BMS Sem IV: Financial Management

Unit II (Cost of Capital) + Unit III Study Material

Table of Contents

Unit II: Cost of Capital............................................................................................. 2

Unit III: Leverage Analysis .................................................................................... 25
Unit III: EBIT – EPS Analysis .................................................................................. 39
Unit III: Capital Structure ...................................................................................... 54
Unit III: Dividend Decision .................................................................................... 77

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 Unit II: Cost of Capital

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 Unit III: Leverage Analysis

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 Unit III: EBIT – EPS Analysis

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 Unit III: Capital Structure

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 Trade-off Theory of Capital Structure
The trade-off theory states that the optimal capital structure is a trade-off between interest tax shields
and cost of financial distress.
Value of firm = Value if all-Equity Financed + PV (Tax Shield) – PV (Cost of Financial Distress)
The trade-off theory can be summarized graphically. The starting point is the value of the all-equity
financed firm illustrated by the black horizontal line in Figure 10. The present value of tax shields is then
added to form the red line. Note that PV (Tax Shield) initially increases as the firm borrows more, until
additional borrowing increases the probability of financial distress rapidly. In addition, the firm cannot be
sure to benefit from the full tax shield if it borrows excessively as it takes positive earnings to save
corporate taxes. Cost of financial distress is assumed to increase with the debt level.
The cost of financial distress is illustrated in the diagram as the difference between the red and blue curve.
Thus, the blue curve shows firm value as a function of the debt level. Moreover, as the graph suggest an
optimal debt policy exists which maximized firm value.
In summary, the trade-off theory states that capital structure is based on a trade-off between tax savings
and distress costs of debt. Firms with safe, tangible assets and plenty of taxable income to shield should
have high target debt ratios. The theory is capable of explaining why capital structures differ between
industries, whereas it cannot explain why profitable companies within the industry have lower debt ratios
(trade-off theory predicts the opposite as profitable firms have a larger scope for tax shields and therefore
subsequently should have higher debt levels).

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 Pecking Order Theory of Capital Structure
Pecking order theory is a theory related to capital structure. It was initially suggested by Donaldson. In
1984, Myers and Majluf modified the theory and made it popular. According, to this theory, managers
follow a hierarchy to choose sources of finance. The hierarchy gives first preference to internal financing.
If internal financing is not enough, then managers would have to shift to external sources. They will issue
debt to generate funds. After a point when it is no longer practical to issue more debt, equity is issued as
a last option.

Internal Financing Vs External Financing

The pecking order theory begins from the asymmetry of information in the organization. Asymmetric
information is an unequal distribution of information. The managers generally have more information
about company’s performance, prospects and risks than outside creditors or investors. Some companies
have a high level of asymmetric information like companies with a complex or technical product,
companies with less accounting transparency etc. Higher the asymmetry of information, higher the risk in
the company. Also, it is not possible for the investors to know everything about a company. So, there will
always be some amount of information asymmetry in every company. If a creditor or an investor has less
information about the company, he/she will demand higher returns against the risk taken. Along with
providing higher returns, the company will have to incur costs to issue the debt and equity. It will also have
to incur some agency cost like paying the board of directors’ fees to ensure shareholders’ interests are
maximized. All these reasons make retained earnings a cheaper and convenient source of finance than
external sources.

Debt Financing Vs Equity Financing

If a company does not have sufficient retained earnings, then it will have to raise money through external
sources. Managers would prefer debt over equity because the cost of debt is lower compared to the cost
of equity. The company issuing new debt will increase the proportion of debt in the capital structure and
it will provide a tax shield. So, this will reduce the weighted average cost of capital (WACC). After a certain
point, increasing the leverage in capital structure will be very risky for the company. In such scenarios, the
company will have to issue new equity shares as a last resort.

Signals from the Choice of Finance

Company’s choice of finance sends some signals in the market. If a company is able to finance itself
internally, it is considered to be a strong signal. It shows that company has enough reserves to take care
of funding needs. If a company issues a debt, it shows that management is confident to meet the fixed
payments. If a company finances itself with new stock, it’s a negative signal. The company generally issues
new stock when it perceives the stock to be overvalued.

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 Unit III: Dividend Decision

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