2 Capital Structure 1
#2
Capital Structure -1
Dr. Kulbir Singh
Advanced Corporate Finance (ACF) Term III 2013-14
IMT-Nagpur
Capital Structure: Introduction
Mix of debt and equity use to finance its business
Goal of CS Decision: to determine the financial leverage or CS that maximizes the value of company by minimizing WACC.
Theory of
Corporate
Financing
MM Theory of
CS Irrelevance
Trade-Off
Theory
Agency Theory
Dr. Kulbir Singh (IMT-Nagpur) ADF 2013-14
Pecking Order
Theory
2
Capital Structure: Introduction……
Theories are conditional, not general. No universal theory of CS
Differ in their relative emphasis on factors that could affect the choice b/w D & E
Factors:
Agency costs
Taxes
Differences in Information
Effects of market imperfections or institutional/regulatory constraints
Each factor could be dominant for some firms or in some circumstances, yet unimportant somewhere else
Easy to find examples of each theory at work,
difficult to distinguish theories empirically
Theories overlap
Blend of all theories needed to explain CS
Dr. Kulbir Singh (IMT-Nagpur) ADF 2013-14
3
Modigliani-Miller Value Irrelevance Propositions
Modern Theory of Optimal CS starts with Nobel-prize winning Economists – Franco Modigliani and Merton
Miller’s (MM’s) Theory (1958) that, given certain assumptions, A company’s choice of capital structure does not affect the value.
Dr. Kulbir Singh (IMT-Nagpur) ADF 2013-14
4
Modigliani-Miller Value Irrelevance Propositions……
Assumptions relate to expectations and market
Expectations are homogeneous
Perfect capital markets
No transaction costs, no taxes, no bankruptcy,
Everyone has same information….. Information symmetry
Two investments with identical cashflow streams and risk must trade for the same price. Borrow and lend at same risk-free IR
No agency costs
Managers always act to maximizing the shareholders’ wealth
Financing decision and investment decisions are independent
Operating income is unaffected by
Capital Structure -1
Dr. Kulbir Singh
Advanced Corporate Finance (ACF) Term III 2013-14
IMT-Nagpur
Capital Structure: Introduction
Mix of debt and equity use to finance its business
Goal of CS Decision: to determine the financial leverage or CS that maximizes the value of company by minimizing WACC.
Theory of
Corporate
Financing
MM Theory of
CS Irrelevance
Trade-Off
Theory
Agency Theory
Dr. Kulbir Singh (IMT-Nagpur) ADF 2013-14
Pecking Order
Theory
2
Capital Structure: Introduction……
Theories are conditional, not general. No universal theory of CS
Differ in their relative emphasis on factors that could affect the choice b/w D & E
Factors:
Agency costs
Taxes
Differences in Information
Effects of market imperfections or institutional/regulatory constraints
Each factor could be dominant for some firms or in some circumstances, yet unimportant somewhere else
Easy to find examples of each theory at work,
difficult to distinguish theories empirically
Theories overlap
Blend of all theories needed to explain CS
Dr. Kulbir Singh (IMT-Nagpur) ADF 2013-14
3
Modigliani-Miller Value Irrelevance Propositions
Modern Theory of Optimal CS starts with Nobel-prize winning Economists – Franco Modigliani and Merton
Miller’s (MM’s) Theory (1958) that, given certain assumptions, A company’s choice of capital structure does not affect the value.
Dr. Kulbir Singh (IMT-Nagpur) ADF 2013-14
4
Modigliani-Miller Value Irrelevance Propositions……
Assumptions relate to expectations and market
Expectations are homogeneous
Perfect capital markets
No transaction costs, no taxes, no bankruptcy,
Everyone has same information….. Information symmetry
Two investments with identical cashflow streams and risk must trade for the same price. Borrow and lend at same risk-free IR
No agency costs
Managers always act to maximizing the shareholders’ wealth
Financing decision and investment decisions are independent
Operating income is unaffected by