Capital Structure, Cost of Capital and Valuation: © Tata Mcgraw-Hill Publishing Company Limited, Financial Management

Tata McGraw-Hill Publishing Company Limited, Financial Management
19-1
Chapter 19
Capital Structure, Cost of
Capital And Valuation
19-2
CAPITAL STRUCTURE, COST OF
CAPITAL AND VALUATION
Capital Structure Theories
Net Income Approach
Net Operating Income (NOI) Approach
Modigliani-Miller (MM) Approach
Traditional Approach
Solved Problems
19-3
Capital Structure
Capital structure is the proportion of debt and
preference and equity shares on a firms
balance sheet.
Optimum capital structure is the capital
structure at which the weighted average cost of
capital is minimum and thereby maximum value
of the firm.
19-4
Assumptions
1) There are only two sources of funds used by a firm: perpetual riskless
debt and ordinary shares.
2) There are no corporate taxes. This assumption is removed later.
3) The dividend-payout ratio is 100. That is, the total earnings are paid
out as dividend to the shareholders and there are no retained
earnings.
4) The total assets are given and do not change. The investment
decisions are, in other words, assumed to be constant.
5) The total financing remains constant. The firm can change its degree
of leverage (capital structure) either by selling shares and use the
proceeds to retire debentures or by raising more debt and reduce the
equity capital.
6) The operating profits (EBIT) are not expected to grow.
7) All investors are assumed to have the same subjective probability
distribution of the future expected EBIT for a given firm.
8) Business risk is constant over time and is assumed to be independent
of its capital structure and financial risk.
9) Perpetual life of the firm.
19-5
Definitions and Symbols
In addition to the above assumptions, we shall make use of some symbols in
our analysis of capital structure theories:
S = total market value of equity
B = total market value of debt
I = total interest payments
V = total market value of the firm (V = S + B)
NI = net income available to equity-holders.
where D
1
= net dividend; P
0
= current market price of shares and g is the
expected growth rate. According to assumption (3), the percentage of
retained earnings is zero. Since g = br, where r is the rate of return on equity
shares and b is the retention rate, g = 0, the growth rate is zero. This is
consistent with assumption (6). In operational terms D
1
= E
1
, g = 0. Therefore,
(3) g
0
P
1
D
)
e
capital(k equity of Cost (2)
(2)
i
k
I
(B) debt of Value
(1)
B
I
i
k debt of Cost 1.
: s definition basic some of use make also shall We
+ =
=
= |
.
|
\
|
19-6
where E
1
= earnings per share. Equation 4 is on a per share basis. Multiplying both the
numerator and the denominator by the number of shares outstanding (N) and
assuming there are no income taxes, we have
Thus, k
e
may be defined on either per share or total basis.
From Eqs. 4 and 5 follow the equations of determining the value of equity shares on
per share basis and total basis.
) 4 (
P
E
0
P
E
g
P
E
k
0
1
0
1
0
1
e
= + = + =
( )
( )
) 5 (
shares equity of value market Total
holders equity to available income Net

S
NI or I EBIT
N P
N E
k
0
1
e
=
=
) 9 (
) 8 (
V
EBIT
V
NI I
0
k or
e
k
S B
S
i
k
S B
B

