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Unit-3 What is the Optimal Capital Structure? - Coggle Diagram
Unit-3
What is the Optimal Capital Structure?
Capital Structure Based on the Traditional Theorem
Fundamental Principles
Capital Structure Definition
Equity Capital vs Debt Capital
Leverage Effect
Assumptions
ROI is Constant
Cost of Debt / Borrowing rate is Constant as you Take on More Debt
Use of Equity is Constant
Borrowing Additional Funds
Provided the intrest on the Borrowed Capital (Borrowing Cost) Remains Lower than the overall income derived from the investment
Results
Results in the increased income From Equity Investments
Note if a Company takes cheap debt, Collectively it is counted as Capital only, Equity and Debt
the Leverage effect represents the starting point for a Company's Deliberations on how to optimize its capital Structure
Types (Out of the Syllabus)
Positive Leverage
"Increases": This only happens if the borrowing rate is lower than the return on investment
ROE Shoots Up.
Ex- If your investment earns 10% and the bank only charges you 5% interest, you keep the extra 5% for yourself. Because you used "other people's money" to make that extra profit.
Negative Leverage
If your investment only earns 4% but the bank charges you 6% interest, you are losing money on every borrowed dollar. You have to take money out of your own pocket (your equity) to pay the bank the difference.
ROE Decreases
Traditional Theoram (Durand,1952)
Compromise between Net Income & Net Operating Income approaches
Optimal debt ratio exists
An increased use of Debt Capital, Minimizes average cost of Capital, maximizes company value.
Capital Structure According to Modigliani-Miller
Assumptions
The interest rate on capital investments and borrowing is uniform.
A perfect capital market exists
An investment policy is taken as given
Borrowing costs are not dependent on the debt-equity ratio (Because it is Perfect Capital market Exists)
Under perfect conditions, Capital structure is irrelevant
Weighted average cost of capital can be depicted graphically as a straight line.
No optimal debt-equity ratio
Dividend Poicy Irrelevance
According to the Modigliani/Miller model regarding a company’s dividend policy, it is
irrelevant to the company value whether a company pays dividends or retains profits.
Neo-Institutional Capital Structure Model
Modification of M&M Model (incudes transaction costs & taxes)
Tax Shield effect
Neo- Istitutional Theory:Trade-Off Theory
Terminology
The Concept of Levered Company
A levered company is one that uses debt (borrowed funds) as part of its capital structure to finance assets, operations, or growth, rather than relying solely on its own equity. While this "leverage"
can boost returns if investments are profitable (as interest paid on debt is often tax-deductible), it also increases financial risk, as the company must still make debt payments
even during downturns, potentially leading to higher losses.
The Trade-Off Theory is a modification of the earlier Modigliani-Miller theorem to reflect real-world factors. It proposes that a company's optimal capital structure is reached by balancing the benefits of debt against its drawbacks:
Calculation of Company Valuation.
Parameters
Value of the all-equity (unlevered) firm V(u): €2,000,000
Plus Net Present Value (NPV) of Tax Benefits (Tax Shield): + €200,000
Minus NPV of Insolvency Costs: - €70,000
Minus NPV of Agency Costs: - €40,000
Total V(l): €2,000,000 + €200,000 - €70,000 - €40,000 = €2,090,000
The Tax Shield: Because interest payments are typically tax-deductible, debt financing creates a "tax shield" that increases company value
Agency Costs: These costs arise from the separation of ownership and management, as well as conflicts between lenders and owners as debt levels rise
Dividend Poicy with Taxes
An optimal capital structure does exist however only an approximate value can be determined.
Capital Structure in Practice
Optimal debt ratio is approximate
Dependent on many factors (e.g., political, industry)
Creditor willingness to provide loans
The "holy grail of corporate financing"
Study Goals
what the capital structure of a company is.
what dividend policy is.
Dividend policy refers to the targeted structuring of payment flows between a corporation and its shareholders regarding the distribution of profits.
Dividends are the specific portion of a company's earnings provided to stockholders in proportion to their ownership stake
The Irrelevance Proposition (Modigliani-Miller):
The Impact of Taxes (Taxes Exist): In real-world "neo-institutional" models, taxes can make dividend policy a critical decision
Role in Valuation: The Dividend Discount Model (DDM) is a valuation method that defines a company’s (or stock's) value as the sum of all future discounted dividends expected to be paid to shareholders
Ex- To better understand this, think of a company’s profit like a harvest of fruit. The dividend policy is the decision of whether to give the fruit to the owners to eat now or to keep the seeds to plant more trees. In a perfect world, the owner’s total wealth is the same whether they have the fruit in their basket or a larger orchard; however, in the real world, "taxes" act like a gatekeeper who might take a different amount of fruit depending on whether it is eaten or replanted.
which theories propose how to optimize capital structure.
The Traditional Theorem (proposed by Durand, 1952)
Net Income Approach
Net Operating Income Approach
The Modigliani-Miller Theorem (M&M)
Neo-Institutional Theory, specifically the Trade-Off Theory
how the proportion of equity and debt capital impacts on the value of a company.
The Traditional Theorem (Relevance)
According to the traditional theory proposed by Durand, capital structure is relevant to a company's valuation
Replacing expensive equity with cheaper borrowed funds lowers the Weighted Average Cost of Capital (WACC)
Cost Reduction: Initially, increasing the proportion of debt (leverage) increases company value because debt is typically cheaper than equity
Risk and Value Maximization: As debt continues to increase, shareholders and eventually creditors perceive higher risk, demanding higher returns or risk premiums. The company's value is maximized at the specific point where WACC is minimized
The Modigliani-Miller Theorem (Irrelevance)
The M&M Theorem asserts that in a perfect capital market, the proportion of debt and equity is irrelevant to a company's value
Offsetting Risks: This theory argues that as a company takes on more debt, the cost of equity increases because shareholders demand higher returns to compensate for the increased financial risk.
Uniform Value: Under these ideal conditions, the total market value remains constant regardless of the debt-to-equity ratio because the benefits of cheaper debt are exactly offset by the rising cost of equity.
The Neo-Institutional / Trade-Off Theory (Tax and Risk)
In a more realistic scenario, the sources describe the Trade-Off Theory, which accounts for taxes and bankruptcy costs
The Tax Shield: Since interest payments on debt are usually tax-deductible, increasing the proportion of debt creates a "tax shield," which reduces the company's tax burden and increases its total value
Agency and Bankruptcy Costs: These positive effects are balanced against agency costs (conflicts between managers and owners) and the rising risk of bankruptcy as indebtedness grows
The Optimal Ratio: The company value increases with more debt until the marginal benefit of the tax shield equals the marginal cost of potential bankruptcy; this is considered the optimal debt-equity ratio
Practical Calculation of Value
In practice, the value of a "levered" company (one with debt) is determined by taking the value of an all-equity firm and adjusting for these factors. The sources provide a framework for this calculation: Value of Levered Company = Value of All-Equity Firm + PV of Tax Shield - PV of Transaction/Insolvency/Agency Costs
Ex To visualize this, imagine tuning a high-performance engine: "Equity" is the engine's core stability, while "Debt" is like a turbocharger. Adding some turbo-boost (debt) makes the engine more powerful and efficient (increases company value). However, if you turn the boost up too high without enough core stability (too much debt relative to equity), the engine risks overheating or exploding (bankruptcy costs), which would destroy the vehicle's total value.
whether there is an ideal debt-to-equity ratio.