Capital Structure It can be described as the arrangement of capital by funds which consists of two broad types, equity and debt Capital structure is defined as the combination ‘of equity and debt that is put into use by a company in order to finance the overall peralions of the company and for its growth ¥ using different sources of long term ‘The different types of funds that are raised by a firm include preference shares, equity shares, retained earnings, long-term loans ete. These funds are raised for running the business, Equity Capital Equity capital is the money ‘owned by the shareholders or owners. It consists of two different types a) Retained earnings: Retained earnings are part of the profit that has been kept separately by the organisation and which will help in strengthening the business. ) Contributed Capital: Contributed capital is the amount of money which the company owners have invested at the time of opening the company or received from shareholders as a price for ownership of the company. Debt Capital Debt capital is referred to as the borrowed money that's utilised in business. There are different forms of debt capital [Link] Term Bonds: These types of bonds are considered the safest of the debts as they have an extended repayment period, and only interest needs tO be repaid while the principal needs to be paid at maturity. 2 Short Term Commercial Paper: This is a type of short term debt instrument that is used by companies to raise capital for a short period of time Optimal Capital Structure Optimal capital structure is referred to as the perfect mix of debt and equity financing that helps in maximising the value of a company in the market while at the same time minimises its cost of capital. Capital structure varies across industries For a company involved in mining or petroleum and oil extraction, 2 high debt ratio is not suitable, but some industries g have a high amount of debt as pat of their capital structure. like insurance or banking importance of Capital Structure Capital structs vital for a firm as it determines the overall stability of a firm. Here are some of the other factors that highlight the importance of capital structure 4. Aim having a sound capital structure has a higher chance of increasing the market price of the shares and securities that it possess°s; It will lead to a higher valuation in the market. 2. Agood capital structure ensures that the available funds are used effectively. It prevents over or under capitalisation 3. Ithelps the company in increasing its profts in the form of higher returns to stakeholders, 4. Aproper capital structure helps in maximising shareholder's capital while minimising the overall cost of the capital 5. A good capital structure provides firms with the flexibility of increasing or decreasing the debt capital as per the situation. Factors Determining Capital Structure Following are the factors that play an important role in determining the capital structure: 1. Costs of capital: It is the cost that is incurred in raising capital from different fund sources. A firm or a business should generate sufficient revenue so that the cost of capital can be met and growth can be financed Degree of Control: The equity shareholders have more rights in a company than the preference shareholders or the debenture shareholders. The capital structure of a firm will be determined by the type of shareholders and the limit of their voting rights. Trading on Equity: For a firm which uses more equity as a source of finance to borrow new funds to increase returns. Trading on equity is said to occur when the rate of return on total capital is more than the rate of interest paid on debentures or rate of interest on the new debt borrowed. Government Policies: The capital structure is also impacted by the rules and policies set by the government. Changes in monetary and fiscal policies result in bringing about changes in capital structure decisions. Net Income (NI) Approach on Capital Structure The Net Income (NI) Approach, proposed by David Durand, is a capital structure theory that suggests a direct relationship between capital structure and a firm's value. It argues that by altering the proportion of debt and equity in its capital structure, a firm can maximize its value and minimize its overall cost of capital (WACC). Key Assumptions of the Net Income Approach . Cost of Debt (Kd) is Less than Cost of Equity (Ke) Debt is cheaper than equity because of tax benefits and lower risk for debt holders. Use of More Debt Reduces Overall Cost of Capital (WACC) Since debt is cheaper, replacing equity with debt lowers the WACC, increasing firm value. No Taxes This theory assumes a world without corporate taxes (though in reality, taxes provide additional advantages to debt financing). Investors Perceive Risk Constantly It assumes that increased debt does not increase the financial risk perception among investors. Implications of the NI Approach More Debt — Lower WACC — Higher Firm Value More Equity + Higher WACC — Lower Firm Value Optimal Capital Structure Exists: A firm should use maximum possible debt to minimize WACC and maximize market value. Criticism of the NI Approach Ignores Financial Risk: Increasing debt increases financial risk, which can lead to higher equity costs. ‘Assumes No Bankruptcy Costs: In reality, excessive debt increases bankruptcy risk. No Taxes Assumption: Taxes influence financing decisions, favoring debt because of interest tax shields.Net Operating