ARSI UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

INDIVIDUAL ASSIGNMENT
Course Title: Financial Management II (AcFn3042)

Students Name Students ID NO.

1. Negese Wedajo……………………………... EX/UG0372/16

Submitted to: ________________

Submission Date: Aug/02/2026

 CAPITAL STRUCTURE THEORIES

1. Introduction

Capital structure refers to the specific combination of debt and equity used by a corporation to finance its overall
operations and growth. Capital structure theories examine whether an optimal financial mix exists that
minimizes the Weighted Average Cost of Capital (WACC) and maximizes firm value. Four major theories form
the theoretical foundation of modern corporate finance:

Four major theories provide for capital structure theories

1. Net Income (NI) Approach 3. Traditional Approach
2. Net Operating Income (NOI) Approach 4. Modigliani-Miller (MM) Approach

[Link] Income (NI) Approach

CORE PROPOSITION: Capital structure MATTERS. A firm can increase its total value and lower its overall
cost of capital by continuously increasing the proportion of debt in its capital structure.

2.1 Key Assumptions

 1. Constant Cost of Debt (Kd): Cost of debt remains constant regardless of the leverage ratio.
 2. Constant Cost of Equity (Ke): Equity holders' required return remains unchanged despite financial risk.
 3. Corporate Taxes Exist: Interest paid on debt provides a tax shield advantage.
 4. Zero Transaction Costs: No issuance or floatation costs exist in capital markets.

2.2 Theoretical Logic

Because debt is inherently cheaper than equity (due to contractually fixed lower risk and tax deductibility),
increasing the weight of debt (Wd) lowers the overall Weighted Average Cost of Capital (WACC). A lower
WACC increases total firm value (V = EBIT / WACC).
Conclusion: 100% Debt represents the Optimal Capital Structure (maximizing firm value).

2.3 Formula Relationships & Graph Pattern

 • WACC Formula: WACC = (Wd × Kd) + (We × Ke)
 • As Debt Increases (D ↑): Wd ↑ → WACC (Ko) ↓ → Firm Value (V) ↑
 • Graph Trajectory: Kd and Ke are flat horizontal lines; WACC slopes downward; Firm Value slopes
upward.

2.4 Main Criticisms

 • Unrealistic Risk Assumption: Ke does not stay constant; financial risk increases required equity return.
 • Ignores Bankruptcy Risk: Extreme leverage causes financial distress and lender default risk.
 • Lender Constraints: Kd will inevitably increase at high debt levels as lenders demand risk premiums.
[Link] Operating Income (NOI) Approach

CORE PROPOSITION: Capital structure DOES NOT MATTER. The market value of a firm depends entirely
on its net operating income (EBIT) and underlying business risk, making capital structure decisions completely
irrelevant.
3.1 Key Assumptions
 1. Constant Overall Capitalization Rate (Ko): The market evaluates total firm risk as a whole.
 2. Proportional Equity Risk: Use of cheap debt increases financial risk, causing Ke to rise proportionally.
 3. EBIT-Based Valuation: Markets capitalize total firm value based on EBIT regardless of financial mix.

3.2 Theoretical Logic

The financial benefit of using cheaper debt is exactly offset by the increase in the cost of equity (Ke) demanded
by shareholders to compensate for increased financial risk. Consequently, WACC (Ko) remains constant.
Conclusion: An optimal capital structure does not exist. All capital structures are equivalent.

3.3 Formula Relationships & Graph Pattern

 • Firm Value Formula: Firm Value (V) = EBIT / Ko
 • As Debt Increases (D ↑): Kd remains low, Ke rises linearly, WACC (Ko) and Firm Value (V) stay
constant.
 • Graph Trajectory: Kd is horizontal; Ke slopes upward linearly; Ko and Firm Value remain horizontal.

3.4 Main Criticisms

 • Ignores Tax Benefits: Fails to account for corporate interest tax shields observed in real markets.
 • Perfect Market Idealization: Assumes market efficiency and proportional Ke adjustments rarely seen in
practice.
4 Traditional Approach (Intermediate
CORE PROPOSITION: Capital structure MATTERS. There exists an OPTIMAL debt-to-equity ratio where
total firm value is maximized and the overall Weighted Average Cost of Capital (WACC) is minimized.

