2.4 The lower the debt (financial leverage) and the higher the equity, the lower the
business risk on the part of stock investors (old + new), but the stock holder may
end up with lower percentage of dividend per share.
2.5 With a rise in debt capital and corresponding rise in returns, the earnings per share
will go up. But the question is whether in this situation, a firm will enhance debt
financing. Why not? The point is that the quantum of benefits arising out of debt
investment (financial leverage) must offset the business risk of equity investors.
2.6 To conclude, the management must plan to find out the lowest investment on
fixed assets with lowest operational or utility cost.
2.7 It the management aims at increasing debt finance, it must see that the business
risk on equity holders is offset by returns on debt.
- Capital Structure Theory
3.1 The use of financial leverage increases the expectations of stockholders along
with the rise in the business risk. This means that the returns and the risk vary
directly. The stockholders sometimes expect more returns, when compared to the
unit of risk. They may not just accept corresponding compensation. The ‘Capital
Structure Theory’ may help us with an analysis in this direction.
3.2 Prof. Franco Modigliani and Merton Miller developed modern capital structure
theory. They made the assumption that a firm’s value will not be affected by its
capital structure that is debt versus equity. In other words, they believed that
capital structure is irrelevant. The Modigliani- Miller (MM) theory was also
based on the assumption of Zero taxes. The Zero Taxes effect means that the
return derived out of use of financial leverage will exactly offset the increase in
risk. In other words, the MM theory believes in the proportionality of returns to
risk. That means net benefit is zero. But in reality such net benefit of using
financial leverage may be positive or negative.
3.3 The MM theory advanced further by removing the assumption of Zero corporate
taxes. While paying corporate taxes, the amount paid towards interest shall be
deducted. Dividends paid to stock holders are not deductable from the amount
payable as corporate tax. The benefit of deduction of interest on debt out of
corporate tax works out as positive point to use debt. Prof. Merton Miller made
further improvements to this theory, by incorporating personal taxes. Prof.
Merton Miller observed that interest will be in form of income on bond, and
dividend will not be in the form of income on shares. This income is liable for
personal tax. Capital gains will be realized only after the stock is sold. The rate
of personal tax on return on share will always be less than the return on bonds.
This is a favorable factor to use equity finance. It is clearly visible that MM
theory considered both corporate tax and personal tax to analyze the capital
structure, i.e., how deduction of interest from corporate tax encourages debt
financing and the situation of lesser tax on returns on shares when compared to