Income Approach The Net Operating Income Approach is in complete contrast to the Net Income Approach According to Net Operating Income Approach, the market value of the firm is not affected by its capital structure, The value of the firm and its overall cost of capital remains same irrespective of the proportion of debt (or financial leverage) in capital structure. The Net Operating Income Approach is based on the following assumptions. [Link] overall cost of capital, Ko, of the firm is known and constant. It depends upon the business risk, which is assumed fo be unchanged [Link] cost of debt, Kd, is known and constant [Link] more and more debt in the capital structure, increases financial risk to equity shareholders and results in the increase in the cost of equity capital, Ke. The increase in Ke is such that it completely off sets the benefits of employing cheaper debt [Link] are no taxes 5. Firm has perpetual life 6, Debt capital is perpetual [Link] of the Firm is Based on NOI and WACC: The total market value of the firm (V) is calculated as :V=NOI + WACCV Since WACC is assumed to be constant, NO! alone determines the firm's value. Implications Firms cannot reduce WACC by increasing leverage 2. The proportion of debt and equity does not impact firm value 3. Investors adjust their required return on equity (Ke) to reflect increased risk when leverage rises 4, Capital structure decisions become irrelevant in determining the firm's market value... Modigliani and ler (M&M) Theory of Capital Structure The Modigliani and Miller (M&M) theory of capital structure, proposed by Franco Modigliani and Merton Miller in 1958, is one of the most influential theories in corporate finance. It explains the relationship between a firm's capital structure (mix of debt and equity) and its overall value The MM Theory in corporate taxes is considered a great milestone in the finance sector. In the MM Theory, the firm's value does not depend on the dividend policy. The value also does not depend on whether or not the firm raises capital by selling the debt or issuing stocks. Another name for the Modigliani-Mliller Theory is the capital structure irrelevance principle. 1. Modigliani and Miller Proposition | (Without Taxes) This proposition states that a firm’s value is independent of its capital structure. ‘Assumptions: [Link] corporate taxes [Link] transaction costs or bankruptcy costs 3. Perfect capital markets (all investors have the same information and can borrow/lend at the same rate as firms) 4, Investment decisions remain unchanged by financing choices Implication: 5. The total value of a firm is determined by its net operating income (NOI) and the overall cost of capital (WACC), not by the debt-equity mix. 6. Changing the capital structure does not affect the firm's value or cost of capital. 7. If a firm increases debt, the cost of equity increases proportionally to compensate for higher risk VL=VUWhere: * VLVL = Value of a levered firm (with debt) * VUVU = Value of an unlevered firm (without debt)wna 2. Modigliani and Miller Proposition I! (Without Taxes) This proposition explains how the cost of equity (Ke) increases as a firm takes on more debt due to financial risk Key Implication: Asa firm increases its debt, its equity becomes riskier because debt holders have a prior claim on earnings, Asa result, shareholders demand a higher return (Ke) to compensate for the added financial risk, However, the Weighted Average Cost of Capital (WACC) remains constant Formula: Ke=Kut(D/E) (Ku-Kd) Where: Ke = Cost of equity K u=Cost of equity for an unlevered firm, Kd = Cost of debt, D/fi= Debi-to-equity ratio M&M Proposition | & II (With Taxes) In 1963, M&M revised their theory to include corporate taxes, leading to new conclusions: 1, Proposition | (With Taxes) Firm value increases with more debt because interest payments are tax-deductible, reducing taxable income. This creates a tax shield, which benefits firms with higher leverage. The value of a leveraged firm is:VL=VU+(TexD) VL=VUs(TexD)Where Tc = Corporate tax rate, D = Debt 2. Proposition Il (With Taxes) The cost of equity still rises with debt, but the WACC decreases because interest payments reduce taxes, This suggests firms should use more debt to maximize their value. Criticism of M&M Theory: No Bankruptcy Costs ~ In reality, excessive debt increases the risk of financial distress. No Agency Costs ~ Managers and shareholders may have conflicting interests. No Transaction Costs — Issuing debt/equity involves fees, Perfect Market Assumption — In reality, markets are not perfectly efficient. ‘Conclusion: Without Taxes: Capital structure does not affect firm value. With Taxes: Debt financing adds value due to the tax shield, encouraging firms to use debt. The theory forms the foundation of modern capital structure decisions, balancing the benefits of debt (tax shield) against the risks (bankruptcy). MM Theory is essential in the economic field as it states what factors affect the optimal capital structure and how they affect it. Modigliani and Miller proposed the MM Theory. Both of them won Noble prizes in the economy for this contribution. Modigliani won the Nobel in 1985, and Miller won in 1990. The MM Theory suggests that two firms, one of which is levered and the other one is unlevered, will have the same enterprise value and will return the same returns on investment after some time. However, this value isn't the same as the firm's equity.Traditional Theory of Capital Structure