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794 views240 pagesFinancial Management Part 2
Uploaded by
Bindu GuptaCopyright
© © All Rights Reserved
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Available Formats
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/ 240
ted
tot
ined
esr
2208
"mon
alu,
»oo00
000
ane
sgcas
O¥10
V0
srage.
Salso
The
Lane
suits
unite
© per unit a
Variable Cost per unit” 050
Fixed Cost £38,000
Funds required = 1,00,000
Financial Plans
Capital Structure A Bc
Equity shares of & 100
each to be issued at 25%
premium 60% 40k 35%
15% Debt 40% GO 50%
10% preference shares of
7100 each
Assume Income Tax rate 30%
Statement of EPS
EBIT
Less: Interest (15%)
EBT
Less: Tax (30%)
EAT
Less Preference dividend
Earning available for equity
shareholders (ND,
No of equity shares (N)
Operating Leverage (OL) =
Financial Leverage (FL)
‘ar - PD
ren)
Combined Leverage (OLX FL)
i) Indifference Point between Plan A and B:
(EBIT~1,) (1-1) (EBIT-1,)0-0)
yt ON
(EBIT—6000)(1-030) ___(EBIT-9000) 1-030)
480 a 320
EBIT =215,000
(ii) Financial Break-even level of EBIT =
Plan A : Interest charges = € 6000
9000
Plan B : Interest charges
PD
Plan C: Interest charges + Geoy
CcInterest charges + Gj
15
= 15001 (Gap) 2.643
CH 7. FINANCING DECISION EIT EPS ANALYSIS et
165
Caleudare
(0 Desres vf Operating Leverage, Financial
Combined Leverage for each fiaanetal plan,
(i). The Indifference point berween Plan Ant B
(iid) The Financial break-even point for each plan and suggest
which plan has more financial risk
(BCom. (Ht) D'S, 2012)
Solution :
Calculation of EBIT :
Sales (1,00,000 units @ #1) £1,00,000
Less : Vatiable cost @ & 0.50 pau 50,0000
Contribution 50,000
Less Fixed cost 38,000
EBIT (Operating Profit)
Financing Plans
B
12,000
34 4174 = 16.68
Plan C having highest financial leverage has higher finan
cial risk
“ise 7
Following information is available in respect of POR Led.
Equity Share Capital (F-V. 210 each) +33200,000
12% Debentures 4250,000
Fixed Cost 408,000
Operating Leverage 4
Combined Leverage 28
Sales 6000.00
Tax rate 30%
Find out the Financial Leverage and EPS of the firm, 165 PARTI
Solution
Caleulation of Financial Leverages:
cL. OLXFL
28 TAXPL, 7
FL. 2
Calculation of EPS:
on = _Lentribution
EBIT
Contribution
14
Conte ibution ~ €3,08,000
1.4 Contribution -85,71,200
§5,71,000
Contribution =
Contibution 14,28000
“ :
PAT ~ (Contthition- Fined Cost-tnteresit=1)
= (142000 408,000 5 19.000) (1 ~ %)
~ s3sre00
ees = AT 570002,
SoH Bout Shares” 340000
Wustration 716
A new project is under consideration in XYZ Ltd, which
requires a capital investment of €450-crore.Intereston Term,
loanis 12% and Corporate taxis 504 Ifthe Debt= Equity ratio,
insisted by the financing agencies 2:1, calculate the point of
indifference for the project {BCom (14) DU, 2074)
Solution:
{n the given case, the indifference level of EBIT can be
calculated between the loan option (given) and the equity
‘option (implied)
Loan Option:
“Total Funds 450.0000
Debi-Equity Ratio 2a
So, 12% Debs + 3,0000000
Equity (FV = 210 each) 1,500,000
Equity Opttor
Equity (F.V. = £10 each) 45000000
lndifference Level of EBIT:
(EBIT - £36,00,000) (1-5)
15700,000, .
IS EBIT-Z5409000 =
BIT
SEBIT
54.0000
pl & Uabiies Amant Are Rooast
iguky Share Capial —ten000 ~ Fuad Irom Tiseo0
each) isi
Reser
20000 Curent Ass 0an0
tons, sone
Cure ites somo
240,000 730.000
ae Fixed Assets turnover of the firm a
Se
FINANCING DECISION
‘The tixed Operating Cosis of the firm are € 1,00,000 od the
Variable Cusis are 40%. The tax rate is 308,
Find out (0) Different leverages for the firm
(2) Likely level of EBIT if the BPS is ca) @ 4
(ye3
(id) Financiol break-even level
Solution
Inorderto find out the leverages, the Income Statement may
be prevented as follows
Income Statement
‘Sales (150,000 X 4) 6.00009
Variable Cost (40%) 2.20009
Contribution 3.0000
“Fixed Cost 1.£0,000
Operating Profit (EBIT) Bene
Interest (80.000 x 10%) 8000
Prolit before Tax (PBT)
Tax (@) 30%
Profit After Tax (PAT)
Calculation of Leverages:
Operating Leverage = -= sas
Ceoieiebichas 240.000
20,000
Cia Financial Lewrngs = ES ee sone
Contribution 300000
(i Combe average = 3 at
Calculation of Desired Level of EBIT :
(EBIT-I00)(
eps =
No. of Equity Shares
For EPS a:
; (EBIT-8,000) (1-3)
6000)
6000 = (EBIT-8,000)(1-3)
eBIT e 16571
For EPS za
: (EBIT- 8,000) (1
6,000
18000 = (EBIT-8,000) (1-3)
EBIT 33714
Financial Break-Even Level:
Financial Break-Even levelis that level of EBIT at which EPS
80.
For EPS 0
EBIT-8,000X(.
‘6000
© = BIT-8,000)(1-3)
EBIT = £8,000
bo, Financial Break Even Level of EBIT 167
OBJECTIVE TYPE QUESTIONS
Sr whather cach of he following saements i Faa [) o
False (F). = Be
(0 EBITis also known as operating profits
(9 {FBBIT Fortwo fins are same, then the EPS ofthese
firms would also always be same.
i) EPSdepends upon the composition of capital
ucture,
(jo) Financial breakeven level occurs when EBIT is zero,
(9) At Ginancial breakeven lovel of EBIT, EPS would be
(09 Indifference level of EBIT is one at which EPS is zero
(vi Indifference level of EBIT is one at which EPS unde
4. Inorder tocalculate EPS, Profit after Tax and Preference
Dividend is divided by
(@ MP of Equity Shares
(D) Number of Equity Shares
(9 Face Value of Equity Shares
(@) None of the above
2 Trading on Equity is
(@ Always beneficial
(0) May be beneficial
(0 Neverbeneticial
(2) None ofthe above,
Benefit of ‘Trading on Equity’ is available only if
(0) Rate of Interest < Rate of Return
(% Rate of Interest > Rate of Return
(6 Both (a and (6)
(4 None of (a) and (4.
Indifference Level of EBIT is one at which
(@) EPSis zero
(8) EPSis Minimum
(0) EPS is highest
(@) None of these
Financial Break-even level of EBIT is one at which
(@ EPSis one
(EPS is zero
(© EPSis infinite
(@) EPS is Negative
Relationship between change in Sates and change in
Operating Profit is known as
(@) Financial Leverage
(8) Operating Leverage
cial plans would be same
ye oF more fi
(oii All equity plan and Deb-equity plus have no indiffer
‘ence level of EBIT.
(és) Preference dividendisnot a factor of indifference level
of EBIT.
(9) BBIT-EPS Analysisisan extension ol financial leverage
+ analysis
[Answers i) T: (i) F (i) Fv) F, (0), fo) B (0) 7, (wt).
() Fay T]
‘MULTIPLE CHOICE QUESTIONS
(0 Net Profit Ratio
(A Gross Profit Ratio.
2, IafirmhasnoPreferencesharecapital, Financial Break
ceven level is defined as equal to
(@ EBIT
(B) Knverest liability
(Equity Dividend
(2) Tax Liability
8 At Indifference level of EBIT, different capital plans
have
(2) Same EBIT
(6) Same EPS
(© Same PAT
(a) Same PBT.
9. Which of the following is not a relevant factor in EBIT-
EPS Analysis of capital structure ?
(@) Rate of Interest on Debt
(b) Tox Rate
(@. Amount of Preference Share Capitol
(@) Dividend paid last year.
