2. Capital Structure &
Dividend Policy
By:
AsHra ReHmat

3. Capital Structure
• In finance, capital structure refers to the way
a corporation finances its assets through some
combination of equity, debt, or hybrid
securities.

4. Overview
• A firm's capital structure is the composition or
'structure' of its liabilities.
• For example, a firm that has $20 billion in equity
and $80 billion in debt is said to be 20% equity-
financed and 80% debt-financed. The firm's ratio
of debt to total financing, 80% in this example, is
referred to as the firm's leverage. In reality,
capital structure may be highly complex and
include dozens of sources of capital.

5. • The Modigliani-Miller theorem, proposed by Franco Modigliani and
Merton Miller, forms the basis for modern thinking on capital
structure
• Though it is generally viewed as a purely theoretical result since it
disregards many important factors in the capital structure process
factors like
– fluctuations and
– uncertain situations that may occur in the course of financing a firm.
• The theorem states that, in a perfect market, how a firm is
financed is irrelevant to its value.
• This result provides the base with which to examine real world
reasons why capital structure is relevant, that is, a company's value
is affected by the capital structure it employs.
• Some other reasons include bankruptcy costs, agency costs, taxes,
and information asymmetry. This analysis can then be extended to
look at whether there is in fact an optimal capital structure: the one
which maximizes the value of the firm.

6. Capital structure in a perfect market
• Consider a perfect capital market firms and individuals can borrow
at the same interest rate; no taxes; and investment returns are not
affected by financial uncertainty.
• Modigliani and Miller made two findings under these conditions.
– Their first 'proposition' was that the value of a company is
independent of its capital structure.
– Their second 'proposition' stated that the cost of equity for a
leveraged firm is equal to the cost of equity for an unleveraged firm,
plus an added premium for financial risk. That is, as leverage
increases, risk is shifted between different investor classes, while total
firm risk is constant, and hence no extra value created.
• Their analysis was extended to include the effect of taxes and risky
debt. Under a classical tax system, the tax deductibility of interest
makes debt financing valuable; that is, the cost of capital decreases
as the proportion of debt in the capital structure increases. The
optimal structure, then would be to have virtually no equity at all,
i.e. a capital structure consisting of 99.99% debt

7. Capital structure in the real world
• If capital structure is irrelevant in a perfect
market, then imperfections which exist in the real
world must be the cause of its relevance. The
theories below try to address some of these
imperfections, by relaxing assumptions made in
the M&M model.
1. Trade-off theory
2. Pecking order theory
3. Agency Costs
4. Structural Corporate Finance
5. Other

8. Trade-off theory
• Trade-off theory allows the bankruptcy cost to exist. It
states that there is an advantage to financing with debt
and that there is a cost of financing with debt (the
bankruptcy costs and the financial distress costs of
debt).
• The marginal benefit of further increases in debt
declines as debt increases, while the marginal cost
increases, so that a firm that is optimizing its overall
value will focus on this trade-off when choosing how
much debt and equity to use for financing.
• Empirically, this theory may explain differences in D/E
ratios between industries, but it doesn't explain
differences within the same industry.

9. Pecking order theory
• This theory maintains that businesses adhere to a hierarchy of
financing sources and prefer internal financing when available, and
debt is preferred over equity if external financing is required (equity
would mean issuing shares which meant 'bringing external
ownership' into the company).
• Thus, the form of debt a firm chooses can act as a signal of its need
for external finance.
• The pecking order theory is popularized by Myers (1984) when he
argues that equity is a less preferred means to raise capital because
when managers (who are assumed to know better about true
condition of the firm than investors) issue new equity, investors
believe that managers think that the firm is overvalued and managers
are taking advantage of this over-valuation. As a result, investors will
place a lower value to the new equity issuance.

10. Agency Costs
• There are three types of agency costs which can help
explain the relevance of capital structure.
1. Asset substitution effect: As D/E increases, management
has an increased incentive to undertake risky (even
negative NPV) projects. This is because if the project is
successful, share holders get all the upside, whereas if it
is unsuccessful, debt holders get all the downside.
2. Underinvestment problem: If debt is risky, the gain from
the project will accrue to debt holders rather than
shareholders. Thus, management have an incentive to
reject positive NPV projects, even though they have the
potential to increase firm value.
3. Free cash flow: unless free cash flow is given back to
investors, management has an incentive to destroy firm
value through empire building and perks etc. Increasing
leverage imposes financial discipline on management.

