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Nprakash 1
Introduction Corporate and personal taxation Modifying MM propositions to account for corporate taxes Traditional trade-off theory, Agency theory and leverage
decision Asymmetric information and leverage Balancing agency costs with information asymmetry.
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Capital structure refers to the pattern of funding a company's long term funding requirements.
It represents the proportionate relationship between Debt and Equity.
Debt includes Debentures, Term Loans, Preference shares and Leasing.
Equity includes paid-up equity capital, share premium, reserves and surplus.
The Debt-equity mix has a bearing on the capital structure of the company which affects the shareholder’s earnings and risk, which in turn will affect the cost of capital and the market value of the firm.
Capital Structure can affect the value of a company by affecting either its expected earnings or the cost of capital or both.
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Financing mix cannot affect the total operating earnings of a firm, as they are determined by the investment decisions, it can affect the share of earnings belonging to the equity shareholders.
The capital structure decision can influence the value of the firm through the earnings available to the shareholders. It can affect the value of the firm through the cost of capital.
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Debt-Fixed claim-High priority on
payments-Tax deductible-Fixed maturity-No management control
Equity-Residual claim-Lowest priority-Not tax deductible-Perpetual or infinite life-Management control
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A firm should select such financing mix which maximises its value/shareholders wealth long term.
Theoretically, it (optimum capital structure) is the capital structure at which the weighted average cost of capital is minimum thereby maximising value of the firm.
Determination of optimum capital structure is difficult because a number of factors influence its decision.
There is no definite model that can suggest ideal capital structure for all business undertakings because of the varying circumstances.
Different industries follow different capital structures and within an industry different companies follow different capital structures.
It is more of an appropriate capital structure than the theoretical optimum capital structure.
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A sound capital structure should have the following features: Profitability – use of leverage to obtain best advantage for
equity shareholders. Solvency – ensure minimum financial risk. Use of excessive
debt independent of future profitability threatens the solvency of the firm.
Flexibility – to meet changing requirements when needed. Conservatism – the future cash flows should be able to
service the debt as per schedule. Control - minimum risk of loss of control of the company. The relative importance of each may differ for each firm.
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Financial Risk – ◦Risk of cash insolvency because of an uncertainty in future
cash flows. ◦Risk of variation in expected earnings to shareholders.
Earnings to shareholders will increase if the return on investment is higher than the cost of debt and vice versa.
Cost of capital - cost of a source is the minimum return expected by its suppliers which depends on the degree of risk (risk return). Theoretically the optimal debt equity mix for the company is at a point where the overall cost of capital is minimum.
Cost of Debt
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Cost of DebtCost of Pref.
shares
Cost of new issue of equity
shares
Cost of retained earnings
8
Cash flow ability to service debt – servicing of debts does not merely depend on the sufficient profits, but availability of cash. It is necessary to estimate cash flows before deciding on the proportion of debt.The analysis brings together the business and financial risk of a company. It allows to address the likelihood of insolvency and the cost therein.
Control – balancing between dilution of control because of more equity and financial risk arising out of variation in expected future earnings in the use of debt.
Flexibility – ability to change the composition in future. Promoters often use unsecured debt to achieve flexibility.
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Size of Company – often smaller companies have to depend on owner’s funds because of reluctance of lenders in providing long term debt.
Taxes – The degree to which a company is subject to taxation is very important.
Much of the advantage of debt is tax related. If the company pays little or no tax, debt is far less attractive than it is for the company subject to the full corporate tax rate.
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Firms stage in the lifecycle :◦ Start-ups – owner’s equity and bank debt.◦Expansion - investment needs will be high and will generally
look for private equity or venture capital or Issue of IPO.◦High Growth - firms will look for more equity issues. If using
debt, convertible debt is most likely to be used.◦Mature growth – the earnings and cash flows will continue to
increase reflecting the past investments. Need for investments in new projects will decline. Funding needs will be covered by internal accruals, debts or bonds.
