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Capital Structure
Presented
Presented to:
to:
Sir
Sir Usman
Usman

Presented
Presented By:
By:
Mahnoor
Mahnoor Javaid
Javaid (MC-24)
(MC-24)
Samra
Samra Bashir
Bashir (MC-47)
(MC-47)
Nida
Nida Mubashar
Mubashar (MC-25)
(MC-25)
Content of Presentation

1) Meaning of capital structure

2) Objectives of Capital Structure decision
3) Type of Capital Structure Theories
a) Net Income Approach (NI)
b) Net operating income approach (NOI)
c) Modigliani and Miller Approach
d) Traditional Approach
4) Article
capital structure

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 Meaning of CAPITAL STRUCTURE

The capital structure is the particular combination of debt and equity used by

a company to finance its overall operations and growth. Debt comes in the
form of debenture issues or loans while equity may come in the form
of common stock , preferred stock or retained earnings.

Components of Capital Structure

There are three components of capital structure .

● Debt
● Preferred stock
● Equity
Retained Earning
Common Stock
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Objectives of Capital Structure decision

Capital structure aims at the following three important objectives:

1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
3. Maximizes the benefit to the shareholders, by giving best earning per share
and maximum market price of the shares in the long run.

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Type of Capital Structure Theories

Relevance Irrelevance
Approach Approach

Net Income Modigliani-Miller

Approach (NI) (MM)
Net operating
Traditional
income
Approach Approach

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Net Income Approach (NI)

David Durand first suggested this approach in 1952, According to this approach a
firm can increase the value of the firm and reduce the overall cost of capital by
increasing the proportion of debt in its capital structure.
In other words, if there's an increase in the debt ratio, capital structure increases,
and the weighted average cost of capital (WACC) decreases, which results in
higher firm value.

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Cont…..
200000
Debenture
10% interest
With Debt without Debt
EBIT 100000 EBIT 100000

Interest 0000
Interest 20000
EBT 100000
EBT 80000
Tax 40% 40000

Tax 40 % 32000 PAT 60000

PAT 48000 Dividend 20000

Dividend 0000 Retained earning 40000

Retained earning 48000

Tax saving
I×T
20000 × 40%
= 8000 8
Net Income Approach (NI)

This approach is based on some assumption.

There are only two source of finance debt and equity.

The increase the debt will not effect the confidence level of investors.

There are no corporate taxes.

The cost of debt is less than the cost of equity.

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 Net operating income approach (NOI)

This theory is suggested by the Durand , this approach is opposite to the NI

approach . This approach is said that the capital decision of the firm is irrelevant. Any
change in the financial leverage ( debt) will not lead to any change in the total value
of the firm and the market price of the shares as well as the overall cost of capital .

Change in cost of equity Capital

The cost of equity is increase with the degree of leverage. The increases in the
proportion of debt in the capital structure that lead to increase in the financial risk to
the ordinary share holders would expect a higher rate of return on their investments.

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Modigliani and Miller Approach

● The M&M theory is a capital structure approach named Modigliani and 

Merton Miller in the 1950s. This approach considered there is no
relationship between firm value and capital structure as same NOI
approach but MM approach provide the proper operational justification
for the irrelevance . The MM approach maintains that the WACC (over
all cost of capital) not change with a change in the proportion of debt and
equity proportion .

Proposition I Proposition II

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Modigliani and Miller Approach

This approach is based on these assumption.

The perfect capital market.

There is no corporate taxes. The assumption is removed later.

The dividend pay out ratio is 100 %

Business risk is equal among all the firms.

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Modigliani and Miller Approach

.
Proposition I
This proposition says that the total
value of the firm is constant irrespective
of the degree of leverage and the value
of firm is not change but it provide the
operational justification through
arbitrage process.
Proposition II
This proposition is same as the NOI
approach. As debt financing
increase the financial risk and in
this way the cost of equity
increase.

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Traditional Approach

This approach partakes some features of both these approach

NOI & NI . It is midway between the NI and NOI . The Variation in traditional
traditional approach to capital structure advocates that there is a approach
right combination of equity and debt in the capital structure, at • Equity capitalization
which the market value of a firm is maximum. As per this increase only after a
approach, debt should exist in the capital structure only up to a certain level of
specific point, beyond which, any increase in leverage would levearge and not
result in the reduction in value of the firm. before…..
• There is no one
single capital
structure , range of
capital structure….