The traditional theory was postulated by Ezra Solomon. The traditional theory of capital Structure states that when the weighted average cost of capital is minimized, and the market value of assets is maximized, an optimal structure of capital exists. This is achieved by utilizing a mix of both equity and debt capital, This point occurs where the marginal cost of debt and the marginal cost of equity are equated, and any other mix of debt and equity financing where the two are not equated allows an opportunity to increase fitm value by increasing or decreasing the firm's leverage. The traditional theory of capital Structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the WACC and maximizes value. Under this theory, the optimal capital structure occurs where the marginal cost of debt is equal to the marginal cost of equity. Assumptions. This theory depends on assumptions that imply that the cost of either debt or equity financing vary with respect to the degree of leverage 1. The rate of interest on the debt stays constant for a certain period and after that, with an increase in leverage, it goes up. 2. The expected rate of interest in investment by equity shareholders remains constant or increases gradually. After reaching the threshold, the equity shareholders start perceiving a financial risk, and then from the optimal point, the expected rate of interest increases quickly. 3. As a result of the rate of interest and expected rate of return working together, the WACC. first starts to decrease, and then it increases. In the capital structure graph, the lowest point refers to the optimal ratio. (1.) What is capital structure ? Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. Definitions of Capital Structure |. James C. Van Home, "The mix ofa firm's permanent long-term financing represented by debt, preferred stock, and common stock equity”. 2. Prasana Chandra, “The composition of a firm's financing consists of equity, preference, and de! 3. Gerstenberg, “The make-up of a firm’s capitalisation”. (2) Differentiate ‘Capitalization’ and ‘Capital Structure’. | Capitalization is a quantitative aspect of financial planning But, Capital Structure is concerned with qualitative aspect of financial planning. 2 Capitalization refers to the total amount of securities issued by a company. Where as Capital Structure refers to the kinds of securities and proportionate amounts that make up capitalization. 3) Differentiate between ‘Financial Structure’ and ‘Capital Structure’, a. Financial Structure: Financial structure means the entire liabilities side of the balance sheet, Nemmers and Grunewald, “Financial Structure refers to all the financial resources marshalled by the firm, short as well as long term, and all forms of debt as well as equity”. Thus, financial structure, generally is composed of a specified percentage of short-term debt, long-term debt and shareholders” funds. +. Capital Structure: Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. |. James C. Van Horne, "The mix of a firm's permanent long-term financing represented by debt, preferred stock, andcommon stock equity". 2. Prasanna Chandra, “The composition of a firm's finan equity, preference, and debt’ 1g consists of 3. Gerstenberg, “The make-up of a firm’s capitalisation”, (4) What is Cost of Capital? Cost of capital fora firm may be defined asthe cost of obtaining funds, ic, the average rate of return that the investors in a firm would expect for supplying funds to the firm, Definitions of Cost of Capital: 1. Hunt, William and Donaldson, “Cost of capital may be defined as the rate that must be eared on the net proceeds to provide the cost el they are due”, ments of the burden at the time, ‘Thus, we can say that cost of capital is that minimum rate of return which a firm, must and, is expected to ear on its investments so as to maintain the market value of its shares (5) write the Significance of cost of capital, The concept of cost of capital is very important inthe financial management, It plays a crucial role in both capital budgeting as well as decisions relating to planning of capital structure. Cost of capital ‘concept can also be used as a basis for ‘evaluating the performance of a firm and it further helps ‘management in taking so many other financial decisions. 1. As an Acceptance Criterion in Capital budgeting 2. As a Determinant of Capital Mix in Capital Structure Decisions 3, As A Basis for Evaluating the Financial Performance 4. As a Basis for taking other Financial Decisions (6) What is meant by Capital Structure? What are the factors determ structure? Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings Definitions of Capital Structure. James C. Van Horne, "The mix of a firm's permanent long-term financing represented by debt, preferred stock, and common stock equ Prasana Chandra, “The composition of a firm's financing consists of equity, preference, and debt", ing the capital FACTORS DETERMINING CAPITAL STRUCTURE: |. Trading on Equity: The word "equity" denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that ‘equity shareholders earn because of issuance of debentures and preference shares. 2. Degree of control: In.a company, itis the directors who are elected representatives of equity shareholders. If the company's management Policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares. 3. Flexibility of financial plan: In an enterprise, the capital structure should be such that there is both Contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans 4. Choice of investors: A capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. 