Thursday, April 5, 2012

Capital Structure and Firm Value - Theory

Net income approach
Neto operation income approach
Traditional position
Modigliani and Miller position
Tradeoff theory
Singaling theory

Modigliani and Miller position


Assumptions of Modigliani – Miller Theory

(a) Capital markets are perfect. All information is freely available and there is no

transaction cost.

(b) All investors are rational.

(c) No existence of corporate taxes.

(d) Firms can be grouped into “Equivalent risk classes” on the basis of their business risk



Propositions made by Modigliani and Miller on Cost of Capital

The propositions made by Modigliani and Miller on cost of capital are:

(i) The total market value of a firm and its cost of capital are independent of its

capital structure. The total market value of the firm is given by capitalising the

expected stream of operating earnings at a discount rate considered appropriate for

its risk class.

(ii) The cost of equity (Ke) is equal to capitalisation rate of pure equity stream plus

a premium for financial risk. The financial risk increases with more debt content in the

capital structure. As a result, Ke increases in a manner to offset exactly the use of less

expensive source of funds.

(iii) The cut-off rate for investment purposes is completely independent of the way in

which the investment is financed.




Pecking order Theory of Capital Structure


The pecking order theory was proposed by Donaldson in 1961. The pecking order theory suggests that firm rely for finance, as much as they can, on internally generated funds. If internally generated funds are not enough then they will move to additional debt finance then equity. This is because the issue cost of internally generated funds have the lowest issue cost and cost of new equity is the highest. Myers has suggested that the firm follows a ‘modified pecking order’ in their approach to financing. Myers has suggested asymmetric information as a reason for heavy reliance on internal generated funds. He demonstrates that with asymmetric information, equity shares are interpreted by the market as bad news since managers are only motivated to issue equity share when share markets are undeveloped. Further, the use of internal finance ensures that there is regular source of finance which might be in line with company’s expansion programme. If additional funds are required over and above internally generated funds, then borrowings will be next alternative in this theory.

Thus, pecking order theory rests on:

(i) Sticky dividend policy,

(ii) A preference for internal funds,

(iii) An aversion to issue equity shares.





Prasanna Chandra, Financial Management, 5th Ed.,  Tata McGraw Hill, 2001

Brealey and Myers, Corporate Finance, Fifth Edition, Prentice Hall India, 2001


OK - 358

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