4.1 Three-Stage Logic

 Stage 1: Moderate Debt (Value Increasing) Cheap debt lowers WACC because Ke increases slowly
without fully offsetting debt advantages. Firm value increases.
 Stage 2: Optimal Mix (Maximum Value) The perfect equilibrium is achieved where WACC reaches its
absolute minimum and firm value reaches its maximum.
 Stage 3: Excessive Debt (Value Decreasing) High debt increases financial distress and bankruptcy risk.
Both Ke and Kd rise sharply, causing WACC to increase and firm value to fall.

4.2 Graph Pattern & Key Insights

 • WACC Curve: U-shaped curve (decreases, hits minimum, then increases).
 • Firm Value Curve: Inverted U-shaped curve (increases, reaches peak, then declines).
 • Real-World Alignment: Explains corporate practices of maintaining moderate debt to balance tax
benefits against financial distress costs.
5. Modigliani-Miller (MM) Approach

Proposed by: Franco Modigliani and Merton Miller (1958, 1963)

5.1 MM Proposition I & II (Without Taxes - 1958)

 • Proposition I Statement: In perfect capital markets without taxes, firm value is independent of capital
structure (VL = VU).
 • Arbitrage Mechanism: Investors engage in personal arbitrage (buying/selling levered/unlevered shares)
to eliminate price discrepancies, restoring valuation equilibrium.
 • Proposition II Formula: Ke = Ko + (Ko − Kd) × (D / E). Cost of equity increases linearly with the debt-
to-equity ratio.

5.2 MM Proposition I & II (With Corporate Taxes - 1963)

TAX-ADJUSTED MM PROPOSITION: With corporate taxes, firm value INCREASES with leverage due to
the present value of the interest tax shield.
 • Levered Firm Value: VL = VU + (Tc × D), where Tc is corporate tax rate and D is debt market value.
 • Tax-Adjusted Cost of Equity: Ke = Ko + (Ko − Kd)(1 − Tc) × (D / E). Ke rises less steeply due to tax
shielding.
 • Conclusion: With corporate taxes, 100% debt maximizes firm value (theoretical maximum).

5.3 Core Assumptions & Practical Limitations

 • Perfect Capital Markets: Assumes zero transaction, agency, or financial distress costs.
 • Equal Borrowing Rates: Assumes individuals and corporations can borrow at identical interest rates.

6. Comparative Summary of Capital Structure Theories

Theory Structure Optimal WACC Pattern Key Driver /

Matters? Structure? Assumption

NI Approach Yes 100% Debt Decreases Ke & Kd remain constant

continuously

NOI Approach No None (All equal) Constant (Ko) Ke increases

proportionally

Traditional Yes Optimal mix exists U-shaped curve Trade-off: Tax vs

Financial Risk

MM (No Tax) No None (Irrelevant) Constant Arbitrage in perfect

markets

MM (With Tax) Yes 100% Debt Decreases with Interest tax shield (Tc ×
leverage D)

Theories of Dividend
A theory states the relationship between a dependent variable and one independent variable
when other independent variables are held constant.
You must have seen that in case of capital structure theories, the value of a company is
taken to be a function of capital structure (Dept/equity ratio) when other determinants or
influencing variables are held constant. Similarly, in a theory of dividend the value of a company
is taken to be a function of dividend decision when other influencing variables are held constant.
On the question of influence of dividend decsion on the value of the company and cost of capital
there are the contradicting views. One view states that the dividend decision does not influence
the value of a company. This school of thought holds that the dividends are irrelevant. Another
school is of the view that dividends are relevant which means that the value of a company depends
on the dividend decision. Therefore, theories of dividend are two types:
i) Dividend Relevance theory
ii) Dividend Irrelevance theory

RELEVANCE Dividend Relevance Theories

Dividend policy significantly impacts the share price and overall market value of the firm.
Traditional Model (Graham & Dodd): Investors
prefer current dividends over uncertain capital gains.
Walter Model: Valuation depends on internal rate of return (r) vs cost of capital (k).
Gordon Model: Bird-in-the-hand perspective; future growth discounted at higher rates.
IRRELEVANCE Dividend Irrelevance Theory
Dividend policy does not affect valuation; market value depends entirely on basic earning power.
Modigliani & Miller (MM) Hypothesis: Capital gain sperfectly offset dividend payouts in perfect capital
markets. Market value is driven solely by investment policy and earning capacity (I and X).

