2 Capital Structure 1

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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

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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

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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

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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