10, For aconstant EBIT, if the debt level is further incveased
then
(@)_ EPS will always i
(0) BPS may increase
(©, EPS will never increase
(d) None of the above
11, Between wo capital plans, if expected EBIT is more than
indifference level of EBIT, then
(2) Both plans be rejected,
(8) Both plans are good,
(9. One is better than other,
(a) None of the above. 12, Financial break-even level of EBIT is
PART II: FINANCING DECISION
(d) None of the above
5
(@) Intercept at Y-asis [Answers 1.0), 2.) 3. (ah 4. 001.S (O16.
(8) Imtercept on Xai 8 (4). 10.) AT ch A2
(©) Slope of EBIT-EPS tine
pie: ASSIGNMENTS;
= ae I
41. What is EBIT-EPS Analysis? How is it different from 7 Examine the effects of change in EBIT of a finn vn the
leverage analysis? TBCon(H) BU, 2013) ~ EPS under () same capital structure and (# ei'reny
2. Explain EBIT-EPS analysis, What is indifference level of capital structure
EBIT? Show graphically a Explain the mechanism of determining the its .ee
evel of EBIT under different combinations 9 mal
3. What do you mean by fifancial break-even? How isi
calculated?
Financing plans
rice levol of EBIT be caleuksts!
4 Explain and dusrate he in ference level oF EBIT ~~ Hew the nd nce ene eguity is
5. ExplaintheEBIT-EPS analysis capitalstructure Show gion comprising of equity and debt finan
saphically, sic final bresk-evem ;
6 What are the shortcomings, any, of the EBITEPS —* Epgr Comment 1BComne 9° “ona
analysis?
ee 7 Pros: sis: fro
P6.1 A firm requires total capital Funds of €25 lacs and has
{so options: All equity, and Half equity and Half 15%
debt. The equity share can becurrenty issued at 100
per share. The expected EBIT of the company is
£2,50,000 with tas rateat 30% Find out the EPS under
both the financial mis;
(ii Determine thedegree of financialles
‘current level of EBIT
is) What additional data do you need to <
‘operating as well as combined lever:
[answer sEPS © 1655 and Financial Levers:
eee eu ae ee P64 Thee financing plans ar being considered!
U 6 and 73.50 respectively] Lad. which requires € 10,00,000 for constr ws ie &
P62 AB Lid. needs € 1000000 for expansion. The expan fic plant, N wants to maaimize the EI sd ihe
sion is expected to yield an annual EBIT of 1.60000, Dennett market price ofthe share is 830 laos tax
In choosing financial pln, AB Lid. hasan objective Seto ot 308 and debe Financing ean be singed a
of manimising earrings per are lis considering the fallows Upto € 10000 @ 10% from 120090 fy
possibility of issuing equity shares and raising debt of 5,00,000 @ 14%; and over® 5,00,000 @ 1€ sa
F 1,00,000 or & $00,000 or € 600000. The current Financing plans and the corresponding
market price pe shares 25 andi expected to drop Tatlows
to € 20 if the funds are borrowed in excess of ; an '
© 5,00,000. Funds can be borrowed at the rates indi- Pla c .todne dete Pere Ene
cated below: (a) up to € 100000 at 8%; (2) over Plan te ® 300,000 debt expected BIT 3,510
120.000" pe 5.00000 a Tab C9 one Plan I 60,000 deb: expected BBIT'¢ = 1100
PEPS far he tae sates Find out the EPS for all the three plans ard suggest
the EPS forthe thro financing alternatives
tibieh plan is better from the point uf vio of he
(Answer 2.96,€ 338 and 7301} company
P63 The operating income of a textile firm amounts to {Answer:@5 60,8924and€ 2058. So, he! 1 I msy
1.86000. I pays 30% tax om is income. Is capital eerie
structure consists of theolowing pesiaiseer te nter prarrraiyeteiany
15% Preference shares vanoon iit Reenl ts aie | ee es ean
Equity shares @ 100 exeh) 00000 144 Term loans «40,0000
14s Debentures 00000 Working eapial borrowings frm
(2 Determine the firm's EPS. banks at 16% 33,00,000 |
(i), Determine the percentage changein EPS assuci- 15% Public deposits 1.0000
ated with 30% change (both increase and de
~ crease) in BIT, CH.7_ FINANCING DECISION
The sates the company are grawing, and tu support
thent the company es 3
Proposes to obtain an additional
hank loanot ®25Iaih.Theincreascin EBIT isexpected
tobe
204. Calculate the change in interest coverage
the additionsl borrowing and comment,
[Answer Interest Coverage Ratio reduces from 1.5210
on i 1
company isconsideringlowering he elling price of
ring the sling price o
product. The following information is avatale on
the cots of producing nd income from sling
product :
Number of units sold 3,00,000
Sate price 210 per wait
Variable costs 26 per unit
Fixed costs £600,000
The management has asked you to prepare a sta
‘ment indicating the percentage increase in volume
hhecessary to maintain a net operating income at the
‘current level on product with decrease in price of 10%
and 20% aysuming other costs remaining constant,
(avewer:Devir sales are 400.000 units and 600.000
AB Lid, has devided to change its capital struct
‘The firm bas one crore Fully paid up equity shares
Market price of shave € 50 and is likely to remain the
same even after proposed capital restructuring, The
restructuring involves increasing the firm existing 29
crore 10% Debt 10 14 crore
The proceeds will be used to retire the equity. The
interest rates on debt is not expected to change as the
debt investors do not perceive the firm to become
More risky. Company is in 40% tax bracket Calculate
that level of EBIT that the firm must earn so that EPS.
doesn't change. :
[Ansiver Indifference level of EBIT is &5,90,000,)
he flowing taferation is vale in respect of
XYZ Ltd. iis
Number af shares issued
Market price per share
10,000
220
12
P69
P6.10
EBIT-EPS ANALYSIS
168
30%
15,000
Tax rate
Expected EBIT
‘The firm needs € 50,000 fur investment next year
Should the firm issue debt or equity toproducehigher
EPS. Also find out the indifference level of EBIT for
the two alternatives? What is the EPS (or that EBIT?
[Answer EPS is 7063 and 0.30; the indifference level
‘Of EBIT is ® 8,400 and the EPS at that level is 20.168]
A-company needs 5,00,000 for construction ofa new
plant, The following three financial plans are feasible:
(9 The company may issue 50,000 common shares at
10 per share, (i) The company may issue 25,000
‘equity shares at? 1 Oper share and 2,500 debenturesof
7 100 bearing a 8 rate of interest, (i) The company
5,000 equity shares at € 10 per share and
encesharesat® 100 persharebearingaB%
under each of the three financial plans? Which alter.
native would you recommen and why? Determine
the indifference points. Assume a corporate tax rate of
30%,
{Answer Alternative F EPS are® 0.14, 0.28, 056, 0.84
and 1.20; Alternative II: EPS are € -0.28, 0, 0.56, 1.12
and ® 224, Alternative Ill: EPS-are® ~052,0,-0.24, 32
0.88 and € 2.00, indifference level of EBIT berween
Alternatives I and Il is 40,000 and between Alterna-
tives Tand If is © 57,143]
company requires capital funds of 5 crores and has
hwo options:())Toraisetheamount by theissue cf 15%
+ debentures, and (i) To issue equity shares at a rateof
© 20 per share. It already has 40 lacs equily shares
issued and debt financing of € 6 crores at the rate of
12%, Find out the expected EPS under both financing,
‘options at the given EBIT levels of 2 crores [email protected],
‘crores, What should be choice of the company given
that the applicable tax rate is 30%.
[Answer EPS of 70.93 and® 10.35 for debt financing:
and EPS of € 1.38 and @ 730 for equity financing} T Gin Leverage, Cost of Capital and Value of the
Firm
SYNOPSIS
‘© Concept of Value of the Firm,
‘© Capital Structure and Cost of Capital
4 Net Income Approach : Capital Structure does Matter
4 Net Operating Income Approach : Capital Structure does not Matter.
‘¢ Traditional Approach : A Practical View Point
‘¢ MM Hypothesis: Behavioural Explanation of NOI Approach,
1» The Arbitrage Process
'* Cost of Equity Capital Under MM Model.
‘© Critical Bvaluation of MM Hypothesis.
&- « MM Hyposhesis with Taxes.
