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Capital Structure
Structure
Determination
Determination
After Studying this topic,
you should be able to:
1. Define “capital structure.”
2. Explain the net operating income (NOI) approach to capital
structure and valuation of a firm; and, calculate a firm's value
using this approach.
3. Explain the traditional approach to capital structure and the
valuation of a firm.
4. Discuss the relationship between financial leverage and the cost
of capital as originally set forth by Modigliani and Miller (M&M)
and evaluate their arguments.
5. Describe various market imperfections and other "real world"
factors that tend to dilute M&M’s original position.
6. Present a number of reasonable arguments for believing that an
optimal capital structure exists in theory.
7. Explain how financial structure changes can be used for
financial signaling purposes, and give some examples.
Capital Structure
Determination
• A Conceptual Look
• The Total-Value Principle
• Presence of Market Imperfections and
Incentive Issues
• The Effect of Taxes
• Financial Signaling
Capital Structure
Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
Capitalization Rate
B S
ko = ki + ke
B+S B+S
0
0 0.25 0.50 0.75 1.0 1.25 1.50 1.75 2.0
Financial Leverage (B/S)
Summary of NOI Approach
• Critical assumption is ko remains
constant.
• An increase in cheaper debt funds is
exactly offset by an increase in the
required rate of return on equity.
• As long as ki is constant, ke is a linear
function of the debt-to-equity ratio.
• Thus, there is no one optimal capital
structure.
structure
Traditional Approach
ke
0.25
ko
0.20
Capital Costs (%)
0.15
ki
0.10
Optimal Capital Structure
0.05
0
Financial Leverage (B / S)
Excel and the
Traditional Approach
Traditional
Approach