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Capital Structure and Firm Value

The document discusses Modigliani and Miller's position on capital structure and firm value. It presents their proposition that firm value is independent of capital structure under certain assumptions. It then discusses criticisms of the MM theory including the impact of taxes, bankruptcy costs, agency costs, financing preferences, information asymmetry, and substitutability of personal and corporate leverage. Later sections discuss how firm value is impacted by taxes, financial distress costs, agency costs, and optimal capital structure.

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48 views18 pages

Capital Structure and Firm Value

The document discusses Modigliani and Miller's position on capital structure and firm value. It presents their proposition that firm value is independent of capital structure under certain assumptions. It then discusses criticisms of the MM theory including the impact of taxes, bankruptcy costs, agency costs, financing preferences, information asymmetry, and substitutability of personal and corporate leverage. Later sections discuss how firm value is impacted by taxes, financial distress costs, agency costs, and optimal capital structure.

Uploaded by

chandan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CAPITAL STRUCTURE AND

FIRM VALUE
MODIGLIANI AND MILLER (MM)
POSITION

•  Perfect Capital Market

•  Rational Investors and Managers

•  Homogenous Expectations

•  Equivalent Risk Classes

•  Absence of Taxation
MM PROPOSITION
The value of a firm is independent of its capital structure.
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
MM IN WORLD OF TAXES
When taxes are applicable to corporate income, debt financing is
advantageous as interest on debt is a tax-deductible expense.
Value of levered firm = Value of unlevered firm + Gain from leverage
VL = VU + tC D
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
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.
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
The Optimal Capital
Structure
Graphically
Ke
Cost
(%)
WACC
K
e
Kd

K
d

0 Target
Capital TD/TA
Structu (%)
re
The Optimal Capital
Structure
Firm Graphically
Value

V = EBIT (1 - t)
WACC

0 Target
Capital TD/TA
Structure (%)
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.
PECKING ORDER OF FINANCING

Some Implications:

Internal equity may be better than external equity.

Financial slack is valuable.

If external capital is required, debt is better. (There is less room for


difference in opinions about what debt is worth).
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.
EBIT – EPS ANALYSIS

The relationship between EBIT and EPS is as follows:

(EBIT – I) (1 – t)
EPS =
n
EARNINGS PER SHARE UNDER
ALTERNATIVE FINANCING PLANS

Current Capital Structure: 10,00,000 equity shares@ 10 each


= Rs. 1,00,00,000

Additional Rs. 1,00,00,000 to be raised

Alternatives:
Issue 10,00,000 equity shares @ 10 each
Take debt of Rs. 1,00,00,000 at 14 %
EARNINGS PER SHARE UNDER
ALTERNATIVE FINANCING PLANS

Equity Financing Debt Financing


EBIT : 2,000,000 EBIT : 4,000,000 EBIT : 2,000,000 EBIT : 4,000,000

Interest - - 1,400,000 1,400,000


Profit before taxes 2,000,000 4,000,000 600,000 2,600,000
Taxes 1,000,000 2,000,000 300,000 1,300,000
Profit after tax 1,000,000 2,000,000 300,000 1,300,000
Number of equity
shares 2,000,000 2,000,000 1,000,000 1,000,000
Earnings per share 0.50 1.00 0.30 1.30
BREAK-EVEN EBIT LEVEL

The EBIT indifference point between two alternative


financing plans can be obtained by solving the following
equation for EBIT*

(EBIT *– I1) (1 – t) (EBIT *– I2) (1 – t)


=
n1 n2
BREAK-EVEN EBIT LEVEL

The EBIT indifference point between two alternative


financing plans can be obtained by solving the following
equation for EBIT*

(EBIT *– I1) (1 – t) - PD 1 (EBIT *– I2) (1 – t) – PD2


=
n1 n2

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