The Islamia University of Bahawalpur

Department of Management Sciences

Capital Structure Theories

Dr. Amna Noor
The Islamia University of Bahawalpur
Department of Management Sciences
 The Islamia University of Bahawalpur
Department of Management Sciences

Assumptions of the MM model

 Homogeneous expectations
 Perpetual cash flows
 Perfect capital markets
 Perfectcompetition
 Firms and investors can borrow/lend at the same rate
 Equal access to all relevant information
 No transaction costs
 No taxes
 The Islamia University of Bahawalpur
Department of Management Sciences

Example: Consider the all-equity firm Glasgow Inc. that is contemplating

going into debt.
Current Proposed
Assets $20,000 $20,000
Debt $0 $8,000
Equity $20,000 $12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50
 The Islamia University of Bahawalpur
Department of Management Sciences

EPS and ROE under current structure

Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 0 0 0
Net income $1,000 $2,000 $3,000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
 The Islamia University of Bahawalpur
Department of Management Sciences

EPS and ROE under proposed structure

Recession Expected Expansion

EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net income $360 $1,360 $2,360
EPS $1.50 $5.67 $9.83
ROA 5.0% 10.0% 15.0%
ROE 3.0% 11.3% 19.7%
The Islamia University of Bahawalpur
Department of Management Sciences
 The Islamia University of Bahawalpur
Department of Management Sciences

Arbitrage example
 Suppose that the total value of the equity of the unlevered firm is
$20,000 and the total value of the equity of the levered firm is
$12,000. The value of debt of the levered firm is $8,000. The
interest rate is 8%. The EBIT is $2,000 for both firms (perpetuity).
 Mrs. Robinson owns 10% of the equity of the unlevered firm.

 How can Mrs. Robinson profit from this situation (how can she
arbitrage)?
 The Islamia University of Bahawalpur
Department of Management Sciences

 The current investment is: 10% of 20,000 = $ 2,000

 The dollar-return on the current investment is:
10% of 2,000 = $200

Under proposed capital structure

 The current investment is: 10% of 12,000 = $ 1200
 The dollar-return on the current investment is:
10% of 1360 = 136
 The current investment is: 800 of 12,000 = 6.67%
 The dollar-return on the current investment is:
6.67% of 1360 = 92.712
Total return : 136+92=226.57
 The Islamia University of Bahawalpur
Department of Management Sciences

 An alternative for her current investment is

 Lend $800 at 8%
 Buy 10% of the equity in the levered firm for: 10% of
12,000 = $1,200
 Total investment = $2,000
 dollar-return from equity = 10% of (EBIT 2,000 – 8% of
8,000) = $136
 dollar-return from lending = 8% of 800 lending = $64
 Total return = $200
 The Islamia University of Bahawalpur
Department of Management Sciences

Since no investment is required, an investor can create large positions to

secure large levels of profit
In efficient markets, profitable arbitrage opportunities will quickly disappear.
The Islamia University of Bahawalpur
Department of Management Sciences