CAPITAL STRUCTURE AND

FIRM VALUE
 MODIGLIANI AND MILLER (MM)
POSITION

• Perfect Capital Market

• Rational Investors and Managers

• Homogenous Expectations

• Equivalent Risk Classes

• Absence of Taxation
 MM PROPOSITION I
The value of a firm is independent of its capital structure.
M&M (Debt Policy Doesn’t Matter)
Example - All Equity Financed

Data
Number of shares 1,000
Price per share $10
Market Value of Shares $ 10,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000
Earnings per share $.50 1.00 1.50 2.00
Expected
Return on shares (%) 5 % 10 15 20
outcome
 M&M (Debt Policy Doesn’t Matter)
Example
cont.
Data
50% debt Number of shares 500
Price per share $10
Market Value of Shares $ 5,000
Market val ue of debt $ 5,000

Outcomes
A B C D
Operating Income $500 1,000 1,500 2,000
Interest $500 500 500 500
Equity earnings $0 500 1,000 1,500
Earnings per share $0 1 2 3
Return on shares (%) 0% 10 20 30
 M&M (Debt Policy Doesn’t Matter)
Example - - All Equity Financed
- Debt replicated by investors

Outcomes
A B C D
Earnings on two shares $1.00 2.00 3.00 4.00
LESS : Interest @ 10% $1.00 1.00 1.00 1.00
Net earnings on investment $0 1.00 2.00 3.00
Return on $10 investment (%) 0% 10 20 30
 MM PROPOSITION II

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)

 M&M Proposition II
Example continued

rE  rA  rA  rD 
D
E

expected operating income

rE  rA 
market val ue of all securities
1500
  .15
10,000
 M&M Proposition II
Example continued
rE  rA  rA  rD 
D
E

rA = expected operating income / market value of all securities

= 1500 / 10000 = 0.15

rE  .15  .15  .10 

5000
5000
 .20 or 20%
 NET OPERATING INCOME APPROACH
According to this approach the overall capitalisation rate (rA) and
the cost of debt (rD) remain constant for all degrees of leverage.
Hence
rE = rA + (rA – rD) (D/E)
Rates of
return

rE

rA

rD

D/E
 CRITICISMS OF MM THEORY

• Firms and investors pay taxes

• Bankruptcy costs can be high

• Agency costs exist

• Managers tend to prefer a certain sequence of financing

• Informational asymmetry exists

• Personal and corporate leverage are not perfect

substitutes
 MM IN WORLD OF TAXES
When taxes are applicable to corporate income, debt financing is
advantageous as interest on debt is a tax-deductible expense.
In general
It means:
Value of levered firm = Value of unlevered firm + Gain from leverage
VL = VU + tC D
 Taxes (Personal & Corp)
Operating Income of Company (1.00)
Paid out as Or paid out as
interest equity income

Corporate Tax None as PBT after Tc as PBT = 1

Interest payout =0

Income after Corp Taxes to 1.00 1.00 – Tc

bondholder/stockholder

Personal Taxes on Tp TpE (1.00-Tc)

Interest/Dividend Income .

Income after All Taxes to 1.00 – Tp 1.00–Tc-TpE (1.00-Tc)

bondholder/stockholder =(1.00-TpE)(1.00-Tc)

To bondholders To stockholders
 Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )

1-Tp
(1-TpE) (1-Tc)

Advantage
RAF > 1 Debt
RAF < 1 Equity
Example : Suppose tc = 50 percent, tpe = 5 percent, and tpd = 30 percent.
The tax advantage of every rupee of debt is:
(1 – 0.5) (1 – 0.05)
1– = 0.32 rupee
(1 – 0.3)
 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
 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.

• The loss in efficiency on account of restrictions on

operational freedom plus the cost of monitoring (which
are almost invariably passed on to shareholders)
represent agency costs associated with debt.
 TRADEOFF MODEL

Value of
the firm Value of the firm considering
the tax advantage of debt

Financial distress costs and

agency costs
Value of the firm considering
the tax advantage and financial
distress and agency costs

Value of the
unlevered firm

D/E
 The Optimal Capital
Structure
Graphically
Cost Ke
(%)
WACC
K
e
Kd

K
d

0 Target
Capital TD/TA
Structu (%)
re
 The Optimal Capital
Structure
Firm Graphically
Value

V = EBIT (1 - t)
WACC

0 Target
Capital TD/TA
Structure (%)
 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 kinds
of equity, internal and external. While the internal
equity is at the top of the pecking order, the external
equity is at the bottom.
 PECKING ORDER OF FINANCING

Some Implications:

Internal equity may be better than external equity.

Financial slack is valuable.

If external capital is required, debt is better. (There is less room for

difference in opinions about what debt is worth).
 SIGNALING THEORY

• 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 the trade-off theory is that all

parties have the same information and homogeneous
expectations. Myers argued that there is asymmetric
information and divergent expectations which explains
the pecking order of financing observed in practice.
 EBIT – EPS ANALYSIS

The relationship between EBIT and EPS is as follows:

(EBIT – I) (1 – t)
EPS =
n
 EARNINGS PER SHARE UNDER
ALTERNATIVE FINANCING PLANS

Current Capital Structure: 10,00,000 equity shares@ 10 each

= Rs. 1,00,00,000

Additional Rs. 1,00,00,000 to be raised

Alternatives:
Issue 10,00,000 equity shares @ 10 each
Take debt of Rs. 1,00,00,000 at 14 %
 EARNINGS PER SHARE UNDER
ALTERNATIVE FINANCING PLANS

Equity Financing Debt Financing

EBIT : 2,000,000 EBIT : 4,000,000 EBIT : 2,000,000 EBIT : 4,000,000

Interest - - 1,400,000 1,400,000

Profit before taxes 2,000,000 4,000,000 600,000 2,600,000
Taxes 1,000,000 2,000,000 300,000 1,300,000
Profit after tax 1,000,000 2,000,000 300,000 1,300,000
Number of equity
shares 2,000,000 2,000,000 1,000,000 1,000,000
Earnings per share 0.50 1.00 0.30 1.30
 BREAK-EVEN EBIT LEVEL

The EBIT indifference point between two alternative

financing plans can be obtained by solving the following
equation for EBIT*

(EBIT *– I1) (1 – t) (EBIT *– I2) (1 – t)

=
n1 n2
 BREAK-EVEN EBIT LEVEL

The EBIT indifference point between two alternative

financing plans can be obtained by solving the following
equation for EBIT*

(EBIT *– I1) (1 – t) - PD 1 (EBIT *– I2) (1 – t) – PD2

=
n1 n2
 Other
Influences
on Capital
Structure
Choice
 SECURITY INNOVATIONS
 Eliminate conflicts of interests among various groups (agency
approach)
 Convey private information to the capital markets or mitigate adverse
selection effects (the asymmetric information approach)
 Influence nature of products or competition
 Affect the outcome of corporate control contests