Chapter Two

Capital Structure Decisions

How do firms choose Capital Structures?
Can managers affect firm value by employing different debt/equity mix?
Contents
o Concept of capital structure
oTheories of capital structure
oDeterminants of capital structure decision
 Introduction
Firms need funds for financing various requirements
The required funds are arranged through different sources both short term and long term
and in various forms.
The long term funds are mobilized through equity shares, preference shares, retained
earnings, debentures and bonds.
The question here is how firms make financing decision and is still a puzzle among finance
scholars
 Capital Structure Defined

• The term capital structure is used to represent the proportionate relationship

between long term debt and equity.

• The capital structure of a firm is the mix of different securities issued by the firm
to finance its operations.

• Capital structure is the mix of the long-term sources of funds used by a firm. It is
made up of debt and equity securities and refers to permanent financing of a firm.
 Financial Structure vs Capital Structure

• Some authors use capital structure and financial structure interchangeably, but both
are different concepts.
• The relative proportion of various sources of funds used in a business is termed as
financial structure. It refers to the way in which the total assets of a firm are
financed. It includes both short term and long term debt.
• Capital structure is a part of the financial structure and refers to the proportion of
the various long-term sources of financing. So it relates to the arrangement of capital
and excludes short-term borrowings.
• Thus, financial structure is a broader one and capital structure is only a part of
it.
 Capital Structure Theories

• The Basic question in capital structure is:

• Is it possible for firms to create value by altering their capital
structure?
• That is , since the objective of financial management is to maximise
shareholders’ wealth, the key issue in the capital structure decision is:
• What is the relationship between capital structure and firm value?
• Alternatively, what is the relationship between capital
structure and cost of capital?
• Note that valuation and cost of capital are inversely related.
oLike capital structure, the concept of cost of capital has its root in the items on the
right hand side-of balance sheet, which includes various types of debt, preferred
stock, common stock and retained earnings which are called the capital
components.

oCost of capital is the minimum rate of return that a firm must earn on its
invested capital if the market value of the firm is to remain unchanged.

o Capitalization rate is the discount rate used to determine the present value of a
stream of expected future cash flows.
oIt is the minimum required rate of return on funds committed to a project .

oThe cost of capital has to be computed for each capital source and security
issue. The cost of each capital source or component is called the specific
cost of capital.

oThe combined cost of all sources of capital is called overall or weighted

average cost of capital(WACC).
 Views on optimum capital structure and cost of capital

The existence of optimum capital structure is not accepted by all financial

experts. In this regard, there are two extreme views.

As per one school of thought capital structure influences value of a firm and cost
of capital and hence there exists an optimum capital structure.

On the other hand, the other school of thought advocates that capital structure
has no relevance and it does not influence the value of the firm and cost of capital.

Financial Management, Ninth Edition © I M Pandey

8
Vikas Publishing House Pvt. Ltd.
Reflecting these views, different theories of capital structure have been developed in
business finance.

The following are the important theories on capital structure, which are discussed as
under:
o Net operating income (NOI) approach
o Net income (NI) approach
o Static trade off theory
o Modigliani-Miller (M-M)
o Pecking order theory
 Net Income (NI) Approach

Developed by David Durand, which says capital structure has relevance, and a firm can increase its value and
minimize the cost of capital by employing debt in its capital structure.

According to this theory, greater the debt capital employed lower will be the overall cost of capital and more
shall be the value of the firm. As a result, the overall cost of capital declines and the firm value increases with debt.

o According to NI approach both the cost of debt and the cost of equity are independent of the
capital structure; they remain constant regardless of how much debt the firm uses.

o This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing
under NI approach.
• According to this approach, the capital structure decision is relevant to the valuation
of the firm.

• This means that a change in the financial leverage will automatically lead to a
corresponding change in the overall cost of capital as well as the total value of the
firm.
• According to NI approach, if the financial leverage increases, the weighted average cost of capital
decreases and the value of the firm and the market price of the equity shares increases.
Assumptions of NI Theory :

oThe ‘cost of debt ’ is cheaper than the ‘cost of capital’ because: Interest rates are lower
than dividend rates due to element of risk, the benefit of tax as the interest is deductible
expense for income tax purpose.

oThere is no corporate tax

oThe risk perception of investors is not changed by the use of debt. as a result, the equity
capitalization rate (ke) and the debt – capitalization rate (kd) don’t change with leverage.

oThe cost of debt capital(kd) and the cost of equity capital (ke ) remain unchanged when
the degree of leverage (the proportion of debt and equity (D/S)) varies.
• The constancy of kd and ke with respect to D/E means that the average cost of
capital or weighted average cost of capital (WACC) (kw), measured as:

Kw = kd (D/(D + E)) + ke (E/(D +E)),

declines as D/E increases. This happens because when D/E increases, kd, which is
lower than ke receivers a higher weight in the calculation of kw.

