Professional Documents
Culture Documents
Capital Structure
Capital Structure
Theories
In this chapter
Capital Structure
Profitability
solvency
Flexibility
Conservation
control
Flexibility
Industry leverage ratios
Degree of competition
Agency cost
Timing of public issue
Period of finance
Legal requirements.
3.
4.
risk
MM Hypothesis
Assumptions
a.
b.
c.
d.
e.
f.
g.
h.
i.
Propositions:
I. Ko and V are independent of capital structure
II. Ke = to capitalisation rate of the pure equity plus a
premium for financial risk.
Ke increases with the use of more debt. Increased Ke
off set exactly the use of a less expensive source of
funds (debt)
III.The cut of rate for investment purposes is completely
independent of the way in which an investment is
financed.
MM Approach [Proposition I]
arbitrage Progress:
Limitations of MM Approach
Traditional Approach
Main Prepositions
1. The pretax cost of debt (Ki) remains more or less constant up to a certain
degree of leverage and /but rises thereafter of an increasing rate
2. The cost of equity capital (Ke) remains more or less constant rises slightly up
to a certain degree of leverage and rises sharper there after, due to increased
perceived risk.
3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of
debt (Ki) and cost of equity (Ke) behavior the following manner: It
(a) Decreases up to a certain point level of degree of leverage [stage I increasing
firm value];
(b) Remains more or less unchanged for moderate increase in leverage
thereafter [stage II optimum value of firm], and
(c) Rises sharply beyond certain degree of leverage [stage III decline in firm
value].