Nprakash

1
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Introduction
Corporate and personal taxation
Modifying MM propositions to account for corporate taxes
Tradit...
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Capital structure refers to the pattern of funding a company's long
term funding requirements.
It repres...
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Financing mix cannot affect the total operating earnings of a
firm, as they are determined by the investment decisio...
Debt
-Fixed claim
-High priority on
payments
-Tax deductible
-Fixed maturity
-No management control

Equity
-Residual clai...
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A firm should select such financing mix which maximises its
value/shareholders wealth long term.
Theoretic...
A sound capital structure should have the following features:
 Profitability – use of leverage to obtain best advantage f...


Financial Risk –
◦ Risk of cash insolvency because of an uncertainty in future
cash flows.
◦ Risk of variation in expec...
Cash flow ability to service debt – servicing of debts
does not merely depend on the sufficient profits, but
availability ...
Size of Company – often smaller companies have to
depend on owner’s funds because of reluctance of
lenders in providing lo...
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Firms stage in the lifecycle :

◦ Start-ups – owner’s equity and bank debt.
◦ Expansion - investment needs will be high...
Typical Income Statement
 

Total Revenue
Less Variable Costs
Contribution
Less Fixed Costs
Operating
Income

Earnings bef...
Typical Income Statement

Total Revenue
Less Cost of Goods Sold (COGS)
Gross Profit
Less Operating Costs (Salaries, rents,...
Return on equity at various debt levels
(value in Rs.)

Debt/capital
0 percent 
Equity
10,000
Debt
0
Total Capital
10,000
...
Debt/equity ratios of some top companies (2008)
Industry
Automobile 

 

Company 

D/E

Maruti Suzuki
Bajaj Auto
Mahindra
...
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Risk attached to a firm can be divided into two categories –
Business risk and Financial risk.
Business Risk aris...
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Leverage refers to use of funds bearing fixed financial
payments like debt in the capital structure.
Operating Le...
Financial Leverage is a measure of Financial Risk.
 Degree of Financial Leverage is defined as “the
percentage change in ...
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Combined Leverage :
Operating and Financial Leverages together cause wide
fluctuations in EPS for a given change in sal...
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Capital budgeting Decision
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Replacement
Modernisation
Expansion
Diversification

Funding Decisions
◦ Interna...
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Capital structure theories explain the theoretical
relationship between Capital Structure, Overall Cost
of Capital (Ko)...
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 cos...
NI approach suggested by Durand states that the
weighted average cost of capital (Ko) of a firm is
dependent on its capita...
Assumptions in NI Approach
1. No Taxes - there are no corporate taxes.
2. Kd < Ke - the cost of debt is less than the cost...
Effect on….

Effect of increase
in Leverage

Effect of decrease
in Leverage

Weighted Average Cost Decreases : because
of ...
Cost of Capital

Ke

.10

Ko
Kd

.05

O

Degree of Leverage

Nprakash

26
Value of the Firm (NI Approach)
Rs.
50,000
20,000
30,000
0.125
2,40,000
2,00,000
4,40,000

Net Operating Income (EBIT)
Les...
Value of the Firm (NI Approach)
Net Operating Income (EBIT)
Less Interest on Debentures (I)
Earnings available to equity h...
Value of the Firm (NI Approach)
Rs.
50,000
10,000
40,000
0.125
3,20,000
1,00,000
4,20,000

Net Operating Income (EBIT)
Les...
NOI approach states that weighted average cost of
capital of a firm (Ko) is independent of its capital
structure.
 A firm...
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Constant Kd – the debt capitalisation rate is constant.



Constant Ko – The weighted average cost of capital (Ko) is
...
Effect on….

Effect

Equity
Increase
Capitalisation
Rate (Ke)

Weighted
Cost of
Capital (Ko)

Effect of Increase

in Lever...
Effect on….

Effect

Effect of decrease in Leverage

Equity
Decrease Decrease in the proportion of Debt in the capital
Cap...
Cost of Capital (per cent)

Ke

.

