CAPITAL STRUCTURE & VALUE OF THE FIRM

Capital structure -

A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds

WEIGHTED AVEREGE COST OF CAPITAL

FORMULA-

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

APPROACHES TOWARDS VALUE OF THE FIRM

net income approach, net operating income approach, and traditional approach are three theoretical frameworks for how a company should set its debtequity mix. All three examine how a company's cost of capital changes with the debt-equity mix and search for the lowest value of the cost of capital, hence the maximum value of the firm, to identify the best mix. They reach different conclusions because they make different assumptions about creditors' and investors' reactions to increasing debt. Each of us will have our own feelings about the reasonableness of the assumptions. Without going into the Modigliani-Miller mathematics, the assumptions of the traditional approach usually seem

1) The net income approach makes the simplest assumptions, that neither creditors nor investors increase their required rates of return as a company takes on debt. The cost of capital declines as higher-cost equity is replaced with lower-cost debt. This approach concludes that the optimal financing mix is all debt
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2) The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing 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 at which creditors and investors increase their required rates of return accelerates and dominates the weighting 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 optimal financing mix consisting of some debt and some equity

MODIGLIANI & MILLER PROPOSITION

MEANING-A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.

PREPOSITIONS 1ST PREPOSITION

M&M Proposition I states that the value of a

firm does NOT depend on its capital structure. For example, think of 2 firms that have the same business operations, and same kind of assets. Thus, the left side of their Balance Sheets look exactly the same. The only thing different between the 2 firms is the right side of the balance sheet, i.e the liabilities and how they finance their business activities.

In the first diagram, stocks make up 70% of the capital structure while bonds (debt) make up for 30%. In the second diagram, it is the exact opposite. This is the case because the assets of both capital structures are the exactly same. M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is irrelevant. The value of the firm is determined by Real Assets and not its capital structure

2nd PREPOSITION
VL = VU + TCD VL is the value of a levered firm V U is the value of an unlevered firm TCD is the tax rate the term TCD assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are nondeductible

ASSUMPTIONS OF MODIGLIANI & MILLERS PROPOSITION

Rational investors & managers Homogeneous expectations Equivalent risk classes Absence of tax

CRITICISMS
Companies are liable to pay taxes on their

income 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 of financing