Name : Putri Zahra Kirana

Student ID : 210810201255
Subject : Advanced Financial Management

RESUME
CAPITAL STRUCTURE

Capital structure is a balance or comparison between foreign capital and own capital.
Several tools or methods can be used to determine a choice related to capital structure,
including:
a. EBIT-EPS Analysis
b. Comparison of Leverage ratios
c. Company cash flow analysis

Theory
1. Modigliani-Miller (MM) theory
A. MM theory without taxes
• Preposition 1:
➢ The value of the indebted company is equal to the value of the non-
indebted company
• Preposition 2:
➢ The cost of share capital will increase if the company makes or seeks
loans from outside parties
➢ The risk of the equity depends on the risk of the company’s operation
(business risk) and the level of the company debt (financial risk)
B. MM theory with taxes
• Preposition 1:
➢ The value of the company that owes is equal to the value of the
company that doesn't owe plus the tax savings due to interest on the
debt.
• Preposition 2:
➢ The cost of share capital will increase as debt increases, but the tax
savings will outweigh the decline in value due to an increase in the
cost of share capital.

2. Trade-off theory
In determining the optimal capital structure, Trade-off theory incorporates
several factors including taxes, agency costs and financial distress costs, but still
 maintains the assumption of market efficiency and symmetric information as a balance
and benefit of using debt.

3. Pecking Order theory

State the order in which new projects should be funded:
1) Retained earnings
2) Debt
3) Equity
Three factors that the pecking order theory is based on & that must be considered by
firm when raising capital:
• Internal funds are cheapest to use and require no private information release
• Managers tend to know more about the future performance of the firm than lenders and
investors
• Debt financing is cheaper than equity financing
Reason for following Pecking Order theory:
• Easier to use retained earnings than obtaining external finance.
• No cost issues if retained earnings are fixed.
• Investors prefer debt as it is safer security
• Some managers believe that debt issues have a better signaling effect than equity issues
• Their view is the market will interpret debt issues as assign of confidence

Equity Market Timing

Funding decision which issuing equity when high price and buy back when low price called as
equity market timing (Baker & Wurgler, 2002)
The purpose: to exploit temporary fluctuations in the cost of equity against the cost of other
forms of capital
Indefference point:
- If expected EBIT > indefference point, company should use debt.
- If expected EBIT < indefference point, company should use share

Formula:
𝐸𝐴𝑇 (𝑆𝑎ℎ𝑎𝑚) 𝐸𝐴𝑇 (𝑈𝑡𝑎𝑛𝑔)
= 𝐽𝑢𝑚𝑙𝑎ℎ 𝑆𝑎ℎ𝑎𝑚
𝑗𝑢𝑚𝑙𝑎ℎ 𝑆𝑎ℎ𝑎𝑚

(𝐸𝐵𝐼𝑇 𝑥−𝐶1)(1−𝑇) (𝐸𝐵𝐼𝑇 𝑥−𝐶2)(1−𝑇)

=
𝑆1 𝑆2

Keterangan:
C1: Biaya bunga pada alternatif pembelanjaan/pendanaan 1
C2: Biaya bunga pada alternatif pembelanjaan/pendanaan 2
S1: Jumlah saham alternatif pembelanjaan/pendanaan 1
S2: Jumlah saham alternatif pembelanjaan/pendanaan 2
T: Tingkat pajak

Business Risk
Is the single most important determinant of capital structure, and it represents the amount of
risk that is inherent in the firm’s operations even if it uses no debt financing.
Factors that affect business risk:
• Competition
• Demand variability
• Sales price variability
• Input cost variability
• Product obsolescence
• Foreign risk exposure
• Regulatory risk and legal exposure
• The extent to which costs are fixed: operating leverage

Leverage Analysis
To determine the effect of each funding alternative on leverage ratios (use of debt)
Leverage ratios are:
1. Debt ratio
• Total debt/ total assets
• Long-term debt/ (long-term debt + modal)
• Total debt/ modal
2. Coverage ratio
• Time interest earned = EBIT/ cost of interest
• Debt service coverage = EBIT/ [cost of interest + (loan principal payment/1 – tax)]