Capital Structure Theory

CAPITAL STRUCTURE THEORY

1.Trade-off Theory
 
-Modern Capital Structure Theory
-Began in 1958
   -It is published by F. Modigliani & M. Miller (MM)

Assumptions

  - No personal Income Tax, No Brokerage Cost

- No Bankruptcy Risk
- Interest on debt is a tax deductible
 - Corporation may use more debt
- Firm value may increase
- May maximize by using almost 100% debt
 - Several Assumptions were & are unrealistic
- MM’s position was only the beginning of Capital
Structure research
- MM themselves extended the theory by relaxing the
Assumptions
- Stocks price and Capital Structure
- Optimum Capital Structure

Extended Assumptions
(1)Debt interest tax deductible
      -Common Stock, Preferred Stock
-Cost more
      -Debt more
-Value high
(2) MM Assumptions do not hold in real world
i) Debt/Assets Ratio increase - Interest Increase
ii) Expected tax rates fall at high debt level
iii) Bankruptcy cost – probability – law charges
2.Signaling theory

Symmetric Information
MM assume that investors have the same information
about a firm’s prospects as managers.
 
Asymmetric Information
The situation in which managers have different (better)
information about the firm than do outside investors.
 
Signal
The announcement of a stock offering by a mature firm
that have multiple financing alternative is taken as a
signal.
Reserve borrowing capacity

The ability to borrow money at a reasonable cost

when good investment opportunities arises, firms
often use less debt than specified by the MM optimal
capital structure to ensure that they can obtain debt
capital later if they need to.
Problem
Given the following information, calculate (i) the Earnings Per
Share (EPS) and (ii) Expected Earnings Per Share (iii) Degree of
Operating Leverage (DOL) (iv) Degree of Financial Leverage (DFL) of
ABC Company for 2002 if :
(i)Debt / Assets = 0%, (ii) Debt / Assets = 50%
 
Probability of Indicated sales 0.2 0.6 0.2

Sales (thousand) $ 200 $400 $600

Fixed Cost (thousand (80) (80) (80)
Variable Cost (thousand (120) (240) (360)
Total Cost (Except Interest) (200) (320 ) (440)
 
EBIT 00 80 160
 
Assume the following:
 
(i)The firm is in the 40 percent tax bracket
(ii) Cost of debt is 12 percent
(iii)The value per share of ABC Company is $ 20
(iv)Total Capital of ABC Company is $ 200000