MODULE 4

 CAPITAL STRUCTURE AND DIVIDEND DECISIONS

4.1 Capital Asset Pricing Model (CAPM)
4.2 Capital Structure, Factors Affecting Capital Structure
4.3 Theories of Capital Structure
4.4 Dividend Decisions, Dividend Policies, Dividend & its
Forms – Objectives of Dividend Policy – Dividend Payout
Ratio
4.5 Dividend Yield – Stock Split, Reverse Split, Buyback of
Shares
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM)
It is a model that describes the relationship between
risk and expected return and that is used in the pricing
of risky securities. It helps to calculate investment risk
and what return on investment we should expect. It
shows that the expected return on a security is equal to
the risk-free return plus a risk premium, which is
based on the beta of that security.
Beta coefficient is a measure of sensitivity of a
company's stock price to movement in the broad
market index. It is an indicator of a stock's systematic
risk which is the undiversifiable risk inherent in the
whole financial system. Beta coefficient is an
important input in the capital asset pricing model
(CAPM).
Capital Asset Pricing Model
Ra= Rrf + Ba (Rm-Rrf)
Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)
 The capital asset pricing model (CAPM) is the equation
that describes the relationship between the expected return
of a given security and systematic risk as measured by its
beta coefficient. Besides risk the model considers the effect
of risk-free interest rates and expected market return.
Assumptions
Basic assumptions of the CAPM model are as follows.
Markets are ideal—no transaction fees, taxes,
inflation, or short selling restrictions.
All investors are averse to risk.
Markets are highly efficient. All investors have equal
access to all available information.
All investors can borrow and lend unlimited amounts
under a risk-free rate.
Beta coefficient is the only measure of risk.
The risk-free rate of return is currently 0.04, whereas the
market risk premium is 0.06. If the beta of RKP, Inc.,
the stock is 1.4, then what is the expected return on
RKP?
Solution:
Expected return = Risk free rate + (Beta * Market Risk
Premium)
Expected return = 0.04 + (1.4 * 0.06)
Expected return = 0.04 + 0.084
Expected return = 0.124
Expected return = 12.4%
Expected return on RKP = 12.4%
Capital Asset pricing model is a method used to
determine the expected return from the common
stock. This model uses the risk-free rate of return, the
market rate of return, and the beta of the stock to
calculate the expected return.
Capital Structure, Factors Affecting Capital Structure
Capital structure is that part of financial structure, which
represents long-term sources. The term capital
structure is generally defined to include only long-term
debt and total stockholders investment. It is the mix of
long-term sources of funds, such as equity shares,
reserves and surpluses, preference share capital,
debentures and long-term debt from outside sources .
In other words, capital structure refers to the
composition of capitalisation,that is ,to the proportion
between debt and equity that make up capitalisation.
Capital structure=Long-term debt+Preferred stock+Net
worth.
Or Capital structure= Total Assets-Current Liabilities.
Financial structure refers to all the financial resources
marshalled by the firm, long-term as well as short-term
sources.
Optimum Capital Structure
Optimum capital structure is that capital structure at
that level of debt-equity proportion where the market
value per share is maximum and the cost of capital is
minimum. The optimum capital structure keeps a
balance between share capital and debt capital. The
primary reason for the employment of debt by an
enterprise can be stated as that up to a certain point,
debt is from the point of view of the ownership, a less
expensive source of fund than equity capital. Hence
optimum capital structure keeps a balance between
debt and equity capital.
Factors affecting capital structure (Features)
Factors Determining Capital Structure
Trading on Equity- The word “equity” denotes the ownership of the company. Trading on
equity means taking advantage of equity share capital to borrowed funds on reasonable
basis. It refers to additional profits that equity shareholders earn because of issuance of
debentures and preference shares. It is based on the thought that if the rate of dividend on
preference capital and the rate of interest on borrowed capital is lower than the general
rate of company’s earnings, equity shareholders are at advantage which means a company
should go for a judicious blend of preference shares, equity shares as well as debentures.
Trading on equity becomes more important when expectations of shareholders are high.