1 In-Depth Analysis of Dividend Relevance Theories

1.1 The Traditional Model (Graham & Dodd)

Benjamin Graham and David Dodd asserted that stock markets inherently favor liberal dividend payouts over
retained earnings. Investors place substantially greater weight on immediate, tangible cash returns than on
speculative future capital gains.
Graham & Dodd Valuation Formula:
P = M × [ D + (E / 3) ] = M × [ (4/3)D + (1/3)R ]
Where: P = Market Price per Share, D = Dividend per Share (DPS), E = Earnings per Share (EPS) = D + R, R =
Retained Earnings per
Share, M = Multiplier.
Key Takeaway: Dividends carry 4 times the weight of retained earnings in market price determination.

1.2 James E. Walter's Model

Professor James Walter proposed that the impact of dividend policy on firm valuation depends fundamentally
on the relationship between the firm’s internal rate of return on investment (r) and its cost of capital (k).
Walter's Valuation Model Formula:
P = [ D + (E - D)(r / k) ] / k
Walter's Three Structural Typologies:
iGrowth Firm r > k 0% Payout (100% Retention) The firm earns higher returns on retained profits than
shareholders could achieve individually. Retention maximizes share price. Declining Firm r < k 100% Payout
(0%Retention) Shareholders can earn a better return elsewhere (k) than the firm's internal investments (r). Full
distribution maximizes value. Normal Firm r = k Irrelevant (Any %Payout) Internal retention yields the exact
rate expected by equity holders. Dividend policy has zero effect on stock price.

1.3 Myron J. Gordon's Model

Myron Gordon developed a mathematical model linking market value directly to dividend payout ratio and
return on equity, under the explicit assumption that investors are risk-averse and prefer current dividends
("bird in the hand") over future capital gains.

Gordon's Dividend Growth Valuation Formula:

P = [ E(1 - b) ] / [ k - (b × r) ] = D₁ / (k - g)
Where: b = Retention Ratio, (1 - b) = Dividend Payout Ratio, r = Return on Investment, g = b × r = Expected
Growth Rate, k = Cost of
Capital (k > g).
Gordon's Policy Implications: Mirroring Walter's conclusions, Gordon proves that when r > k, market price
increases as retention increases (payout ratio decreases). When r < k, market price increases as payout ratio
increases.

2. Franco Modigliani & Merton Miller (MM) Hypothesis

Modigliani and Miller (1961) presented the seminal Dividend Irrelevance Theorem. They argued that under
perfect capital market assumptions, a firm's dividend policy has no impact on its market value or the total
return to its shareholders. Valuation is dictated solely by the firm's earnings power and investment policy.
2.1 Critical Underlying Assumptions

Perfect Capital Markets: No transaction costs, zero flotation costs, and infinite divisibility of securities.
Rational Behavior: Investors are price-takers and seek to maximize utility with equal access to information.
No Taxes: Zero corporate or personal income tax differentials between dividends and capital gains.
Fixed Investment Policy: The firm's future investment decisions (I) are given and independent of dividend
policy.

2.2 Theoretical Proof & Arbitrage Mechanism

MM demonstrate that any increase in cash dividends (D₁) paid to shareholders reduces retained earnings,
forcing the firm to issue new equity shares to finance its investment opportunities (I). The exact increase in
wealth from dividends is offset by a dilution in value per existing share.
Step-by-Step Mathematical Derivation:
1. Single share market price today: P₀ = ( D₁ + P₁ ) / ( 1 + k )
2. Total value for n current shares: n P₀ = [ n D₁ + (n + m) P₁ - m P₁ ] / ( 1 + k )
3. Total external capital raised for new investment I: m P₁ = I - ( X - n D₁ ) (where X = Net Income)
4. Substituting m P₁ into equation 2 eliminates D₁ completely:
n P₀ = [ (n + m) P₁ - I + X ] / ( 1 + k )
MM Theorem Takeaway: Dividend per share (D₁) cancels out completely in Equation 4. Therefore, total firm
value (n P₀)
is completely independent of dividend payout policy.

 Comparative Summary

Theory / Model Key Proponents Core Stance Optimal Policy (r > k) Optimal Policy (r < k)
Traditional Model Graham & Dodd RELEVANT Maximum Payout Maximum Payout
Walter Model James E. Walter RELEVANT 0% Payout (100% Retention) 100% Payout (0% Retention)
Gordon Model Myron J. Gordon RELEVANT 0% Payout (100% Retention) 100% Payout (0% Retention)
MM Hypothesis Modigliani & Miller IRRELEVANT Indifferent / No Impact Indifferent / No Impact