Alternatively:

• Overall cost of capital =EBIT/(Total value of a firm)

• Value of firm = Value of equity + Value of debt

Computation of the Total Value of Firm :
• TotalValue of the Firm (V) = S + D
Where, S = Market value of Shares and
D = Market value of Debt

• MarketValue of Shares(S) = (EBIT-I)/ke or

= E/ ke
Where, E = Earnings available for equity shareholders
ke = Cost of Equity capital or Equity capitalization rate.

• Market value of Debt (D) = Interest/ kd

When degree of leverage is zero (i.e. no debt capital employed), overall cost of
capital is equal to cost of equity (ko = ke).

When the debt capital is employed further and further, which is relatively cheaper
compared to the cost of equity, the overall cost of capital declines, and it becomes
equal to cost of debt (kd,) when leverage is one (i.e. the firm is fully debt financed).

Thus, according to this approach, the firm's capital structure will be optimum,
when degree of leverage is one.
Example:

• Assume there are two firms A and B and they are similar in all aspects except in the degree of
leverage employed by them.

• Both firms expect annual net income (EBIT) of Br. 80,000 and equity capitalization rate of
10%. Assume that firms A has no debt but firms B employed Br. 200,000 ,8% bond.

Case 1: Calculate the value of the firm and overall (weighted average) cost of capital
according to the NI Theory for both firm A & B.

Case 2: What will be the effect on the value of the firm and overall cost of capital, if
the firm B decides to raise the amount of bond to Br. 300,000 .
Case 1 : Solution
Firm A Firm B
EBIT 80,000 80,000
Interest on debt - 16,000
Equity earnings (Earnings available to equity shareholders) 80,000 64,000
Cost of equity capital (Equity capitalization rate) 10% 10%
Market value of equity (S) 80000*100/10 & 64000*100/10 800,000 640,000
Market value of bond(D) - 200,000
Value of the Firm (S+D) 800,000 840,000

The average cost of firm A = 10% * 800,000/800,000 = 10%

The average cost of firm B = 8% * 200,000/840,000 + 10% * 640,000/840,000

= 1.90 + 7.62
= 9.52%
Case 2 : Solution
Firm A Firm B
EBIT 80,000 80,000
Interest on debt - 24,000
Equity earnings (Earnings available to equity shareholders) 80,000 56,000
Cost of equity capital (Equity capitalization rate) 10% 10%
Market value of equity (S) 80000*100/10 & 64000*100/10 800,000 560,000
Market value of bond(D) - 300,000
Value of the Firm (S+D) 800,000 860,000

The average cost of firm A = 10% * 800,000/800,000 = 10%

The average cost of firm B = 10% * 560,000/860,000 + 8% * 300,000/860,000

= 6.51 + 2.79
= 9.3%
 Net Operating Income (NOI) Approach

o This approach is also suggested by David Durand, which is another extreme view on the capital
structure and value of the firm. As per this approach the capital structure of the firm does not
influence cost of capital and value of the firm.
o According to NOI approach the value of the firm and the weighted average cost of capital are
independent of the firm’s capital structure.

o In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash
flows regardless of the capital structure and therefore, value of the company is the same.

o This approach is of the opposite view of Net Income approach.

• According to the net operating income approach, the overall capitalisation rate and the cost
of debt remain constant for all degrees of leverage. In the equation

kw= kd ( D/(D+S)) + k e (S/(D+S))

• kw and kd are constant for all degrees of leverage. Given this the cost of equity can be expressed as:

ke = kw + (kw - kd ) (D/S)

• An increase in the use of debt funds, which are apparently cheaper, is offset by an increase in the
equity capitalisation rate.

