CHAPTER 8

Theories of Capital Structure

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 Leverage effect of EPS
All Equity Moderately Highly
firm levered firm levered firm
No. of Shares (Tk.50 each) 4 3 1
Equity Tk.200 Tk.150 Tk.50
10% Bond Nil Tk.50 Tk.150
Total Assets Tk.200 Tk.200 Tk.200
Return on Assets (20%) Tk.40 Tk.40 Tk.40
Interest payments Nil Tk.5 Tk.15
Taxable Income Tk.40 Tk.35 Tk.25
Tax 40% (Tk.16) (Tk.14) (Tk.10)
Net Income Tk.24 Tk.21 Tk.15
EPS 24/4=Tk.6 21/3=Tk.7 15/1=Tk.15
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Capital Structure Controversy
 Relevancy Proposition: Advantage of leverage
observed in the last slide demonstrates that firm
can maximize wealth by increasing its debt rather
than profitability. This is the relevancy proposition
of capital structure.
 Irrelevancy Proposition: Modigliani-Miller (M-M)
argues that wealth can not be influenced by
anything other than profitability. So there may be
arbitrage effects to adjust the price to give the
same return on investment. (See the next slide.)
Advantage of leverage may also be compensated
by bankruptcy cost and agency cost. (See the
following slide.)

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Arbitrage effect: Irrelevancy Proposition
Price

S3

150
D3
S2

S1
70
60
D2
D1

Quantity of Shares
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Optimum Capital Structure

Value of the firm

Bankruptcy and agency cost

Actual

Irrelevancy Proposition

Optimum Capital structure

Debt/Assets

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CHAPTER 10
Theories of Dividend Policy
 Controversy of dividend policy
 Bird-in-hand view
 MM proposition of irrelevancy
 Signaling effects
 Clientele effect
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Theories of dividend policy
 Dividend policy relates to the company
decision to payout the dividends out of the
earnings. The management has the choice to
go for no distribution to full distribution of
earnings. Theories of dividend policy relates
such management decision to the value of
the firm. Like high payout firms having higher
shares price, or low payout firm having lower
share price. Or vice versa.

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Theories of dividend policy
 Three theories of dividend policy:
 Dividend irrelevance: Investors don’t
care about payout.
 Bird-in-the-hand: Investors prefer a
high payout.
 Tax preference: Investors prefer a low
payout.

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MM Proposition of Irrelevancy
Dividend irrelevance: Investors don’t care about payout. MM
argues that dividend distribution policy should not be related
to the value of the firm. The undistributed dividends should
increase the share price by the same amount. Distribution of
dividend is just an alternative to capital gain. In that case,
people can go for ‘home-made dividend policy.’ For example,
If investors expect high payout of dividends when the firm
goes for low payout of dividends, then they can sell part of
their stock as the share price increases, and realize the
cash. Conversely, if the investors likes less dividends when
the firm goes for high payout, then investors can buy more
shares by the dividend earnings. Such home made dividend
policy suggests that changing the dividend policy a firm can
not maximize its share price

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Bird-in-the-hand: Investors prefer
a high payout.
 This group believes that stock holders
like more payout firms rather than low
payout firm. Because, distribution of
dividend is an immediate gain like bird-
in-hand, but increase in share price (in
consequence of retention) is not so
certain, like bird–in-bush.

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Tax Effects
 MM argued that if a firm goes for retention
then investors realize capital gain. Capital
gain tax is less than dividend tax. So after
tax income in case of retention is more than
the after tax income from dividend earnings
of the same amount. So the apparent
advantage of dividend income in terms of
certain income is neutralized.

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 Other factors
 Signaling effects suggest that distribution or retention of
dividends gives a signal. When a good firm goes for retention,
investors take the signal positively like the firm has attractive
investment opportunity, so share price increases. If a bad firm
does the same, investors take the signal negatively, like the
firm is suffering from inadequate liquidity, so share price goes
down. Similarly, when a good firm goes for high distribution,
then investors think that the firm has strong liquidity. If a bad
firm does the same, investors think that the firm lacks
investment opportunity so share price goes down.
 Clientele Effects suggest that every firm should stick to the
same dividend policy no matter what is the nature of it.
Different types of investors with different preference pattern
can then select the right firm that suits him the best.

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