Capital Structure Theories and

Decision
• How do firms choose Capital Structures?
• Can managers affect firm value by
employing different debt/equity mix?
What is the optimal debt-equity
ratio?

• Need to consider two kinds of risk:

– Business risk
– Financial risk
Example of Business Risk
• Suppose 10 people decide to form a
corporation to manufacture disk drives.
• If the firm is capitalized only with common
stock – and if each person buys 10% -- each
investor shares equally in business risk
Example of Relationship Between
Financial and Business Risk
• If the same firm is now capitalized with 50%
debt and 50% equity – with five people
investing in debt and five investing in equity
• The 5 who put up the equity will have to bear
all the business risk, so the common stock will
be twice as risky as it would have been had
the firm been all-equity (unlevered).
 Capital Structure
Capital Structure -- The mix (or proportion) of a firm’s permanent long-
term financing represented by debt, preferred stock, and common
stock equity.

– Concerned with the effect of capital structure decisions

on security prices.
– Assume: (1) investment and asset management
decisions are held constant, and (2) consider only debt-
versus-equity financing.
Types of Capital
Capital structure theories
• Relevant Theory & Irrelevant Theory

• Net Income approach

• Traditional approach

• Net operating income approach

• Modigliani-Miller approach
Traditional Approach
The Modigliani-Miller (MM) Theory
The Modigliani-Miller (MM) Theory
The assumptions of the MM model:
• There are perfect capital markets, with perfect information
available to all investors and no transaction costs.
• The investors are rational.
• The firms can be classified into distinct homogeneous risk
classes.
• There is a zero-tax environment.
• Earnings are perpetual. Future earnings are known and
definite.
• Investment decision are known and are definite.
The Modigliani-Miller (MM) Theory (Contd)

• Only debt and equity are issued in case the firm needs funds and
debt is riskless
• There are no costs of financial distress and liquidation. Under
liquidation condition the shareholders receive an amount equivalent
to the market value of their share before liquidation.
• Individuals can borrow as cheaply as corporations, i.e., r = k. if
investors and firms can borrow at same rate, then the investors can
neutralize any capital structure decision of the firm by creating home
made leverage.
• There are no transaction costs in the arbitrage process.
The Modigliani-Miller (MM) Theory: An
Example
Radhika Alloys Ltd is setup in the outskirts of Gurgaon. The company
requires a capital of INR 10,00,000 for the establishment. The business
to be generated by the investment is likely to have a given systematic
risk, and the required return on that level of systematic risk for an all-
equity firm is 20 per cent. The earnings expected to be generated
annually will be constant at INR 2,00,000 in perpetuity. The generated
earnings will be used to pay out the investors of the firm every year. In
this example, it is assumed that the WACC remains constant at 20 per
cent regardless of the debt–equity ratio.
There are three different capital structures that the firm is considering;
they are:
– Structure 1: All equity (10,000 shares at INR 100 each).
– Structure 2: INR 5,00,000 of debt capital at 10% per annum. Plus
INR 5,00,000 equity capital (5,000 shares at INR 100 each).
– Structure 3: INR 7,00,000 debt capital at 10% per annum. Plus INR
3,00,000 equity capital (3,000 shares at INR 100 each).
Analyse the value of the firm under the three capital structure
alternatives.
The Modigliani-Miller (MM) Theory: An Example (Contd)
Solution
The table below shows the cost of capital analysis for the company:
MM’s THEORY OF IRRELEVANCE
 Trade-off theory
• As per this theory, the optimal debt-equity ratio
depends on balancing the tax advantage of
using debt with the additional distress and
agency cost involved.
 Signaling Theory
• There is a pecking order of financing which goes as
follows:

• Internal finance (retained earnings)

• Debt finance
• External equity finance

• Given the pecking order of financing, there is no well-

defined target debt-equity ratio, as there are two kinds
of equity, internal and external. While the internal
equity is at the top of the pecking order, the external
equity is at the bottom.
Capital Structure Decision
• Maximize the value of firm
• Highest EPS
• Minimum WACC
EBIT-EPS Analysis
• Technique for comparing alternative capital
structures
• Determine the level of EBIT where EPS would
be identical under either debt or equity
financing:

(EBIT – Id) (1 - T) – Dp (EBIT – Ie) (1 – T) – Dp

=
Nd Ne
Debt financing Equity financing
40
EBIT–EPS chart