• This happens because equity investors seek higher return as they are exposed to greater risk arising
from increase in the degree of leverage.
Assumptions of Net Operating Income Theory

• The debt capitalization rate (Kd) is constant

• Value of equity is residual (Derived by subtracting value of debt from value of firm) i.e. Value of Equity = Total
value of the firm - Value of debt

• The market capitalizes the value of the firm as a whole and the split between debt and equity is not important

• The corporate income tax does not exist.

According to this view, the use of less costly debt increases the risk to the equity
shareholders which causes the equity capitalization rate (Ke) to increase. As a result, the
low cost advantage of the debt is exactly offset by the increase in the equity
capitalization rate. Thus, the overall capitalization rate (Ko) remains constant and
consequently the value of the firm does not change.
Case 1:
Assume EBIT is Br. 1,350; the average cost of capital is 15% and Br. 1,800
debt @ 10% interest.
Required : Calculate the firm value and required rate of return on equity

Total firm value = EBIT / kw = Br. 1,350 / .15 = Br. 9,000

Market value of equity = V - D= Br. 9,000 – Br. 1,800 = Br. 7,200

Required return on equity = (EBIT-I)/Share value

= (Br. 1,350 - Br. 180) / Br. 7,200 = 1170/7200=16.25%

Examine a variety of different debt-to-equity ratios and the resulting
required rate of return on equity.

D/S kd ke kw
0.00 --- 15.00% 15%
0.25 10% 16.25% 15%
0.50 10% 17.50% 15%
1.00 10% 20.00% 15%
2.00 10% 25.00% 15%
 Exercise:
• Assume that a firm has an EBIT level of Br. 25,000, cost of debt 10%, the total value of debt
Br. 100,000 at 10% interest(Kd)and theWACC is 12.5%.

Required:

o Find out the total market value of the firm and the cost of equity capital (the equity
capitalization rate) in case of NOI approach.

o Show the relation between capital structure and cost of equity graphically

o Now, assume that the proportion of debt increases from 100,000 to 200,000 and
everything else remains same and calculate market value of the find and cost of equity capital
 Solution:
• Total market value of the firm(V) = EBIT/Kw
= 25,000/0.125 = 200,000
Cost of equity capital(ke) = Earnings available to equity holders(E)/Total market value of
equity shares (S)
ke = E/S
E = EBIT – I = 25,000 - (100,000 * 10%) = 25,000 -10,000 = 15,000
S =V- D = 200,000 – 100,000 = 100,000
Therefore, ke = E/S = 15,000/100,000 = 15%
• Or….. ke = kw + (kw - kd ) (D/S)
= 12.5% +(12.5% - 10%) * (100,000/100,000)
= 12.5% + 2.5% = 15%
 Modigliani & Miller Framework
• Modigliani-Miller (MM) Propositions-- 3 situations with differing set of
assumptions:
1. World without taxes:
2. World with Corporate Taxes
3. World with Corporate & Personal Taxes
What do the two Propositions say for each of the 3 situations?

oProposition I-- Deals withValue of firm and WAAC

oProposition II-- Deals with RE of firm
 MM Proposition I Without Tax(MM 1958)

o Modern capital structure theory began in 1958, when Professors Franco Modigliani and Merton
Miller published what has been called the most influential finance article ever written

o MM’s Proposition I states that the firm’s value is independent of its capital structure.

o With personal leverage, shareholders can receive exactly the same return, with the same risk, from
a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy
shares of the underpriced firm until the two values equate.This is called arbitrage.

o Arbitrage support for Prop. I: Homemade Leverage can be substituted for Corporate
Leverage i.e firm cannot do anything for the investors that they can’t do for themselves.

o VL =VU = EBIT/Ro
The value of a firm is defined to be the sum of the value of the firm’s debt and the
firm’s equity:

V=B+S

If the goal of the management of the firm is to make

the firm as valuable as possible, the firm should pick
the debt-equity ratio that makes the pie as big as
possible.
Value of levered Firm is equal with value of unlevered firm
 Assumptions of Modigliani and Miller (1958)

o No brokerage costs

o No taxes

o No bankruptcy costs

o Investors can borrow at the same rate as corporations

o All investors have the same information as management about firm’s future
investment opportunities

o EBIT is not affected by the use of debt

 Summary
The value of the firm levered (VL) is equal to the value of the firm unlevered
(VU )
Implications of Proposition I:
A firm’s capital structure is irrelevant.
A firm’s weighted average cost of capital (WACC) is the same no matter what
mixture of debt and equity is used to finance the firm.
 MM’s Proposition II without tax
• The cost of equity for a levered firm equals the constant overall cost of capital plus a
risk premium that equals the spread between the overall cost of capital and the cost
of debt multiplied by the firm’s debt-equity ratio.