‘© Graded illustrations in Valuation of the Firm. eer eee eee
sic PART Ii: FINANCING DECISION _
he discussion in the preceding two chapters on the
Leverage Analysis and the EBIT-EPS Analysis,
shown that the lationship between the finan:
ial leverage and the earnings available ta the equity share
holders. In case of favourable financial leverage, the increase
insales or more particulatly the increase in EBET, willhave a
magnifying effect on the EPS. The firm should select such a
capital structure or financial leverage which will maximize
the expected EPS. itis already seemtliat the basic objective of
financial management istornaximize theshareholders wealth
and therefore all financial decisions in any firm should be
taken n the light ofthis objective, The decision regarding the
capital structureor the financialleverage or the financing mix
should also be based on the objective of achieving the maxi
mization of shareholders wealth. The present chapter at
tempts to analyze the relationship between capital structure
and the value of the firm in terms of different theories and
mudels un the subject-matter:
Concept of Value of the Firm : The valucol a lirmdepends on
the earsiings of the firm and the earnings of the firma depend
‘upon the investment decisions of thefirm, The earnings of the
firm are capitalized at a rate equal to the cost of capital in
order to find out the value of the firm, Thus, the value of the
firm depends on two basic factor ie, the earnings ofthe firm
and the cost of capital,
‘Theoperating profit ofthe firm £2, the EBITie divided among
three main claimants () the debt holders who receive their
share in the form of interest, (i the Government which
receivesits sharein the form of taxesand (ii) the shareholders
‘who receive the residual. So, the EBIT isa poo! which isto be
divided among the three claimants, The investment decisions
2f the firm determine the size of the EBIT pool while the
capital structure mix determines the way itis to besticed. The
‘otalvalueof the firm isthe sum of its value to the debtholders
and to its shareholders and is dotermined by the amour of
EBIT goingto them respectively. The investment decision can
therefore, increase the value ofthe firm by increasing thesize
of the BBIT whereas the capital structure mix can affect the
value only by reducing the share of the EBIT going to the
Government in the form of taxes,
‘The financing mix or the financial leverage or the capital
structure does not affect the total earnings ofthe firm which
isa factor ofthe investment decisions and the cost structure
ofthe firm, However, the earings available tothe sharehold-
eré may be influenced by the eapital mix as itis already seen
{atthe financial leveragehelps increasing the EPS fora given
level of EBIT. The EPS on the other hand, affects the market
value of the share and hence aflects the value ofthe frm.
‘Theoverallcostofcapitalofthefirm ie, the weightedaverage
cost of capital, WACC, depends upon the specific cast of
capital of individual sources of frtance and the proportion of
different sources in the totalcapitalstructare of theficm.One
financing mix or capital structure is represented by one
WACC which may change whenever there is change in the
financing mix. So, a firm can change its WAC by changing
the financing mix and can thas affect the value ofthe fiem. It
may be noted that the cost of capital and the valueof the firm
acc inversely related, For a given level of earnings, lower the
‘ost of capital, the higher would be the value of firm. But
‘shat istherelationship between financing mix, cost of capital
‘and value of the firm ? Is there an optimal capital structure?
Can the value of the firm be maximized by affecting the
financing mix or by affceting the cost of capital? F leverage
affectsthe cost of capitaland the value of the firm, then a firm
should try to achieve an optimal capital structure or optimal
financing mix and minimizing the cost of capital, Is there
really 2 capital structure whick may be called the optinal
capital structure ?
CAPITAL STRUCTURE THEORIES
When the degree of debt financing is increased in the earital
are exposed to higher
structure, the equity shareholders
degree of risk. This results from:
G@. The debt investors have first elufat on the profits, aod
Gi Incase of 1n, the claim ot the equity sharchote
cersis only residual and arises only after payment to debt
investors,
So, the degree of financial leverage has an impact on the
returns to equity sharcholders (discussed in the preceding
chapter) and on the riskiness of the equity investment, effeet-
ing the market price of the equity or the value of the firm
Divergent views have been expressed on the relationship
between leverage, costof capital and valu ofthe firm. Infact,
establishing the relationship between the leverage, cost of
capital and value ofthe firm is one of the most controversial
issue in financial management. Broadly speaking, diferent
views on such relationship, known as theories of captal
structure, can be studied and analvzed by grouping into
(That capital structure matters for the valuation of the
firm, presented by Net Income Approach,
(i That capital structure does not matter for the valuation
of the firm, presented by Net Operating Income Ap:
proach, and
(ii) A more pragmatic approach between the two above,
presented by Traditional Approach.
Inaddition, there is a Modigliani Miller Model which prov
justification for the Net Operating Income Approach. All the
‘above approachesand M-M Model have beendiscussed inthe
present chapter. In order to understand the relationship
between leverage, cost of capital and value of the firm, the
following assumptions are made:
1. That there are only two sources of funds ie, the equity
and the debt, which is having fixed interest.
‘That the total assets ofthe firm are given and there would
be no change in the investment decisions ofthe firm.
3, That the firm has.apoliey of distributing the entire profits
among the sharcholders implying that thereis noretained
‘earnings,
4. The operating profits of the firm are given and are not
expected to grow.
3. Bo
lev
aj
‘The N
finane
firm
thank
deere:
willee: Ha ‘The business risk complexion of the firm is xiven and is
Bee comune and sno atfcute by the financing mix and
pita) That there inno corporate or personal taxes
Site lowing dtiatns ond nanos tarcbecn ed
oe i E = Total Market Value of the Equity
tim J | > = Twat Market Valuc ofthe Debt
there | V = Total Market Value of the Firm ie, D+
the eFim ie,D+E |
1 Total Interest Payment. |
| NOP = Net Operating Profit de, EDIT
| NP = Net Profit or Profit after Tax (PAD.
apital | —D, = Dividend Paid by the Company at Time 0
Saher 3 (a, 208)
= Expected Dividend at the end of Year 1
wa BI firm nen)
wit. SEY = Curioni Market Prive of the Share,
ae] = EsestedManet seashore
nile | k= afer Tax Cost of Dette (L(L-0YD
feed |e = Costof Equity de, D/P,
rm K, = Overall Cost of Capital fe, WACC
aig [DAD + Bk, + [EMD + BY,
NOP _ BIT
ost of SOE. at
versial L 4 : !
ferent
-apital
of the
NET INCOME APPROACH :
CAPITAL STRUCTURE MATTERS
Te Net Income (approach the relationship Been
leverage, cos of apt nd vale the firm theses
inapproach and explanation. As suggested by Durand. ths
theory stats tht there a rlatenshp between cpt
Sevcureandihevaiucttnchimandeefretelrmeen
ae vey ning dren hed par
| ftowing adonal ssurpene N rronenmekesth
sation
ve Ape
vides
filthe af That the total capital requicement of the firm are given
inthe and remain constant
onship 2. That k, is less thank
inthe 7
Both k, and k, remain constant and inerease in financial
leverage Le, use of more and more debt financing inthe
capital structure does not affect the risk perception of the
Investors,
‘The NI approach Statts from the argument that change in
finncing mint afr wiliead'o changein WACC-hy ofthe
firm result ed
profits resulting in the change in value of the firm. Ask, is less
tained gf onk, theincreasing use of cheaper debt (and simuliancous
decrease in eq
se In equity proportion) inthe overall capital structure
; willzesult in the magnified returns availableto thesharebold
CH @: LEVERAGE, COST OF CAPITAL AND VALUE OF THE FIRM
a3
crs, The iacreased vetures t the shareholders vel neress
Ihe total value of the eq
of the firm, The WAC. b, swill decrease and the value ol the
Firm will increase. On theether hand, if the financial lever
ierecuced by the decrease in the deb! financing, the WAC,
of the firs wiltinerease andl the total value of the firia will
Ucerease, The Nlapproach to the relationship between lever
lage cost ol capital hashevn presented graphically in 2yeure8.1
sand thus increases the total value
con |
of
Capital Le<-——
om
FIGURES.1; NETINCOME APPROACH TO COST OF CAPITAL,
“The Figure 8.1 shows that the k, and k, are constant for all
levels of leverages e, forall levels of debt financing. As the
debt proportion or thefinancial leverage increases. the WAC.