Ko

Kd

O

Degree of Leverage

Nprakash

34
This approach is also known as Intermediate approach as it takes
a midway between NI approach (the value of firm is depend...
2)Beyond the reasonable limit of leverage, the cost of debt
(Kd) plus the increased cost of equity (Ke) (due to the use of...
Ke
Cost of Capital (per cent)

Stage II
Ko

.
Stage III
Stage I

O

Kd

Degree of Leverage

Nprakash

37
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Stage I Increasing Value : Ke either remains constant or increases
slightly with debt. Ke does not increase fast ...
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Franco Modigliani and Merton Miller (M & M) revolutionized the financial
world when they published their ar...
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According to MM Approach, the weighted average cost of capital
(Ko) is independent of its capital structure. It does no...
1. Investment opportunities of the firm remain fixed. Corporate real

investment and operating decisions are not affected ...
There are 3 basic propositions of MM approach.
1)The overall cost of capital (Ko) and the value of the firm (V)
are indepe...
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The market value of a firm depends upon its expected net operating
income (EBIT) and the overall capitali...
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Firms with identical EBIT and business risk (operating), but different
capital structure should have the...
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Size of the corporate pie = PV of cash flows
Any Other
ratio of
Debt to
Equity

100% Equity

50% Debt
50% Equity

20% D...
When a waitress asked Yogi Berra (Baseball Hall of Fame Catcher for
the New York Yankees) whether he wanted his pizza cut ...
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Since equity investors bear financial risk in addition to business
risk, cost of equity will be more than the ...
Miller (1991) explains the intuition for the Theorem with a simple analogy.
“Think of the firm as a gigantic tub of whole ...
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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 o...
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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...
Net Operating Income (EBIT)
Less Interest on Debentures
Earnings available to equity holders (NI)
Equity Capitalisation ra...
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According to MM, this situation cannot continue, as arbitrage will drive
the total values of the two firms tog...
Borrow Rs. 3000 at 5% interest. This personal debt is equal to 1% of the
debt of the Company L – his previous proportional...
Nprakash

54
MM hypothesis that the value of the firm is
independent of its debt policy is based on the critical
assumption that corpor...
Income

Firm U

Firm L

Net operating income

2500

2500

Interest

0

500

Taxable income

2500

2000

Tax @ 50%

1250

1...
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Interest Tax shield = T x Interest
= T x Kd D

Present value of interest tax shield = Corporate Tax rate X interest
Cos...
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When the corporate tax rate is positive (t >0) the value of the
levered firm will increase continuously with debt.
Theo...
MM’s revised view of recognising corporate tax
suggests that a firm can increase its value with
leverage.
 Optimum capita...
Nprakash

60
Nprakash

61
Unlevered Firm
Total Market Value of
Unlevered Firm (Vu)
Overall Capitalisation
rate

With No Tax
Vu = NOI/Ke

With Tax
Vu...
Levered Firm
Total Market Value of
Levered Firm (Vl)
Equity Capitalisation Rate
(Ke)
Overall Capitalisation Rate
(Ko)

Wit...
Nprakash

64
Optimal Capital Structure is a trade-off between interest
tax shields and cost of financial distress (bankruptcy).
 This ...
Nprakash

66
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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 ...
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Equity shareholders will become more concerned about default on the
loans (bankruptcy risk- losing the...
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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 ...
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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 cap...
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmet...
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The pecking order theory suggests that the firm will first use
internal funds. More profitable companies will therefore...
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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 ...


There are three factors that the pecking order theory
is based on and that must be considered by firms
when raising cap...
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmet...
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The pecking order theory suggests that the firm will first use
internal funds. More profitable companies will therefore...
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1b.leverage decision

