Copyright © 2015 by McGraw Hill Education (India) Private Limited

Chapter 19
CAPITAL STRUCTURE AND
FIRM VALUE

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 OUTLINE
• Assumptions and Definitions
• Net Income Approach
• Net Operating Income Approach
• Traditional Position
• Modigliani and Miller Position
• Taxation and Capital Structure
• Tradeoff Theory
• Signaling Theory

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 ASSUMPTIONS

To examine the relationship between capital structure and cost

of capital, the following simplifying assumptions are
commonly made:
• No income tax

• 100 percent dividend payout

• Identical subjective probability distributions of

operating income
• No growth

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 FOCUS OF ANALYSIS

I Annual interest charges

rD = =
D Market value of debt

P Equity earnings
rE = =
E Market value of equity

O Operating income
rA = =
V Market value of the firm

D E
rA = rD + rE
D+E D+E

What happens to rD, rE, and rA when financial leverage, D/E, changes?

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 NET INCOME APPROACH
According to this approach, rD and rE remain unchanged when D/E
varies. The constancy of rD and rE with respect to D/E means that rA
declines as D/E increases.
Rates of
return

rE

rA
rD

D/E
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 NET OPERATING INCOME APPROACH
According to this approach the overall capitalisation rate (rA) and the
cost of debt (rD) remain constant for all degrees of leverage. Hence
rE = rA + (rA – rD) (D/E)

Rates of
return
rE

rA

rD

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D/E
 TRADITIONAL POSITION

Rates of
return rE

rA
rD

D/E

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 MODIGLIANI AND MILLER (MM)
POSITION

• Perfect Capital Market

• Rational Investors and Managers

• Homogenous Expectations

• Equivalent Risk Classes

• Absence of Taxation

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 MM PROPOSITION I
The value of a firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is
independent of its capital structure.
V = D + E = O/r
where V = market value of the firm
D = market value of debt
E = market value of equity
O = expected operating income
r = discount rate applicable to the risk class to which
the firm belongs

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 MM PROPOSITION II

The expected return on equity is equal to the expected rate of

return on assets, plus a premium. The premium is equal to the

debt-equity ratio times the difference between the expected

return on assets and the expected return on debt

rE = rA + (rA – rD) (D/E)

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 THE RISK-RETURN TRADEOFF

As leverage increases, equity shareholders require a higher

return because equity beta increases.

E = A + D/E (A - D)

where E = equity beta

A = asset beta

D/E = debt-equity ratio

D = debt beta
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 CRITICISMS OF MM THEORY

• Firms and investors pay taxes

• Bankruptcy costs can be high

• Agency costs exist

• Managers tend to prefer a certain sequence of financing

• Informational asymmetry exists

• Personal and corporate leverage are not perfect

substitutes

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 CORPORATE TAXES
When taxes are applicable to corporate income, debt financing is advantageous
as interest on debt is a tax-deductible expense.
In general
O ( 1 - tC)
V = + tC D
r
where V = value of the firm
O = operating income
tC = corporate tax rate
r = capitalisation rate applicable to the unlevered firm
D = market value of debt
It means:
Value of levered firm = Value of unlevered firm + Gain from leverage
VL = VU + tC D

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 CORPORATE TAXES AND
PERSONAL TAXES
When personal taxes are considered along with corporate taxes, the tax
advantage of a rupee of debt is:
(1 – tc) (1 – tpe)
1–
(1 – tpd)
where tc = corporate tax rate
tpd = personal tax rate on debt income
tpe = personal tax rate on equity income
Example : Suppose tc = 50 percent, tpe = 5 percent, and tpd = 30 percent.
The tax advantage of every rupee of debt is:
(1 – 0.5) (1 – 0.05)
1– = 0.32 rupee
(1 – 0.3)
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LEVERAGE AND FIRM VALUE
IN THE PRESENCE OF TAXES

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 COST OF FINANCIAL DISTRESS
A high level of debt may lead to financial distress that entails
certain costs:
Direct Costs
• Delay in liquidation may diminish asset value
• Distress sale fetches lower price
• Legal and administrative costs are high
Indirect Costs
• Managers become myopic
• Stakeholders dilute their commitment

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 AGENCY COSTS
• There is an agency relationship between the
shareholders and creditors of firms that have
substantial amounts of debt. Hence lenders impose
restrictive covenants and monitor the behaviour of the
firm.

• The loss in efficiency on account of restrictions on

operational freedom plus the cost of monitoring (which
are almost invariably passed on to shareholders)
represent agency costs associated with debt.

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 TRADEOFF MODEL

Value of
the firm Value of the firm considering
the tax advantage of debt

Financial distress costs and

agency costs
Value of the firm considering
the tax advantage and financial
distress and agency costs

Value of the
unlevered firm

D/E

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 PECKING ORDER OF FINANCING
• 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.

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 SIGNALING THEORY
• Noting the inconsistency between trade-off theory and
the pecking order of financing, Myers proposed a new
theory, called the signaling, or asymmetric information,
theory of capital structure.
• A critical premise of the the trade-off theory is that all
parties have the same information and homogeneous
expectations. Myers argued that there is asymmetric
information and divergent expectations which explains
the pecking order of financing observed in practice.

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 SUMMING UP
• Several positions have been taken on the relationship between capital
structure and firm value (or cost of capital)
• According to the net income approach the average cost of capital
declines as the leverage ratio increases
• According to the net operating income approach, the cost of capital does
not vary with capital structure
• According to the traditional approach, the cost of capital decreases upto
a point, remains more or less unchanged for moderate increases in
leverage thereafter, and rises beyond that at an increasing rate
• Modigliani and Miller (MM) restated and amplified the net operating
income approach in terms of two basic propositions: (a) the value of a
firm is independent of its capital structure. (b) The expected return on
equity is equal to the expected return on assets, plus a premium. The
premium is equal to the debt-equity ratio times the difference between
the expected return on assets and the expected return on debt

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• The beta of a firm’s equity may be expressed as:
E = A + D/E (A – D)
• The imperfections in the real world cast their shadow over the leverage
irrelevance theorem of MM
• The value of a firm, when corporate taxation is considered, is :
V = [O (1 – tc) + tcD]/r
• When personal taxes are considered, along with corporate taxes, the
gain in the value per rupee of debt is equal to :
[1 – (1 – tc) (1 – tpe) / (1 – tpd)]
• Considering the tax effect and financial distress and agency costs, the
value of a levered firm is:
Value of the unlevered firm
+ Tax advantage of debt
- Financial distress and agency cost
• In the real world, firms seem to follow a pecking order of financing
which goes as follows; internal finance, debt finance, and external
equity. Myers explains this with the help of the signaling theory

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