k, decreases as the k sess than k, This result in theincrease
in value of the firm, In the Figure 8.1 it may be noted that k
‘willapproach k,asthedebt proportion isincreased. However
, will never touch k, as there cannot be a 100% db firm
Some element of equity must be there. However, ithe firm
is 100% equity firm, then the k, is equal fo k.. The rate of
decline in k, depends upon the relative position of hand k
Net Income Approach suggests that higher the degree uf
leverage, better iti, as the value of the Firm would be highe
Inother words, firm can inerease its value just by increas
the debr proportion in the eapital steucture
The NI approach may beillusivated with the help of Example
The expected EBIT of a firm is €2,00,000- thas issued Equity
Share capital withk, @ }0% and Debt of €5,00,000.Find out
the value ol the firm and the overall cost of capital, WACC
Solution:
BIT €2,00,000
-Interest 30,000
Net Profit 1.70,000
k, 10%
Value of equity, B= 1.70,000/.10 17,00.000
Value of debt. D, 5,00,000
Total value of the fiw. V, F,00,000
eBITIV
WAC, k,
= 2,00,000/22,00,000
- 19 or 9% 174
‘The WAC can also be caleulated as follows
WACE = (DD + EVk, + [EMD + EV,
= B/G +1706 + (17/5 + 17))10
+= 09 oF 9,
Now, if the firm has issued 6% Debt of € 7,00,000 instead of
£ 5,00000, the position would have been as Fallows
EBIT +22,00,000
Interest 42,000
Net Profit 1.58000
k, 10%
Value of equity, E, = 1,$8,000/.10 15,80,000
Vatue of debs, D, 700.000
+ Total value of the firm, V, 22,80,000
WACC, EBITV
= 20,000/22,80,000
087 oF 87%
So, when the 6% Debt is increased from ¥ 5,00,000 to
¥7,00,000, the value of the firm increases From €22,00,000 10
£22,80,000.and WACC decreases from 9% t08,7%, Now, say the
firm has istued 6% debt of €2,00,000 only instead of €5,00,009,
the position would be as Follows:
EBIT 22,0000
Imerest 12,000
Net Profit 1,88,000
k 10%
Valve of equity, E, = 1,88,000/.10 18,80,000,
Value of debt, D, 2,00,000
Total value of the firm, V, 20,80,000
WAC, k,, ~EBIT/V.
= 2,00,000/20,80,000
7 096 oF 9.6%
So, when the proportion of 6% Debt is reduced to €2,00,000
the value of the firm reduces to ¥ 20,80,000 and the
WAC increases from 9% to 9.6%, Thus, as per the NI ap-
proach. a firm is able to increaseits value and to decrease its
WAC by increasing the debt proportion inthe capita struc-
The eect of changing proportions of debi on the market
trice ofthe share ean also be analyze, Presently, the value of
the equity, E, €17,00000 and the frm has 1,00,000 equity
shares outstanding, So, the market price ofthe share would
te 17 Now If the fin increases ts debt proportion from
350,0001027,00000and usesthe proceed ocetire 1 76470
shares (Le, €200,000/8 17} ofthe lr In this case the total
value ofthe equity is & 15,0000 (already calculated) repre
sented by 8.23530 shares or the market price of €17.90 per
sare €15,80,000/86,735.30) The BPS in this case, woul be
2179(ce,€ 158,000/88 23530) giving 108 yieldon themarket
price of 81790.
SS
IW: FINANGING DECISION
However, if the firm wishes to reduce the debt fom
£500,000 t0 2,00,000, it will be required to issue additions}
shares at the market price of € 17. The number of new shares
tobe issued 18% 3,00,000/17=17,54705, making total nunvaee
‘of outstanding shares to be 1,17,647.05. In this ease, the total
market value of the equity shares is € 18,80.000 and the
market priceof the share would be® 15.98 and the EPS would
be 1.59 giving a yield of 10% on the market price. Thus, he
‘market price ofthe share also movesin line with the valuc of
the firm in response tothe variationsin debt proportion ofthe
capital structure, Under NI Approach, the value of the firm
can be defined as
Conclusion : The Mapproch, though eass to understand, it
is 100 simple to be realistic. tt ignores, perhaps the most
linportant aspects of leverage, that the marker price depends
upon the risk which varies in direct relation wy the changing
proportion of debt the capital structure
NET OPERATING INCOME APPROACH :
CAPITAL STRUCTURE DOES NOT MATTER
‘The Net Operating Income (NOD) approach is opposite to the
Nlapproach. Thisis also known as Independence Hypothesis
According to the NOI approach, the market value of the fim
dependsuponthe netoperating profitorEBITand the over
cost of capital, WACC. The financing mix or the capéal
Structure is irrelevant and does not affect the value of the
firm. The NOT approach makes the following sssumptions
1. The investors see the firm as a whole and thus eapitalizes
the total carnings ofthe firm to find the value ofthe fim
asa wh
The overall cost of capital, k, of the firm is constant and
depends upon the business risk which also is assumedto
be unchanged.
3. The cost of debt, ky is also taken as constant
4. The use of more and more debt in the capital structure
increases the tisk of the shareholders and thus resulisin
the increase in the cost of equity capital ie, k, The
increase in k, is such as to completely offset the benefits
cof employing cheaper debt, and
5, That there is no tax.
“The NOL approach is based on the argument that the market
values the firm as a whole fora given risk complexion, This,
for a given value of BBIT, the value of the firm remain same
irrespective of the capital composition and instead depends
‘on the overall cost of capital. The value of the Equity may be
found by deducting the value of debt from the total valucof
the firm ie,
EBIT
Ky
v-p
0
and E
od the
as, th
ave of
pebt-es
jarcho
re, the
roportt
fe lever the cost of equity capital, kis
k= EBT zintere
7 ro 2)
thus the financing mix is irrelevant and dues not affect the
‘she of the firm. The value remains same for all types of
Werequity mix. Since there will be change in tisk of the
holders as a result of change in Debt-equity mix, there
ge, the k, will be changing linearly with change in debt
sportions. The NOI approach ta the relationship between
leverage and cost of capital has been presented in Figure
"URE 8.2: THE NOI APPROACH TO COST OF CAPITAL,
re82 shows that the cost of debt, ky andthe overall cost
feapital k, are constant foralllevelsof leverage. As the debt
eportion oF the financial leverage increases. the risk of the
dcholdersalsoincreasesand thus the cost of equity capital,
abo increases, However, the increase ink, is such tha the
value of the firm remains same. tt may be noted that
an all-equity firm, the k, is just equal to k, As the debt
portion is increased, the, also increases. However, the
costo capital remains constant because increase,
jest sufficient to off-set the benefits of cheaper debt fi:
'NOL approach considers k, to be constant and therefore,
's no optimal capital structure; rather every capital
Esters 2s good as any other and every capital structure
®optinial one. The NOLapproach can be explained with the
of Example 8.2 4
atthe valu of cos of equi eptalifvemplovs
ths extent of 30%, 408 or 308 ofthe total capita und
'10.00,000 .
ect of changirig debt proportion on the cost of equity
can be analyzed as follows :
Tee TW be] sea
20900 | 200900] 0900
‘aeeooee (0% tos 10%
of th fem, 2000000} 2090000 2090000
iso ae D> 3.0000 490000} 500.000
sfeauy.ce-v-0}] 1799000 | séan000) 1509000
LEVERAGE, COST OF CAPITAL AND VALUE OF THE FIRM
Mo 175
f Beebe | wena | we ba]
Se rr a
Me iar te frase |
The k, of 10.7%, 11% and 11.33% can be verified for efferent
proportion of debt by calculating WACC, k,, as follows:
For 30% debi. k, = [DD + Ek, +E + Bk,
(343 + 17)}06-+ 117/8-+ 1}107
= 10%,
[DAD + Bk, + EMD + Bk,
= [4/4 + 16106 + [16/04 + 169).11
= 10%.
For 50% debt, k, = [D/(D + E)]k, + [B/D + Pk,
= [55+ 15)}06 + [15/15 + 15)}113
= 10%.
For 40% debt, k,
‘These calculations of WACC testity that the benefit of er
ployment of moreand more debtin thecapitalstructureis oft
set by the increase in equity capitalization rate, k The above
analysis shows that under the NOT Approach, the value of the
firm is found by capitalizing the EBIT at the rate of k, and
from this value, the value of debt is deducted to find out the
value of the equity. This can be stated as follows:
“Waludof Equity = Value of Firm — Value of Bebe
‘The NOIsuggests that total market valucof thefirms ourstand:
ing securities isnot affected by the mannerin which different
long-term sources of funds have been tapped. In other words,
thesumof the market valueof the debt and equity willalways
be same regardless of how much or little debt is used by the
company. So, one capital structure is as good as any other.
