capital structure theories.pptx

7/27/2019 Capital Structure Theories.pptx

1/13

CALCULATION OFCOST OF CAPITAL


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A Break Down of Risk

Competition

may be

stronger or

weaker than

expected

Project

may do

better or

worse than

expected

Entire sectormay be

affected by

action

Exchange

rate and

Political risk

Interest rate,

Inflation &

news about

economy

Firm

SpecificMarket

Actions/ Risk

that affect only

one firm

Actions/ Risk

that affect all

investments

Affects few

firms

Affects many

firms

Firms can

reduce by

Investing in

lots of

projects

Acquiring

competitor

s

Diversifying

across

sectors

Diversifying

across

countries

Cannot affect

Investors canreduce by

Diversifying across domesticstocks

Diversifying globallyDiversifying

across asset

classes

Source: Aswath Damoda


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CAPM Assumptions

There are no transaction costs and securities

are infinitely divisible

All assets are correctly valued and information

flows freely

Investors are diversified across all assetclasses


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Historical Risk Premium - USA


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CAPITAL STRUCTURETHEORIES


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Broad Assumptions

There are only two sources of funds used by a firm: perpetual riskless debtand ordinary shares

There are no corporate taxes. This assumption is removed later

The dividend payout ratio is 100%. That is, the total earnings are paid out asdividend to the shareholders and there are no retained earnings

The total assets are given and do not change. The investment decisionsare, in other words, assumed to be constant

The total financing remains constant. The firm can change its degree ofleverage (capital structure) either by selling shares and use the proceeds toretire debentures or by raising more debt and reduce the equity capital

The operating profits (EBIT) are not expected to grow

All investors are assumed to have the same subjective probabilitydistribution of the future expected EBIT for a given firm

Business risk is constant over time and is assumed to be independent of itscapital structure and financial risk

Perpetual life of the firm


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CAPITAL STRUCTURETHEORIES

MM Aproach


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Proposition

The overall cost of capital (Ko) and the valueof the firm (V) are independent of the capitalstructure. The Ko and V are constant for all

degrees of leverage. The total value is givenby capitalizing the expected stream ofoperating earnings at a discount rateappropriate for its risk class

The cut off rate for investment purposes iscompletely independent of the way in which aninvestment is financed


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Assumptions

1. Perfect capital markets

Securities are infinitely divisible

Investors are free to buy/ sell securities

Investors can borrow without restrictions on the same terms andconditions the firm can

There are no transaction costs Information is perfect, that is, each investor has the same information

which is readily available to him without cost

Investors are rationale and behave accordingly

2. All investors have the same expectation of firms net operatingincome (EBIT) with which to evaluate the value of the firm

3. Business risk is equal among all firms within similar operatingenvironment

4. The dividend payout ratio is 100%

5. There are no taxes. This assumption is removed later.


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Implications of the assumptions

There are no taxes

Managers have stockholder interests at heart and dowhats best for stockholders

No firm ever goes bankrupt

Equity investors are honest with lenders; there is nosubterfuge or attempt to find loopholes in loanagreements

Firms know their future financing needs with certainty

What happens to the trade off between debt and equity?How much should a firm borrow?


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The Debt Equity Tradeoff

Advantages of Debt Disadvantages of Debt

Tax Benefit

Added discipline

Expected Bankruptcy Cost

Agency Cost

Loss of Flexibility

Source: Aswath Damodar

Capital Structure is irrelevant to the valuation of the fir


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Limitations

Risk perception

Cost

Convenience

Double leverage

Transaction costs

Taxation


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Factors for designing capital structure

Liquidity Aspect

Control

Nature of industry

Stability of cash flows

Life cycle stage

Timing of Issue

capital structure theories.pptx

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