Unit 3: Capital structure and dividend policy
Strategic Financial Management notes · PTU syllabus (MCOP302-18)
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Unit summary
Capital structure and payout policy decide how a firm funds itself and rewards owners. This unit covers business and financial risk, determinants of capital structure, EBIT–EPS and ROI–ROE analysis, theories of capital structure including the Miller model, financial distress and agency costs, and dividend policy — payout ratio, share buy-backs, bonus issues and stock splits.
After this unit you can
- Distinguish business and financial risk and explain determinants of capital structure
- Apply EBIT–EPS and ROI–ROE analysis
- Explain NI, NOI, traditional, MM and Miller theories, financial distress and agency costs
- Explain dividend policy, buy-backs, bonus issues and stock splits
PTU syllabus topics
- Business and financial risk
- determinants of capital structure
- EBIT/EPS and ROI/ROE analysis
- capital structure theories (Net Income, Net Operating Income, Traditional, Modigliani-Miller, Miller Model)
- financial distress and agency cost
- dividend policy decisions
- payout ratio
- share buybacks
- bonus issues and stock splits
Net Income approach
Yes
More debt lowers WACC and raises value
Net Operating Income approach
No
WACC stays constant
Traditional approach
Yes, up to a point
An optimal debt level exists
Modigliani-Miller (no tax)
No
Arbitrage keeps values equal
MM with taxes
Yes
Interest tax shield adds value
Topic 1
Business and financial risk
- Business risk: variability of EBIT due to the nature of business — demand variability, price variability, input costs, operating leverage.
- Financial risk: additional variability of EPS and risk of default due to debt (financial leverage).
- Total risk is reflected in the combined leverage (DOL × DFL).
Topic 2
Determinants of capital structure
Internal factors
Cash flow position, cost of capital, risk appetite, control considerations, size and age of firm, asset structure
External factors
Capital market conditions, interest rates, tax rates, regulatory norms (SEBI, RBI), lenders' policies
Business factors
Stability of sales and earnings, growth rate, nature of industry
- Stable cash flows and tangible assets support more debt (utilities, infrastructure); volatile businesses use more equity (technology start-ups).
Topic 3
EBIT–EPS analysis
EBIT–EPS analysis compares financing plans by their effect on EPS at various levels of EBIT.
EPS
[(EBIT − I)(1 − t) − Preference dividend] ÷ Number of equity shares
Indifference point (equity vs debt)
[(X − I1)(1 − t)] ÷ N1 = [(X − I2)(1 − t)] ÷ N2
Example
Need ₹10 lakh. Plan A: all equity (1,00,000 shares of ₹10). Plan B: ₹5 lakh equity (50,000 shares) + ₹5 lakh debt at 10%. Tax 30%. At EBIT ₹2,00,000: EPS A = 1,40,000 ÷ 1,00,000 = ₹1.40; EPS B = (2,00,000 − 50,000) × 0.7 ÷ 50,000 = ₹2.10. Indifference point: X ÷ 1,00,000 = (X − 50,000) ÷ 50,000 → X = ₹1,00,000. Above ₹1 lakh EBIT, debt gives higher EPS.
Topic 4
ROI–ROE analysis
ROE (after tax)
[ROI + (ROI − i) × D/E] × (1 − t)
Interpretation
If ROI > cost of debt (i), more debt raises ROE (favourable leverage)
Example
ROI 18%, interest 10%, D/E 1, tax 25%: ROE = [18 + (8 × 1)] × 0.75 = 19.5%; with D/E 0, ROE = 13.5%.
Topic 5
Theories of capital structure
Net Income (NI) approach — Durand
Yes
Kd and Ke constant; more debt lowers WACC and raises value
Net Operating Income (NOI) approach — Durand
No
WACC constant; Ke rises with debt, offsetting cheap debt
Traditional approach
Yes, up to a point
Moderate debt lowers WACC; excessive debt raises it — optimal structure exists
Modigliani–Miller (1958, no taxes)
No
Arbitrage keeps value equal for levered and unlevered firms
MM with taxes (1963)
Yes
Interest tax shield: VL = VU + tD
Example
NI approach: EBIT ₹2,00,000; debt ₹5,00,000 at 10%; Ke 12.5%. Earnings for equity = 1,50,000; value of equity = 1,50,000 ÷ 0.125 = ₹12,00,000; value of firm = ₹17,00,000; overall cost = 2,00,000 ÷ 17,00,000 = 11.76%.