The same is also suggested by the risk-return trade off
principle that investors do not take on additional risk unless
compensated with additional return, This means that using
more debt by a company will not be ignored by the investors
who will require higher return on equity share capital to be
smpensated for the increased uncertainty stemming from
the addition of the debt securities in the capital structure,
TRADITIONAL APPROACH :
APRACTICAL VIEWPOINT
‘The NI and the NOI approach hold extreme views on the
relationship between the leverage, cost of capital and the
value of the firm. In practical situations, both these ap-
proaches seem to be unrealistic. The traditional approach
takesacompromising view betweenthetwoandincorperates
the basie philosophy of both. It takes @ mid way between the
NI approach (that the value of the firm can be increased by
increasing the leverage) and the NO approach that the'value
of the firm is constant irrespective of the degree of financial
leverage)
‘As per the traditional approach, a firm should make a judi
cious use of both the debt and the equity to achieve a cepital
structure which may be called the optimal capital structure
Ac this capital structure, the overall cost of capital, WAC, of,
the firm will be minimum and the value of the firm maximum, “The Traditionaiviewstatesthat the valueofthefirmin
‘with inerease in Financial leverage but vp to a certain limit
‘only. Beyond this limit, the increase in financial leverage will
increase its WAUCalso, and the value ofthe firm will decline
Under the Traditional approach, the cost of debs,
sumed to be less thaa the cost of equity k,. In cas
equity firm, is equal to the k, but when (cheaper) debt is
introduced in he capital structure and the financial leverage
increases, the k, remains same as the equity investors expect
a minimum leverage in every firm. The k, does not increase
leven with increase in leverage. The argument for k, remain:
ing unchanged may be that up to a particular degree of
leverage, the interest charge may not be large enough to pose
‘arBal threat tothe dividend payable tothe shareholders. This
constant k, andk, makes the k, fall niialy. Thus, it shows
that the benefitsof cheaper debisare available tothe firm.But
this position docs not continue when leverage is further
increased,
‘The increase in leverage beyond a limit increases the risk of
the equity investors also and as a result the k, also starts
increasing, However, the benefits of use of debt may be so
large that even after offseting the effects of increase in k, the
may still godownormay become constant for somedegree
Of leverages IF firm increases the leverage further, then the
WAC
tisk of the debt i
thek, also sta
cost of
Capnat
Scereane inva thet tee
Tt val of Fnac vege 8 apy te
which it favourably affects the value uf the firm but thereas. J Prof
terif the leverageis increased further, hen the effect may 4 | EM
duyerse andthe valueol the firm may decrease. There maybe § | Vee?
Spurcular overage orarangea leveroge which eprte f v
the favourable leverage from theunfavourable leverage. Te f |, (8
tdina iw pon hasbeen show the Figure 3 JU
The Figure 83 shows that there can citer bea parte f PSS
Tneaeverageonn Pars )orarangco inaralienge Oy,
{asin Pact B) when the overall cost of capital. is minima. | #19981
‘The figuee in Part A shows that atthe financial leveragetera f dept ar
Ope rm has the kowent kh scores the capa
sivrorest ht inna eerane opt he Pat ag ea
SRofgure show hat tore nt ome optimal capital are | 9
‘ture, rather there is @ range of optimal capital structure from a ae
leverage level O to level P. Every capital structure over this a
— reduce
i from 14
owes
thou!
dono
reds
father
eves:
Se or
Miller
Loworage
(degree)
MODIC
eee
* (degree)
a eae JUSTH
pts! capital fans fi sed
| Suctue Copia! Sect :
rans) Pan8) tn)
They hs
FIGURE 8. : TRADITIONAL VIEWPOINT ON THE RELATIONSHIP BETWEEN LEVERAGE,
‘COST OF CAPITAL AND THE VALUE OF THE FIRM,
‘Thus, asper the Traditional approach. a firm can be benefited
from a moderate level of leverage when the advantages of
using debt (havinglower cost) outweigh the disadvantages of
increasing k, (asa result of higher financial risk). The overall
cost of capital, k,, therefore is a function of the financial
leverage. The value ofthe firm can be affected therefore, by
the judicious use of debt and equity inthe capital structure
Baiiole'6.8
ABC Ltd. having an EBIT of € 1,50,000 is contemplating (0
redeem a part of the capital by introducing debt financing,
Presently, itis a 100% equity firm with equits capitalization
rate, k, of 16%, The firm isto redeem the capital by introduc-
the cap
valueol
does ne
indeper
may be
restatec
justifies
follows
\. The
ing debt financing up to ¥ 3,00,000 ie, 30% of total fundsor up
10 5,00,000 i, 508 of total funds. It is expected that forthe
debt financing up to 30%, the rate of inerest will be 10% and}
the k, will increase to 17%, However, ifthe firm opts for 50%
debt financing, then interest willbe payable atthe rate of 24
and the k,, will be 20%, Find out the value of the firm andi
WACC under different levels of debs financing
Solution iss
(nthe basis ofthe information given, the totl funds othe] OF
firm seems tobe of € 10,00,000(whole of whichis provided by
the equity capital) out oF which 30% or 50% fe, @3,00,000 oF
500.000 may be replaced by the issue of debt beating islerest at 10%or 12% respectively. The valuc of the firm and
1s WACC may be ascertained as follows
~ a
aa ae} ros
Ss tussos| uss] wots
Anterest 1 7 60.000
Mitieers a Se
peeomme uct een 7
o— so| eno
“| Ste
[iets tant [tise
Brample 8.3 shows that with theincreasein leverage rom 0%
19308, the firm isable wo reduceits WAC from 166 0 14.9%
aad the value of the firm increases from & 9,37,500 to
{1005,882. This happensas thebenefits of employing cheaper
‘debtareavailableand thek, doesnot rise too much, However,
fal erealter, when the leverage isincreased further 050% the
tof debt as well asthe cos of equity, both, rise to 12% and
respectively. The equity investors have increased the
Ficity capitalization rate vo 20% as they are now finding the
Him to be more risky (as a result of 504 leverage), The
‘erease in cost of debt and the equily capitalization rate has
foreased thek,andhence asaresult the value ofthe firm h
ieduced from @ 1005,882 to € 9.501000 and k, has increase:
fom 14.9% to 15.8%. sei
However, in spite ofthe arguments presented above there is
school ofthough which ays thatcapalstructure desons
donor really affect the value ofthe im. The NOT approach,
1g tend discussed, emphasizes ths aspect. The same has
finer been substantiated in one of the most influential
fA ppe ever writen in comporate finance, containing one of
Be corporate Finance's best known model. the Modlin’
ier model
MODIGLIANI-MILLER MODEL: BEHAVIOURAL
JUSTIFICATION OF THE NOI APPROACH
he present section examines the Modiglani-Miller Model
) which was presented in 1958 on the relationship be
the leverage, cost of capital and the value of the firm.
Affiey have maintained that under a given set of assumptions,
sg tecopital structure and its composition has no effect on the
lueofthe firm. MM Model shows hat the financial leverage
ot matter and the cost of eapital and value of firm are
dependent ofthe capital structure. There is nothing which
abe called the optimal capital structure, they have, in Fac,
ts fond tated the NOLapproach and haveadded toit the behavioural
ated fication for their model. The MM Model is based on the
in wing assumptions:
1 Thecapitalmarketsareperfectand complete information
‘savailabletoall the investors fgeof cost, Theimplication
ofthis assumption is that investors can borrow and lend
funds atthe same rate and can move quickly from one
CH. 8: LEVERAGE, COST OF CAPITAL AND VALUE OF THE FIRM
wT
security to another without incurring any transaction
2. These
3. Investors are rational and wellinformyed about the risk,
return of all the securities.
4. Alltheinvestorshave same probability distributica about
the expected future earnings.
5, Thereismecorporaic income tax (However, thisassump.
_ tion was relaxed later)
6. The personal leverage and the corporate leverage are
perfect substitute
On the basis of these assumptions, the MM Model derived
that
(a) Thetotal value ofthe firm isequalto the capitalized value
of the operating earningsof the firm. The capitalizations
tg be made at a rate appropriate to the tisk class of the
firm.
(b) Thetotalvalucof the firnsisindependent ofthe financing
ix Ze, the financial leverage.
(0) ‘The cut-off rate for the investment decision of the fim
depends upon the risk class to which the firm belongs,
‘and thusis not affected by the inancing pattern of these
investinent
MM Model can be discussed in terms of two propositions
Tand I
MM Proposition I: Proposition I states that it is completely
irrelevant how a firm arranges its capital funds.
