THEORY OF CAPITAL STRUCTURE

Presented by-

TASNEEM TAJ A30601911030

MBA SEM - II
FRANCO MODIGLIANI MERTON MILLER

Introduction
Capital structure is the proportionate relationship

between debt & equity.

Early theoreticians believed that the average cost of

capital decreased with the use of leverage and the value of the firm increased while the value of the equity remained constant.

Risks
Business risk
Financial risk

Effect of leverage on cost of capital

0.12
0.10 0.08 0.06 0.04 0.02 0.00 0.2 0.4 Kd KO KE 0.6 0.8

Modigliani miller theory

In perfect capital markets without taxes & transaction costs, a firms market value & cost of capital remain invariant to the capital structure changes.

Assumptions

Perfect capital markets.

Homogeneous risk classes.

Risk

No taxes.

Full payout.

Proposition I no tax
For firms in the same risk class, the total market value is

independent of the debt-equity mix . It is given by capitalizing the expected the net operating income by the capitalization rate. VU = VL , where VU = Value of unlevered firm. VL = Value of levered firm.
Arbitrage process.

Proposition ii
Levered firms cost of capital remains constant with

financial leverage. Cost of equity under M-M approach

0.25 0.20 0.15

KD KO KE

0.10
0.05 0.00
LEVERAGE

Example Cash flows

UNLEVERED (100% Equity) LEVERED (80% Equity & 20% Debt) 1000
50 950 0 950

EBIT
(-) Interest (5%) EBT (-) Tax Net Income

1000
0 1000 0 1000

With tax
PROPOSITION - I
After introduction of

PROPOSITION - II
Proposition II, shows that

corporate tax, the optimal capital structure is 100 % debt.

because interest payments are tax-deductible, the value of a levered firm (VL) increases with debt.

VL = VE + TC * D

example
UNLEVERED (100% Equity) LEVERED (80% Equity & 20% Debt) 1000 50 950 323 627

EBIT (-) Interest (5%) EBT (-) Tax (34%) Net Income

1000 0 1000 340 660

Criticisms
Lending & borrowing rates discrepancy.

Transaction costs.

Institutional restrictions.

Existence of corporate tax. Non-substitutability of personal & corporate leverage.