Development of Capital Structure Theory n PRE-MM THEORIES Net Income (NI) Theory Net Income (NI) Theory Net Operating Income (NOI) Theory Net Operating Income (NOI) Theory Traditional Theory Traditional Theory

Development of Capital Structure Theory n MM & POST-MM THEORIES Modigliani & Miller’s original 1958 theory Modigliani & Miller’s amended 1963 theory Extension of MMs 1963 theory to include bankruptcy & agency costs The static trade-off theory

WEIGHTED AVERAGE COST OF CAPITAL n USED IN CAPITAL BUDGETING DECISIONS TO CALCULATE NPV n EXPECTED RETURN ON PORTFOLIO OF ALL COMPANY’S SECURITIES r A = (D/D+E)r D + (E/D+E)r E n EXAMPLE: FIRM HAS £2 MILLION DEBT –CURRENT BORROWING RATE, r D = 8% –100,000 SHARES PRICED AT £30 PER SHARE –EXPECTED RATE OF RETURN ON SHARES, r E = 15% n D=£2M, E=100,000 x £30= £3M, V = D+E=2+3 = £5M n WACC = (D/D+E)r D + (E/D+E)r E = (2/5).08 + (3/5).15 = (2/5).08 + (3/5).15 =.122 OR 12.2% =.122 OR 12.2%

Financial Leverage rDrD rArA Stock Price Financial Leverage PoPo rErE Capital Cost Net Income Theory

n No matter how modest or excessive the firm’s use of debt financing, both its cost of debt capital, r D, and cost of equity capital, r E, remain CONSTANT n The weighted average cost of capital, r A, and the firm’s share price, P o, ARE affected by the firm’s use of financial leverage n Since the cost of debt is lower than the cost of equity, greater use of debt reduces the weighted average cost of capital, ie the firm’s stock value increases with increase in financial leverage Net Income (NI) Theory

Net Operating Income Theory Financial Leverage Capital Costs rErE rDrD rArA Stock Price Financial Leverage PoPo

Net Operating Income (NOI) Theory n The firm’s market value is unaffected by it’s capital structure n As financial leverage increases cheaper debt, r D, is substituted for more expensive equity n However, the firm’s cost of equity, r E, will gradually rise in line with the increasing use of debt n The value of the firm’s equity is therefore unaffected by the increase in financial leverage n Suggests that capital structure is irrelevant

Financial Leverage Capital Costs rErE rArA rDrD Traditional Theory

n Intermediate Position n At moderate levels of financial leverage investors don’t notice the risk of borrowing n This results in a decrease in the weighted average cost of capital, r A n The probability that the firm will not be able to meet its financial obligations increases as more and more debt is employed n Thus investors “wake up” when debt is excessive and eventually at some point the expected cost of default outweighs the advantage of debt Traditional Theory

IMPLICATIONS OF PRE-MM THEORIES n Net Income (NI) Theory Financial leverage is beneficial Financial leverage is beneficial n Net Operating Income (NOI) Theory Financial leverage is irrelevant Financial leverage is irrelevant n Traditional Theory There exists an optimal capital structure There exists an optimal capital structure