logging in or signing up UNIT - III Capital Structure prabhu_gampala Download Post to : URL : Related Presentations : Share Add to Flag Embed Email Send to Blogs and Networks Add to Channel Uploaded from authorPOINT lite Insert YouTube videos in PowerPont slides with aS Desktop Copy embed code: (To copy code, click on the text box) Embed: URL: Thumbnail: WordPress Embed Customize Embed The presentation is successfully added In Your Favorites. Views: 1875 Category: Business & Fin.. License: All Rights Reserved Like it (1) Dislike it (0) Added: May 07, 2010 This Presentation is Public Favorites: 1 Presentation Description No description available. Comments Posting comment... By: abhishekgarg2891 (13 month(s) ago) hiii i want to download this presentation please allow me to download the same presentation.thank you abhishekgarg2891@gmail.com Saving..... Post Reply Close Saving..... 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Unit details : : Capital structure theories Net income approach Net operating income approach Traditional theory Modigliani Miller theory Dividend theories Relevance theories MM hypothesis Factors determining dividend policy Declaration and payment of dividends Bonus shares Rights issue Share-splits Walter model Gordon model 2 Unit details : Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Slide 3: Capital structure / composition of capital /pattern of securities mix is the second important aspect of financial planning. once the financial manager has determined the firm’s financial requirements, his next task is to see that these funds are on hand .This capital comes in any forms –long & short term debt, secured and unsecured debts and so on. To decide upon the ratio of these securities in the total capitalization is to decide the capital structure. 3 Meaning of Capital structure Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Slide 4: “Capital structure is the permanent financing of the firm represented by long term debts ,preferred stock and net worth” 4 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Determinants of capital structure : Nature of business Stability of earnings Amount of funds Rapidity of growth Nature of investors Financial leverage 5 Determinants of capital structure Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Optimal capital structure : “it can be defined as the mix of debts and equity which will maximize the market value of the company and minimize its cost of capital” 6 Optimal capital structure Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Slide 7: Net income approach Net operating income approach Modigliani Miller theory Traditional theory 7 Capital structure theories Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Net Income (NI) Approach : Net Income (NI) Approach This approach was suggested by the ‘Durand’. According to NI approach ,the capital structure decision is relevant to the valuation of the firm. In other words , a change in a financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. 8 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Assumptions : Assumptions There are no taxes That the cost of debt is lass then the equity capitalization rate (or) Kd < ke That the use of debt does not change the risk perception of investors 9 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Net Operating Income (NOI) Approach : Net Operating Income (NOI) Approach According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. It is diametrically opposite to NI approach. The essence of this approach is that the capital structure decisions of a firm is irrelevant. any change in leverage will not lead to any change in the total value of the firm and the market price of the shares. 10 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Assumptions : Assumptions Overall cost of capital(Ko )Is constants V=EBIT/Ko (there is no effect of fixed financial charges on EBIT) Value of equity is a residual value V=S+B S-Total Market value of equity sahare B-total Value of debt V-total value of a firm S=V-B 11 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Modigliani-Miller Theory : Modigliani-Miller Theory This theory was propounded by Franco Modigliani and Merton Miller. They have given two approaches In the Absence of Corporate Taxes When Corporate Taxes Exist 12 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Approach Without Tax: Proposition I : MM Approach Without Tax: Proposition I MM’s Proposition I states that the firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage. 13 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Arbitrage : 14 Arbitrage Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Arbitrage : 15 Arbitrage Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM’s Proposition II : MM’s Proposition II The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firm’s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases. 16 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Propositions I and II : 17 MM Propositions I and II Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Hypothesis With Corporate Tax : Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs. 18 MM Hypothesis With Corporate Tax Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Hypothesis with Corporate Tax : 19 MM Hypothesis with Corporate Tax Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Traditional Approach : Traditional Approach This theory was propounded by Ezra Solomon. The traditional approach argues that moderate degree of debt can lower the firm’s overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity. 20 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.