◦Decline – existing investments will continue to yield cash flows but at a lower pace. Firms unlikely to make fresh funding and are likely to retire existing debt and buy back stocks.
Others : market conditions, period of finance, industry (capital intensive).
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Typical Income Statement
Total Revenue
Less Variable Costs
Contribution
Less Fixed Costs
Earnings before interest and tax (EBIT)
Less Interest on Debt
Profit Before tax (EBT or PBT)
Less Corporate Tax
Profit After Tax (EAT or PAT)
Less Preference Dividend (if any)
Equity Earnings
Operating Income
12
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Typical Income Statement
Total Revenue
Less Cost of Goods Sold (COGS)
Gross Profit
Less Operating Costs (Salaries, rents, administrative expenses, D&A & other expenses)
Operating Profit (EBIT)
Less Interest on Debt
Profit Before tax (EBT or PBT)
Less Corporate Tax
Profit After Tax (EAT or PAT)
Less Preference Dividend (if any)
Equity Earnings
13
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Return on equity at various debt levels(value in Rs.)
Debt/capital
0 percent 10 percent 20 percent 30 percent
Equity 10,000 9,000 8,000 7,000Debt 0 1,000 2,000 3,000Total Capital 10,000 10,000 10,000 10,000EBIT 3,000 3,000 3,000 3,000Interest @ 15% 0 150 300 450PBT 3,000 2,850 2,700 2,550Tax @ 35 percent 1,050 998 945 892PAT 1,950 1,852 1,755 1,658ROE (percentage) 19.50 20.57 21.93 23.68
14
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Debt/equity ratios of some top companies (2008)
Industry Company D/EAutomobile
Maruti Suzuki 0.106Bajaj Auto 0.288Mahindra 0.439Tata Motors 0.574
TelecomBharti Airtel 0.410Reliance Comm. 0.810
Diversified ITC 0.019
L & T 0.358 Grasim Ind 0.472
Pharmaceuticals Cipla 0.036Dr. Reddy’s 0.074Ranbaxy 1.273
15
Risk attached to a firm can be divided into two categories – Business risk and Financial risk.
Business Risk arises because of the variability of EBIT. It results from internal and external environment (business cycle, technological obsolescence) in which the firm operates. It is measured by calculating operating leverage. Its degree does not differ with the use of different forms of financing.
Financial Risk arises because of the variability of EAT. It results from use of financial leverage – source of funds bearing fixed returns like debt. It is associated with the capital structure decision and the degree varies with use of different forms of financing.
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Leverage refers to use of funds bearing fixed financial payments like debt in the capital structure.
Operating Leverage affects a firm’s Operating Profit (EBIT) while the Financial Leverage affects Profit After tax (EAT / PAT) or EPS.
Degree of Operating Leverage is defined as “the percentage change in the EBIT relative to a given percentage change in sales”. It exists because of fixed costs. Example: DOL of 1.5 means for a 1% increase in sales will result in 1.5% increase in EBIT.
% change in EBIT OR EBIT /EBIT DOL = % change in Sales Sales/Sales
Q (S-V) OR Contribution DOL = Q (S-V) – F EBIT
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Financial Leverage is a measure of Financial Risk. Degree of Financial Leverage is defined as “the percentage
change in the EPS due to a given percentage change in EBIT” % change in EPS EPS/EPS DFL = % change in EBIT OR EBIT/EBIT
EBIT Q (S-V) – F If no pref .dividend = EBT DFL = Q(S-V) - F - I
EBIT If preference dividend exists = EBT – ( Pref. dvd / 1-t)
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Combined Leverage : Operating and Financial Leverages together cause wide
fluctuations in EPS for a given change in sales. If a firm employs a high level of Operating and Financial Leverage, a small change in the level of sales will have a dramatic effect on EPS.
