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Chapter 9

Introduction of the Theory

Capital Structure: Is the proportion of debt instruments and preferred and common stock on a companys balance sheet. What happens to the total valuation of the firm and to its cost of capital when the ratio of debt to equity or degree of leverage is varied? We use capital market equilibrium approach because it allows us to abstract from factors other than leverage that affect valuation.

Assumptions and Definitions




There are no corporate or personal income taxes and no bankruptcy costs. The ratio of debt to equity for a firm is changed by issuing debt to repurchase stock or issuing stock t o pay off debt. In other words a change in capital structure is affected immediately. In this regard we assume no transaction cost. The firm has a policy of paying 100% of its earnings in dividends. Thus we abstract from the dividend decision.



The expected values of the subjective probability distributions of expected future operating earnings for each company are the same for all investors in the market. The operating earnings of the firm are not expected to grown. The expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.


We are concerned with the following three rates: K i=F = Annual interest charges B Market value of debt outstanding Ki is the yield on the companys debt, assuming this debt to be perpetual. K e = E = Earnings available to common stockholders S Market value of stock outstanding The earnings/ price ratio: is the required rate of return for investors in a company whose earnings are not expected to grow and whose dividend payout ratio is 100%.


With our restrictive assumptions then the earnings/price ratio represents the market rate of discount that equates the present value of the stream of expected future dividends with the current market price of the stock. K 0 = O = Net operating earnings V Total Market value of the firm Where V = B + S. K0 : is an overall capitalization rate for the firm. It is defined as the weighted average cost of capital. It can be expressed as K0 = Ki B + Ke S B+S B+S


What happens to ki, ke and k0 when the degree of leverage as noted by the ratio of B/S increases. Capital Structure Theories Net Operating Income Approach. Traditional Approach. Modigliani- Miller Position.

Net Operating Income Approach

One approach to the valuation of the earnings of a company is know as the net operating income approach. With this approach net operating income is capitalized at an overall capitalization rate to obtain the total market value of the firm. The market value of the debt then is deducted from the total market value to obtain the market value of the stock. With this approach the overall capitalization ate as well as the cost of debt funds stay same regardless of the degree of leverage. The required return on equity increases linearly with leverage.

Incentive Issues and Agency Costs

Agency Costs: Arises when different stakeholders monitor each others behavior. Capital structure decisions lead to a number of incentive issues among equity holders, debt holders, management and other stakeholders in the corporation. These considerations can and often do influence the choice of security used in financing as well as whether to fianc and invest at all. Debt versus equity in an option pricing model framework.

Debt Holders versus Equity Holders

Option Price: Portrayal of debt versus equity is a zero-sum game. The equity of a firm can be viewed as a call option on the firms total value, the value being the associated or underlying asset of the option. The writers of the option are the debt holders. Example: Assume debt is represented by discount bonds that pay only at maturity. We can then view stockholders as having sold the firm to the debt holders with an option to buy it back at a specified price. The option has an exercise price equal to the face


The value of the option at the expiration date which by definition is the value of the stock is V 0=max(V f-D, 0) Where Vf is the value of the firm at the expiration date D is the face value of the debt, which is the exercise price of the option max means the maximum value of Vf -D or zero whichever is greater. The value of the debt at the expiration date is simply


min means Vf or D whichever is less. If Vf is greater than D the debt holders are entitled on ly to the face value of the debt and the stockholders exercise their option. If Vf is less than D the debt holders as owners of the firm are entitled to its full value. The stockholders receive nothing. The value of their option at expiration cannot be negative because they have limited liability.

Value of debt and equity at the debts expiration date.

Value Of Debt Vd Value Of Equity V0

Vd =Vf

Vd =D V0 =0 Value Of The Firm Vf

V0 =Vf - D


In the left panel the value of the debt is shown and in the right panel the value of equity. The value of the firm at the expiration date of the debt is shown along the horizontal axis in both panels with the face value of the debt again being represented by D. Depending on whether the value of the firm is above or below D equity and debt values will be those shown. The debt holder-stock holder relationship can be pictured in an option pricing framework.

Financial Signaling

Managers may use capital structure changes to convey information about the profitability and risk of the firm. Insiders know something about the firm that outsiders do not. Example: instead of announcement, our company is undervalued you alter your companys capital structure by issuing more debt. Instead leverage implies a higher probability of bankruptcy, and since you would be penalized contractually if bankruptcy occurred, investors conclude that you have good reason to believe the things really are better than the stock price reflects.

Asymmetric Information

Credibility: of a financial signal depends on asymmetric information. A signaling effect assumes there is information asymmetry between management and stockholders. When financing an investment project, management will want to issue the overvalued security if it is acting in the interests of current stockholders. Myers & Majluf: suggest it will issue stock if it believes the existing stock is overvalued and debt if it believes the stock is undervalued. Investors are not unmindful of this phenomenon so debt issues are regarded as good news and stock issues as bad news.


The greater the asymmetry in information between insider (management) and outsiders (security holders), greater the likely stock price reaction to a financing announcement. Empirical evidence is consistent with asymmetry of information idea. Around the time of the announcing leverage increasing transactions tend to result in positive excess returns to stockholders whereas leverage decreasing transaction results in the opposite. The evidence overall is consistent with a financial signaling effect accompanying the choice of security

From Where Does Value Cometh?

It is the signal conveyed by the change that is significant. This signal pertains to the underlying profitability and risk of the firm, as that is what is important when it comes to valuation. Unless the managerial contract is very precise, the manager is tempted to give false signals.