• For financial leverage to be irrelevant, the overall cost of capital must remain
constant, regardless of the amount of debt employed.

• This implies that the cost of equity must rise as financial risk increases.
RE = RA + (RA - RD) x (D/E)
where R A is the WACC, RD is the cost of debt, and DE is the debt– equity
ratio.
 Cost of Equity Capital : Example

ABC corporation has a weighted average cost of capital (ignoring taxes) of 12 percent.
It can borrow at 8 percent. Assuming that the company has a target capital structure
of 80 percent equity and 20 percent debt, what is its cost of equity? What is the cost
of equity if the target capital structure is 50 percent equity? Calculate the WACC
using your answers to verify that it is the same .
 Solution
According to M&M Proposition II, the cost of equity, RE, is:
RE= RA + (RA -RD) * (DE )
In the first case, the debt– equity ratio is .2/.8 =.25, so the cost of the equity
is:
RE= 12% + (12% - 8%) *.25 =13%
In the second case, verify that the debt– equity ratio is 1.0, so the cost of
equity is 16 percent
RE= 12% + (12% - 8%) *1 =16%
We can now calculate the WACC assuming that the percentage of equity financing is 80
percent, the cost of equity is 13 percent, and the tax rate is zero:

WACC = (E/V ) * RE + (D/V ) *RD

=(.80* 13% ) + (.20 *8%)
=12%
In the second case, the percentage of equity financing is 50 percent and the cost of
equity is 16 percent. The WACC is:
WACC =(E/V ) *RE + (D/V )* RD
= (.50 *16%) + ( .50 * 8%)
= 12%
As it is calculated, the WACC is 12 percent in both cases.
 Summary
RE = RA + (RA - RD) x (D/E)
where R A is the WACC, RD is the cost of debt, and DE is the debt– equity
ratio.
Implications of Proposition II:
The cost of equity rises as the firm increases its use of debt financing.
The risk of the equity depends on two things: the riskiness of the firm’s operations
(business risk) and the degree of financial leverage (financial risk). Business risk
determines RA; financial risk is determined by D/E
 The MM Proposition I (Corp. Taxes) (MM 1963)

. In 1963, MM published a follow-up paper in which they relaxed the assumption

that there are no corporate taxes

Clearly ( EBIT  rB B )  (1  TC )  rB B 
 EBIT  (1  TC )  rB B  (1  TC )  rB B
 EBIT  (1  TC )  rB B  rB BTC  rB B
The present value of the first term is VU
The present value of the second term is TCB

VL  VU  TC B
 MM Proposition I (Corp. Taxes)

ABC Company expects its EBIT to be birr 85,000 every year forever. The firm can
borrow at 11 percent. The company currently has no debt, and its cost of equity is 18
percent. If the tax rate is 35 percent, what is the value of the firm? What will the
value be if it borrows birr 60,000 and uses the proceeds to repurchase shares?
Value of the unlevered firm Value of the levered firm

VU = EBIT(1 – TC)/RU VL = VU + TC*D

VU = 85,000(1 – .35)/.18 VL = 306,944 + .35(60,000)
VU= 306,944 VL = 306,944 + 21,000
VL = 327,944
 Summary
M&M Proposition I with taxes state the value of the firm levered (VL) is equal to the
value of the firm unlevered (VU) plus the present value of the interest tax shield:
VL =VU + (TC x D)
where TC is the corporate tax rate and D is the amount of debt.

