Development of Capital Development of Capital Structure Theory Structure Theory

PRE-MM THEORIESPRE-MM THEORIES Net Income (NI) TheoryNet Income (NI) Theory

Net Operating Income (NOI) TheoryNet Operating Income (NOI) Theory

Traditional TheoryTraditional Theory

Development of Capital Development of Capital Structure Theory Structure Theory

MM & POST-MM THEORIESMM & POST-MM THEORIESModigliani & Miller’s original 1958 Modigliani & Miller’s original 1958 theorytheory

Modigliani & Miller’s amended 1963 Modigliani & Miller’s amended 1963 theorytheory

Extension of MMs 1963 theory to Extension of MMs 1963 theory to include bankruptcy & agency costsinclude bankruptcy & agency costs

The static trade-off theoryThe static trade-off theory

WEIGHTED AVERAGE COST OF CAPITALWEIGHTED AVERAGE COST OF CAPITAL

USED IN CAPITAL BUDGETING DECISIONS TO USED IN CAPITAL BUDGETING DECISIONS TO CALCULATE NPVCALCULATE NPV

EXPECTED RETURN ON PORTFOLIO OF ALL EXPECTED RETURN ON PORTFOLIO OF ALL COMPANY’S SECURITIESCOMPANY’S SECURITIES

rrA A = (= (D/DD/D++EE))rrDD + ( + (E/DE/D++EE))rrEE

EXAMPLE: FIRM HAS £2 MILLION DEBTEXAMPLE: FIRM HAS £2 MILLION DEBT

– CURRENT BORROWING RATE, CURRENT BORROWING RATE, rrDD== 8% 8%

– 100,000 SHARES PRICED AT £30 PER SHARE100,000 SHARES PRICED AT £30 PER SHARE

– EXPECTED RATE OF RETURN ON SHARES, rEXPECTED RATE OF RETURN ON SHARES, rEE = 15% = 15%

DD=£2M, =£2M, EE=100,000 x £30= £3M, =100,000 x £30= £3M, VV = = DD++EE=2+3 = £5M=2+3 = £5M WACC = (D/D+WACC = (D/D+EE))rrDD + ( + (EE//DD++EE))rrEE

= (2/5).08 + (3/5).15= (2/5).08 + (3/5).15

=.122 OR 12.2%=.122 OR 12.2%

Financial Leverage

rD

rA

StockPrice

Financial Leverage

Po

rECapitalCost

Net Income TheoryNet Income Theory

No matter how modest or excessive the firm’s use of No matter how modest or excessive the firm’s use of debt financing, both its cost of debt capital, rdebt financing, both its cost of debt capital, rDD, and , and cost of equity capital, rcost of equity capital, rEE, remain CONSTANT, remain CONSTANT

The weighted average cost of capital, rThe weighted average cost of capital, rAA, and the , and the firm’s share price, Pfirm’s share price, Poo, ARE affected by the firm’s , ARE affected by the firm’s use of financial leverageuse of financial leverage

Since the cost of debt is lower than the cost of Since the cost of debt is lower than the cost of equity, greater use of debt equity, greater use of debt reducesreduces the weighted the weighted average cost of capital, ie the firm’s stock value average cost of capital, ie the firm’s stock value increasesincreases with increase in financial leverage with increase in financial leverage

Net Income (NI) TheoryNet Income (NI) Theory

Net Operating Income TheoryNet Operating Income Theory

Financial Leverage

CapitalCosts

rE

rD

rA

StockPrice

Financial Leverage

Po

Net Operating Income Net Operating Income (NOI) Theory(NOI) Theory

The firm’s market value is unaffected by it’s The firm’s market value is unaffected by it’s capital structurecapital structure

As financial leverage increases cheaper debt, rAs financial leverage increases cheaper debt, rDD, is , is substituted for more expensive equitysubstituted for more expensive equity

However, the firm’s cost of equity, rHowever, the firm’s cost of equity, rEE, will , will gradually rise in line with the increasing use of gradually rise in line with the increasing use of debtdebt

The value of the firm’s equity is therefore The value of the firm’s equity is therefore unaffected by the increase in financial leverage unaffected by the increase in financial leverage

Suggests that capital structure is irrelevant Suggests that capital structure is irrelevant

Financial Leverage

Capital Costs

rE

rA

rD

Traditional TheoryTraditional Theory

Intermediate Position Intermediate Position At moderate levels of financial leverage investors At moderate levels of financial leverage investors

don’t notice the risk of borrowingdon’t notice the risk of borrowing This results in a decrease in the weighted average This results in a decrease in the weighted average

cost of capital, rcost of capital, rAA

The probability that the firm will not be able to The probability that the firm will not be able to meet its financial obligations increases as more meet its financial obligations increases as more and more debt is employedand more debt is employed

Thus investors “wake up” when debt is excessive Thus investors “wake up” when debt is excessive and eventually at some point the expected cost of and eventually at some point the expected cost of default outweighs the advantage of debtdefault outweighs the advantage of debt

Traditional TheoryTraditional Theory

IMPLICATIONS OF IMPLICATIONS OF PRE-MM THEORIES PRE-MM THEORIES

Net Income (NI) TheoryNet Income (NI) Theory

Financial leverage is beneficialFinancial leverage is beneficial Net Operating Income (NOI) TheoryNet Operating Income (NOI) Theory

Financial leverage is irrelevantFinancial leverage is irrelevant Traditional TheoryTraditional Theory

There exists an optimal capital structureThere exists an optimal capital structure