Degree of control- In a company, it is the directors who are so called elected

representatives of equity shareholders. These members have got maximum voting rights in
a concern as compared to the preference shareholders and debenture holders. Preference
shareholders have reasonably less voting rights while debenture holders have no voting
rights. If the company’s management policies are such that they want to retain their voting
rights in their hands, the capital structure consists of debenture holders and loans rather
than equity shares.
3.Flexibility of financial plan- In an enterprise, the
capital structure should be such that there is both
contractions as well as relaxation in plans. Debentures
and loans can be refunded back as the time requires.
While equity capital cannot be refunded at any point
which provides rigidity to plans. Therefore, in order to
make the capital structure possible, the company
should go for issue of debentures and other loans.
 4.Choice of investors- The company’s policy generally is
to have different categories of investors for securities.
Therefore, a capital structure should give enough choice
to all kind of investors to invest. Bold and adventurous
investors generally go for equity shares and loans and
debentures are generally raised keeping into mind
conscious investors.
5.Capital market condition- In the lifetime of the
company, the market price of the shares has got an
important influence. During the depression period, the
company’s capital structure generally consists of
debentures and loans. While in period of booms and
inflation, the company’s capital should consist of share
capital generally equity shares.
6.Period of financing- When company wants to raise finance for short
period, it goes for loans from banks and other institutions; while for
long period it goes for issue of shares and debentures.
7.Cost of financing- In a capital structure, the company has to look to
the factor of cost when securities are raised. It is seen that debentures
at the time of profit earning of company prove to be a cheaper source of
finance as compared to equity shares where equity shareholders
demand an extra share in profits.
8.Stability of sales- An established business which has a growing
market and high sales turnover, the company is in position to meet
fixed commitments. Interest on debentures has to be paid regardless of
profit. Therefore, when sales are high, thereby the profits are high and
company is in better position to meet such fixed commitments like
interest on debentures and dividends on preference shares. If company
is having unstable sales, then the company is not in position to meet
fixed obligations. So, equity capital proves to be safe in such cases.
Theories of Capital Structure
1.Net Income Approach
2.Net operating Income Approach
3.The Traditional Approach
4.Modigliani and Miller Approach.

Net Income Approach(NI)

According to this approach, a firm can minimise the
weighted average cost of capital and increase the value
of the firm as well as market price of equity shares by
using debt financing to the maximum possible extent.
The theory propounds that a company can increase its
value and decrease the overall cost of capital by
increasing the proportion of debt in its capital structure.
This approach is based upon the following assumptions:
(i)The cost of debt is less than the cost of equity.
(ii)There are no taxes.
(iii)The risk perception of investors is not changed by the
use of debt.
It is argued that as the proportion of debt financing in
capital structure increases, the proportion of a less
expensive source of funds increases. This results in the
decrease in overall(weighted average)cost of capital
leading to an increase in the value of the firm.
The reasons for assuming cost of debt to be less than the
cost of equity are that interest rates are usually lower
than dividend rates due to element of risk and the
benefit of tax as the interest is a deductible expense.
On the other hand, if the proportion of debt financing
in the capital structure is reduced or when the
financial leverage is reduced, the weighted average cost
of capital of the firm will increase and the total value
of the firm will decrease.
2.Net Operating Income Approach
This theory as suggested by Durand is another extreme
of the effect of leverage on the value of the firm. it is
diametrically opposite to the net income approach.
According to this approach, change in the capital
structure of a company does not affect the market value
of the firm and the overall cost of capital remains
constant irrespective of the method of financing.
It implies that the overall cost of capital remains the same whether
the debt equity mix is 50:50 or 20:80 or 0:100.Thus there is
nothing as an optimal capital structure and every capital
structure is the optimum capital structure. This theory
presumes that:
(i)The market capitalises the value of the firm as a whole.
(ii)The business risk remains constant at very level of debt equity
mix.
(iii) There are no corporate taxes.
The reasons propounded for such assumptions are that the
increased use of debt increases the financial risk of the equity
shareholders and hence the cost of equity increases. On the
other hand, the cost of debt remains constant with the
increasing proportion of debt as the financial risk of the lenders
is not affected.
