term
securities a firm has used and its equity
capital.
• In a broader sense, the authors define
capital structure as the permanent
financing of a firm represented by long-
term debts plus preferred stock and net
worth.

5. Confusions…???
Capital Structure vs Financial Structure
Capital Structure Financial Structure
Definition Capital structure represents
only the permanent source of
financing.
Financial structure represents both
the permanent and temporary
source of financing.
Nature It denotes to the left hand/
upper side of the Balance
Sheet. So, it represent capital
and debt.
It denotes to the right hand/lower
side of the Balance Sheet. So, it
represents property and assets.
Importance It is important from the view
point of capital and long-term
debt.
It is important from the view point of
property and assets
Total/part
financing
It is the part of total financing. It is the total or whole financing.

6. Goals and Significance of Capital
Structure
The ultimate goal of capital structure of a firm is to
formulate its debt-equity policy in such a way that
maximizes the value of the firm.
In order to achieve the main goal, the sub-goals of capital
structure are as follows :
• i. To increase the equity shareholders’ stock price by
determining an ideal debt-equity mix;
• ii. To take advantage of favorable financial leverage;
• iii. To avoid using of high risky debt capital in capital
structure and
• iv. To take advantage of corporate tax.

7. Target Capital Structure
• The ideal mix of debt, preferred stock, and
common equity with which the firm plans
to finance its investments

8. Theories of Capital Structure
• So far, the following theories of capital structure
have been developed in the literature of finance :
i) Traditional Theory;
ii) Modigliani and Miller Theory;
iii) Net Income Approach;
iv) Net Operating Income Approach
v) The Trade Off Theory
vi) The Pecking Order Theory and
vii) Signaling Theory

9. Does Capital Structure Matter??
• Traditional Theory
• According to this approach, the value of
the firm can be increased or the cost of
capital can be decreased by a judicious
mix of debt and equity capital.

10. Traditional Theory….Cont
Criticism of Traditional Approach
The validity of the traditional view has been questioned on
the ground that the market value of the firm depends upon
the net operating income and risk. The form of financing
can neither change the net operating income nor the risk
involved in it. It can only change the way in which net
operating income and risk are distributed between debt and
equity. Thus, the firm with identical net operating income
and risk but differing in modes of financing should have
same market value. The traditional view is criticized
because it implies that totality of risk incurred by all security
holders of a firm can be altered by changing the manner in
which the totality of risk is distributed among the various
classes of security.

11. Modigliani and Miller Theory (1958)
Concept: The market value of the firm depends
on its net operating income and risk involved in
it, not on the form of financing.
• M-M approach is based on the following
assumptions :
• (i) Investors can borrow or lend at the same
market rate of interest;
• (ii) There is absence of bankruptcy costs;
• (iii)The capital market is highly competitive;

12. Modigliani and Miller Theory (1958)
• (iv)The capital markets are efficient, so the
information flows freely to the
• investors and there exists no transaction
costs;
• (v) There is absence of tax;
• (vi)Investors are indifferent between
dividend and retained earnings and
• (vii) There is co-incidence of expectation
among investors.

13. Factors Affecting Capital Structure
Decisions
• A. Quantitative/ Financial Factors:
• i) Profitability Aspect
• ii) Growth Rate
• iii) Liquidity Aspect
• iv) Relative Costs of Sources of Fund
• v) Stability of Sales/ Investments
• vi) Financial Risk
• (vii) Corporate Tax
• viii) Operating Risk

14. • B. Qualitative/ Non-financial factors
• i) Availability of Fund
• ii) Proper Timing
• iii) State of Capital Market
• iv) Control of Business
• v) DFIs’ Recommendation
• vi) Regulatory Framework of SEC
• vii) Restriction by Lenders
• viii) Chief Executives’ Values and Philosophy

15. Optimal Capital Structure
Determination
• Traditional Approach
• Under traditional approach, optimal capital
structure is that point where weighted average
cost of capital (WACC) is the minimum.
Algebraically -
• K0 = Ke . We + Kd . Wd
• Where k0 = WACC; ke = equity capitalization
rate; we = weights of equity capital to total
capitalization; kd = rate of interest on debt and
wd = weights of debt to total capitalization.

16. • MM Approach
• Under MM approach, cost of capital
remains constant and the cost of equity
increases linearly with the debt. Equity
capitalization rate is calculated as follows :
•
• Ke = K0 + (K0 – Kd) debt/equity

17. Determining the
Optimal Capital Structure:
• Seek to maximize the price of the firm’s
stock.
• Changes in use of debt will cause
changes in earnings per share, and, thus,
in the stock price.
• Cost of debt varies with capital structure.
• Financial leverage increases risk.

18. 18
The Effect of Capital Structure on Stock
Prices and the Cost of Capital
• The optimal capital structure
maximizes the price of a firm’s stock.
• The optimal capital structure always
calls for a debt/assets ratio that is lower
than the one that maximizes expected
EPS.

19. 19
Debt/
Assets
kd Expected
EPS
Estimated
Beta
ks = [kRF +
(kM – kRF)s]
Estimated
Price
Resulting
P/E Ratio
WACC
0% - $2.40 1.50 12.0% $20.00 8.33 12.00%
10 8.0% 2.56 1.55 12.2 20.98 8.20 11.46
20 8.3 2.75 1.65 12.6 21.83 7.94 11.08
30 9.0 2.97 1.80 13.2 22.50 7.58 10.86
40 10.0 3.20 2.00 14.0 22.86 7.14 10.80
50 12.0 3.36 2.30 15.2 22.11 6.58 11.20
60 15.0 3.30 2.70 16.8 19.64 5.95 12.12
All earnings paid out as dividends, so EPS = DPS.
Assume that kRF = 6% and kM = 10%. Tax rate = 40%.
WACC = wdkd(1 - T) + wsks
= (D/A) kd(1 - T) + (1 - D/A)ks
At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%
Stock Price and Cost of Capital Estimates
with Different Debt/Assets Ratios

20. Problem
• Suppose that the present capital structure
of Meghna Vegetable oil Ltd. is as follows:
• the company is planning to expand its capacity that will require
additional capital of Tk. 60 lakh. There are four alternative method of
financing:
• 1) issuing 14% debenture
• 2) Issuing 12% PS
• 3)Issuing CS at Tk.100/share
• 4) 50% Debenture and 50% SC
• Note: EBIT is 40 lakh and tax rate is 40%. Find EPS?
Common Stock Capital (100000 share @ Tk.100) Tk.100,00,000
12% Debt capital 50,00,000
Total Capital 1,50,00,000

21. 21
Country Equity Total Debt Long-Term
Debt
Short-Term
Debt
United Kingdom 68.3% 31.7% N/A N/A
United States 48.4 51.6 26.8% 24.8%
Canada 47.5 52.5 30.2 22.7
Germany 39.7 60.3 15.6 44.7
Spain 39.7 60.3 22.1 38.2
France 38.8 61.2 23.5 37.7
Japan 33.7 66.3 23.3 43.0
Italy 23.5 76.5 24.2 52.3
Capital Structure Percentages for Selected Countries Ranked by Common
Equity Ratios, 2015
Capital Structures Around the World