Implications of Proposition I with taxes

Debt financing is highly advantageous, and, in the extreme, a firm’s optimal capital
structure is 100 percent debt.
A firm’s weighted average cost of capital (WACC) decreases as the firm relies more
heavily on debt financing
 World With Corp. Taxes (Prop. II)
• Cost of equity still as B/S
• However, some of the increase in equity risk and return is offset by interest tax shield
• Thus, overall the cost of capital continues to ¯ as leverage

Rs = ro + B/S * (ro - rB) * (1 - TC)

• Ro :Wacc Tc:Tax rate
• S: Equity Rs :cost of equity
• B: Debt Rb :Cost of debt
ABC Company expects its EBIT to be birr 85,000 every year forever. The firm can
borrow at 11 percent. The company currently has no debt, and its cost of equity is
18 percent. what is the cost of equity after recapitalization if it borrows birr 60,000
assuming that the tax rate is 35%. What is the WACC? What are the implications for
the firm’s capital structure decision?
Cost of equity using M&M Proposition II with taxes
RE = RU + (RU – RD)(D/E)(1 – t)
RE = .18 + (.18 – .11)(60,000/327,944)(1 – .35)
RE = .1902 or 19.02%
Using this cost of equity, the WACC for the firm after recapitalization is:
WACC = (E/V)*RE + (D/V)*RD*(1 –TC)
WACC = .1902(266,944/327,944) + .11(1 – .35)(60,000/327,944)
WACC = .1685 or 16.85%

Implication: When there are corporate taxes, the overall cost of capital for the firm declines the
more highly leveraged is the firm’s capital structure.
 Summary
Under M& M Proposition II with taxes, the cost of equity, RE, is:

RE= RU + (RU - RD) x(DE) x (1 - TC)

where RU is the unlevered cost of capital—that is, the cost of capital for the firm if it has
no debt. Unlike the case with Proposition I, the general implications of Proposition II
are the same whether there are taxes or not.
 World With Corporate & Personal Taxes {Miller 1977}

• Merton Miller (this time without Modigliani) later brought in the effects of personal taxes.

• The income from bonds is generally interest, which is taxed as personal income at rates (TB)

• The presence of personal taxes reduces but does not completely eliminate the advantage of debt financing

• Miller (1977)
• Interest on bonds taxed as personal income
• Income from stocks:
• Partly from dividends (taxed as personal income) & partly from capital gains (taxed at lower CG rate Also CG taxes
can be deferred
The cash flows to investors are typically taxed twice. Once at the corporate level
and then investors are taxed again when they receive their interest or dividend
payment or realize their capital gain.
For individuals, interest payments received from debt are taxed as income. Equity
investors also must pay taxes on dividends and capital gains.
Personal taxes reduce the cash flows to investors and can offset some of the
corporate tax benefits of leverage.
The actual interest tax shield depends on both corporate and personal taxes that
are paid.
To determine the true tax benefit of leverage, the combined effect of both
corporate and personal taxes needs to be evaluated.
Including personal taxes in the interest tax shield, therefore, in terms of after-tax
cash flows, debt is more favorable than equity as long as:

Birr 1 *(1-personal income tax rate) >Birr 1 *(1-personal income tax rate) *(1-corporate tax
rate)
We could think of an annual tax shield from using debt, compared to equity, after
corporate and personal taxes as:
((1-personal income tax rate from interest )-(1-corporate tax rate) *(1-personal income tax
rate from equity))*Interest
Where Interest = debt * cost of debt
If we are to consider a perpetual level of Debt and a fixed annual interest
payment, we would get the present value of the interest tax shield as:
PV of interest tax shield = ((1-PITR from interest )- (1-CRT) *(1-PITR from equity))*Interest
Cost of debt* (1-PITR from interest )
Finally, the Effective Tax Advantage of Debt can be seen as:
Tax advantage = 1 - (1 - TC)*(1 - TS)
(1 - TB)
 After-Tax Investor Cash Flows from Birr 1 EBIT
Paid as Paid as dividend/capital Case
interest to gain to equity holders
debt
holders
Pretax Birr 1 Birr 1*(1-corporate tax Corporate
investor cash rate) tax
flow
After tax Birr 1 *(1- Birr 1 *(1-personal Corporate
investor cash ipersonal income tax rate) *(1- tax &
flow income tax corporate tax rate) personal tax
rate)
World With Corporate & Personal Taxes (Prop. I)

VL = VU + PV of tax-shield

PV of tax-Shield = 1 - (1 - TC)*(1 - TS) * B

(1 - TB)
Where
Tc is the corporate tax rate, Ts is the personal tax rate on income from stocks,
and TB is the tax rate on income from debt
49
Effect of Fin. Lev. on Firm Value with both corp. & personal Taxes

 (1  TC )  (1  TS ) 
VL  VU  1  B
 1  T B 

VL = VU+TCB when TS =TB

VL < VU + TCB
when TS < TB
but (1-TB) > (1-TC)×(1-TS)
VU VL =VU
when (1-TB) = (1-TC)×(1-TS)