(MM model argues that if wo firms are alike in all respect
except that they differ in respect of their Financing pattern
and their market value, then the investors will develop 2
tendency to sell the shares ofthe over valued firm (creating a
selling pressure) and to buy the shares of the under valued
firm (creating a demand pressure). This, buying and selling
pressures will continue till the two firms have same market
values. MM model can be further explained with the help of
an example as Follows
‘Suppose, therearetwo firms, LEV & Co.and ULE& Co.These
firms are alike and identical in allrespect except that the LEV
& Co. isu levered firm and has 10% debt of € 30,0000) in its
capital structure. On the other hand, the ULE & Co. is an
unlevered firm and has raised funds only by the issue of
equity share capital Both these firms have an EBIT of
£ 10,00,000.and the equity capitalization rate k, of 20% Under
these parameters, the total value and the WAC of bath the
firms may be ascertained as follows
unites ave infinitely divisible.
TEVE&Co, | ULB& Co
mar = ® io}00900” | —€ 165000
Interest 300.000 :
Net Profit 7.00.00 | 10,03000
Equity capitalization rate 20 20 ae PART lll. FINANCING DECISION
ievece, | bets
| Valo of ain J sn000~ | ~ sean060"7
| Value of Debi 200.000 -|
| Tout Value, v, | ssooo00 | sooaoo0 |
Wace, aERtrvy ry 205 |
‘Though, both the LEV & Co.and ULE Co. have same EBIT
FF 10.00.000 and samek, of 20%and stilthe LEV & Co. the
levered firm, has a lower k, and higher value as against the
ULE & Co, which is an unievered firm. MM argue thet this
Position cannot persist fora long and scon there will be an
‘equality inthe values ofthe two firms, They have suggested
an arbitrage mechanism 0 prave ther hypothesis. This arbi-
{eageprocess,as seen inthe following discussion providesthe
behavioural justification the madd
The Arbitrage Process : The arbitrage process refers 10
undertaking by a person of two related actions cr steps
simultaneously in order to derive some tish- less benett e.
buying bya spec srket a
the same time in some other market. or selling one type
‘investment and investing the proceed in some other inves
ment. The profit orbenefit from the arbitrage process may be
in any form increased ineome from the same level of
investment or same income from lesser investment. This
arbitrage proces has beon used by MM to testify their hy-
fothesi of Financia leverage, cust of capital and valve of the
Inorder to understand the working ofthe arbivage process
theabove example of LEV Co. ie may be taken Suppose
aninvestoriva holder of 1Ovequty share capital of LEVE Co
The valve of his ownership right is € 330000 te, 106 of
E 35.0000. Further, that out of the total net profits of
£7.00 000 of LEV & Go, he sented wo 10 Les € 70000 pr
annum and geting a rez of 20% his bon his worth Ia
order to aval the opportunity of making a prfit he now
Aeeides io convert hiss from LEV & Co to ULE& Co.
He disposes ff his holdingin LEV & Co for €3 50.000, but n
order obuy1O%holdingof ULES Co. herequresttal fonds
£85 00000, whereas is proceeds are only € 350000, Serhe
takesa loan @ 10% of an amount equalto€30.000(ce, 10%
ofthe deb ofthe LEV Co)and no helsing fn
of € 650000 (ie, the proceeds of € 3.50000 and the loa
of on f 3.50.00 andthe loan of
Sutofthe total funds of 630.00, heinvesis5 0000 bu
10% shares of ULE & Co, stil he has funds of € 150.000
Bvallabl with hm. Assuming that the ULE Co contnesto
éarathesameEBIT of 7100000, thenetreurnsavalblete
‘be investor from the ULE co are
Profit Available from ULE & Co.
(being 10% of net profit) ¥1,00,000
“Interest payable @ 10% on & 300,000 loan 30,000
Net Return) "70,000
So. the investors abte to get thesame return of € 70,000 From
ULE & Co. also, which he was receiving as an investor of LEV
& Go, but he has funds of € 150,000 leit over for investment
schewhere. Thus, his total income may now be more than
(tenement
spel
70,000 (inclusive of some income on the investment of
£1,50,000}. Moreover his riskisthe sameas before. Thoughhis
new outlet ie, ULE& Co. ‘san unlevered firm (hence notise
bout the position of the investor is levered because he hay fink
created a homemade leverage by borroring® 300,000 irom fseapit
the market Infact, he has replaced thecorporate leverage ot 4 pdt
LEV&Co, by his personal leverage. fem. A
The above example shows that the investor who originally eval t
‘owns a part ofthe levered firm and enter into the arbitrage’ 4 forexa
process as above, will be better off selling the hotdirg iq. yd 10)
levered firm and buying the holding in unlevered firm sing | overall:
forthe
his home made leverage
MM model argues that this opportunity to earn extra income
through arbitrage process, will attract so many investors. The
gradualincreasein sales ofthe shares of thelevered firm LEV
& Co, will push ite prices down and the tendency to purchase
the shares of unlevered firm, ULE & Co., will drive is prices
howe
he deb
Usthereeliganpurchasingpretsurcwiicononcnd |
‘Renu vl of thetwotuneareeguel Al is sage
‘slocoftheleered ad theunlevere amendalehe con
ctl ere sume; and ths th vera cont of epithe
Independent ofthe natal verge ferese
The arbitrage proces dexenhedaboeinvavesatrantrot | tO
investment from a levered firm to unlevered firm. This arbi. JY ®
stageprosesuwerkinhereveredivestonsto whens {Fi
Cohseftheeverdtomitetianthevakwoftheurteed | k
Ten Sathetorevataot LEV&C 5 450,00 (consg
OFF 30000 gabe capt and ® 1500000 ey hore
capital). and the value of the ULE&Co. isthe same as before, Hy soit
{, 2 30,00,000. Now, the investor holding 1Okshare capitalof
ULE. Co, sells his ownership right for ®5,00,000. Out ofthese
proceeds, he buys 10% of share capital of LEV&Co. for
1,50,000 andinvestsé 3,00,000 ée, 10%oF€ 30,00,000) in 10%
Government Bonds. Still he will be having funds of
£50,000 with hima and his position in respect of incomes from
two firms would be as under
[ ULE& Co. | LEV & Ga | J MitiealE
Toe oF Boe © 1901058, ‘eo | | elevan
108 tnterest on Bonds : 30,00 | faalysis
Total income eToTHG | —~ETompos | feverall
cost of de
Thus, by performing the arbitrage process, the investor will
rot only be able to maintain his income level, but also e
having additional cash flows of € 50,000 at his disposal. Tae
prices of the share of ULE & Co, and LEV & Co, must adjust
‘until the values of both the firms are equal.
MM Proposition I: Proposition I states that the cost of equ
depends upon three factors ée, overall cost of capital of the
firm, cost of debt and the firm's debt equity ratio, In MM
model there iss linear relationship between the cost of equl'y
and the leverage (as measured by the Debt-equity ratio és,
D/E), When the leverage is increased, the earnings available
forthe equity shareholder will increase, but the cost of equily
will also increase as a result of increase in financial risk. The
benefits of increasing leverage are completely offset by the
increase in cost of equity capitaland consequently te market
value of the firm remains same, rent ofA per the MM Mod, he cos of equity capital i
ea Zag ETE
hhe bag Jaf ie, k_ for the given risk class is equal to the fixed overall cost
2Ofeum “capital, plusa premium forts financial isk, Iinay be
rageot“ qacdthat ithe Equation 133 kyisthecost ol debtotlevered
firm, As there isan assumption of no corporate taxes ks
iginaly equal 0 the rate of interest on debt eemploved by the fir
batrage J rorexample, ABC Co. has raised quite ,
ding if and 10% debt of €20:00,000. It belongs toa ak clss having
i usgll veal cost of capital, of 18%. The cost of equity eapta ke
Ta ee the irm is,
Ke = kt OKIE)
18% (18-210)2/3)
233.00 233%,
I.however, the company issuesadditional debt of &10,00,000,
thedebt-equity ratio will be I and the k., will be
A = 18 +(4st0Ki/1)
. 2o or 26%
$e, the overall cost of capital, K, remain same, but with the
‘crease in Financial leverage, the risk premium of equity
areholders has increased from 5.34t08% The k,canalsobe
vetify as Follows:
E debi equity ratio is 23, then
k= (DAD + Bik, + [EMD + VK,
2/2 + 3910+ (3/@ + 39).233
18%
debt equity ratio It, then
[DMD + Ek, + [EMD + EY,
Wi + 0+ + 126
= 18%,
Thus, it means that, as per MM model, the overall cost of
capital, will nat rise evenif the degree of financial leverage
sincreased
Citical Evaluation of MM Model:If the financing decision is
‘relevant as shown by the MM Model, then the financial
alysis relating to financial decision is so simplified, The
eerall cost of capital, which isthe weighted average of the
fst of debt and cost of equity, i unaffected by the changes
Bproportion of debt and equity. This might seem unreason-
He, especially asthe cost of debt is lower than the cost of
Jauity. AS per the MM Model, however, any benefits of
Substituting cheaper debt for more expensive equity are off
=: by increase in both the costs.