Thus the advantage of using the cheaper source of funds,
that is, debt is exactly offset by the increased cost of
equity.
According to the Net Operating Income(NOI) approach,
the financing mix is irrelevant and it does not affect
the value of the firm.
3.The Traditional Approach
The traditional approach also known as Intermediate
approach, is a compromise between the two extremes of
net income approach and net operating income
approach. According to this theory, the value of the firm
can be increased initially or the cost of capital can by
using more debt decreased bt as the debt is a cheaper
source of funds than equity. Thus optimum capital
structure can be reached by a proper debt-equity mix.
Beyond a particular point, the cost of equity increases
because increased debt increases the financial risk of
the equity shareholders. The advantage of cheaper debt
at this point of capital structure is offset by increased
cost of equity.
4.Modigiani and Miller Approach
M&M hypothesis is identical with the net operating income
approach if taxes are ignored. However when corporate
taxes are assumed to exist, their hypothesis is similar to
the net income approach.
(a) In the absence of taxes(Theory of Irrelevance)
The theory proves that the cost of capital is not affected by
changes in the capital structure or say that the debt-equity
mix is irrelevant in the determination of the total value of
a firm. The reason argued is that though debt is cheaper to
equity, with increased use of debt as a source of finance
increases the financial risk and the cost of equity. This
increase in cost of equity offsets the advantage of the low
cost of debt.
Net result of this process is the overall cost of capital remain
unchanged. The theory emphasizes the fact that a firm’s
operating income is a determinant of its total value.
(b) When there are corporate taxes(Theory of Relevance)
MM argued that the capital structure would affect the cost of
capital and the value of the firm even there are corporate
taxes. In any firm having debt content in its capital
structure, the cost of capital will decrease and the market
value of the shares increases. A levered firm should have
therefore a greater market value as compared to an
unlevered firm. The value of the firm will increase or the
cost of capital will decrease with the use of debt on account
of deductibility of interest charges for tax purpose. Thus
the optimum capital structure can be achieved by
maximising the debt mix in the equity of a firm.
Assumptions
The MM hypothesis is based upon the following
assumptions:
i.There are no corporate taxes.
ii.There is a perfect market.
iii.100% payment to shareholders, that is, all the earnings
are distributed to the shareholders.
iv.There are no transaction costs.
v. All the firms can be grouped into homogenous risk
classes. Investors’ expected earnings have identical risk
characteristics.
Arbitrage Process
Arbitrage means buying of an asset or any security in one
market at low price and selling it to another market at a
higher price. The impact of such action is that the
market value of the securities of both the firms are
similar in all respects except in their capital structures.
It restores the equilibrium value of the securities.
For example, two firms namely X and Y are identical
except that Y uses debt content in its capital structure
while X does not have debt in its capital structure. The
market value of the firm Y is higher than the market
value of the firm X.Investors in firm Y will sell their
shares in the overvalued firm. And at the same time they
will buy the shares in under valued firm.
Dividend
The term dividend refers to that part of the earnings or profits
of a company which is distributed among its shareholders on
the basis of their shareholding. It is the reward to the
shareholders for their investments made in the company.
According to the Institute of Chartered Accountants of India,
Dividend is a distribution to shareholders out of profits or
reserves available for this purpose.
Dividend Policy
Dividend policy means it is the policy of the company with
regard to quantum of profits to be distributed as dividend.
The basic concept of the dividend policy is that the company
desires and take any future action regarding the payment of
dividend with the help of the company law board.
The main objectives of a dividend policy are
i. Wealth Maximization:
According to some schools of thought dividend policy has
significant impact on the value of the firm. Therefore the
dividend policy should be developed keeping in mind the
wealth maximization objective of the firm.
ii. Future Prospects:
Dividend policy is a financing decision and leads to cash
outflows and also leads to decrease in availability of cash
for financing of profitable projects. If sufficient funds are
not available, a firm has to depend on external financing.
