FINANCIAL MANAGEMENT

FINANCING DECISIONS
SUMMARY CAPITAL STRUCTURE

Financing Decision Process

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 Capital Structure Decision

Capital Structure Theories Designing an Optimal

 Net Income (NI) Approach Capital Structure
 Traditional Approach
 Net Operating Income(NOI)Approach
 Modigliani- Miller (MM) Approach
 Trade-off Theory
 Pecking Order Theory EBIT- EPS Analysis

Capital Structure

D
V/S E
E D

Designing on Optimal Capital Structure :

EBIT – EPS Relationship

EPS 
 EBIT  I  (l  t)  DP
N
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 Steps in sums

STEP 1
STEP 2
Calculation of interest and number of
Calculation of EPS
shares under each alternative

Calculation of EPS

Alternative 1 Alternative 2 Alternative 3

A. EBIT
B. Interest
C. PBT (A-B)
D. PAT@(1-t)%
E. Number of shares
F. EPS (D/E)

Types of Sums

Normal Calculate indifference point.

i.e. the level of EBIT where EPS1 = EPS 2
(Take EBIT = and µ equate )
BEP point where EPS = o
Financial BEP = Interest expenses +
Preference dividend/(l-t)

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  D
 Roi   Roi  i    l  t   ROE
E

In case of unlevered firm

ROE  ROI(l  t)

In case of Preference Dividend (Dp)

 D P
ROE  ROI   ROI  i    l  t   ROI  l  t   D p 
 E E

Capital Structure Theories

Capital Structure Capital Structure

Relevance Irrelevance
Theory Theory

Net Operating Modigliani and

Net Income (NI) Traditional
Income (NOI) Miller (MM)
Approach Approach
Approach Approach

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 Net Income (NI) Approach

As a firm raises more and more debt –

 Kd remains constant (Say 10%)

 Ke remains constant (Say 14%)
 Therefore, Kc Keeps on falling (masti)
Conclusion : Optimum Debt - Equity Ratio – 100%

Traditional Approach

Debt → ↑ses
Kd and Ke → Constant
 Kc falls
But, financial risk →↑ses
 Kd and Kd → rises
 Kc rises

Some Debt – good

Too much debt - bad

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 Kc

B/S

Optimum D/E Ratio

Static trade off theory

Perfect balance between

Trade Advantage of debt

Cost of financial distress

VL  VU  t B  ExpectedBankruptcy Cost

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 Pecking order theory

Info Mgmt.
Asymmetry knows
more

Hence the order in which funds are raised

Retained Earnings Debt External Equity

Assumption of MM Model
• Perfect Markets
• Rational investors
• No taxes
• No transaction cost
• No floatation cost
• No restrictions on short selling
• Fully divisible securities
• No difference between personal and corporate leverage

1. In this section we assume that the firm is a no growth firm and 100% payout
ratio.
EBIT  1  t 
Value of firm (V) =
Kc
Value of Debt(B) = given
PAT
Value of Equity (S) =
Kc
Of course V = B + S

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2. As Per MM Capital Structure decisions
Case I :
MM without taxes
VL= VU
Kc = Kc
B
Ke = Kc +(Kc – i)
S
(No sum comes)

Case II :
MM with taxes
Debt is good because it generates Interest Tax Shield (ITS)

Tax advantage of debt = PV of perpetual ITS

iBt
=  tB
i

EBIT  1  t 
Step 1 : VU 
Kc

Step 2 : Tax advantage of debt –tB

Step 3 : VL = VU + TB

Step 4 : S = VL – B

PAT B
Step 5 : K e  or K e  K c   K c  i  (1  t)
S S

EBIT  1  t 
Step 6 : K c  or Kc = WdKd + WeKe
VL

Here Kc refers to Opportunity Cost of Capital or Discount Rate for the risk class
to which the firm belongs or discount rate for unlevered firm.

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 Optimum Capital Structure

Refers to optimum mix of debt and equity at which K c is minimum and value of
the firm is maximum.

• Financial leverage or Trading on equity

• Growth and stability of sales
• Cost wise , therefore Kd preferred
Factors affecting
• Risk principle (Business risk + Financial risk)
capital structure • Control principle
• Flexibility principle

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