11. Summary
• The goal of the capital structure decision is to determine the financial leverage
that maximizes the value of the company.
• In the Modigliani and Miller theory developed without taxes, capital structure is
irrelevant and has no effect on company value.
• Using more debt in a company’s capital structure reduces the net agency costs of
equity.
• The costs of asymmetric information increase as more equity is used versus debt,
suggesting the pecking order theory of leverage, in which new equity issuance is
the least preferred method of raising capital.
• A company may identify its target capital structure, but its capital structure at any
point in time may not be equal to its target for many reasons.
• Many companies have goals for maintaining a certain credit rating, and these goals
are influenced by the relative costs of debt financing among the different rating
classes.
• In evaluating a company’s capital structure, the financial analyst must look at the
capital structure of the company over time, the capital structure of competitors
that have similar business risk, and company-specific factors that may affect
agency costs.

12. What is Dividend Policy :
• “ Dividend policy determines the division of
earnings between payments to shareholders
and retained earnings”.
- Weston and Bringham
Dividend Policies involve the decisions, whether-
– To retain earnings for capital investment and
other purposes; or
– To distribute earnings in the form of dividend
among shareholders; or
– To retain some earning and to distribute
remaining earnings to shareholders.

13. Dividend Theories
Relevance Theories
(i.e. which consider dividend
decision to be relevant as it
affects the value of the firm)
Walter’s
Model
Gordon’s
Model
Irrelevance Theories
(i.e. which consider dividend
decision to be irrelevant as it does
not affects the value of the firm)
Modigliani and
Miller’s Model
Traditional
Approach

14. Walter’s Model
• Prof. James E Walter argued that in the long-run the
share prices reflect only the present value of expected
dividends. Retentions influence stock price only
through their effect on future dividends. Walter has
formulated this and used the dividend to optimize the
wealth of the equity shareholders.
• Assumptions of Walter’s Model:
– Internal Financing
– constant Return in Cost of Capital
– 100% payout or Retention
– Constant EPS and DPS
– Infinite time

15. Model Description
• If r>ke, the firm should have zero payout and make
investments.
• If r<ke, the firm should have 100% payouts and no
investment of retained earnings.
• If r=ke, the firm is indifferent between dividends and
investments.
Mathematical representation
• Mandar Mathkar has given a mathematical model for
the above made statements :

16. Gordon’s Model
• According to Prof. Gordon, Dividend Policy almost always
affects the value of the firm. He Showed how dividend
policy can be used to maximize the wealth of the
shareholders.
• Assumptions:
– All equity firm
– No external Financing
– Constant Returns
– Constant Cost of Capital
– Perpetual Earnings
– No taxes
– Constant Retention
– Cost of Capital is greater then growth rate (k>br=g)

17. where,
P = Market price of the share
E = Earnings per share
b = Retention ratio (1 - payout ratio)
r = Rate of return on the firm's investments
ke = Cost of equity
br = Growth rate of the firm (g)
Therefore the model shows a relationship between the payout ratio, rate of
return, cost of capital and the market price of the share.

18. • Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration :

19. • Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration :

20. • Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)
Illustration :

21. Modigliani & Miller’s Irrelevance Model
Value of Firm (i.e. Wealth of Shareholders)
Firm’s Earnings
Firm’s Investment Policy and not on dividend policy
Depends on
Depends on

22. Assumption
– Capital Markets are Perfect and people are
Rational
– No taxes
– Floating Costs are nil
– Investment opportunities and future profits of
firms are known with certainty (This assumption
was dropped later)
– Investment and Dividend Decisions are
independent

23. MM Argument
• If a company retains earnings instead of giving it out as
dividends, the shareholder enjoy capital appreciation
equal to the amount of earnings retained.
• If it distributes earnings by the way of dividends
instead of retaining it, shareholder enjoys dividends
equal in value to the amount by which his capital
would have appreciated had the company chosen to
retain its earning.
• Hence,
the division of earnings between dividends and retained
earnings is IRRELEVANT from the point of view of
shareholders.

24. Traditional Approach
• This theory regards dividend decision merely
as a part of financing decision because
– The earnings available may be retained in the
business for re-investment
– Or if the funds are not required in the business
they may be distributed as dividends.
• Thus the decision to pay the dividends or
retain the earnings may be taken as a residual
decision

25. • This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
• Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.