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Registration number:

Assignment: 3

Class: BBA-6

Course: Financial Management

Submission on: May 18, 2020

Submit to: Sir Hassan Zada

 Capital structure Irrelevance Theory

Assumptions

o There is not brokerage or transaction cost.

o No corporate tax
o There is no bankruptcy cost
o Investors can borrow at same rate as corporations
o Investors have same information as management about the firm’s future investment
opportunity
o EBIT is not affected by the use of debt
o Company will not reinvest its cash flows

Proposition

Market value of the firm is not affected by the change in capital structure. If the share of debt is
increased in the capital structure the risk of share holders also increase. They demand higher rate
of return on their investment. The cost of equity increases in the same proportion as the debt and
this neutralizes any affect on the WACC. As a result the WACC is same after the change in
capital structure and the firm’s value remains the same. For Example:

Company A

Weight age Cost

Debt 20% 10%
Equity 80% 15%
WACC 14%

Company B
 Weight age Cost
Debt 50% 10%
Equity 50% 18%
WACC 14%

As the ratio of debt increases in the capital structure, the risk associated with bankruptcy also
increase. Due to this the investor demand higher returns, which increase the cost of equity for the
company. It is given by KeL = KeuL + ( KeuL – kd )(D/E)

Irrelevance Theory of Dividend Policy

It is indicated by the irrelevance theory that the value of the company stock is unaffected by the
dividend strategy. Regardless of whether the firm chooses to give dividends to its stock holder or
they decided to hold the whole benefit; will neither increment nor decline the benefit or hazard
created for the stockholder.

The dividend approach is useless in light of the fact that the equity holder can make their own
dividend strategy. Suppose a firm doesn't offer dividend, investor can just sells 5% of its
complete stock to get reserves. For another situation if organization issues 5% dividend, the
investor can utilize that add up to purchase a greater amount of company's stock. In both the
cases the stock holder has the power to choose how much dividend ought to be made. This is the
explanation for which Miller and Modigliani believed that the company's dividend arrangement
is unimportant.

This is absurd without setting up some assumptions. The tax rate does not apply to this theory
and there is no brokerage cost either. As both tax expenses and business cost are available in
practical world, accordingly this theory can't be constant except if under perfect conditions.