CHAPTER 8 Theories of Capital Structure


Controversy of Capital structure Arbitrage effects Optimum capital structure Signaling effects

16) Tk.15 15/1=Tk.24 Moderately levered firm 3 Tk.200 Tk.25 (Tk.15 Tk.Leverage effect of EPS All Equity firm No.21 Highly levered firm 1 Tk.50 each) 4 Equity 10% Bond Total Assets Return on Assets (20%) Interest payments Taxable Income Tax 40% Net Income EPS Tk.150 Tk.10) Tk.40 Tk.200 Tk.200 Tk.35 (Tk.14) Tk.6 21/3=Tk. of Shares (Tk.150 Tk.50 Tk.40 Nil Tk.50 Tk.15 1-2 24/4=Tk.200 Nil Tk.5 Tk.40 Tk.40 (Tk.7 .

Capital Structure Controversy   Relevancy Proposition: Advantage of leverage observed in the last slide demonstrates that firm can maximize wealth by increasing its debt rather than profitability.) 1-3 .) Advantage of leverage may also be compensated by bankruptcy cost and agency cost. (See the following slide. Irrelevancy Proposition: Modigliani-Miller (M-M) argues that wealth can not be influenced by anything other than profitability. (See the next slide. This is the relevancy proposition of capital structure. So there may be arbitrage effects to adjust the price to give the same return on investment.

Arbitrage effect: Irrelevancy Proposition Price S3 150 D3 S2 70 60 S1 D2 D1 Quantity of Shares 1-4 .

Optimum Capital Structure Value of the firm Relevancy proposition Bankruptcy and agency cost Actual Irrelevancy Proposition Optimum Capital structure Debt/Assets 1-5 .

CHAPTER 10 Theories of Dividend Policy      Controversy of dividend policy Bird-in-hand view MM proposition of irrelevancy Signaling effects Clientele effect 1-6 .

1-7 .Theories of dividend policy  Dividend policy relates to the company decision to payout the dividends out of the earnings. or low payout firm having lower share price. Like high payout firms having higher shares price. Or vice versa. Theories of dividend policy relates such management decision to the value of the firm. The management has the choice to go for no distribution to full distribution of earnings.

Tax preference: Investors prefer a low payout. 1-8 .Theories of dividend policy  Three theories of dividend policy:    Dividend irrelevance: Investors don t care about payout. Bird-in-the-hand: Investors prefer a high payout.

Distribution of dividend is just an alternative to capital gain. If investors expect high payout of dividends when the firm goes for low payout of dividends. then investors can buy more shares by the dividend earnings.MM Proposition of Irrelevancy Dividend irrelevance: Investors don t care about payout. In that case. then they can sell part of their stock as the share price increases. and realize the cash. Conversely. Such home made dividend policy suggests that changing the dividend policy a firm can not maximize its share price 1-9 . MM argues that dividend distribution policy should not be related to the value of the firm. The undistributed dividends should increase the share price by the same amount. For example. people can go for home-made dividend policy. if the investors likes less dividends when the firm goes for high payout.

1-10 . like bird in-bush. distribution of dividend is an immediate gain like birdin-hand. Because.Bird-in-the-hand: Investors prefer a high payout. but increase in share price (in consequence of retention) is not so certain.  This group believes that stock holders like more payout firms rather than low payout firm.

So the apparent advantage of dividend income in terms of certain income is neutralized. 1-11 . So after tax income in case of retention is more than the after tax income from dividend earnings of the same amount. Capital gain tax is less than dividend tax.Tax Effects  MM argued that if a firm goes for retention then investors realize capital gain.

Clientele Effects suggest that every firm should stick to the same dividend policy no matter what is the nature of it. when a good firm goes for high distribution. 1-12 . When a good firm goes for retention.Other factors   Signaling effects suggest that distribution or retention of dividends gives a signal. investors take the signal negatively. so share price increases. like the firm is suffering from inadequate liquidity. Similarly. so share price goes down. investors take the signal positively like the firm has attractive investment opportunity. investors think that the firm lacks investment opportunity so share price goes down. Different types of investors with different preference pattern can then select the right firm that suits him the best. then investors think that the firm has strong liquidity. If a bad firm does the same. If a bad firm does the same.

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