5. Capital market condition: In the lifetime of the company, the market price of the shares hhas got an important influence. During the depression period, the company's capital structure generally consists of debentures and loans, While in period of booms and inflation, the company's capital should consist of share capital generally equity shares,6, Period of financing: When company wants to raise finance for short period, it goes for loans from banks and other institutions, while for long period it goes for issue of shares and debentures. 7. Cost of financing: In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove tobe a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits - 8. Stability of sales: When sales are high, thereby the profits are high and company better position to meet such fixed commitments like interest on debentures and be dividends on preference shares. If company is having unstable sales, then the company is notin position to meet fixed obligations. So, equity capital proves to be safe in such cases - 9. Sizes of a company: Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, Stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. Explain the Traditional Approach and Modigliani and Miller Approach of Capital Structure Different kinds of theories have been propounded by different authors to explain the relationship between capital structure, cost of capital and value of the firm. The main contributors to the theories are Durand, Ezra, Solomon, Modigliani and Miller. The important theories are [Link] Income Approach. 2. Net Operating Income Approach.: 3. The Traditional Approach 4. Modigliani and Miller Approach. sin The Traditional Approach: The traditional approach, also known as Intermediate approach, is a compromise between the two extremes of net income approach and net operating income approach ‘According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity. Thus, optimum capital structure can be reached by a proper debt-equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity ‘Afier this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt. Thus, overall cost of capital, according to this theory, decreases up toa certain point, remains more or less unchanged for moderate increase in debt thereafter, and increases or rises beyond a certain point. Even the cost of debt may increase at this stage due to increased financial risk. Modigliani and Miller Approach Modigliani and Miller approach states that the financing decision ofa firm does not affect the market value of a firm in a perfect capital market. In other words, MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital structures of the firm. Modigliani and Miller approach is based on the following important assumptions. There is a perfect capital market.e There are no retained earnings.e There are no corporate taxes. The investors act rationally.» The dividend pay-out ratio is 100% The business consists of the same level of business risk.» Value of the firm can be calculated with the help of the following formula: EBIT.- where EBIT= earnings before interest and tax Ko Ko=Over all cost of capital , t= Tax rateFinancial Distres: Financial distress occurs when a company faces difficulties in meeting its financial obligations, such as paying interest, principal on debt, or operational expenses If unresolved, it can lead to bankruptcy or liquidation. Causes of Financial Distress 1. Excessive Debt - High leverage increases financial risk [Link] Revenues — Poor sales and lower profitability reduce cash flow 3 Poor Financial Management — Inefficient cost control, overexpansion, or bad investments 4,Economic Downturns ~ Recession, inflation, or market instability affecting business performance. [Link] and Regulatory Issues — Lawsuits, fines, or government restrictions 6. Industry-Specific Challenges — Competitive pressures, technology disruptions, or raw material shortages Signs of Financial Distress 1. Frequent loan defaults or delayed payments. 2. Declining profit margins and negative cash flow. 3. Credit rating downgrades. 4. 5. Employee layoffs and budget cuts Increasing dependence on external financing Consequences of Financial Distress 1. - Lenders charge higher interest rates due to increased risk.2 — Share prices drop, and investors withdraw funds.-[Link] may take legal action for debt recovery.4 — Selling assets to generate cash, often at lower-than-market value. 5. — If financial distress worsens, the company may file for bankruptcy or restructure debt. Ways to Manage Financial Distress Debt Restructuring — Renegotiating loan terms with creditors, Cost Reduction — Cutting unnecessary expenses, optimizing operations. Improving Cash Flow — Selling non-core assets, improving receivables collection. Raising Capital — Seeking additional funding through equity or new debt. Strategic Changes - Mergers, acquisitions, or changes in business models to improve sustainability. Proper financial planning, risk management, and maintaining an optimal capital structure can help prevent financial distress and ensure long-term business stability. geeps Trade-Off Theory of Capital Structure The Trade-Off Theory of capital structure suggests that firms balance the benefits and costs of debt and equity financing to determine an optimal capital structure. The theory acknowledges the tax advantages of debt while considering the financial distress costs associated with excessive leverage. Components 1. Tax Benefits of Debt + Interest payments on debt are tax-deductible, reducing the overall tax burden (tax shield). This makes debt financing attractive, as it lowers the firm's taxable income. 