% change in EBIT X % change in EPSDCL = % change in Sales % change in EBIT
= % change in EPS OR Contribution% change in Sales Profit before tax
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Capital budgeting Decision ◦ Replacement◦ Modernisation◦ Expansion◦ Diversification
Funding Decisions◦ Internal sources◦ Debt◦ External equity
Capital Structure Decision◦ Existing Capital Structure◦ Payout Policy◦ Desired Debt-Equity Mix
Effect on Return Effect on Cost of Capital Effect on Risk Value of the firm
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Capital structure theories explain the theoretical relationship between Capital Structure, Overall Cost of Capital (Ko) and Valuation (V).
The 4 important theories of capital structure :1. Net Income Approach (NI)2. Net Operating Income Approach (NOI)3. Traditional Approach4. Modigliani Miller Approach (MM)
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Kd = I / MVd where Kd is cost of debt, I is annual interest charge, MVd is market value of debt
Ke = E/MVe where Ke is cost of equity, E is equity earnings and MVe is market value of equity
Ko = EBIT/V where V is market value of firm or the weighted average cost of capital
Alternatively Ko = Kd (MVd/(MVd+MVe) + Ke(MVe/MVd+MVe)
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NI approach suggested by Durand states that the weighted average cost of capital (Ko) of a firm is dependent on its capital structure. A firm can change its value and cost of capital through a judicious mix of Debt and Equity.
If the degree of financial leverage as measured by the ratio of Debt- Equity is increased, the weighted average cost of capital will decline, while the value of the firm as well as the market value of equity will increase. The reverse will hold good if the Debt-Equity is decreased.
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Assumptions in NI Approach1. No Taxes - there are no corporate taxes.2. Kd < Ke - the cost of debt is less than the cost of equity.3. No change in risk - there is no change either in the cost of
debt or equity. The cost of debt and cost of equity being constant, increased use
of debt (increase in leverage) will increase equity earnings and thereby market value of the equity shareholders.
With a judicious mix of debt and equity, a firm can evolve an optimum capital structure which will be the one where the value of the firm is the highest and the overall cost of capital will be the lowest. At this level, the market price per share will be the maximum.
If the firm uses no debt at all - means that the financial leverage is zero, the overall cost of capital will be equal to the equity capitalisation rate (cost of equity).
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Effect on…. Effect of increase in Leverage
Effect of decrease in Leverage
Weighted Average Cost of Capital ( Ko)
Decreases : because of advantage associated with use of relatively less expensive debt
Increases : because of disadvantage associated with the use of relatively more expensive equity
Total Value of firm (V) Increases : because of decrease in Weighted Average Cost of Capital
Decreases : because of increase in Weighted Average Cost of Capital
25
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O
Ko
Ke
Kd
Degree of Leverage
Cos
t of
Cap
ital
.05
.10
26
Value of the Firm (NI Approach)Rs.
Net Operating Income (EBIT) 50,000 Less Interest on Debentures (I) 20,000Earnings available to equity holders (NI) 30,000Equity Capitalisation rate (Ke) 0.125Market Value of Equity (Mve) NI/Ke = 30,000/0.125 2,40,000Market value of Debt (MVd) 2,00,000Total Value of Firm (V) 4,40,000
Overall Cost of Capital (Ko) EBIT/V= 50,000/440,000 11.36%
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Value of the Firm (NI Approach)Rs.
Net Operating Income (EBIT) 50,000 Less Interest on Debentures (I) 30,000Earnings available to equity holders (NI) 20,000Equity Capitalisation rate (Ke) 0.125Market Value of Equity (Mve) NI/Ke = 20,000/0.125 1,60,000Market value of Debt (MVd) 3,00,000Total Value of Firm (V) 4,60,000
Overall Cost of Capital (Ko) EBIT/V= 50,000/460,000 10.86%The use of additional debt has caused the total value of the firm to increase from Rs. 4,40,000 to 4,60,000 and the overall cost of capital has decreased from11.36% to 10.86%
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Value of the Firm (NI Approach)Rs.