heoretially speaking, the MMmodel,thatthereisnorelation-
8p between the leverage and the value of the firm, seems to
Sceood enough inthe light of the assiumptions underlying the
Jnodel However, most of these assumptions are unrealistic
fd untenable. Moreover, the arbitrage process, which pro-
ies the Beiavioural justification for the model i sell
lusstionable in therallifeas thepertectcompetitionis never
rend and the transaction costs are inevitable. The validity of
he model, on practical considerations, can be examined as
ftiows f oe
19
Non-substitutability of Personal and Corporate Lever:
tages: Under the MM model, the arbitrage mechanism
1 the personal leverage of
‘operates on the assumption
the investorand the corporat
‘ante, However, this may not be trucin real life. These
be difference in the effects of persunal leverage and the
corporate leverage, and it may be substantiated as
follows
(a). Different Borrowing Rates forthe Corporatesandthe
Individuals: The arbitrage process presupposes that
an individual investoris able to borrow funds at the
same rate of interest at whieh the leverage firm can
and hence the personal home made leverage of the
individual investor Is a perfect substiture of the
‘corporate leverage. An individual catmot borrow or
Tend fundsatthesamerate at whicha corperate firm
can, However, acorporatcentity having bettercredit
standing inthe market can definitely borrow at rates
lower than the rates which an individual has to pay.
Jeverageare perfect substi
(8) Personal Gearing versus Corporate Gearing *In the
arbitrage process, when an investor takes «personal
loan, he creates a personal gearing and then pur:
chases shares of unlevered firm. So, asa result, the
gearing has shifted from the corporate leverage to
the personal leverage of the investor: Are these two
gearings substitute ? When an investor borrows
Funds in his personal capacity, he ia fact incurs an
tnlimite! liability towards the lender: However. asa
shareholder ofthe levered firm, hisliabilityi limited
only tothe capital subscribed irrespective ofthe evel
‘of borrowings by the firm, So, the personal ieverage
is not a substitute of the corporate gearing.
(©) Leverage Capacity :The firms usually have a higher
leverage capacity as compared to the leverage capa
city ofthe individuals. The creditors may notlend,to
an individual, beyond a particular level.
(a) inconveniences of Personal Leverage : Borvowings
cither by firms or by an individual involve a lot of
formalities and inconveniences, An individual inves:
tor may have preference for corporate borrowing,
because in thiscase, he will remain an outsider tothe
act of borrowing, Thus, the personal leverage may
not at all be sufficient replacement for corporate
leverage.
So, the factors such as difference in borrowings/lending
rates, risk exposure of personal and corporate leverage in
terms of liability of the investors the leverage capacity of
the individuals and the firms and the inconveniences of
borrowingsdonotmakethepersonalleverageasapertegt
substitute of corporate leverage. Hence, the efficicney of ,
the arbitrage process in particular, and the MM model in
general is questionable
‘Transaction Costs : The assumption of no transaction
costs of the MM models also imaginary. The buying and
selling of shares by the investors willsurely involv: some
transaction costs which willmakethearbitrage process to
stop short of completion. Though, the quantum of trans. = PART Il: FINANCING DECISION iH
action costs will generally be small, yet the efficiency uf
the arbitrage process will be affected.
3. Institutional Investor : If an institution or a firm is a
sharcholderinalevered firm whichis valued higherinthe
‘market, can ths institutional investor take benefit by the
arbitrage mechanism? Generally, it cannot. The reason
being that the institutional investor may not beallowed to
create a Personal leverage and then to buy the shares of
unlevered firm,
4. Avallability of Complete Information : In real life. the
‘assumption that all the investors have complete informa:
tion, is also illusory, However, this assumption is compul
soty otherwise the very emergence of the arbitrage pro-
cess will become impossible. The arbitrage process re:
quires thatthe investorshave completeinformationabout
the levered and unlevered firtn,
5. Corporate Taxes: The MM Modells based on the assump.
tion that there is no corporate tax. This assumption is also.
unrealistic and the tax aspects of the levered firm is very
significantin practice. Out of twoalike firms differingonly
inrespect of leverage, the levered firm will definitely have
higher eash profitto be distributed among the sharehold
ersas compaied toan unlevered firm. Thisis particulacly
due to the fact that the interest istax deductible. This wil
result in higher value of the levered firm than the value of
the unlevered firm,
MIM also agreed in their acer analysis that the leverage may.
increase the value of thefirm. The effect ofcorporatetaxeson
the value of the firm can be explained with the help of an
cxample, Say, A Ltd.and Bd, both alikeinall respect, except
that out of total capital fund of & 10,00,000, B Ltd. has raised
%5,00,000 by the issue of 10% debenture. Hoth the Firms have
to pay tax @ 30%. The position of their EBIT and its appro:
riation under two types of economic conditions have been
shown as follows
Eee. Conanton | Average | Goad] Aveage [Good
ait *som60 | eran} eSon6e | FT soa
terest seas | 5000
Pett tetoretax | “Sana | (FBS ‘ome
“taco 304 1500 | “iso zs
frofeatertox | 35000 | Gesu
etal Cashflow for |
Des and sh
sarcbtsers "| 35000 | 105000] sao } 1200
From this table, itcan be seen that A Lid. (anlevered firm) has
tax liability of € 15,000 and € 45,000 in case of average and
ood economic conditions respectively; whereas B Ltd, (le
vered firm), having same level of EBIT of ¥ 50,000 and
150,000, has to pay only zero,or® 30,000taxesin average and
‘good economic conditions respectively.
So,forB Lid, having 50% leverage inits capital structure, the
‘2% liability becomes smaller under both types of economic
conditions. Therefore, use of leverage reduces the portion of
EBIT goingout as taxes, Similarly, the two groupsof investors
ie, the debt holders and the shareholders of the firm, who
collectively determine the total valuc of the firm, also receiv
et
alargershare of EBIT in caseofleveragetirm than theirstare 4] BBeam
inthe unlevored firm. The cash flow tothe otal investon ff Pac |
A Lud and B Lid are €35000 and € 50000 under avenge | ASSL
economic conditions and ® 10500 and € 12000 uniee_ J 3000.
good cconomicconditons hist because fuhefact thane | 2th
Interests an-deduetible in case ofthe levered firm, bal
The excess cashflow available to the investors of 3 ved
fim can be calculoted as interest charged % tax racic, JW
250000 30-=€ 15000 Thisisthedifference berweenthy Po
cosh flows trom levered firm and vnlevered frm fo, Tes
E1000 ~€ 1050) This ference of € 1500015 a5 | £5000
now as Interest Tax Shield nzle
Thetotalmarketvalueoafirmincreaseswitloverageashe | Ut
Cosh flown avalele to total investor ako inrowses with
increase in leverage. Higher the leverage used by a fem the
larger will be the eash available for the investors and higher
will be the value of the firm, The value of the unlevered fmm
istound by capitalizing the profit afler tax at the exert ust
of capital, k, However, in order ty fiud vat
levered firm, the extent of interest tax-shield isto be caleu
lated, The value of the levered and unlevered firm will differ
‘only with respect to this interest tax-shield which will be
available to the investor of the levered firm perpetually (an
the assumption of permanent levered capital structure).
the present value of the perpetuity of this interest tax-shield
is added to the value of the unlevered fiem 10 find out the
value of the unlevered firm.