Therefore the dividend policy needs to be devised in such a
manner that prospective projects may be financed through
retained earnings.
iii. Stable Rate of Dividend:
Fluctuation in the rate of return adversely affects the
market price of shares. In order to have a stable rate of
dividend, a firm should retain a high proportion of
earnings so that the firm can keep sufficient funds for
payment of dividend when it faces loss.
iv. Degree of Control:
Issue of new shares or dependence on external
financing will dilute the degree of control of the
existing shareholders. Therefore, a more conservative
dividend policy should be followed in order that the
interest of existing shareholders is not hampered.
Forms of dividend policy
1. Stable dividend policy
The term stable dividend means when the company
maintains more or less stable rate of dividend. It may be
in three forms:
 Constant dividend per share
 Constant payout ratio
 Stable rupee dividend plus extra dividend.
 2.Regular dividend policy
 Regular dividend policy indicates that the payment of
dividend at the usual rate. If a concern follows a regular
dividend policy, automatically it creates confidence
among the shareholders.
3.Policy to pay irregular dividend
It implies when the company follows this policy ,it could not
pay the regular dividend because the company has uncertainty
of earnings or inadequate profit. As per this policy, if the
company earns a higher amount of profit it could pay a higher
rate of dividend. If there is no profit in any particular year, the
company does not declare dividend to its shareholders.
4.Policy of no immediate dividend.
A company may follow a policy of paying no dividends
immediately even when it earns huge amount of profit. This is
due to its unfavourable working capital position or on account
of requirements of funds for future expansion.
Forms of Dividend
1.Cash dividend
 Dividend is paid to the shareholders in the form of
cash is called cash dividend. The usual practice
followed by the company is to pay dividend in cash. The
firm should maintain adequate cash resources for
payment of cash dividend.
2.Bond dividend
The company does not have sufficient cash reserves to
pay the dividend, it may issue bonds as against the
amount due to the shareholders by way of dividend is
known as bond dividend. It is not popular in India.
3.Property Dividend
Property dividend are those which can be paid by the
company to its shareholders in the form of property
instead of payment of dividend in cash.
4.Stock dividend
 Payment of stock dividend is popularly known as
issue of bonus shares in India.In any particular year,if
the company does not have an adequate cash reserves,it
must decide to pay dividend in the form of shares.
5.Scrip Dividend
 Scrip dividend refers to when a company instead of
automatically giving their shareholders a cash dividend,
gives their shareholders the choice of either receiving a
cash dividend or the equivalent in additional shares of
the company.
Dividend payout ratio
The dividend payout ratio is the ratio of the total
amount of dividends paid out to shareholders relative
to the net income of the company. It is
the percentage of earnings paid to shareholders
in dividends. It is sometimes simply referred to as the
'payout ratio.
In finance, the dividend-payout ratio is a way of
measuring the fraction of a company's earnings that are
paid to investors in the form of dividends rather than
being re-invested in the company in a given time
period (usually one year).
In general, companies with higher dividend-payout
ratios tend to be older, more established companies
that have already grown significantly, while companies
with low payout ratios tend to be younger companies
with high growth potential.
Dividend payout ratio = Dividend per share
 Earnings per share
Dividend Yield – Stock Split, Reverse Split, Buyback of
Shares
The dividend yield, expressed as a percentage, is a
financial ratio that shows how much a company pays
out in dividends each year relative to its stock price.
The reciprocal of the dividend yield is the dividend 
payout ratio.
Dividend yield = Dividend per share
 Market price per share
Stock split
Stock split is an issue of new shares in a company to
existing shareholders in proportion to their current
holdings. A stock split or stock divide increases the number
of shares in a company. A stock split causes a decrease of
market price of individual shares, not causing a change of
total market capitalization of the company. 
Reverse split
A reverse stock split is a type of corporate action which
consolidates the number of existing shares of stock into
fewer, proportionally more valuable shares. The process
involves a company reducing the total number of
its outstanding shares in the open market, and often
signals a company in distress.
A reverse stock split does not directly impact a
company's value.
A reverse stock split, however, often signals a company
in distress since it raises the value of otherwise low-
priced shares.
Stock buybacks
It refer to the repurchasing of shares of stock by the
company that issued them. A buyback occurs when
the issuing company pays shareholders the market
value per share and re-absorbs that portion of its
ownership that was previously distributed among
public and private investors.