  1. 1. Nprakash 1
  2. 2.       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. Nprakash 2
  3. 3.       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 . Nprakash 3
  4. 4.   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. Nprakash 4
  5. 5. 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 Nprakash 5
  6. 6.       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. Nprakash 6
  7. 7. 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. Nprakash 7
  8. 8.  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 Cost of new Cost of Debt Cost of Pref. Cost of Debt shares retained earnings issue of equity shares Nprakash 8
  9. 9. 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.  Nprakash 9
  10. 10. 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.  Nprakash 10
  11. 11.  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). Nprakash 11
  12. 12. Typical Income Statement   Total Revenue Less Variable Costs Contribution Less Fixed Costs Operating Income 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                                                   Nprakash 12
  13. 13. 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                                                 Nprakash 13
  14. 14. Return on equity at various debt levels (value in Rs.) Debt/capital 0 percent  Equity 10,000 Debt 0 Total Capital 10,000 EBIT 3,000 Interest @ 15% 0 PBT 3,000 Tax @ 35 percent 1,050 PAT 1,950 ROE (percentage) 19.50 10 percent  20 percent  30 percent 9,000 1,000 10,000 3,000 150 2,850 998 1,852 20.57 8,000 2,000 10,000 3,000 300 2,700 945 1,755 21.93 7,000 3,000 10,000 3,000 450 2,550 892 1,658 23.68 Nprakash 14
  15. 15. Debt/equity ratios of some top companies (2008) Industry Automobile    Company  D/E Maruti Suzuki Bajaj Auto Mahindra Tata Motors 0.106 0.288 0.439 0.574 Bharti Airtel Reliance Comm. 0.410 0.810 ITC L&T Grasim Ind 0.019 0.358  0.472 Cipla Dr. Reddy’s Ranbaxy 0.036 0.074 1.273 Telecom Diversified Pharmaceuticals  Nprakash 15
  16. 16.    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. Nprakash 16
  17. 17.    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 DOL = Q (S-V) Q (S-V) – F OR Contribution EBIT Nprakash 17
  18. 18. 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 DFL = Q (S-V) – F Q(S-V) - F - I OR EBIT/EBIT EBIT If no pref .dividend = EBT EBIT If preference dividend exists = EBT – ( Pref. dvd / 1-t) Nprakash 18
  19. 19.  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 EPS DCL = % change in Sales % change in EBIT = % change in EPS OR % change in Sales Contribution Profit before tax Nprakash 19
  20. 20.  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 Risk Effect on Cost of Capital Value of the firm Nprakash 20
  21. 21.  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 Approach 4. Modigliani Miller Approach (MM) Nprakash 21
  22. 22. 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) Nprakash 22
  23. 23. 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 DebtEquity is decreased.  Nprakash 23
  24. 24. Assumptions in NI Approach 1. 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). Nprakash 24
  25. 25. Effect on…. Effect of increase in Leverage Effect of decrease in Leverage Weighted Average Cost Decreases : because of advantage of Capital ( Ko) 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 Nprakash 25
  26. 26. Cost of Capital Ke .10 Ko Kd .05 O Degree of Leverage Nprakash 26
  27. 27. Value of the Firm (NI Approach) Rs. 50,000 20,000 30,000 0.125 2,40,000 2,00,000 4,40,000 Net Operating Income (EBIT) Less Interest on Debentures (I) Earnings available to equity holders (NI) Equity Capitalisation rate (K e) Market Value of Equity (Mve) NI/Ke = 30,000/0.125 Market value of Debt (MVd) Total Value of Firm (V) Overall Cost of Capital (Ko) EBIT/V= 50,000/440,000 11.36% Nprakash 27
  28. 28. Value of the Firm (NI Approach) Net Operating Income (EBIT) Less Interest on Debentures (I) Earnings available to equity holders (NI) Equity Capitalisation rate (K e) Market Value of Equity (Mve) NI/Ke = 20,000/0.125 Market value of Debt (MVd) Total Value of Firm (V) Rs. 50,000 30,000 20,000 0.125 1,60,000 3,00,000 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 from 11.36% to 10.86% Nprakash 28
  29. 29. Value of the Firm (NI Approach) Rs. 50,000 10,000 40,000 0.125 3,20,000 1,00,000 4,20,000 Net Operating Income (EBIT) Less Interest on Debentures (I) Earnings available to equity holders (NI) Equity Capitalisation rate Market Value of Equity (Mve) NI/Ke = 40,000/0.125 Market value of Debt (MVd) Total Value of Firm (V) 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 Nprakash 29
  30. 30. 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.  Nprakash 30
  31. 31.  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.    Nprakash 31
  32. 32. Effect on…. Effect Equity Increase Capitalisation Rate (Ke) Weighted Cost of Capital (Ko) Effect of Increase in Leverage 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. Remain Advantage of using less expensive Debt in Constant 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 Remain Since Ko remain constant. the firm (V) Constant Nprakash 32