evalu oF he
Kmay t
interest
Ge, taxs
Equity rs
The over
asfollow
Under MM Model the value of levered firm is found out as
follows
First, ind out the value of the unlevered firm by capitaliziag
the profit after tax ie, EBIT (I ~ t), at the overall cost af
capital
In the above equation, the velue of EBIT will be equal 10 PET
because in an unlevered firm, there will not be aay interes
liability. Then, the present value of the perpetuity of interes
tax-shield is added! to this value, V, tofind outthe vakueof the
levered firma,
Thus, the
unleverec
Bess
“MSV, tivo] Jo Ten
The PV ofineresttoxshieldis calculated bydscouningte | S22"
intrest ta shed at an appropriate ate ic
Now vale of levered firm en be defined a: ae
fae Woe Sey eee | -
Tntheabove formulations thefallwingnotatonshaveben f, et
used betwe
Vz = Valu ofthe Levre firm on
Vy = Vole ofthe Unlvered frm ae
Debt = Total debt raised by the levered firm, and not rs
t Tax rate. ‘¢ Then
“hus, the value of the evered frm under MM model tier | HE
incorporating the enporte tne wl be higher han the Et
value of the unlevered firm, (CH. : LEVERAGE, COST OF CAPITAL AND VALUE OF THE Fi
181
Sits ibe (Tare Preteen iii
stone a asec Tanna} — son] T0605
ABC Ltd. is an unlevered firm having wial assets of | ABET [79 sow | sate | 11258 f reonaeo |
sven fl {sono0catsopesencdby smrecteleetponshas [sib | Se | an |e [|
ana HY caPtaizaion rate. k (which is ao, k, forthe unlev- So, withreference tocorporate taxes, the vahueof thelevered
hat besff ered firm) of 10% it has ah EBIT of € 10,0000 subject to” fnnis nore than the vali of the wnlevered firm even under
corporate @ 308. The value ofthe frm ABC Lids MM model, The resus of the sal of MM model ean Be
leversd £100000011-3) 560,099 summarised as follows
cog 0 i MA Mode without Taxes
re 6 another fem XYZ Lie also having total asets of fire's capital structure is irelevant
om (ie, am Ther f eB 1. That the firm's capital structure is ir
Tr skejadf€5200.000 and alike ia all respects to ABC Lid except thet :
28 ah 812 11 has insued Ste do of € 200,000, Te toa market The WACC isthe same no matt what mixture of debt
B and equity is tsed to finance the firm,
salue of XYZ Lid, is more than the value of ABC Ltd. by an
amount equal to Debt X (0) Thus, the value of ABC Ltd is"
Yo =v, + babu)
= €70,00,000 + 20,00.000(.3) = 8 76,00,000.
Inthis ease, the market value of the equity is €56,00,000 (ce,
£76,00.000 - 20,00.000). Fhe cost of equity, k, ean be ascer
ssined as Follows
B= K+ kgDd-o/e]
= 10-+ (10-05) 20,00,000(.7)/56,00,000]
= 104.0125 = 11.25%
Hi may be noted that in the Equation 85. ky is the rate of
dtcrest paid by thetevered firm, Thefenefitof debt financing
(ie.tax shield of interest) has been incorporated in the Debt
Equity ratio.
The overall vost uf vapital of the firm can nove be ealeulated
@s
lows
k= [DAD + EK ky + BD + EY,
[20/20 + 56}05¢7) + [55/(20 + 561125
= 9218,
The value of k, can also be caleulated as
x, = 210000003) sy
© 76,00,000 a
Thus, the position of the levered firm ABC Ltd. and the
nlevered firm XYZ Ltd. can be sumuniarized as Follows
ES
+ Therelationship between capitalstructure,costof capital
and value of the firm has been one of the most debated
area of financial management
There have been several questions raised: Can the value
of the firm be affected by changing the capital mix? fs
there a capital structure which may be called the optimal
Capital structure?
Broadly speaking, differing views on the relationship
between capital structure and value of the firm can be
Brouped into () That capital structure matters for the
value of the fica, and (i) That the eapital structure does
snot matter,
‘TheNet Income Approach argues that achangein financ:
ingmix efforts the WAC, k, of the firm and thereby also
effects the value of the firm. Higher the degree of debt,
higher would be the value of the Firm,
del (afte
than the
3. Total value of the firm is independent ofthe level of debt
in the capital structure, andthe valuecan becalevlated by
‘capitalizing the operating profit at appropriate rate. The
value of the levered firm is equal to the value of the
uunlevered firm, and
4, Cost of equitss k= &, 1 (pA COME) Th
ina levered firms equal 3 the overall capitalization rate
of the unlevered firm plus 2 premium for the financial
risk. It implies that the cost of equity rises as the
increases its use of debt
MM Model with Taxes
1, The value of the levered firm is 69
tunlevered firm + the present value of the interest Tax
shield, fe
v=v, + D0)
So, debt Financing is advantageous and it inereeses the
value of the firm,
Ito the salue of
2. ‘The WACC of the firm decreases a the firm relies more
and more on debs financing.
43. -The cost of Equity, k, = B+ 0k (O/B) (1-0)
or = K+ (ek IDU-/E}
where, k, is the WAC of the unlevered firm.
'¢ The Net Operating Income Approach argues that the
capital mix irrelevant and does not affect the velue, of
the firm, The value on the other hand, depends uzon the
EBIT. The value of the firm may be found by capitalizing
the EBIT at the capitalization rate for the risk class ofthe
firm, Therefore, any capital mix is as good as any other.
¢ Modigliani-Miller have provided a behavioural justfica-
tion for the NOT approach through the arbitrage process
However, in later analysis, they have agreed that the
value of the levered firm may be more than unlevered
firm because the former has the tax advantage ofinterest
payment.
¢ TheTraditional Approach, takesainiddle wayand argues
that leverage may increase the value of the firm but to.a
certain degree only and therefore, a judicious use of
debit-equity mix can help maximizing the value of the
firm, S.Ltd. and Lid, are in the same risk class and ave Klgntical
im all respects except that company § uses debt while com
any T does not use debt. The levered firm has ¥ 9,00,000
debentures carrying 1O'urate of interest. Both the firms earn
20% operating profit on their total assets of & 15 lakhs, The
‘company is in thetax bracket of 35%and capitalisation rateor
15% on all equity shares
You are
quired to cowpute the value of § Lid. and T Ltd
using Net Income appriach, [BCom (61), DL, 2012)
Solution :
Calculation of Value of S. Ltd. and T. Ltd. using Net Income
Approach
Profit after tan
Equity Capitalization rate,
Value of (PAT,
[ [ena Th |
Total Asse 7 is00000 |e isoq000|
Operating Profits 208
EBIT
| Interest
Profit before tax
AT 358 }
|
|
|
Vacs
ee Co
Noein ht give case, he ox Tate hasbeen ape ond
‘out the value of the Equity. may be noted that Net Income
Approach assumes that taxes are not there. So, in the given
case, value of firm, without tax can also be calculated.
z
‘Aparna Steel Ltd. has employed 1S¥ debt of ® 12,00,000 in its
capital structure. The net operating income of the firm is
% 5,00,000 and has an equity capitalization ratio of 16%.
‘Assuming that there is no tax, find out the value of the firm
under the NI Approach
Net operating income 75.00.00,
Less Interest on Debt 180,000,
Earnings for Equity Investors 3.20000
Equity Capitalization rate 16%
Value of Equity (3,20,000 + .16) €2000,000
Value of Debt 12,00,000
Total value ofthe firm
OL Ltd. belongs to a risk class of 108 and expects EBIT of
€4,00,000.lt empioys 8¥debt in the capital structure. Findout
the value of the firm and cost of equity capital k, if icemploys
debi the extent of 20%, 35% or 50% of the total financial
requirement of € 20,00,000.
Graven LusTRAT =
Solution + Ik .
Statement of Value of the firm and cost of Equity Itsy
[eae sie | |e
woo a ee |
erst on Dob
et refer Sg NP
Vatcet Fem Yeceantios; | Esou0pe0 | FTaoosw
suet Dei D
Vue ot Bau
| Siteweo | “seem
| “stow: ] aaa”
ont Egy 4 =P
‘wanes 1100
rath a capita
‘The act operating profit of 3 Hem fe E Bares
market value of its 12% eeb« is €3,00,000. The equity capital
ization rate of an untevered fin of the same risk class is 16h
Find out the value ofthe levered firm given that the tay rate
is 30% for both the firms.
return
capita
capita
Irene find othe a towed i fe |
In order to find out the value of the levered firm, irs, the
value of unleverel fen should be founel Net 0;
BI Ue
Value of unevere! tt : ee
roa
Now, value ofovered fem Value of unlevered firm + Dey | Values
9.18730 + 300000 (3)
= 1008750
[ABC Ltd, with EBIT of ¥ 3,00,000 is evaluating a numberof
possible capital structures, given below. Which of the cai
structure will you recommend and why ?
Copal Saco | Dw @ | eS | _RM
T 300000 | 109] 120 a
A zoo | too | as |
a som | 0 | ons Wve
w soo00 | 120 | iso |feY2t
v room | io | uso [PE 400
Solution: capital
In this case, the k, and, of the firm are given and changing | (9 De
‘The firm may adopt that capital structure which has the least Te
overallcostofeaptalor the maximum value. Theoveralles | (i) De
of capa kof te firm may be calculated by apeving | Gi
“Traditional Approach as Follows 7
i, =EBIT/Total Market Value a