Net Operating Income (EBIT) 50,000 Less Interest on Debentures (I) 10,000Earnings available to equity holders (NI) 40,000Equity Capitalisation rate 0.125Market Value of Equity (Mve) NI/Ke = 40,000/0.125 3,20,000Market value of Debt (MVd) 1,00,000Total Value of Firm (V) 4,20,000
Overall Cost of Capital (Ko) EBIT/V= 50,000/420,000 11.90%The decrease in the leverage has increased overall cost of capital and has reduced value of the firm
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NOI approach states that weighted average cost of capital of a firm (Ko) is independent of its capital structure.
A firm cannot change its value (V) and cost of capital through any change in the mix of Debt and Equity.
As per NOI approach, there is nothing like an optimum capital structure. Rather every capital structure is an optimal one.
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Constant Kd – the debt capitalisation rate is constant. Constant Ko – The weighted average cost of capital (Ko) is
constant for all degree of debt equity mix since business risk on which Ko depends is assumed to remain constant.
No Split – the market capitalises value of a firm as a whole. The split between debt and equity is not important.
Neutralisation – increase in the proportion of debt in the capital structure will lead to increase in the financial risk of equity shareholders. The advantage associated with the use of the relatively less expensive debt in terms of explicit cost is exactly neutralised by the implicit cost of debt represented by the increase in the cost of equity capital.
No Taxes – there are no corporate taxes.
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Effect on…. Effect Effect of Increase in Leverage
Equity Capitalisation Rate (Ke)
Increase Increase in the proportion of Debt in the capital structure will lead to increase in the financial risk of equity shareholders. To compensate for the increased financial risk, the shareholders would expect a higher rate of return on their investments.
Weighted Cost of Capital (Ko)
Remain Constant
Advantage of using less expensive Debt in terms of explicit cost is exactly neutralised by the implicit cost of debt represented by the increase in the cost of equity capital.
Total Value of the firm (V)
RemainConstant
Since Ko remain constant.
32
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Effect on…. Effect Effect of decrease in Leverage
Equity Capitalisation Rate (Ke)
Decrease Decrease in the proportion of Debt in the capital structure will lead to decrease in the financial risk of equity shareholders. For the decreased financial risk, the shareholders would expect a lower rate of return on their investments.
Weighted Cost of Capital (Ko)
Remain Constant
Disadvantage of using less expensive Debt in terms of explicit cost is exactly neutralised by the advantage in terms of decrease in the implicit cost of debt represented by the decrease in the cost of equity capital.
Total Value of the firm (V)
RemainConstant
Since Ko remain constant.
33
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O
Ko
Ke
Kd
Degree of Leverage
Cos
t of
Cap
ital
(p
er c
ent)
.
34
This approach is also known as Intermediate approach as it takes a midway between NI approach (the value of firm is dependent of the degree of financial leverage) and the NOI approach (the value of the firm is independent irrespective of the degree of financial leverage).
Basic Propositions of Traditional Approach1)Upto a reasonable limit of leverage, the cost of debt (Kd) plus
the increased cost of equity (due to the use of debt) will be less than the cost of equity (Ke) (in case of only equity financing).
As a result, the overall cost of capital (Ko) is decreased and the value of the firm (V) increases.
At this limit, the capital structure is optimum since the overall cost of capital is the least and the value of the firm is maximum.
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2)Beyond the reasonable limit of leverage, the cost of debt (Kd) plus the increased cost of equity (Ke) (due to the use of debt) will be more than the cost of equity (in the case of equity financing only) since the financial risk of the equity shareholders and the suppliers of debt also start increasing.As a result the overall cost of capital (Ko) increases and the value of the firm (V) decreases.
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O
Ko
Ke
Kd
Degree of Leverage
Cos
t of
Cap
ital
(p
er c
ent)
.
Stage II
Stage I
Stage III
37
Stage I Increasing Value : Ke either remains constant or increases slightly with debt. Ke does not increase fast enough to offset the advantage of low-cost debt. During this stage Kd remains constant. Ko decreases with increasing leverage and value of firm V also increases.
Stage II Optimum Value : Beyond stage I any subsequent increase in leverage have a negligible effect on Ko and hence value of the firm. Increase in Ke due to the added financial risk just offsets the advantage of low cost debt. Within this range, at a specific point Ko will be minimum and the value of the firm will be maximum.