2. Bankruptcy and Financial Distress Costs———$—$ $$ + Excessive debt increases the risk of bankruptcy and associated legal costs. Firms with high leverage may face financial distress, leading to asset devaluation, lower credit ratings, and loss of customer confidence. [Link] Costs + Equity holders vs. debt holders conflict: Debt holders may impose restrictive covenants limiting managerial flexibility Debt overhang problem: High debt discourages equity investment since new investors may see returns going toward debt repayment + 4,Optimal Capital Structure + Firms aim to find a balance where the marginal benefit of debt (tax shield) equals the marginal cost (financial distress risk). This results in an optimal debt-to-equity ratio that maximizes firm value Comparison with Other Theories + Modigliani & Miller (M&M) Theory (Without Taxes): Suggests capital structure is irrelevant in a perfect market. + Pecking Order Theory: Firms prefer internal financing (retained earnings) over debt and issue equity as a last resort, rejecting the idea of an optimal capital structure. + Market Timing Theory: Suggests firms choose financing based on market conditions rather than maintaining a target capital structure. Implications + Firms with stable cash flows (e.g., utilities) tend to take on more debt due to predictable income. + High-growth firms (e.g., tech startups) rely more on equity financing to avoid distress costs. + The theory explains capital structure variations across industries and firms.Dividend policy A dividend is a payment made by a company to Its shareholders, usually from its profits, It represents a share of the company's earnings, given periodically to investors as a reward for their investment and trust in the business, Types of Dividend Policy . Regular Dividend Policy Companies with a regular dividend policy aim to provide consistent payouts to shareholders, often on a quarterly or annual basis. This approach is ‘common among mature, financially stable companies with predictable cash flows. By paying dividends regularly, companies reassure shareholders of a steady income stream, which can enhance investor loyalty. This policy is ideal for investors seeking income stability over long-term growth, Stable Dividend Policy Under a stable dividend policy, a company pays dividends at a consistent rate, regardless of its earnings fluctuations. This type of policy is popular with well-established companies that prioritize shareholder trust and aim to build a reputation for reliability, For example, if a company sets a dividend rate of &5 per share, it will continue to pay this amount even if profits dip. A stable policy attracts risk-averse investors, as they can rely on a predictable return even in uncertain market conditions Irregular Dividend Policy Companies with an irregular dividend policy distribute dividends only when they achieve high profits or have excess cash reserves. Since payouts are unpredictable, this policy suits companies with variable earnings or those in Volatile industries. For instance, companies in technology or startups may choose this policy to retain more cash during lean periods and reward shareholders only during profitable years. While it offers flexibilty, an irregular policy may deter investors looking for consistent returns. 4, No Dividend Policy Companies with a no dividend policy reinvest all profits back into the business rather than paying dividends. This policy is common among high-growth companies or startups that need substantial funds for expansion, research, and development. By retaining earnings, these companies focus on building long-term value and capital appreciation for shareholders, rather than short-term income. Investors in such companies expect higher capital gains over time instead of regular payouts. Importance + Building Investor Confidence: A clear dividend policy shows the company's financial health. Consistent dividends reassure shareholders and build loyalty among investors who seek regular returns. + Balancing Growth and Income: Dividend policies help decide how much profit to retain versus distribute. This balance lets the company fund growth while offering income to shareholders, attracting a wider range of investors. + Enhancing Market Reputation: Companies with strong dividend policies often gain a better market standing. A reliable payout track record attracts investors and can improve the company's market perception. + Supporting Cash Flow Management: Dividend policies help companies manage their cash flow by setting a fixed approach to payouts. This supports planning for expenses and investments while ensuring resources for dividends. + Attracting Suitable Investors: Different dividend policies appeal to various types of investors. For example, regular dividends attract income-focused investors, while no- dividend policies appeal to growth-oriented investors.