UNIT - III Capital Structure prabhu_gampala Download Post to : URL : Related Presentations : Share Add to Flag Embed Email Send to Blogs and Networks Add to Channel Uploaded from authorPOINT lite Insert YouTube videos in PowerPont slides with aS Desktop Copy embed code: (To copy code, click on the text box) Embed: URL: Thumbnail: WordPress Embed Customize Embed The presentation is successfully added In Your Favorites. Views: 1875 Category: Business & Fin.. License: All Rights Reserved Like it (1) Dislike it (0) Added: May 07, 2010 This Presentation is Public Favorites: 1 Presentation Description No description available. Comments Posting comment... By: abhishekgarg2891 (13 month(s) ago) hiii i want to download this presentation please allow me to download the same presentation.thank you abhishekgarg2891@gmail.com Saving..... Post Reply Close Saving..... Edit Comment Close By: harikmk82 (19 month(s) ago) I WOULD LIKE TO DOWNLOAD THE PRESENTATION FOR MY MBA .PLS PROVIDE ME THE SAME.THANK YOU. HARIKRISHNAN harikmk82@gmail.com Saving..... Post Reply Close Saving..... Edit Comment Close By: pierregihinji (20 month(s) ago) i WOULD LIKE TO DOWNLOAD THE PRESENTATION FOR MY STUDY PURPOSES PLEASE. Saving..... Post Reply Close Saving..... Edit Comment Close Premium member Presentation Transcript UNIT - III : UNIT - III Capital Structure and dividend theories 1 G.Prabhakar, Dept.of Business Management, VBIT-Aushapur Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Unit details : : Capital structure theories Net income approach Net operating income approach Traditional theory Modigliani Miller theory Dividend theories Relevance theories MM hypothesis Factors determining dividend policy Declaration and payment of dividends Bonus shares Rights issue Share-splits Walter model Gordon model 2 Unit details : Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Slide 3: Capital structure / composition of capital /pattern of securities mix is the second important aspect of financial planning. once the financial manager has determined the firm’s financial requirements, his next task is to see that these funds are on hand .This capital comes in any forms –long & short term debt, secured and unsecured debts and so on. To decide upon the ratio of these securities in the total capitalization is to decide the capital structure. 3 Meaning of Capital structure Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Slide 4: “Capital structure is the permanent financing of the firm represented by long term debts ,preferred stock and net worth” 4 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Determinants of capital structure : Nature of business Stability of earnings Amount of funds Rapidity of growth Nature of investors Financial leverage 5 Determinants of capital structure Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Optimal capital structure : “it can be defined as the mix of debts and equity which will maximize the market value of the company and minimize its cost of capital” 6 Optimal capital structure Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Slide 7: Net income approach Net operating income approach Modigliani Miller theory Traditional theory 7 Capital structure theories Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Net Income (NI) Approach : Net Income (NI) Approach This approach was suggested by the ‘Durand’. According to NI approach ,the capital structure decision is relevant to the valuation of the firm. In other words , a change in a financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. 8 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Assumptions : Assumptions There are no taxes That the cost of debt is lass then the equity capitalization rate (or) Kd < ke That the use of debt does not change the risk perception of investors 9 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Net Operating Income (NOI) Approach : Net Operating Income (NOI) Approach According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. It is diametrically opposite to NI approach. The essence of this approach is that the capital structure decisions of a firm is irrelevant. any change in leverage will not lead to any change in the total value of the firm and the market price of the shares. 10 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Assumptions : Assumptions Overall cost of capital(Ko )Is constants V=EBIT/Ko (there is no effect of fixed financial charges on EBIT) Value of equity is a residual value V=S+B S-Total Market value of equity sahare B-total Value of debt V-total value of a firm S=V-B 11 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Modigliani-Miller Theory : Modigliani-Miller Theory This theory was propounded by Franco Modigliani and Merton Miller. They have given two approaches In the Absence of Corporate Taxes When Corporate Taxes Exist 12 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Approach Without Tax: Proposition I : MM Approach Without Tax: Proposition I MM’s Proposition I states that the firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage. 13 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Arbitrage : 14 Arbitrage Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Arbitrage : 15 Arbitrage Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM’s Proposition II : MM’s Proposition II The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firm’s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases. 16 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Propositions I and II : 17 MM Propositions I and II Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Hypothesis With Corporate Tax : Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs. 18 MM Hypothesis With Corporate Tax Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. MM Hypothesis with Corporate Tax : 19 MM Hypothesis with Corporate Tax Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301. Traditional Approach : Traditional Approach This theory was propounded by Ezra Solomon. The traditional approach argues that moderate degree of debt can lower the firm’s overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity. 20 Vignana Bharathi Institute of Technology-Aushapur (V), Ghatkesar (M), R.R. Dist. – 501 301.