e
(S/V)k
i
(B/V)k
weights) relative are
2
W and
1
W (where
e
k
2
W
i
k
1
W
0
K
: capital of cost average weighted or capital of cost ll (iii)Overa
(7)
e
k
I EBIT
N
0
P S basis, Total (2)
(6)
e
k
1
E
0
P basis, share Per (1)
=
+
=
(
+
+
(
+
= + =
+ =
= =
=
19-7
(11)
k
I EBIT
k
I
V ely, Alternativ
(10)
k
EBIT
V
Thus, firm. the of value total of equation the follows 9 Eq. From
e i
0
+ =
=
( )
( )
( ) (12) B/S k k k k
S
B k S k B k
k
S B
B S B
/
S B
B k S B k
S B
B
/1
S B
B
k k k
have we 8.2, Eq. in 8.3 Eq. of value the ng Substituti
S B
B
1
S B
S
V
S
: as expressed be can S/V ratio, equity Therefore, S. B V that know We
S/V
B/V k k
k
V
S
k
V
B
k
k
S B
S
k
S B
B
k
ly, Symbolical debt. of cost the and equity of cost the of average weighted the is k know We
: below described is capital equity of cost the measuring of way useful Another
i 0 0 e
i 0 0
e
i 0
i 0 e
i 0
e
e i
e i 0
0
+ =
+
=
+ +
+
=
+
+
+
+
=
+
+
=
+
=
+
=
+ =
=
|
.
|
\
|
+ |
.
|
\
|
=
(
+
+
(
+
=
) 6 . 8 (
) 5 . 8 (
S B
S
/
S B
B k S k B k
) 4 . 8 (
) 3 . 8 (
) 2 . 8 (
) 1 . 8 (
) 8 (
i 0 0
19-8
Capital structure theories explain the theoretical
relationship between capital structure, overall
cost of capital (k
0
) and valuation (V ). The four
important theories are:
1) Net income (NI) approach,
2) Net operating income (NOI) approach,
3) Modigliani and Miller (MM) approach and
4) Traditional approach.
19-9
Net Income Approach
According to the NI approach, capital structure is
relevant as it affects the k
0
and V of the firm. The core
of this approach is that as the ratio of less expensive
source of funds (i.e., debt) increases in the capital
structure, the k
0
decreases and V of the firm increases.
With a judicious mixture of debt and equity, a firm can
evolve an optimum capital structure at which the k
0

would be the lowest, the V of the firm the highest and
the market price per share the maximum.
19-10
Example 1
A companys expected annual net operating income (EBIT) is Rs 50,000. The
company has Rs 2,00,000, 10% debentures. The equity capitalisation rate (k
e
)
of the company is 12.5 per cent.
Solution: With no taxes, the value of the firm, according to the Net Income
Approach is depicted in Table 1.
TABLE 1 Value of the Firm (Net Income Approach)
Net operating income (EBIT) Rs 50,000
Less: Interest on debentures (I) 20,000
Earnings available to equity holders (NI) 30,000
Equity capitalisation rate (k
e
) 0.125
Market value of equity (S) = NI/k
e
2,40,000
Market value of debt (B) 2,00,000
Total value of the firm (S + B) = V 4,40,000
Overall cost of capital = k
0
= EBIT/V (%) 11.36
Alternatively: k
0
= k
i
(B/V) + k
e
(S/V) where k
i
and k
e
are cost of
debt and cost of equity respectively, = 0.10 [(Rs 2,00,000/Rs
4,40,000) + 0.125 (Rs 2,40,000 / Rs 4,40,000)] %

11.36
19-11
Increase in Value
In order to examine the effect of a change in financing-mix on the firms