Stage III Declining Value : Beyond the acceptable level of leverage, the value of the firm decreases with leverage as Ko increases with leverage. Investors perceive a high degree of financial risk and demand a higher equity capitalization rate which exceeds the advantage of low-cost debt.
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Franco Modigliani and Merton Miller (M & M) revolutionized the financial world when they published their article “The Cost of Capital, Corporation Finance and the Theory of Investment” in The American Economic Review in June 1958.
Prior to their landmark study, the "traditional approach" to capital structure maintained that there was an optimal level of debt that a company should have.
In other words, according to the traditional approach, there was one "best" debt-to-equity ratio for a company and Managers should identify this point and not deviate from it.
M & M wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration of Carnegie Mellon University. Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance.
Modigliani was awarded Nobel Prize in 1985 for this & other contributions and Miller got Nobel Prize in Economics in 1990.
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According to MM Approach, the weighted average cost of capital (Ko) is independent of its capital structure. It does not change with the change in the proportion of debt to equity in the capital structure.
The value of a firm depends on the earnings and risk of its assets (business risk) rather than the way in which the assets are financed.
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Degree of Leverage
Cos
t of
Cap
ital
( %
)
Ko
O
40
1. Investment opportunities of the firm remain fixed. Corporate real investment and operating decisions are not affected by capital structure.
2. Perfect Capital Markets – (a) securities are infinitely divisible, (b) investors are free to buy/sell, (c) investors can borrow without any restrictions at the same rate as companies (d) no transactions costs (e) investors are well informed about the risk & return and they behave rationally.
3. Same Expectations - All investors have the same expectation of firm’s future earnings (EBIT) and volatility of these earnings with which to evaluate the value of firm.
4.Homogeneous Risk class - The business risk of a firm can be measured and firms can be grouped into distinct business risk classes.
5.Debt is risk free and the interest rate on debt is the risk free rate.
6.The dividend payout is 100%.
7.There are no taxes (modified later).
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There are 3 basic propositions of MM approach. 1)The overall cost of capital (Ko) and the value of the firm (V)
are independent of its capital structure. The Ko and V are constant for all degrees of leverage for both levered and unlevered firms.
2) Ke is equal to the capitalisation rate of a pure equity stream + a premium for financial risk equal to the difference between the pure equity capitalisation rate (Ke) and Kd times the ratio of debt to equity. Ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt.
3) The cut-off rate for investment is completely independent of the way in which an investment is financed.
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The market value of a firm depends upon its expected net operating income (EBIT) and the overall capitalisation rate Ko or the opportunity cost of capital.
Since the capital structure can neither change the firm’s EBIT nor its operating risk, the values of levered or unlevered firms ought to be the same.
The firm’s capital structure merely indicates how EBIT is divided between shareholders and bondholders.
It is the magnitude and riskiness of EBIT and not the partitioning between shareholders and bondholders that determines the market value of the firm.
Whether you cut a pizza (EBIT) into six slices or eight does not Whether you cut a pizza (EBIT) into six slices or eight does not increase the size of the pizza. The same is also true of companies. increase the size of the pizza. The same is also true of companies.
Companies can make money by good investment decisions Companies can make money by good investment decisions and not by good financing decisions.and not by good financing decisions.
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Firms with identical EBIT and business risk (operating), but different capital structure should have the same firm value.
Value of a levered firm = Value of unlevered firm VL = VU Value of firm = Net Operating Income = NOI
Firm’s opportunity cost of capital Ko Both Net Operating Income and firm’s opportunity cost are assumed to
be constant at all levels of financial leverage. For a levered firm, the expected net operating income (EBIT) is the sum
of the income of shareholders and the income of debt holders. The average rate of return required by all security holders in a levered
firm is the firm’s weighted average cost of capital Ko. In the case of unlevered firm, the entire net operating income is the
shareholder’s net income & hence its WACC is equal to cost of equity.
