This document outlines various theories on the relationship between a firm's capital structure (the mix of debt and equity used to finance its assets) and its value. It discusses the net income approach, net operating income approach, Modigliani-Miller positions, tradeoff theory, and signaling theory. It also examines how factors like taxes, bankruptcy costs, agency costs, and asymmetric information impact the optimal capital structure.

1. CAPITAL STRUCTURE AND
FIRM VALUE
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2. OUTLINE
• Assumptions and Definitions
• Net Income Approach
• Net Operating Income Approach
• Traditional Position
• Modigliani and Miller Position
• Taxation and Capital Structure
• Tradeoff Theory
• Signaling Theory
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3. ASSUMPTIONS
To examine the relationship between capital structure and
cost of capital, the following simplifying assumptions are
commonly made:
• No income tax
• 100 percent dividend payout
• Identical subjective probability distributions of
operating income
• No growth
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4. FOCUS OF ANALYSIS
Annual interest charges
I
rD =
=
Market value of debt
D
Equity earnings
P
rE =
=
Market value of equity
E
Operating income
O
rA =
=
V
Market value of the firm
D
rA = rD
D+E
E
+ rE
D+E
What happens to rD, rE, and rA when financial leverage, D/E, changes?
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5. NET INCOME APPROACH
According to this approach, rD and rE remain unchanged when D/E
varies. The constancy of rD and rE with respect to D/E means that rA
declines as D/E increases.
Rates of
return
rE
rA
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rD
D/E

6. NET OPERATING INCOME APPROACH
According to this approach the overall capitalisation rate (rA) and
the cost of debt (rD) remain constant for all degrees of leverage.
Hence
rE = rA + (rA – rD) (D/E)
Rates of
return
rE
rA
rD
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D/E

7. TRADITIONAL POSITION
Rates of
return
rE
rA
rD
D/E
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8. MODIGLIANI AND MILLER (MM)
POSITION
• Perfect Capital Market
• Rational Investors and Managers
• Homogenous Expectations
• Equivalent Risk Classes
• Absence of Taxation
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9. MM PROPOSITION I
The value of a firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is
independent of its capital structure.
V = D + E = O/r
where V = market value of the firm
D = market value of debt
E = market value of equity
O = expected operating income
r = discount rate applicable to the risk class to which
the firm belongs
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10. MM PROPOSITION II
The expected return on equity is equal to the expected rate
of return on assets, plus a premium. The premium is equal
to the debt-equity ratio times the difference between the
expected return on assets and the expected return on debt
rE = rA + (rA – rD) (D/E)
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11. THE RISK-RETURN TRADEOFF
As leverage increases, equity shareholders require a higher
return because equity beta increases.
β E = β A + D/E (β A - β D)
where β E = equity beta
β A = asset beta
D/E = debt-equity ratio
β D = debt beta
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12. CRITICISMS OF MM THEORY
• Firms and investors pay taxes
• Bankruptcy costs can be high
• Agency costs exist
• Managers tend to prefer a certain sequence of financing
• Informational asymmetry exists
• Personal and corporate leverage are not perfect
substitutes
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13. CORPORATE TAXES
When taxes are applicable to corporate income, debt financing is
advantageous as interest on debt is a tax-deductible expense.
In general
O ( 1 - tC )
V =
where V
O
tC
r
D
=
=
=
=
=
+ tC D
r
value of the firm
operating income
corporate tax rate
capitalisation rate applicable to the unlevered firm
market value of debt
It means:
Value of levered firm = Value of unlevered firm + Gain from leverage
VL
=
VU
+
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tC D

14. CORPORATE TAXES AND
PERSONAL TAXES
When personal taxes are considered along with corporate taxes, the tax
advantage of a rupee of debt is:
(1 – tc) (1 – tpe)
1–
(1 – tpd)
where tc = corporate tax rate
tpd = personal tax rate on debt income
tpe = personal tax rate on equity income
Example : Suppose tc = 50 percent, tpe = 5 percent, and tpd = 30 percent.
The tax advantage of every rupee of debt is:
(1 – 0.5) (1 – 0.05)
1–
= 0.32 rupee
(1 – 0.3)
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15. COST OF FINANCIAL DISTRESS
A high level of debt may lead to financial distress that
entails certain costs:
Direct Costs
• Delay in liquidation may diminish asset value
• Distress sale fetches lower price
• Legal and administrative costs are high
Indirect Costs
• Managers become myopic
• Stakeholders dilute their commitment
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16. AGENCY COSTS
• There is an agency relationship between the
shareholders and creditors of firms that have
substantial amounts of debt. Hence lenders impose
restrictive covenants and monitor the behaviour of the
firm.
• The loss in efficiency on account of restrictions on
operational freedom plus the cost of monitoring (which
are almost invariably passed on to shareholders)
represent agency costs associated with debt.
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17. TRADEOFF MODEL
Value of
the firm
Value of the firm considering
the tax advantage of debt
Financial distress costs and
agency costs
Value of the firm considering
the tax advantage and financial
distress and agency costs
Value of the
unlevered firm
D/E
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18. PECKING ORDER OF FINANCING
• There is a pecking order of financing which goes as
follows:
• Internal finance (retained earnings)
• Debt finance
• External equity finance
• Given the pecking order of financing, there is no welldefined target debt-equity ratio, as there are two kinds
of equity, internal and external. While the internal
equity is at the top of the pecking order, the external
equity is at the bottom.
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19. SIGNALING THEORY
• Noting the inconsistency between trade-off theory and
the pecking order of financing, Myers proposed a new
theory, called the signaling, or asymmetric information,
theory of capital structure.
• A critical premise of the the trade-off theory is that all
parties have the same information and homogeneous
expectations. Myers argued that there is asymmetric
information and divergent expectations which explains
the pecking order of financing observed in practice.
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