overall (weighted average) cost of capital and its total value, let us suppose
that the firm has decided to raise the amount of debenture by Rs 1,00,000 and
use the proceeds to retire the equity shares. The k
i
and k
e
would remain
unaffected as per the assumptions of the NI Approach. In the new situation,
the value of the firm is shown in Table 2.
e
) 0.125
e
1,60,000
K
0
= (Rs 50,000 / Rs 4,60,000) or 0.10 (Rs 3,00,000 / Rs 4,60,000) +
0.125 (Rs 160,000 / Rs 4,60,000)
10.9 %
19-12
Decrease in Value
If we decrease the amount of debentures in Example 1, the total value of the firm,
according to the NI Approach, will decrease and the overall cost of capital will
increase. Let us suppose that the amount of debt has been reduced by Rs 1,00,000
to Rs 1,00,000 and a fresh issue of equity shares is made to retire the debentures.
Assuming other facts as given in Example 1, the value of the firm and the weighted
average cost of capital are shown in Table 3.
e
) 0.125
e
3,20,000
k
0
= (Rs 50,000 / Rs 4,20,000) or 0.10 (Rs 1,00,000 / Rs 4,20,000) +
0.125 (Rs 3,20,000 / Rs 4,20,000)(%)
11.9
Thus, we find that the decrease in leverage has increased the overall cost of
capital and has reduced the value of firm.
19-13
Market Price
Thus, according to the NI Approach, the firm can increase/decrease its total value
(V) and lower/increase its overall cost of capital (k
0
) as it increases/decreases the
degree of leverage. As a result, the market price per share is affected.
To illustrate, assume in Example 1 that the firm with Rs 2,00,000 debt has 2,400
equity shares outstanding. The market price per share works out to Rs 100 (Rs
2,40,000 2,400). The firm issues Rs 1,00,000 additional debt and uses the proceeds
of the debt to repurchase/retire Rs 1,00,000 worth of equity shares or 1,000 shares.
It, then, has 1,400 shares outstanding. We have observed in Example 1 that the total
market value of the equity after the change in the capital structure is Rs 1,60,000
(Table 2). Therefore, the market price per share is Rs 114.28 (Rs 1,60,000 1,400), as
compared to the original price of Rs 100 per share.
Likewise, when the firm employs less amount of debt, the market value per share
declines. To continue with Example 1, the firm raises Rs 1,00,000 additional equity
capital by issuing 1,000 equity shares of Rs 100 each and uses the proceeds to retire
the debenture amounting to Rs 1,00,000. It would then have 3,400 shares (2,400 old +
1,000 new) outstanding. With this capital structure, we have seen in Example 1 that
the total market value of equity shares is Rs 3,20,000 (Table 3). Therefore, the market
price per share has declined to Rs 94.12 (Rs 3,20,000 3,400) from Rs 100 before a
change in the leverage.
We can graph the relationship between the various factors (k
e
, k
i
, k
0
) with the degree
of leverage (Fig. 1).
19-14
The degree of leverage (B/V) is
plotted along the X-axis, while
the percentage rates of k
i
, k
e

