CONTENTSIntroductionNet Income ApproachNet Operating Income ApproachMM Theory of Capital Structure – Without TaxesProposition IProposition IIProposition IIIThe Arbitrage ArgumentAssumptions and Limitations of MM’s Theory of Irrelevance
CONTENTSMM Theory of Capital Structure – With TaxesProposition IProposition IIProposition IIIMiller’s ModelLeverage and Financial DistressCost of Financial DistressAgency Cost of DebtTrade-off Theory of Capital StructureDonaldson’s Pecking Order TheorySignalling, Asymmetric Information TheoryFree Cash Flow Hypothesis
CAPITAL STRUCTURE AND VALUECapital 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.
COMMON ASSUMPTIONS FOR THE ANALYSIS Following assumptions are required to arrive at optimal capital structureTo analyse effects of capital structure one form of capital needs to be replaced with another formMaximisation of value of the firm is consistent with maximisation of shareholders’ wealth Optimal capital structure is one that minimises WACC Earning levels remain constant
TARGET CAPITAL STRUCTURETarget 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 likemarket practices, lenders’ perspectives, and industry norms.
NET INCOME APPROACH Net Income (NI) approachassumes 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+DEBIT=firmtheof valueMarketsupplierscapitalalltoEarnings=rWACC;.Ei-EBIT=equityof valueMarketrsshareholdeequityforEarnings=rEquity;of CostDi=debtof valueMarketInterest=rDebt;of Costed
NET INCOME APPROACHScenario AScenario BScenario CProject Cost1,000.001,000.001,000.00Sources of Finance Equity (Book Value)Debt (Book Value)900.00100.00500.00500.00100.00900.00Capitalisation RateEquity, reDebt, rd20%10%20%10%20%10%EBIT500.00500.00500.00Interest (I)10.0050.0090.00EBT490.00450.00410.00
NET INCOME APPROACHCAPITALIZATION RATESEBT490.00450.00410.00TaxesAssumed no taxesEarnings available to shareholders490.00450.00410.00Market value of debt (I/rd)100.00500.00900.00Market value of equity (EBIT – I - Taxes)/re2,450.002,250.002,050.00Total Value of the firm2,550.002,750.002,950.00Overall capitalisation rate (r)19.61%18.18%16.95%
NET INCOME APPROACHNET INCOME APPROACH: CAPITALISATION RATESRates ofReturnrerrdD/E0
NET INCOME APPROACHOPTIMAL CAPITAL STRUCTURENet Income approach assumes that capitalisation rates are constant and increasing debt would