VL < VU when (1-TB) < (1-TC)×(1-TS)

Debt (B)
Cases 1: if TS = TB , the introduction of personal taxes does not affect our
valuation formula as long as the equity income are taxed identically to interest at
the personal lever and the case will be same as case with only corporate tax
Case 2: if (1 - TC)(1 - TS) = (1 - TB ) , there is no gain from leverage at all.
In other words, the value of the levered firm is equal to the value of the
unlevered firm. This lack of gain occurs because the lower corporate taxes for a
levered firm are exactly offset by higher personal taxes.
Case 3: if (1 - TC)(1 - TS) > 1 – TB then VL < VU. This happens because the personal tax rate on interest is
much higher than the personal tax rate on equity income. In other words, the reduction in corporate taxes from
leverage is more than offset by the increase in taxes from leverage at the personal level Ex: TB = 50%, TS =
18%,Tc = 34%
The reasons that taxes on equity income might be less than debt income [TS < TB] are
o The personal tax rules favored equity because the low tax rate on capital gains.
o The taxes on the capital gains can be deferred until shares are sold

Case 4: if (1 - TC)(1 - TS) > 1 – TB then VL > VU.

Criticisms of MM & Miller Models

Reading Assignment
 Financial Distress
• Financial distress arises when a firm is not able to meet its obligations to debt-holders.

• For a given level of debt, financial distress occurs because of the business (operating) risk .

• with higher business risk, the probability of financial distress becomes greater.

• Determinants of business risk are:

• Operating leverage (fixed and variable costs)

• Cyclical variations

• Intensity of competition

• Price fluctuations

• Firm size and diversification

• Stages in the industry life cycle

 Consequences of Financial Distress
oBankruptcy costs
Specific bankruptcy costs include legal and administrative costs along with the sale of assets at “distress” prices to meet
creditor claims. Lenders build into their required interest rate the expected costs of bankruptcy which reduces the
market value of equity by a corresponding amount.

o Indirect costs
• Investing in risky projects.
• Reluctance to undertake profitable projects.
• Premature liquidation.
• Short-term orientation.
 The static Theory: Traditional view
The static theory states that for a company or investment ,there is an optimal
mix of debt and equity financing that minimizes WAAC and maximizes value.
It is a compromise view between the two extremes of net income approach and
net operating income approach.
The theory that a firm borrows up to the point where the tax benefit from an
extra dollar in debt is exactly equal to the cost that comes from the increased
probability of financial distress
 It recommends that optimal level of the debt is where the marginal benefit of
debt finance is equal to its marginal cost.
Thus, the traditional theory on the relationship between the capital structure and
the value of the firm has three stages, which are discussed as under:
 First Stage: Increasing Value
In this first stage, the cost of equity (Ke) and the cost of debt (Kd) are
constant and cost of debt is less than cost of equity.

The employment of debt capital up to a reasonable level will cause the

overall cost of capital to decline due to the low cost advantage of debt.

As a result, the Ko decreases with increasing leverage, and thus, the total
value of the firm, V, also increases.
 Second Stage: Optimum Value

Once the firm has reached a certain degree of leverage, a further increase in debt
will have no effect on the value of the firm and the cost of capital.

This is because of the fact that a further rise in debt capital increases the risk to
equity shareholders that leads to a rise in Ke.

This rise in Ke exactly offsets the low - cost advantage of debt capital so that the
overall cost of capital(Ko) remains constant, which maximize the value of the firm.
 Third Stage: Declining Value
If the firm involves the debt capital beyond an acceptable level, it will cause an
increase in risk to both equity shareholders and debt – holders, because of which
both cost of equity (Ke) and cost of debt (Kd) start rising in this stage, which will in
turn cause an increase in the overall cost of capital (Ko).
 It can be inferred from the foregoing discussion that the cost of capital (Ko) is a
function of leverage.
The cost of capital declines and the value of the firm increases with a rise in debt
capital up to a certain level and beyond this level, the overall cost of capital (Ko)
tends to rise and as a result the value of the firm will decline
• Therefore, there exists an optimum value of debt to equity ratio at which the WACC
is the lowest and the firm’s market value is the highest.

• Once the firm crosses that optimum value of debt to equity ratio, the cost of equity
rises to give a detrimental effect on theWACC.

