capital structure & value of the firm

7/31/2019 Capital Structure & Value of the Firm

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CAPITAL STRUCTURE & VALUE OF

THE FIRM Capital structure -

A mix of a company's long-term debt, specific

short-term debt, common equity andpreferred equity. The capital structure is howa firm finances its overall operations andgrowth by using different sources of funds


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WEIGHTED AVEREGE COST OF

CAPITAL FORMULA-

C=(E/K)y+(D/K)b(1-X)

where K= D+Ey= expected rate of return on equity

b= expected rate of return on debt

X = corporate tax

D= total debt

E= total equity

K= total capital


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APPROACHES TOWARDS VALUE OF

THE FIRMnet income approach, net operating income approach,and traditional approach are three theoreticalframeworks for how a company should set its debt-

equity mix. All three examine how a company's cost ofcapital changes with the debt-equity mix and search forthe lowest value of the cost of capital, hence themaximum value of the firm, to identify the best mix.They reach different conclusions because they makedifferent assumptions about creditors' and investors'reactions to increasing debt. Each of us will have our ownfeelings about the reasonableness of the assumptions.Without going into the Modigliani-Miller mathematics,

the assumptions of the traditional approach usually seem


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(1) The net income approach makes thesimplest assumptions, that neither creditors

nor investors increase their required rates ofreturn as a company takes on debt. The cost ofcapital declines as higher-cost equity isreplaced with lower-cost debt. This approachconcludes that the optimal financing mix is alldebt


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(2) The net operating income approach assumesthat creditors do not increase their required rate

of return as a company takes on debt, butinvestors do. Further, the rate at which investorsincrease their required rate of return as the

financing mix is shifted toward debt exactlyoffsets the weighting away from the moreexpensive equity and toward the cheaper debt.The result is that the cost of capital remainsconstant regardless of the financing mix. Thisapproach concludes that there is no optimalfinancing mixany mix is as good as any other


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(3) The traditional approach assumes that both

creditors and investors increase their required rates of

return as a company takes on debt. At first this increase

is small, and the weighting toward lower-cost debt

pushes the cost of capital down. Eventually, the rate atwhich creditors and investors increase their required

rates of return accelerates and dominates theweighting toward debt, pushing the cost of capital back

upward. The result is that the cost of capital declines

with debt and reaches a minimum point before rising

again. This approach concludes that there is a optimalfinancing mix consisting of some debt and some equity


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MODIGLIANI & MILLER

PROPOSITIONMEANING-A financial theory stating that themarket value of a firm is determined by itsearning power and the risk of its underlyingassets, and is independent of the way it choosesto finance its investments or distributedividends. Remember, a firm can choosebetween three methods of financing: issuingshares, borrowing or spending profits (as

opposed to dispersing them to shareholders individends). The theorem gets much morecomplicated, but the basic idea is that, undercertain assumptions, it makes no differencewhether a firm finances itself with debt or equity.


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PREPOSITIONS

1

ST

PREPOSITION M&M Proposition I states that the value of a

firm does NOT depend on its capitalstructure. For example, think of 2 firms that

have the same business operations, and samekind of assets. Thus, the left side of theirBalance Sheets look exactly the same. Theonly thing different between the 2 firms is the

right side of the balance sheet, i.e theliabilities and how they finance their businessactivities.


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In the first diagram, stocks make up 70% of the capital structure whilebonds (debt) make up for 30%. In the second diagram, it is the exactopposite. This is the case because the assets of both capital structuresare the exactly same.

M&M Proposition 1 therefore says how the debt and equity isstructured in a corporation is irrelevant. The value of the firm isdetermined by Real Assets and not its capital structure


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2nd PREPOSITION

VL = VU+TCD

VLis the value of a levered firm

VUis the value of an unlevered firm

TCDis the tax rate

the term TCD assumes debt isperpetual


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ASSUMPTIONS OF MODIGLIANI &

MILLERS PROPOSITION Rational investors & managers

Homogeneous expectations

Equivalent risk classes

Absence of tax


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CRITICISMS

Companies are liable to pay taxes on theirincome

Dividend declared should pay dividend tax Agency cost exist because of conflict of

interest between managers & shareholders &between shareholders & creditors

Managers seem to have certain sequence offinancing

capital structure & value of the firm

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