capital-structuretheory.pptx - CHAPTER 16 CAPITAL STRUCTURE THEORY CONTENTS Introduction Net Income Approach Net Operating Income Approach MM Theory of

capital-structuretheory.pptx - CHAPTER 16 CAPITAL STRUCTURE...

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CAPITAL STRUCTURE THEORY CHAPTER 16
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CONTENTS Introduction Net Income Approach Net Operating Income Approach MM Theory of Capital Structure – Without Taxes Proposition I Proposition II Proposition III The Arbitrage Argument Assumptions and Limitations of MM’s Theory of Irrelevance
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CONTENTS MM Theory of Capital Structure – With Taxes Proposition I Proposition II Proposition III Miller’s Model Leverage and Financial Distress Cost of Financial Distress Agency Cost of Debt Trade-off Theory of Capital Structure Donaldson’s Pecking Order Theory Signalling, Asymmetric Information Theory Free Cash Flow Hypothesis
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CAPITAL STRUCTURE AND VALUE Capital structure decision is one of the key decisions that focuses on finding the capital structure with the objective of maximisation of value of the firm. It is perhaps the key strategic decision that has occupied much of the time and attention of academicians and managers alike. The issue revolves around the question of an optimal capital structure, if there is any.
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COMMON ASSUMPTIONS FOR THE ANALYSIS Following assumptions are required to arrive at optimal capital structure To analyse effects of capital structure one form of capital needs to be replaced with another form Maximisation of value of the firm is consistent with maximisation of shareholders’ wealth Optimal capital structure is one that minimises WACC Earning levels remain constant
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TARGET CAPITAL STRUCTURE Target capital structure is the debt equity ratio deemed most appropriate by the management. Target capital structure is determined by several factors like taxes, Interest, And practical issues like market practices, lenders’ perspectives, and industry norms.
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NET INCOME APPROACH Net Income (NI) approach assumes that capitalisation of the firm is based on the net income derived by each supplier of capital discounted at fixed rates irrespective of levels of debt. E + D EBIT = firm the of value Market suppliers capital all to Earnings = r WACC; . E i - EBIT = equity of value Market rs shareholde equity for Earnings = r Equity; of Cost D i = debt of value Market Interest = r Debt; of Cost e d
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NET INCOME APPROACH Scenario A Scenario B Scenario C Project Cost 1,000.00 1,000.00 1,000.00 Sources of Finance Equity (Book Value) Debt (Book Value) 900.00 100.00 500.00 500.00 100.00 900.00 Capitalisation Rate Equity, r e Debt, r d 20% 10% 20% 10% 20% 10% EBIT 500.00 500.00 500.00 Interest (I) 10.00 50.00 90.00 EBT 490.00 450.00 410.00
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NET INCOME APPROACH CAPITALIZATION RATES EBT 490.00 450.00 410.00 Taxes Assumed no taxes Earnings available to shareholders 490.00 450.00 410.00 Market value of debt (I/r d ) 100.00 500.00 900.00 Market value of equity (EBIT – I - Taxes)/r e 2,450.00 2,250.00 2,050.00 Total Value of the firm 2,550.00 2,750.00 2,950.00 Overall capitalisation rate (r) 19.61% 18.18% 16.95%
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NET INCOME APPROACH NET INCOME APPROACH: CAPITALISATION RATES Rates of Return r e r r d D/E 0
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NET INCOME APPROACH OPTIMAL CAPITAL STRUCTURE Net Income approach assumes that capitalisation rates are constant and increasing debt would
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