Q.1 Explain the assumptions and implications of the NI approach and the NOI approach.

Illustrate your answer with hypothetical examples. A.1 Under the Net Income (NI) approach, the cost of debt and cost of equity are assumed to be independent to the capital structure. The weighted average cost of capital declines and the total value of the firm rises with increased use of leverage. Under the net operating income (NOI) approach, the cost of equity is assumed to increase linearly with leverage. The weighted average cost of capital remains constant and total value of firm also remains constant as leverage is changed. Example: Assume that EBIT (i.e., Net Operating Income) is Rs. 100,000. The amount of debt employed by firm Rs. 700,000; the cost of debt 6%; and the rate of return expected by equity shareholders 10%. ko = 8%. NI Approach: Rs. NOI 100,000 Less: Interest costs 42,000 ---------Net income available to shareholders 58,000 ---------Market value of equity(S) 580,000 (58000/0.10) Market Value of Debt (D) 700,000 ---------Total value of firm (S+D) 1,280,000 ---------NOI Approach: Rs. NOI 100,000 Market value of firm 1,250,000 (100,000/0.08) Market value of Debt (D) 700,000 Market value of Share (S) 550,000 Now, assume that value of debt increases to Rs. 900,000 NI approach: Rs. NOI 100,000 Less: Interest cost 54,000 (900,000 x 6%) --------Equity Earnings 46,000 Market value of shares (S) 460,000 (46000/0.10) Market value of debt (D) 900,000 --------Total value of firm 1,360,000 ---------NOI approach: Rs. NOI 100,000 Market value of firm 1,250,000 Market value of debt (D) 900,000 Market value of share (S) 350,000 From the above, it is clear that as per NI approach the value of firm increases as the use of debt increases, i.e., from Rs. 1,250,000 to Rs. 1,360,000. As per NOI approach, the value of firm remains constant. Q.2 Describe the traditional view on the optimum capital structure. Compare and contrast this view with the NOI approach and the NI approach.

A.2 According to traditional approach, the cost of capital declines and the value of the firm increases with leverage up to a prudent debt level and after reaching the optimum level, leverage cause the cost of capital to increase and the value of the firm to decline. The optimum capital structure occurs when the cost of capital is minimum or the value of firm is maximum. The NI approach indicates that the total value of firm rises with increased use of leverage, and weighted average cost of capital declines. The NOI approach assumes that the total value of firm remains constant as leverage is changed, because the cost of equity increases linearly with leverage and sets off the benefits of debt capital. The NI approach is valid, if financing decisions have an important effect on the value of firm. NOI approach is valid, if the financing decisions is not of great concern, but overall cost of capital depends on business risk. Traditional approach is based on the NI approach. Q.3 Explain the position of M-M on the issue of an optimum capital structure, ignoring the corporate income taxes. Use an illustration to show how home-made leverage by an individual investor can replicate the same risk and return as provided by the levered firm. A.3 The Modigliani-Miller hypothesis is identical with the NOI approach. M-M approach indicates that a firms market value and the cost of capital remain invariant to the capital structure changes, i.e., any combination of debt and equity is as good as any other. M-M hypothesis indicates that securities are traded in perfect capital market situation, and firms can be grouped into homogeneous risk classes. Further, it is also assumed that no corporate income taxes exist, and firms distribute all net earnings to the shareholders. If two identical firms, except for the degree of leverage, have different market values, arbitrage will take place to enable investors to engage in personal or home-made leverage as against the corporate leverage to restore equilibrium in the market. Example: Assume that two firms, i.e., un-leveraged firm U and leveraged firm L have identical expected NOI of Rs. 10,000. The value of leveraged firm is Rs. 110,000 the value of equity shares being Rs. 60,000 and the value of debt Rs. 50,000, and the value of un-leveraged firm is Rs. 100,000. Firm L have borrowed at the expected rate of return of 6%. Assume that an investor, Mr. X, holds 10% of shares of leveraged firm. How arbitrage benefits him? Mr. Xs value of investment in firm L = Rs. 6,000 (60,000 x 10%) Mr. Xs return from firm L = 10% of (EBIT INT) = 10% (10,000 3,000) = Rs. 700. Now, Mr. X will sell his shares of firm L for Rs. 6,000, and will borrow Rs. 5,000 (Rs. 50000 10%) at 6% interest rate on his personal account. He will invest Rs. 11,000 to purchase shares of firm U (Rs 110,000 10%). Mr. Xs return from firm U Rs. = 10% x 11,000 = 1100 Less: Interest on personal borrowing = 6% x 5,000 = 300 ----Rs. 800 ----This strategy pays to Mr. X more return at same investment. As a result of this switching, i.e., arbitrage process, the market value of leveraged firms share will decrease and that of unleveraged firm will increase. So, equilibrium takes place when values of both firms, i.e., U and L are identical.