• Above the threshold, the WACC increases, and the firm’s market value starts a
downward movement.
 Static Theory: The Optimal Capital Structure and the Value of the Firm

-
 Static Theory: Optimal Capital Structure and the Cost of Capital

.
 The Pie Again
Although it is comforting to know that a firm might have an optimal capital structure when we
take account of such real-world matters as taxes and financial distress costs, it is disquieting to
see the elegant original M&M intuition (that is, the no-tax version) fall apart in the face of these
matters.
Critics of the M&M theory often say that it fails to hold as soon as we add in real-world issues
and that the M&M theory is really just that: a theory that doesn’t have much to say about the real
world that we live in.
In fact, they would argue that it is the M&M theory that is irrelevant, not capital structure.
 The extended Pie Model
In the extended pie model, taxes represent another claim on the cash flows of the firm. Because taxes are reduced
as leverage is increased, the value of the government’s claim (G) on the firm’s cash flows decreases with leverage.

Bankruptcy costs are also a claim on the cash flows. They come into play as the firm comes close to bankruptcy
and has to alter its behavior to attempt to stave off the event itself, and they become large when bankruptcy
actually takes place.Thus, the value of this claim (B) on the cash flows rises with the debt– equity ratio

The extended pie theory simply holds that all of these claims can be paid from only one source: the cash flows
(CF) of the firm.
Algebraically, firms must have:
Cash flow = Payments to stockholders + Payments to creditors + Payments to the
government + Payments to bankruptcy courts and lawyers + Payments to any and all
other claimants to the cash flows of the firm
The value of the firm depends on the total cash flow of the firm.
The firm’s capital structure just cuts that cash flow up into slices without altering the
total.
What is recognized in extended pie, from M&M, is that the stockholders and the
bondholders may not be the only ones who can claim a slice.
The Extended Pie Model
With the extended pie model, there is an important distinction between claims such as
those of stockholders and bondholders, on the one hand, and those of the government
and potential litigants in lawsuits on the other.
 The first set of claims are marketed claims, and the second set are non-marketed claims.
A key difference is that the marketed claims can be bought and sold in financial markets
and the no marketed claims cannot.
When we speak of the value of the firm, we are generally referring to just the value of
the marketed claims,VM, and not the value of the non-marketed claims,VN.
 If we write VT for the total value of all the claims against a company’s cash flows, then:
VT = E + D + G + B + . . .
VT = V M + VN
VL = VU + PV of TS - PV of expected costs of financial distress - PV of agency cost of debt
The essence of our extended pie model is that this total value, VT, of all the
claims to the firm’s cash flows is unaltered by capital structure. However, the
value of the marketed claims, VM, may be affected by changes in the capital
structure.

Based on the pie theory, any increase in VM must imply an identical decrease in
VN.

The optimal capital structure is thus the one that maximizes the value of the
marketed claims or, equivalently, minimizes the value of non-marketed claims
such as taxes and bankruptcy costs.
 Pecking Order Theory

o A key element in the pecking order theory is that firms prefer to use internal financing
whenever possible. . A simple reason is that selling securities to raise cash can be expensive, so it
makes sense to avoid doing so if possible. If a firm is very profitable, it might never need external
financing; so it would end up with little or no debt.

o If external finance is required, firms issue debt first and equity as a last resort.

o The most profitable firms borrow less not because they have lower target debt ratios but
because they don't need external finance.
 Implications of Pecking Order Theory
[

No target capital structure: Under the POT, there is no target or optimal
debt– equity ratio. Instead, a firm’s capital structure is determined by its need for
external financing, which dictates the amount of debt the firm will have.
Profitable firms use less debt: Because profitable firms have greater internal
cash flow, they will need less external financing and will therefore have less debt.
Companies will want financial slack: To avoid selling new equity, companies
will want to stockpile internally generated cash. Such a cash reserve is known as
financial slack. It gives management the ability to finance projects as they appear and
to move quickly if necessary.
 Practical Considerations in Determining Capital Structure
o Nature and size of firm
o Risk
o Cost of capital
o Financial leverage
o Control of business
o Cash flow
o Inflation
o Requirement of investors
o Growth and stability of sales
o Flotation cost
o flexibility and firm’s ability to adapt its capital structure to the needs of the changing conditions
o Capital market conditions