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Traditional Approach to Capital Structure Assumption Examples

Thus, the question of capital gearing arises as to on which fund a fixed rate of interest or dividend is paid. Companies have only three ways to raise money to finance their operations and fuel their growth and expansion. They can borrow money by issuing bonds or obtaining loans; they can re-invest their profits in their operations, or they can issue new stock shares to investors. At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits. Step 2 Work out the equation ‘backwards’ to calculate the cost of equity for an electronics company with 60% equity and 40% debt. In this case the equity beta of the electronics industry reflects alower level of gearing than that for the proposed project.

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. To summarize, it is essential for finance professionals to know about the capital structure.

The reason is that interest expense is an allowable deduction from taxable income; thus, levered firms have a tax shield. Their view is based on the belief that the value of a companydepends upon the future operating income generated by its assets. Theway in which this income is split between returns to debt holders andreturns to equity should make no difference to the total value of thefirm (equity plus debt).

Just as a firm must consider the costs of electricity, raw materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting capital so that it can purchase its assets. To see why this should be true, suppose an investor is considering buying one of the two firms, U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L’s debt. Nonetheless, since investors are better off putting their money into companies with strong balance sheets, the optimal measurement of debt to equity generally should reflect lower levels of debt and higher levels of equity.

  1. The level of operating gearing will be largely a result of the industry in which the firm operates.
  2. The main rationale behind the theorem is that tax-deductible interest payments positively affect a company’s cash flows.
  3. Where keL is the required rate of return on equity of a levered firm, keU is the required rate of return on equity of an unlevered firm, D is the market value of debt, E is the market value of equity, and kD is the required rate of return on debt.

The WACC is a weighted average of the various sources of finance used by the company. When capital structure is composed of more than one source or identical nature, the same is known as Complex Capital Structure. In other words, if the capital structure is composed of Equity Share Capital, Preference Share Capital, Retained Earnings, Debentures, Long-term Loans and Current Liabilities etc., the same is known as complex capital structure. Let us make an in-depth study of the meaning, assumptions and classification of the capital structure. The ratings provided by reputable credit agencies also help shed light on the capital structure of a firm.

An increase in leverage level induces a higher default probability to a company. Therefore, investors tend to demand a higher cost of equity (return) to be compensated for the additional risk. The first proposition essentially claims that the company’s capital structure does not impact its value.

Capital Structure Theory: What It Is in Financial Management

The Modigliani-Miller theorem argues that the option or combination of options that a company chooses has no effect on its real market value. (iii)on management from disposing of any major fixed assets without the debenture holders’ agreement. Once again they were able to produce a proof to support theirarguments and show that as gearing increases, the WACC steadilydecreases. If a bankruptcy situation finally occurs, the assets may be soldoff quickly and cheaply. A large proportion of management time is spent’fire fighting’, i.e. focusing on short-term cash flow rather thanlong-term shareholder wealth. When the capital structure is composed of Equity Capital only or with Retained Earnings, the same is known as Simple Capital Structure.

Modigliani–Miller theorem

Where wd is the proportion of debt in total capital (debt ratio) and we is the proportion of equity (1 – debt ratio). When the optimal capital structure is reached, the value of a firm is maximized as shown in the figure below. At the time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration at Carnegie Mellon University. Both were required to teach corporate finance to business students but, unhappily, neither had any experience in corporate finance. After reading the course materials that they were to use, the two professors found the information inconsistent and the concepts flawed.

The Securities and Exchange Commission conducts an oversight study of credit rating agencies annually on behalf of investors. Investment literature often equates a company’s debt with its liabilities. However, there is an important distinction between operational liabilities and debt liabilities. Conversely, the second version of the M&M Theorem was developed to better suit real-world conditions. The assumptions of the newer version imply that companies pay taxes; there are transaction, bankruptcy, and agency costs; and information is not symmetrical. In order to explain the theories of capital structure we are to use the following systems in addition to the above assumptions.