and k
0
are on the Y-axis. This
graph is based on Example 1.
Due to the assumptions that k
e

and k
i
remain unchanged as
the degree of leverage
changes, we find that both the
curves are parallel to the X-
axis. But as the degree of
leverage increases, k
0

decreases and approaches the
cost of debt when leverage is
1.0, that is, (k
0
= k
i
). It will
obviously be so owing to the
fact that there is no equity
capital in the capital structure.
At this point, the firms overall
cost of capital would be
minimum. The significant
conclusion, therefore, of the NI
Approach is that the firm can
employ almost 100 per cent
debt to maximise its value.
5.0
10.0
15.0
0 0.5 1.0
Degree of Leverage (B/V)
Figure 1: Leverage and Cost of Capital (NI Approach)
X
Y
K
e
,

k
i

a
n
d

k
0

(
%
)

k
0
k
i
k
e
19-15
Net Operating Income (NOI)
Approach
The NOI approach is diametrically opposite to the NI
approach. The essence of this approach is that capital
structure decision of a corporate does not affect its cost of
capital and valuation, and, hence, irrelevant.
The NOI Approach is based on the following propositions.
Overall Cost of Capital/Capitalisation Rate (k
0
) is Constant
The NOI Approach to valuation argues that the overall capitalisation
rate of the firm remains constant, for all degrees of leverage. The
value of the firm, given the level of EBIT, is determined by Eq. 13.
V = (EBIT/k
o
) (13)
19-16
Changes in Cost of Equity Capital
The equity-capitalisation rate/cost of equity capital (k
e
) increases
with the degree of leverage. The increase in the proportion of debt
in the capital structure relative to equity shares would lead to an
increase in the financial risk to the ordinary shareholders. To
compensate for the increased risk, the shareholders would expect a
higher rate of return on their investments. The increase in the
equity-capitalisation rate (or the lowering of the price-earnings
ratio, that is, P/E ratio) would match the increase in the debt-equity
ratio. The k
e
would be
K
0
+ (k
0
k
i
) [B/S]
Residual Value of Equity
The value of equity is a residual value which is determined by
deducting the total value of debt (B) from the total value of the firm
(V). Symbolcially, Total market value of equity capital (S) =
V B.
19-17
Cost of Debt
The main argument of NOI is that an increase in the
proportion of debt in the capital structure would lead to
an increase in the financial risk of the equityholders. To
compensate for the increased risk, they would require a
higher rate of return (k
e
) on their investment. As a result,
the advantage of the lower cost of debt would exactly be
neturalised by the increase in the cost of equity.
The cost of debt has two components: (i) explicit,
represented by rate of interest, and (ii) implicit,
represented by the increase in the cost of equity capital.
Therefore, the real cost of debt and equity would be the
same and there is nothing like an optimum capital
structure.
19-18
Example 2
Assume the figures given in Example 1: operating income Rs 50,000; cost of debt,
10 per cent; and outstanding debt, Rs 2,00,000. If the overall capitalisation rate
(overall cost of capital) is 12.5 per cent, what would be the total value of the firm
and the equity-capitalisation rate?
Solution: The computation is depicted in Table 4.
TABLE 4 Total Value of the Firm (Net Operating Income Approach)
Net operating income (EBIT)
Overall capitalisation rate (k
0
)
Total market value of the firm (V) = EBIT/k
0
Total value of debt (B)
Total market value of equity (S) = (V B)
Equity-capitalisation rate, k
e
= [(EBIT I) / (V B)] = (Earnings
available to equityholders / Total market value of equity shares) = [(Rs
50,000 Rs 20,000) / Rs 2,00,000]
Alternatively, ke = k
0
+ (k
0
k
i
)B/S: 0.125 + (0.125 0.10) (Rs 2,00,000 /
Rs 2,00,000)
Rs 50,000
0.125
4,00,000
2,00,000
2,00,000