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 Capital structure

● Article: Capital structure

● Author (s); Stewart C Myers
● Source: The Journal of Economic Perspective Vol. 15, No.2(spring ,
2001)
● Published by :American Economic Association

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Capital structure

● The study of capital structure attempts to explain the mix of securities and
financing sources used by corporation to finance real investment. Most of the
research on capital structure has focused on the proportions of debt vs. equity.

● There is no universal theory of the debt-equity choice and no reason to expect

one. There are several useful conditional theories which are discuss in this
article.

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 Capital structure

● Trade-off Theory;
The trade-off theory of capital structure is the idea that a company chooses how much debt finance and
how much equity finance to use by balancing the costs and benefits an important purpose of the theory is to
explain the act that corporations usually are financed partly with debt and partly with equity. The tradeoff
theory predicts moderate borrowing by tax-paying firms.

Packing Order Theory;

The packing-order theory stating that firms prefer to issue debt rather than equity if internal finance
is insufficient
● Rule 1: use internal financing first
● Rule 2: issue debt next, equity last
Managers choose the least expensive capital first then move to increasingly costly capital when the
lower- cost source of capital are no longer available. 17
 Capital structure

● Free cash flow theory;

● The free cash flow theory says that dangerously high debt levels will increase value, despite the threat
of financial distress when a firm ’s operating cash flow significantly exceeds its profitable
investment opportunities. It is designed for mature firms that are prone to overinvest.

● Modigliani and Miller (1958);

● This theory says that the choice between debt and equity financing has no material effects on the value of the
firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which
financial innovation would quickly put out any deviation from their predicted equilibrium.
● The logic of the Modigliani and Miller (1958) results is now widely accepted.

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 Some Facts about Financing

● Most of the aggregate gross investment by U.S.

nonfinancial corporations has been financed from
internal cash flow. External financing in most years
covers less than 20 percent of real investment, and
most of that financing is debt. . For example, in 1999
internal cash flow financed about 85 percent of
aggregate investment by U.S. nonfinancial
corporations External financing was $139 billion.
Debt ratios vary across industries.
● Debt ratios are also low or negative for many
prominent growth companies. Intangible assets are
also associated with low debt ratios.
● In this article author reported that Debt ratios for U.S.
corporations are generally lower than in other 19
industrialized countries.
 Financial Innovation and the Modigliani'-Miller
Propositions:

Theory of optimal capital structure always start with the Modigliani and Miller (1958) proof that financing doesn't
matter in perfect capital markets.

• Modigliani and Miller's

Proposition 2. It shows why • .Modigliani and Miller's
"there is no magic in (1958) Proposition 1 says
financial leverage." Any that Value of firm is constant,
attempt to substitute "cheap" regardless of the proportions
debt for "expensive" equity of D and E, provided that the
fails to reduce the overall assets and growth
cost of capital because it opportunities are held
makes the remaining equity constant.
still more expensive.
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Financial innovation and the modigliani-miller
proposition:

● We see constant innovation in the design of securities and in new financing schemes.
Innovation proves that financing can matter. If new securities or financing tactics never added
value, then there would be no incentive to innovate.
● Modigliani and Miller's (1958) theory is difficult to test directly, but financial innovation
provides convincing evidence. Because the costs of designing and creating new securities and
financing schemes are low.
● For regulators and policymakers, the Modigliani and Miller propositions are the ideal end
result because All firms would have equal access to capital.
● But for students or practitioners of corporate finance, the Modigliani and Miller propositions
are benchmarks, not end results.

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 Taxes and the Tradeoff Theory

● The tradeoff theory justifies moderate debt ratios. It says that the firm will borrow up to the point
where the marginal value of tax shields on additional debt is just offset by the increase in the present
value of possible costs of financial distress.

● The tradeoff theory is in immediate trouble on the tax front, because it seems to rule out conservative
debt ratios by taxpaying firms. If the theory is right, a value-maximizing firm should never pass up
interest tax shields when the probability of financial distress is remotely low.
● Studies of the determinants of actual debt ratios consistently find that the most profitable companies in
a given industry tend to borrow the least.