+ Objectives Ensuring Regular Income for Shareholders: A well planned dividend policy Provides shareholders with consistent income. This regular income builds trust and attracts investors who rely on steady earnings from their investments. + Supporting Growth and Expansion: Dividend policies ensure that sufficient funds are retained for business growth. By controlling the payout ratio, the policy allows Companies to reinvest in projects and expansion, contributing to sustainable development. + Improving Market Perception: A reliable dividend policy boosts the company's mage in the market. It demonstrates financial stability and commitment to Shareholders, which can attract more investors and increase the company's stock value over time. Dividend Decision Theory ; Dividend theories investigate the When and Why companies Pay dividends to shareholders as well as how these distributions affect a company's value and shareholder wealth. The theories are divided into two groups as follows: Dividend Decision Theories] Relevant relevant Theories Theories : Miltor Walter's Gordon's | : Modigiiani Model Model rodigliay IRRELEVANCE OF DIVIDENDS : 1) GENERAL VIEW: The argument supporting the irrelevance of dividends to valuation is that the dividend policy of a firm is a part of its financing decision, As a part of the financing decision, the dividend policy of the firm is a residual decision and dividends are a passive residual. Itimplies that when a firm has sufficient investment opportunities, it will retain the earnings to finance them. Conversely, if acceptable investment opportunities are inadequate, the implication is that the earnings would be distributed to the shareholders. The test of adequate acceptable investment opportunities is the relationship between the return on the investments (r) and the cost of capital (k) As long as (r) exceeds (k), a firm has acceptable investment opportunities That dividend are irrelevant, or are passive residual, is based on the assumption that the investors are indifferent between dividend and capital gains So long as the firm is able to earn more than the equitycapitalisation rate (ke ), the investors would be content with the firm retaining the earings. In contrast, if the return is less than the (ke ), investors would prefer to receive the earnings i.e. dividends MM hypotheisis ‘The Modigliani and Miller Dividend Irrelevance Theory was proposed by Franco Modigliani and Merton Miller in 1961. The theory suggests that, in a perfect capital market, a firm's dividend policy has no effect on its value or cost of capital. Instead, the firm's value is determined solely by its investment decisions and earnings, not by how profits are distributed to shareholders.Be Assumptions Perfect Capital Markets — No taxes, no transaction costs, and all investors have access to the same information. No Taxes or Same Tax Rate for Dividends and Capital Gains ~ Investors are indifferent between receiving dividends or selling shares. No Transaction Costs - Buying and selling shares has no cost Investment Policy is Fixed - The firm's future earings and investment decisions are not influenced by dividend policy. No Information Asymmetry — Investors and managers have the same information about the firm's prospects MM's Argument for Dividend Irrelevance Investors can create their own "homemade dividends" by selling a portion of their shares if they prefer cash over retained earnings. Since investors can replicate dividends through stock sales, dividend distribution does not affect the firm's stock price or market value The firm's value depends on its investment opportunities and earnings potential, not its dividend payout. Implications of MM Theory Dividends do not affect stock prices in a perfect market. Firms should focus on profitable investments rather than dividend payouts. Investors should be indifferent between receiving dividends or capital gains, as both yield the same total return. Criticism & Real-World Limitations Taxes Exist - Dividends are often taxed higher than capital gains, making capital gains preferable for investors. Transaction Costs Exist - Selling shares to generate "homemade dividends” incurs brokerage fees. Investor Preferences - Some investors, such as retirees, prefer stable dividend income over capital gains. Market Imperfections — Information asymmetry, agency costs, and signaling effects impact dividend decisions, WALTER'S MODEL: This model supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are interlinked. ‘The key argument in support of the relevance of Walter's model is the relationship between the return on a firm's investment (r) and its cost of capital/ required rate of return . Ifr> k ( growth firms) the firm should retain the earnings or D/P ratio should be zero as it is able to earn higher than what the shareholders could by investing on their own. In case r < k (declining firms) it implies that shareholders can eam a higher return by investing elsewhere. Therefore, the entire earnings (D/P ratio should be 100 percent) should be distributed to them. Finally, when r =k (normal firms), it is a matter of indifference whether earnings are retained or distributed. This is so because for all D/P ratios (ranging between zero and 100) the market price of shares will remain constant. For such firms, there is no optimum. dividend policy (DIP ratio). By following such a policy in all the three cases, the market price of shares will be maximisedASSUMPTIONS: 1) All financing is done through retained eamings. 2) With additional investments undertaken, the firm's business risk does not change. It implies that r and k are constant. 