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Size of the corporate pie = PV of cash flows
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100% Equity 50% Debt50% Equity
20% Debt80% Equity
Any Other ratio of Debt to Equity
45
When a waitress asked Yogi Berra (Baseball Hall of Fame Catcher for the New York Yankees) whether he wanted his pizza cut into four pieces or eight, Yogi replied: ‘Better make it four; I don’t think I can eat eight.’
Yogi’s quip helps convey the basic insight of Modigliani and Miller (M&M). The firm’s leverage choice ‘slices’ the distribution of the firm’s future cash flows in a way that is like slicing a pizza. M&M recognize that if you fix a company’s investment activities, it’s like fixing the size of the pizza; no information costs means that everyone sees the same pizza; no taxes means the IRS (Internal Revenue Service) gets none of the pie; and no ‘contracting’ cost means nothing sticks to the knife. And so, just as the substance of Yogi’s meal is unaffected by whether the pizza is sliced into four pieces or eight, the economic substance of the firm is unaffected by whether the liability side of the balance sheet is sliced to include more or less debt.
Source: Michael J Barclay et al. (1995).
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Since equity investors bear financial risk in addition to business risk, cost of equity will be more than the cost of debt.
MM argue that an increase in financial leverage increases the systematic risk (of the firm’s stock) that equity investors have to bear.
Being risk averse, equity investors will demand a corresponding increase in the return on equity. The increase in the cost of equity will exactly offset the effect of lower cost of debt.
Likewise, decrease in financial leverage will not increase the WACC, as the reduction will result in an offsetting decrease in the cost of equity due to lower systematic risk. So the weighted average cost of capital is the same at all debt levels.
Nprakash 47
Miller (1991) explains the intuition for the Theorem with a simple analogy. Miller (1991) explains the intuition for the Theorem with a simple analogy. “Think of the firm as a gigantic tub of whole milk. The farmer can sell the “Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring.” “The considerably higher price than the whole milk would bring.” “The Modigliani-Miller proposition says that if there were no costs of separation, Modigliani-Miller proposition says that if there were no costs of separation, (and, of course, no government dairy support program), the cream plus the (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk.” The essence of the skim milk would bring the same price as the whole milk.” The essence of the argument is that increasing the amount of debt (cream) lowers the value of argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) – selling off safe cash flows to debt-holders outstanding equity (skim milk) – selling off safe cash flows to debt-holders leaves the firm with more lower valued equity, keeping the total value of the leaves the firm with more lower valued equity, keeping the total value of the firm unchanged. Put differently, any gain from using more of what might firm unchanged. Put differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity. seem to be cheaper debt is offset by the higher cost of now riskier equity. Hence, given a fixed amount of total capital, the allocation of capital Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of two costs of capital to the firm is the same for all possible combinations of the two. the two.
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The WACC is independent of leverage in an MM world without taxes.
How you finance a project is only a matter of detail. It has no bearing on firm value. If a project is unviable with one package of securities, it’ll be unviable with any other package of securities.
A firm should look for making money by good investment A firm should look for making money by good investment decisions and not by good financing decisions. decisions and not by good financing decisions.
ROE might increase with leverage but so does cost of equity.ROE might increase with leverage but so does cost of equity.
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As per MM, the total risk of all security holders of a firm is not altered by changes in its capital structure.
Therefore, the total value of the firm should be the same regardless of its financing mix.
This is supported by the presence of arbitrage in the capital markets.
The value of two or more firms with same risk class in the same industry should be the same even with different capital structures; otherwise, arbitragers will enter the market and drive the values of the two firms together.
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Company U Companuy LNet Operating Income (EBIT) 1,00,000 1,00,000 Less Interest on Debentures 15,000Earnings available to equity holders (NI) 1,00,000 85,000Equity Capitalisation rate 0.10 0.11Market Value of Equity (Mve) NI/Ke 10,00,000 7,72,727Market value of Debt (MVd) 3,00,000Total Value of Firm (V) 10,00,000 10,72,727
Implied Overall Capitalisation rate (Ko) EBIT/V 10.00% 9.33%Debt-to-equity Ratio (%) 0 38.80%
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According to MM, this situation cannot continue, as arbitrage will drive the total values of the two firms together and will bring prices to equilibrium.