0.15

0.15
The weighted average cost of capital to verify the validity of the NOI Approach:
k
0
= ki(B/V) + ke(S/V) = 0.10 (Rs 2,00,000 / Rs 4,00,000) + 0.15 (Rs
2,00,000 / Rs 4,00,000)
0.125
19-19
Thus, we find that the overall cost of capital is 12.5 per cent as per the
requirement of the NOI Approach.
In order to examine the effect of leverage, let us assume that the firm
increases the amount of debt from Rs 2,00,000 to Rs 3,00,000 and uses the
proceeds of the debt to repurchase equity shares. The value of the firm would
remain unchanged at Rs 4,00,000, but the equity-capitalisation rate would go
up to 20 per cent as shown in Table 5.
TABLE 5 Value of the Firm (NOI Approach)
0
) 0.125
0
4,00,000
Total value of debt (B) 3,00,000
Total market value of equity (S) = (V B) 1,00,000
k
e
= [(Rs 50,000 Rs 30,000) / Rs 1,00,000] 0.20
Alternatively: k
e
= 0.125 + (0.125 0.10) (Rs 3,00,000 / Rs 1,00,000) 0.20
k
0
= 0.10 (Rs 3,00,000 / Rs 4,00,000) + 0.20 (Rs 1,00,000 / Rs
4,00,000)
0.125
19-20
Let us further suppose that the firm retires debt by Rs 1,00,000 by issuing
fresh equity shares of the same amount. The value of the firm would remain
unchanged at Rs 4,00,000 and the equity-capitalisation rate would come down
to 13.33 per cent as manifested in the calculations in Table 6.
TABLE 6 Total Value of the Firm (NOI Approach)
0
) 0.125
0
4,00,000
Total value of debt (B) 1,00,000
Total market value of equity (S) = (V B) 3,00,000
k
e
=[(Rs 50,000 - Rs 10,000) / Rs 3,00,000] 0.133
Alternatively: k
e
= 0.125 + (0.125 0.10) (Rs 1,00,000 / Rs
3,00,000)
0.133
K
0
= 0.10 (Rs 1,00,000 / Rs 4,00,000) + 0.133 (Rs 3,00,000 / Rs
4,00,000)
0.125
19-21
Market Price of Shares
In example 2, let us suppose the firm with Rs 2 lakh debt has 2,000
equity shares (of Rs 100 each) outstanding. The firm has issued
additional debt of Rs 1,00,000 to repurchase its shares amounting
to Rs 1,00,000; it has to repurchase 1,000 shares of Rs 100 each
from the market. It, then, has 1,000 equity shares outstanding,
having total market value of Rs 1,00,000. The market price per
share, therefore, is Rs 100 (Rs 1,00,000 1,000) as before.
In the second situation the firm issues, 1,000 equity shares of Rs
100 each to retire debt aggregating Rs 1,00,000. It will have 3,000
equity shares outstanding, having total market value of Rs 3,00,000,
thus, giving a market price of Rs 100 per share.
Thus, we note that there is no change in the market price per share
due to change in leverage.
We have portrayed the relationship between the leverage and the
various costs, viz. k
i
, k
e
and k
0
in Fig. 2.
19-22
The graph is based on Example 2. Due to the assumption that k
0
and k
i
remain
unchanged as the degree of leverage changes, we find that both the curves are
parallel to the x-axis. But as the degree of leverage increases, the k
e
increases
continuously.
5.0
10.0
15.0
0 0.5 1.0
Figure 2: Leverage and Cost of Capital (NOI Approach)
X
Y
K
e
,

k
i

a
n
d

k
0

(
%
)

k
0
k
i
k
e
20.0
25.0
19-23
Modigliani-Miller (MM) Approach
Modigliani and Miller (MM) concur with NOI and
provide a behavioural justification for the
irrelevance of capital structure. They maintain
that the cost of capital and the value of the firm
do not change with a change in leverage.
19-24
The MM Approach maintains that the weighted average
(overall) cost of capital does not change, as shown in Fig. 3,
with a change in the proportion of debt to equity in the
capital structure (or degree of leverage). They offer
operational justification for this and are not content with
merely stating the proposition.
x
(in Rs)
v
k
0