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PACKING ORDER THEORY

The Pecking Order Theory, also known as the Pecking

Order Model, relates to a company’s capital structure.
Suggested by Donaldson in 1961 and later modified and
made popular by Stewart Myers and Nicolas Majluf in
1984, 

The pecking order theory arises from the concept

of asymmetric information

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Why the firm prefer the debt over equity ?
. Debt has the prior claim on assets and earnings; equity is
the residual claim.
Eckbo (1986) and Shyam-Sunder (1991) says that, The
announcement of a debt issue should have a smaller
downward impact on stock price than announcement of an
equity issue.
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 Different author’s views related to theory

● This leads to the pecking order theory of

capital structure:
● 1) Firms prefer internal to external finance.
● 2) Dividends are "sticky,"
● 3) If external funds are required for capital
investment, firms will issue the safest
security first, that is, debt before equity. If
internally generated cash flow exceeds
capital investment, the surplus is used to
pay down debt.

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 Testing the Pecking Order vs.
the Tradeoff Theory

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 Different author’s view

Shyam-Sunder and Myers (1999) tested these time-series predictions on a

panel of 157 firms from 1971 to 1989. They found support for both the pecking
order and tradeoff theories. Each showed impressive statistical significance.

The tradeoff theory implies a target-adjustment model (Taggart,

1977; Jalilvand and Harris, 1984; Auerbach, 1985). In this model, firms have a
target debt level or ratio to which they gradually adjust. The target cannot be
observed directly, but proxies can be calculated.

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Cont…..

Shyam-Sunder and Myers (1999) found that the target-adjustment

model worked just as well on these simulated financing decisions as
on the real decisions. The tradeoff theory, expressed as a target-
adjustment model, was "consistent with" financing choices driven
solely by the pecking order

The pecking order says that this financial deficit will be covered
entirely by borrowing, at least at low or moderate debt ratios. If the
deficit is negative, the surplus of internal funds is used to pay down
debt.

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  Investors would like to reward effort, commitment
and good decisions, but these inputs are
imperfectly observable. Even if good performance
on these dimensions were observable by some
informed monitor, the performance would not be
verifiable. A contract offering a bonus for say,
Agency Costs and the Financial
"good decisions" would not be enforceable,
Objective of the Firm because the decisions could not be valuated by a
disinterested outsider or by a c court of law.

 We have assumed that the interests of the firm's financial managers and its shareholders are perfectly aligned,
and that financial decisions are in the shareholders' interest. But perfect alignment is implausible in theory
and impossible in practice.
 Jensen and Meckling (1976) argued for the inevitability of agency costs in corporate finance. Corporate
managers, the agents, will act in their own interests, and will seek higher-than-market salaries, job security
and, in extreme cases, direct capture of assets or cash flows

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Conflicts Between Debt and Equity Investors

● Conflicts between debt and equity

● Managers act in the interests of
investors only arise when there is a stockholders and that the risk of
risk of default. If debt is totally free of default is significant. The managers
default risk, debtholders have no will be tempted to take actions that
interest in the income, value or risk of transfer value from the firm's creditors
the firm. to its stockholders

● But if there is a chance of default, the

● Investor try to write debt contracts
shareholders can gain at the expense according to the nature of risk Debt
of debt investors. Equity is a residual covenants may restrict additional
claim, so shareholders gain when the borrowing, limit dividend payouts or
value of existing debt falls, even when other distributions to stockholders,
the value of the firm is constant. and provide that debt is immediately
due and payable if other covenants are
seriously violated.
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Conclusions

The completes review of the tradeoff, pecking order and free cash flow theories of
capital structure. Although these theories date back to the 1970s and 1980s, there is no
letup in the rate of flow of research. There are convincing examples of all three theories
at work. The economic problems and incentives that drive the theories-taxes,
information and agency costs-show up clearly in financing tactics.

These firms act as organizations, not individuals. They act in the interests of some
group or employees who make, or are affected by, the financial decisions of the firm.
Treynor (1981), Donaldson (1983) and Myers (1993, 2000b) suggest that the firm acts
to maximize the present value of current and future benefits to "insiders." The benefits
come in various forms: cash, over and above opportunity wages; stock or options in the
firm.

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Cont…..

The theories are not designed to be general. They are

conditional theories of capital structure. Each emphasizes
with certain costs and benefits of alternative financing Modigliani-miller theory are
strategies. Because the theories are not general, testing them widely accepted in the
on a broad, heterogeneous sample of firms can be world, but different company
uninformative. The researcher may find statistical results use the different capital
"consistent " two theories because each works for a structure according to the
subsample. nature of the company

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Reference

http://www.investopedia.com
https://corporatefinanceinstitute.com/resources/knowledge/finance
https://www.theinternationaljournal.org
http://www.jstor.org/stable/2696593

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