  33. 33. Effect on…. Effect Effect of decrease in Leverage Equity Decrease Decrease in the proportion of Debt in the capital Capitalisation structure will lead to decrease in the financial risk of equity shareholders. For the decreased Rate (Ke) financial risk, the shareholders would expect a lower rate of return on their investments. Weighted Cost of Capital (Ko) Remain Disadvantage of using less expensive Debt in Constant 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) Remain Since Ko remain constant. Constant Nprakash 33
  34. 34. Cost of Capital (per cent) Ke . Ko Kd O Degree of Leverage Nprakash 34
  35. 35. 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 Approach 1)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.  Nprakash 35
  36. 36. 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. Nprakash 36
  37. 37. Ke Cost of Capital (per cent) Stage II Ko . Stage III Stage I O Kd Degree of Leverage Nprakash 37
  38. 38.    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. Nprakash 38
  39. 39.      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. Nprakash 39
  40. 40.  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. Cost of Capital ( %)  Ko O Degree of Leverage Nprakash 40
  41. 41. 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). Nprakash 41
  42. 42. 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. Nprakash 42
  43. 43.       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 increase the size of the pizza. The same is also true of companies. Companies can make money by good investment decisions and not by good financing decisions. Nprakash 43
  44. 44.       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. Nprakash 44
  45. 45.  Size of the corporate pie = PV of cash flows Any Other ratio of Debt to Equity 100% Equity 50% Debt 50% Equity 20% Debt 80% Equity Nprakash 45
  46. 46. 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). Nprakash 46
  47. 47.     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
  48. 48. 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 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 Modigliani-Miller proposition says that if there were no costs of separation, (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 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 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 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 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 the two. Nprakash 48
  49. 49.     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 decisions and not by good financing decisions. ROE might increase with leverage but so does cost of equity. Nprakash 49
  50. 50.     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. Nprakash 50
  51. 51. Net Operating Income (EBIT) Less Interest on Debentures Earnings available to equity holders (NI) Equity Capitalisation rate Market Value of Equity (Mve) NI/Ke Market value of Debt (MVd) Total Value of Firm (V) Implied Overall Capitalisation rate (Ko) EBIT/V Debt-to-equity Ratio (%) Company U Companuy L 1,00,000 1,00,000 15,000 1,00,000 85,000 0.10 0.11 10,00,000 7,72,727 3,00,000 10,00,000 10,72,727 10.00% 0 9.33% 38.80% Nprakash 51
  52. 52.     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 Nprakash 52
  53. 53. 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. 1000 Less interest (Rs. 3000 @5%) Rs. 150 Net 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.  Nprakash 53
  54. 54. Nprakash 54
  55. 55. 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.  Nprakash 55
  56. 56. 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 Nprakash 56
  57. 57.  Interest Tax shield = T x Interest = T x Kd D Present value of interest tax shield = Corporate Tax rate X interest Cost 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 Nprakash 57
  58. 58.  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. Vl Value  Value of interest tax shield Vu Leverage Nprakash 58
  59. 59. 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.  Nprakash 59
  60. 60. Nprakash 60
  61. 61. Nprakash 61
  62. 62. Unlevered Firm Total Market Value of Unlevered Firm (Vu) Overall Capitalisation rate With No Tax Vu = NOI/Ke With Tax Vu = NOI (1-t) /Ke Ko = Ke (since no debt) Ko = Ke (since no debt) Nprakash 62
  63. 63. Levered Firm Total Market Value of Levered Firm (Vl) Equity Capitalisation Rate (Ke) Overall Capitalisation Rate (Ko) With No Tax Vl = Vu With Tax Vl = Vu+Dt Ke = NOI-Interest Vl - D Ke = NOI – Interest – Tax Vl -D Ko = Ko = (NOI – I) (1-t) + I Vl NOI Vl D = Debt amount t = tax rate Nprakash 63
  64. 64. Nprakash 64
  65. 65. 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.  Nprakash 65
  66. 66. Nprakash 66
  67. 67.      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. Nprakash 67
  68. 68.        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. Nprakash 68
  69. 69.  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 69
  70. 70.  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. Nprakash 70
  71. 71. 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 Nprakash 71
  72. 72.  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
  73. 73.  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
  74. 74.  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. Nprakash 74
  75. 75. 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 Nprakash 75
  76. 76.  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
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