3) The firm has perpetual life. According to Walter, the value of the firm, as measured by the market price per share (P) is given by the following equation P=( D+ t/Ke(E- D) ) /Ke Where P= The prevailing market price of the share, D = Dividend per share, E = Earnings per share and r= The rate of return on the firm’s investment. GORDON’S MODEL: Another theory which contends that dividends are relevant is Gordon's model. This mode! which ‘opines that dividend policy of a firm affects its value, is based on the following assumptions: 1) The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings 2)rand ke are constant. 3) The firm has a perpetual life 4) The retention ratio, once decided is constant. Thus, the growth rate, ( g = br) is also constant. 5)Ke> br ARGUMENTS: Gordon's model contends that dividend policy of the firm is relevant and that investors put a premium on current incomes/dividends. AAs investors are rational, they want to avoid risk. The payment of current di removes any chance of risk. If current dividends are withheld, the investors can expect to get a dividend in future. The future dividend is uncertain, both with respect to the amount as well as the timin; ‘Thus the rational investors can reasonably be expected to prefer current dividend. They will place less importance on future dividend as compared to current dividend. The retained earnings are evaluated by the investors as a risky promise, thus if earnings are retained, the market price of share would be adversely affected. ‘The above argument underlying Gordon’s model of dividend relevance is also described as a bird-in- the-hand argument. That a bird in hand is better than two in the bush is based on the logic that what, is available at present is preferable to what may be available in future. FORMULA: A simplified version of Gordon’s model is expressed as P= E (1-b)/ Ke- br Where P = Price of a share, E = earnings per share, b = retention ratio or percentage of earnings retained, 1-b = D/P ratio, ke = Capitalisation rate/ cost of capital, Br= g = Growth rate = rate of return on investment of an all equity firmLeverage Analysis Leverage refers to borrowing funds for a particular purpose with an obligation to repay these funds, with interest, according to an agreed schedule The idea behind leverage is to help borrowers achieve a higher return with a smaller investment Definition of Leverage James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return. Two ways to borrow capital are to issue bonds (equity financing) or borrow directly from lenders (debt financing), Equity financing involves selling your equity in exchange for funding. One of the biggest benefits of equity financing is that it doesn’t lead to the company having to make interest payments or any principal repayment Debt financing involves a company borrowing money to fund working capital requirements. When a company borrows money, it needs to make interest payments as well as repay the principal ‘Types: FINANCIAL LEVERAGE Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company's earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure, is described as financial leverage or gearing or trading on equity. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share’. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders, “The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”. Financial leverage may be favourable or unfavourable depends upon the use of fixedcost funds Favourable financial leverage occurs when the company ears more on the assets purchased with the funds, then the fixed cost of their use. Hence, itis also called as positive financial leverage. Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, itis also called as negative financial leverage. Financial leverage can be calculated with the help of the following formula FL=OP/PBT Where, FL = Financial leverage 35 OP = Operating profit (EBIT) PBT Profit before tax. Degree of Financial Leverage Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax (EBIT). This can be calculated by the following formula DFL = Percentage change in taxable income/ Percentage change in EBITOPERATING LEVERAGE: The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company's ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz,, fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis. Operating leverage can be calculated with the help of the following formula; OL= C/OP Where, OL = Operating Leverage C = Contribution OP = Operating Profits Degree of Operating Leverage The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula: DOL = Percentage change in profits/ Percentage change in sales. Combined leverage Combined leverage accounts for your organization's total business risks. As the name suggests, combined leverage aggregates the effects of operating and financial leverages to present a complete picture of your company's financial health. Capital-intensive businesses with expansion potential but insufficient levels of cash or equity ‘can use combined leverage. To effectively use combined leverage though, be sure of your business's future expenses and expected market conditions. High levels of combined risk ‘can make retums susceptible to variable inputs, such as sales volumes, importance Provide a comprehensive view of a company's risk profile Help in making informed decisions about expansion or investments Illustrate the potential impact of changes in sales on net income Calculate combined leverage by multiplying the degree of operating leverage (DOL) and the degree of financial leverage (DFL). A high combined leverage indicates that a small change in sales can lead to a large change in earnings per share.