Dharan Roads Case

In the next two sessions, we will be dealing with the issue of capital structure decision. It is the debt policy of a firm. The question we are trying to answer is "what is the optimal level of debt?" or "is there anything like that?" In the capital budgeting decision (chapters 5, 6, 7, and 13), we have dealt with 'where to invest.' Now, we are dealing with 'how to finance.' The following cash flow chart we have seen in session 1 lecture explains the connection between these two types of decisions. The left-hand-side is the investment decisions, and the right-hand-side is the financing decisions. The capital structure decision is a part of the financing decisions.

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In the next several sessions, we will be dealing with two financing decisions: (1) capital structure decision (= debt policy), and (2) dividend policy. The former is discussed in chapters 16 (session 11), and 17 (session 13); the latter in chapter 19 (session 15). In chapter 18 (session 14), we will see the connection between capital budgeting decision and capital structure decision. In other words, we will discuss how we can handle capital budgeting decision of a levered company, i.e., a company that used debt financing.

In this session's lecture, we'll go over some basic developments in capital structure theory. We will discuss the first part of Modigliani-Miller (M-M) theory on capital structure. Modigliani and Miller are Nobel Prize winning financial economists who did pioneering work on capital structure theory. The question they tried to answer was whether the value of a firm can be changed by changing its capital structure, or debt policy. We will start with the case of no taxes, then we'll allow corporate taxes. Later, in the next session, personal taxes as well as corporate taxes will be allowed. Also considered in the next session are the bankruptcy costs. This series of developments