(
%
)

Figure 3: Leverage and Cost of Capital (MM Approach)
V
0
k
0

19-25
Basic Propositions
1) The overall cost of capital (k
0
) and the value of the firm
(V) are independent of its capital structure. The k
0
and V
are constant for all degrees of leverage. The total value is
given by capitalising the expected stream of operating
earnings at a discount rate appropriate for its risk class.
2) The second proposition of the MM Approach is that the
k
e
is equal to the capitalisation rate of a pure equity
stream plus a premium for financial risk equal to the
difference between the pure equity-capitalisation rate (k
e
)
and k
i
times the ratio of debt to equity. In other words, 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 purposes is completely
independent of the way in which an investment is
financed.
19-26
Assumptions
a) Perfect capital markets: The implication of a perfect capital
market is that (i) securities are infinitely divisible; (ii) investors are
free to buy/sell securities; (iii) investors can borrow without
restrictions on the same terms and conditions as firms can; (iv)
there are no transaction costs; (v) information is perfect, that is,
each investor has the same information which is readily available
to him without cost; and (vi) investors are rational and behave
accordingly.
b) Given the assumption of perfect information and rationality, all
investors have the same expectation of firms net operating
income (EBIT) with which to evaluate the value of a firm.
c) Business risk is equal among all firms within similar operating
environment. That means, all firms can be divided into equivalent
risk class or homogeneous risk class. The term
equivalent/homogeneous risk class means that the expected
earnings have identical risk characteristics. The dividend payout
ratio is 100 per cent.
d) There are no taxes. This assumption is removed later.
19-27
Example 3
Assume there are two firms, L and U, which are identical in all
respects except that firm L has 10 per cent, Rs 5,00,000 debentures.
The earnings before interest and taxes (EBIT) of both the firms are
equal, that is, Rs 1,00,000. The equity-capitalisation rate (k
e
) of firm
L is higher (16 per cent) than that of firm U (12.5 per cent).
Solution:
The total market values of firms L and U are computed in Table 7.
19-28
TABLE 7 Total Value of Firms L and U
Particulars Firms
L U
EBIT Rs 1,00,000 Rs 1,00,000
Less: Interest 50,000
Earnings available to equity-holders 50,000 1,00,000
Equity-capitalisation rate (k
e
) 0.16 0.125
Total market value of equity (S) 3,12,500 8,00,000
Total market value of debt (B) 5,00,000
Total market value (V) 8,12,500 8,00,000
Implied overall capitalisation rate/cost of capital (k
0
)
= EBIT/V
0.123 0.125
Debt-equity ratio = B/S 1.6
Thus, the total market value of the firm which employs debt in the capital structure (L) is
more than that of the unlevered firm (U). According to the MM hypothesis, this situation
cannot continue as the arbitrage process, based on the substitutability of personal
leverage for corporate leverage, will operate and the values of the two firms will be
brought to an identical level.
19-29
Arbitrage Process The modus operandi of the arbitrage process is as follows:
Suppose an investor, Mr X, holds 10 per cent of the outstanding shares of the
levered firm (L). His holdings amount to Rs 31,250 (i.e. 0.10 Rs 3,12,500) and his
share in the earnings that belong to the equity shareholders would be Rs 5,000
(0.10 Rs 50,000).
He will sell his holdings in firm L and invest in the unlevered firm (U). Since firm U
has no debt in its capital structure, the financial risk to Mr X would be less than in
firm L. To reach the level of financial risk of firm L, he will borrow additional funds
equal to his proportionate share in the levered firms debt on his personal
account. That is, he will substitute personal leverage (or home-made leverage) for
corporate leverage.
In other words, instead of the firm using debt, Mr X will borrow money. The
effect, in essence, of this is that he is able to introduce leverage in the capital
structure of the the unlevered firm by borrowing on his personal account. Mr X in
our example will borrow Rs 50,000 at 10 per cent rate of interest. His
proportionate holding (10 per cent) in the unlevered firm will amount to Rs 80,000
on which he will receive a dividend income of Rs 10,000. Out of the income of Rs
10,000 from the unlevered firm (U), Mr X will pay Rs 5,000 as interest on his
personal borrowings. He will be left with Rs 5,000 that is, the same amount as he
was getting from the levered firm (L). But his investment outlay in firm U is less
(Rs 30,000) as compared with that in firm L (Rs 31,250). At the same time, his risk
is identical in both the situations. The effect of the arbitrage process is
summarised in Table 8.
19-30
TABLE 8 Effect of Arbitrage
(A) Mr Xs position in firm L (levered) with 10 per cent equity-holding
(i) Investment outlay Rs 31,250
(ii) Dividend Income 5,000
(B) Mr Xs position in firm U (unlevered) with 10 per cent equity holding
(i) Total funds available (own funds, Rs 31,250 + borrowed funds, Rs
50,000)
81,250
(ii) Investment outlay (own funds, Rs 30,000 + borrowed funds, Rs 50,000) 80,000
(iii) Dividend Income:
Total Income (0.10 Rs 1,00,000) Rs
10,000
Less: Interest payable on borrowed funds 5,000 5,000
(C) Mr Xs position in firm U if he invests the total funds available
(i) Investment costs 81,250.00
(ii) Total income 10,156.25
(iii) Dividend income (net) (Rs 10,156.25 Rs 5,000) 5,156.25
It is, thus, clear that Mr X will be better off by selling his securities in the levered firm
and buying the shares of the unlevered firm.
19-31
Arbitrage Process:
Reverse Direction According to the MM hypothesis, since debt
financing has no advantage, it has no disadvantage either. In other
words, just as the total value of a levered firm cannot be more than
that of an unlevered firm, the value of an unlevered firm cannot be
greater than the value of a levered firm. This is because the arbitrage
process will set in and depress the value of the unlevered firm and
increase the market price and, thereby, the total value of the levered
firm. The arbitrage would, thus, operate in the opposite direction.
Example 4
Assume that in Example 3, the equity-capitalisation rate (k
e
) is 20 per
cent in the case of the levered firm (L), instead of the assumed 16 per
cent. The total values of the two firms are given in Table 9.
19-32
TABLE 9 Total Value of Firms L and U
Particulars L U
EBIT
Less: Interest
Income to equity holders
e
)
Market value of equity
Market value of debt
Total value (V)
(k
0
)
B/S
Rs 1,00,000
50,000
50,000
0.20
2,50,000
5,00,000
7,50,000
0.133
2
Rs 1,00,000