Degree of Combined Leverage

In the same way a decrease in sales wouldbring about a greater fall in B’s earnings than in A’s. When using diagrams to illustrate your discussion,draw the diagramscarefully and clearly label the axes and all lines illustrating costsof capital. Make sure you can explain clearly the two effects of introducing moredebt finance and the differing conclusions as to the combined impactthese assumptions of capital structure may have on the WACC. (6)Restrictions in the articles of association may specify limits on the company’s ability to borrow. In 1963they amended their model to include corporation tax.This alterationchanges the implication of their analysis significantly. In 1963, M&M modified their model to reflect the fact that the corporate tax system gives tax relief on interest payments.

Since debt interest is tax-deductible the impact of taxcould not be ignored. M&M supported their case by demonstrating that marketpressures (arbitrage) will ensure that two companies identical in everyaspect apart from their gearing level, will have the same overall MV.This proof is outside the syllabus. NB Since preference shares are treated as debt finance, preference dividends are treated as debt interest in this ratio. Note that preference shares are usually treated as debt (see chapter on sources of finance for logic). Financial gearing is a measure of the extent to which debt is used in the capital structure. The level of operating gearing will be largely a result of the industry in which the firm operates.

Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability. Their ratings of the debt issued by companies can help investors determine whether that debt is risky as an investment. If the overleveraged company’s particular business sector is extremely competitive, competing companies could take advantage of its position by swooping in to grab more market share. In finance, leverage (debt) is a perfect example of the proverbial two-edged sword.

From a theoretical point of view, capital structure affects either cost of capital or expected yield, or both, of a firm. On the contrary, financing-mix affects the yield per share which belongs to the equity shareholders but do not affect the total earnings, since they are determined by investment decisions of a firm. From theoretical point of view capital structure affects either cost of capital or expected yield or both of a firm. On the contrary, financing-mix affects the yield per share which belongs to the equity shareholders but do not affect the total earnings since, they are determined by investment decisions of a firm. The above equations are used by all capital structure theories, only the controversy lies in relation to the degree of leverage of the variable cost of equity (Ke), weighted average cost of capital (Kw) and total firms value (V). The main point of the improved theory of capital structure is the hypothesis that valuation of a levered firm will be higher than the valuation of an unlevered firm within the same class of business risk.

Astute use of leverage can increase the financial resources available to a company for growth and expansion. Current and operational liabilities, especially the latter, represent ongoing obligations. Also, unlike with long-term debt, there are no fixed payments of principal or interest attached to operational liabilities. When analyzing a company’s balance sheet, seasoned investors would be wise to use this comprehensive total debt figure. By using three broad types of measurements—working capital, asset performance, and capital structure—you may evaluate the strength of a company’s balance sheet, and thus, its investment quality. This is the first version of the M&M Theorem with the assumption of perfectly efficient markets.

This discussion also clarifies the role of some of the theorem’s assumptions. A credit rating agency is a company that offers ratings for debt issued by companies. An agency, such as Moody’s or Standard & Poor’s, rates the debt according to a company’s ability to pay principal and interest to the debt holders.

Thus, the total value of the firm will notchange with gearing, and therefore neither will its WACC. The above equations are used by all capital structure theories, the controversy only lies in relation to the degree of leverage of the variable cost of equity (Ke), weighted average cost of capital (Kw), and total firm’s value (V). The Modigliani-Miller theory of capital structure was criticized because the assumption that capital markets are perfect is completely unrealistic. The arbitrage, as proof of the Modigliani-Miller theory, was also strongly criticized.

These can give investors and analysts a view of how a company compares with its peers and therefore its financial standing in its industry. Referred to as the long-term debt to capitalization ratio, it’s calculated as long-term debt divided by (long-term debt plus shareholders’ equity). Many analysts define the debt component of capital structure as a balance sheet’s long-term debt.

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