- MM assumptions: perfect capital markets, no transaction costs, homogeneous expectations, same risk class, 100% payout, no taxes (1958). Arbitrage process equalises values.
- Trade-off theory: balances tax benefits of debt against bankruptcy and agency costs. Pecking order theory: firms prefer internal funds, then debt, then equity.
- Miller model (1977): with corporate and personal taxes, the gain from leverage = [1 − (1 − tc)(1 − tps) ÷ (1 − td)] × D; if personal tax on debt income is high enough, the advantage of corporate debt may vanish — capital structure irrelevance in equilibrium.
Topic 6
Financial distress and agency costs
- Costs of financial distress: direct (legal and administrative costs of bankruptcy) and indirect (lost sales, supplier credit withdrawn, employee exit, underinvestment).
- Agency costs of debt: asset substitution (risk shifting), underinvestment (debt overhang), claim dilution — controlled by covenants.
- Agency costs of equity: perquisites, empire-building — reduced by debt discipline (Jensen's free cash flow hypothesis).
- Trade-off theory: optimal debt balances tax shields against distress and agency costs; pecking order theory (Myers–Majluf): internal funds → debt → equity, due to information asymmetry.
Topic 7
Dividend policy, buy-backs, bonus issues and stock splits
Dividend policy decides the proportion of earnings paid as dividend (payout) vs retained (retention).
- Determinants: profitability and stability of earnings, liquidity, growth needs, cost of external funds, shareholders' preference, taxation, legal restrictions (Section 123), loan covenants, control, inflation, market conditions.
- Types of dividend policy: stable dividend per share, stable payout ratio, regular + extra dividend, irregular, no dividend.
- Forms of dividend: cash, bonus shares (stock dividend), interim and final; buy-back as an alternative.
- Payout ratio = DPS ÷ EPS; retention ratio = 1 − payout.
Cash outflow
Yes — returns cash
No cash outflow
Effect on shares
Reduces number of shares; raises EPS
Bonus: more shares, reserves capitalised; split: face value reduced, more shares
Effect on reserves
Reduces reserves/premium
Bonus reduces free reserves; split no change
Signal
Undervaluation, surplus cash
Confidence, improved liquidity
Law
Section 68, Companies Act; SEBI Buy-back Regulations
Section 63 (bonus); split under Section 61
- Tax note: from October 2024, buy-back proceeds are taxed as dividend in shareholders' hands.
Key terms
- Business risk
- Variability of operating income
- Financial risk
- Additional risk from using debt
- Financial distress
- Difficulty in meeting obligations to creditors
- Pecking order theory
- Preference for internal finance, then debt, then equity
- Stock split
- Dividing shares into more shares of lower face value
Quick revision
- Business vs financial risk; DOL and DFL.
- Determinants: cash flows, asset structure, tax, control, market conditions.
- EBIT–EPS indifference point; ROE = [ROI + (ROI − i)D/E](1 − t).
- NI, NOI, traditional, MM, Miller; trade-off and pecking order.
- Payout, buy-backs, bonus, splits.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Distinguish business and financial risk.
- Q2.What is the indifference point?
- Q3.State the Miller model.
- Q4.What are the costs of financial distress?
- Q5.What is the pecking order theory?
- Q6.Distinguish bonus issue and stock split.
Long-answer questions
- Q1.Explain the determinants of capital structure and EBIT–EPS and ROI–ROE analysis.
- Q2.Explain the theories of capital structure including the MM and Miller models.
- Q3.Explain financial distress, agency costs and the trade-off theory.
- Q4.Explain dividend policy, buy-backs, bonus issues and stock splits.
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