Company L cannot command a higher total value simply because it has a different financing mix than Company U.
MM argue that investors in company L are able to obtain the same amount of return with no increase in financial risk by investing in Company U. Moreover they are able to do this with smaller investment outlay.
The investors will sell their shares in Company L and buy shares in company U. This arbitrage will continue until Company L shares declined in price and company U shares increased in price enough so that the total value of both companies are same.
Example: suppose a rational investor owned 1 percent of Company L worth Rs.7727 (market value of equity) and also invested in debt of Rs.3,000.
He will sell his stock in Company L for Rs. 7727
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Borrow Rs. 3000 at 5% interest. This personal debt is equal to 1% of the debt of the Company L – his previous proportional ownership of the company.
Buy 1% of the shares of U, for Rs. 10,000.Prior to these transactions, the investor’s expected return on the investment in
Company L was 11% on Rs. 7727 investment, or Rs. 850. His expected return on investment in Company U is 10% or Rs. 1,000 on investment of Rs. 10,000. From this return he must deduct the interest charges on his personal borrowings. The net rupee return is :Return on investment in Company U is Rs. 1000Less interest (Rs. 3000 @5%) Rs. 150Net Return Rs. 850
Thus the rupee return is Rs. 850 is the same as it was for his investment in Company L. However his cash outlay of Rs.7000 (Rs. 10,000 less borrowings of Rs. 3,000) is less than Rs. 7727 invested in company L . Because of the lower investment, the investor would prefer company U.
In essence, the investor is able to lever the stock of the unlevered firm by taking personal debt. The investor is engaged in personal or homemade leverage as against the corporate leverage to restore equilibrium in the market.
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MM hypothesis that the value of the firm is independent of its debt policy is based on the critical assumption that corporate income taxes do not exist.
However, since corporate taxes is a reality, interest paid to debt holders is treated as a deductible expense and is an advantage to the firm.
In 1963, MM modified their argument to show that value of the firm will increase with debt due to the tax shield on interest charges and the value of the levered firm will be higher than the unlevered firm.
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Income Firm U Firm L
Net operating income 2500 2500
Interest 0 500
Taxable income 2500 2000
Tax @ 50% 1250 1000
Pat 1250 1000
Dividend to shareholders 1250 1000
Interest to debt holders 0 500
Total income to investors 1250 1500
Interest tax shield 0 250
Relative advantage of debt 1500/1250 1.20
56
Interest Tax shield = T x Interest = T x Kd D
Present value of interest tax shield = Corporate Tax rate X interestCost of Debt
Using the formula the PVINTS of the levered firm is 0.50 X 5,000 = Rs. 2,500
Value of the unlevered firm = After-tax Net operating income Unlevered firm’s cost of capital
Value of levered firm = Value of unlevered firm + PV of tax shield
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When the corporate tax rate is positive (t >0) the value of the levered firm will increase continuously with debt.
Theoretically, value of the firm will be maximised when it employs 100% debt as shown in the chart.
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Leverage
Val
ue
Value of interest tax
shield
Vl
Vu
58
MM’s revised view of recognising corporate tax suggests that a firm can increase its value with leverage.
Optimum capital structure is reached when the firm employs almost 100% debt.
However, in practice firms do not meet almost all of its capital requirement by debt nor are the lenders ready to lend beyond certain limits which is decided by them.
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Unlevered Firm With No Tax With Tax Total Market Value of Unlevered Firm (Vu)
Vu = NOI/Ke Vu = NOI (1-t) /Ke
Overall Capitalisation rate
Ko = Ke (since no debt) Ko = Ke (since no debt)
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Nprakash
Levered Firm With No Tax With Tax Total Market Value of Levered Firm (Vl)
Vl = Vu Vl = Vu+Dt
Equity Capitalisation Rate (Ke)
Ke = NOI-Interest Vl - D
Ke = NOI – Interest – Tax Vl -D
Overall Capitalisation Rate (Ko)
Ko = NOI Vl
Ko = (NOI – I) (1-t) + I Vl
D = Debt amount t = tax rate
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Optimal Capital Structure is a trade-off between interest tax shields and cost of financial distress (bankruptcy).
This theory suggests that firms trade-off tax shields and bankruptcy costs and move towards an optimal debt ratio.
The firms stop borrowing when the present value of bankruptcy costs exceeds the present value of tax shields.
Profitable firms that can avail tax shields will borrow relatively more than the less profitable firms.
Studies conducted in US and elsewhere do not support this hypothesis as profitable firms borrow less.
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When a company is new, it is likely to be financed entirely with equity, so its average cost of capital is the same as its cost of equity (10% for 0/100 debt/equity ratio).
As the company grows, it establishes a track record and attracts the confidence of lenders. As the company increases use of debt, the company's debt/equity ratio increases and the average cost of capital decreases.
The company starts substituting cheaper debt for the more expensive equity, thereby decreasing its overall cost.
As the company's debt/equity ratio keeps increasing, the cost of debt and the cost of equity will increase.
Lenders will become more concerned about the risk of the loan and will increase the interest rate on its loans.
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Equity shareholders will become more concerned about default on the loans (bankruptcy risk- losing their investment) and will insist on a higher rate of return to compensate them for the higher risk.
Since both the cost of debt and equity increases, the average cost of capital will also increase.
This results in a minimum point on the Average cost of capital curve. If the company move far to the left-side of the curve, the cost of equity
is higher and it would be better to borrow debt and buyback shares to reduce the cost.
If the company move to the right-side of the curve, it is perceived as risky and therefore reduce debt by issuing more equity.
There is a range of debt/equity ratios that will allow the company to stay in the shallow portion of the curve.
This gives flexibility to the company in choosing debt/equity ratio within the range explained as Optimal Range.
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The pecking order theory suggests that there is an order of preference for the firm of capital sources when funding is needed.
The firm will seek to satisfy funding needs in the following order:◦ Internal funds◦External funds
Debt Equity
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There are three factors that the pecking order theory is based on and that must be considered by firms when raising capital.
1. Internal funds are cheapest to use (no issuance costs) and require no private information release.
2. Debt financing is cheaper than equity financing.
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3. Managers tend to know more about the future performance of the firm than lenders and investors. Because of this asymmetric information, investors may make inferences about the value of the firm based on the external source of capital the firm chooses to raise. Equity financing inference – firm is currently overvalued Debt financing inference – firm is correctly or undervalued
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The pecking order theory suggests that the firm will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios.
If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity .
Only at this point will firms issue new equity.
This theory also suggests that there is no target debt-equity mix for a firm.
Nprakash 72
The pecking order theory suggests that there is an order of preference for the firm of capital sources when funding is needed.
The firm will seek to satisfy funding needs in the following order:◦ Internal funds◦External funds
Debt Equity
Nprakash 73
There are three factors that the pecking order theory is based on and that must be considered by firms when raising capital.
1. Internal funds are cheapest to use (no issuance costs) and require no private information release.
2. Debt financing is cheaper than equity financing.
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3. Managers tend to know more about the future performance of the firm than lenders and investors. Because of this asymmetric information, investors may make inferences about the value of the firm based on the external source of capital the firm chooses to raise. Equity financing inference – firm is currently overvalued Debt financing inference – firm is correctly or undervalued
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The pecking order theory suggests that the firm will first use internal funds. More profitable companies will therefore have less use of external sources of capital and may have lower debt-equity ratios.
If internal funds are exhausted, then the firm will issue debt until it has reached its debt capacity .
Only at this point will firms issue new equity.
This theory also suggests that there is no target debt-equity mix for a firm.
Nprakash 76