1,00,000
0.125
8,00,000

8,00,000
0.125
0
Since both firms are similar, except for financing-mix, a situation in which their total
values are different, cannot continue, as arbitrage will drive the two values together.
Suppose, Mr Y has 10 per cent shareholdings of firm U. He earns Rs 10,000 (0.10 Rs
1,00,000). He will sell his securities in firm U and invest in the undervalued levered firm,
L. He can purchase 10 per cent of firm Ls debt at a cost of Rs 50,000 which will provide
Rs 5,000 interest and 10 per cent of Ls equity at a cost of Rs 25,000 with an expected
dividend of Rs 5,000 (0.10 Rs 50,000). The purchase of a 10 per cent claim against the
levered firms income costs Mr Y only Rs 75,000, yielding the same expected income of
Rs 10,000 from the equity shares of the unlevered firm. He would prefer the levered
firms securities as the outlay is lower. Table 10 portrays the reverse arbitrage process.
19-33
TABLE 10 Effect of Reverse Arbitrage Process
(A) Mr Ys current position in firm U
Investment outlay Rs 80,000
Dividend income 10,000
(B) Mr Y sells his holdings in firm U and purchases 10 per cent of the levered firms
equity and debentures
Investment Income
Debt Rs 50,000 Rs 5,000
Equity 25,000 5,000
Total 75,000 10,000
Y would prefer alternative B to A, as he is able to earn the same income with a smaller
outlay.
(C) He invests the entire sum of Rs 80,000 in firm L
Investment Income
Debt Rs 53,333.00 Rs 5,333.30
Equity 26,667.00 5,333.40
Total 80,000,00 10,666.70
He augments his income by Rs 666.70.
The above illustrations establish that the arbitrage process will make the values of
both the firms identical. Thus, Modigliani and Miller show that the value of a levered
firm can neither be greater nor smaller than that of an unlevered firm; the two must be
equal
19-34
Limitations
The most crucial element in the MM Approach is the arbitrage process which
forms the behavioural foundation of, and provides operational justification to,
the MM hypothesis. The arbitrage process, in turn, is based on the crucial
assumption of perfect substitutability of personal/home-made leverage with
corporate leverage. The arbitrage process is, however, not realistic and the
exercise based upon it is purely theoretical and has no practical relevance.
Risk Perception
In the first place, the risk perceptions of personal and corporate leverage are
different. If home-made and corporate leverages are perfect substitutes, as the
MM Approach assumes, the risk to which an investor is exposed, must be
identical irrespective of whether the firm has borrowed (corporate leverage) or
the investor himself borrows proportionate to his share in the firms debt. If
not, they cannot be perfect substitutes and consequently the arbitrage
process will not be effective
Convenience
Apart from higher risk exposure, the investors would find the personal
leverage inconvenient.
19-35
Cost
Another constraint on the perfect substitutability of personal and corporate
leverage and, hence, the effectiveness of the arbitrage process is the
relatively high cost of borrowing with personal leverage.
Institutional Restrictions
Yet another problem with the MM hypothesis is that institutional
restrictions stand in the way of a smooth operation of the arbitrage process.
Several institutional investors such as insurance companies, mutual funds,
commercial banks and so on are not allowed to engage in personal leverage.
Double Leverage
A related dimension is that in certain situations, the arbitrage process
(substituting corporate leverage by personal leverage) may not actually work.
For instance, when an investor has already borrowed funds while investing in
shares of an unlevered firm. If the value of the unlevered firm is more than that
of the levered firm, the arbitrage process would require selling the securities
of the overvalued (unlevered) firm and purchasing the securities of the levered
firm. Thus, an investor would have double leverage both in personal portfolio
as well as in the firms portfolio. The MM assumption would not hold true in
such a situation.
19-36
Transaction Costs
Transaction costs would affect the arbitrage process. The effect of
transaction/flotation cost is that the investor would receive net
proceeds from the sale of securities which will be lower than his
investment holding in the levered/unlevered firm, to the extent of the
brokerage fee and other costs. He would, therefore, have to invest a
larger amount in the shares of the unlevered/ levered firm, than his
present investment, to earn the same return.
Taxes
Finally, if corporate taxes are taken into account, the MM Approach will
fail to explain the relationship between financing decision and value of
the firm. Modigliani and Miller themselves, as shown below, are aware
of it and have, in fact, recognised it.
19-37
Corporate Taxes
The MM contend that with corporate taxes, debt has a definite
advantage as interest paid on debt is tax-deductible and leverage
will lower the overall cost of capital. The value of the levered firm
(V
1
) would exceed the value of the unlevered firm (V
u
) by an
amount equal to levered firm's debt multiplied by tax rate.
V
l
= V
u
+ Bt (14)
where V
l
= value of levered firm
V
u
= value of unlevered firm
B = amount of debt
t = tax rate
19-38
Example 5
The earnings before interest and taxes are Rs 10 lakh for companies
L and U. They are alike in all respects except that Firm L uses 15 per
cent debt of Rs 20 lakh; Firm U does not use debt. Given the tax rate
of 35 per cent, the stakeholders of the two firms will receive different
amounts as shown in Table 11.
TABLE 11 Effect of Leverage on Shareholders
Particulars Company L Company U
EBIT Rs 10,00,000 Rs 10,00,000
Less: Interest 3,00,000
Earnings before taxes 7,00,000 10,00,000
Less: Taxes 2,45,000 3,50,000
Income available for equity-holders 4,55,000 6,50,000
Income available for debt-holders and
equity-holders
7,55,000 6,50,000
19-39
The total income to both debt holders and equity holders of levered
Company L is higher. The reason is that while debt-holders receive interest
without tax-deduction at the corporate level, equity-holders of Company L
have their incomes after tax-deduction. As a result, total income to both
types of investors increases by the interest payment times the rate, that is,
Rs 3,00,000 0.35 = Rs 1,05,000.
Assuming further that the debt employed by Company L is permanent, the
advantage to the firm is equivalent to the present value of the tax shield, that
is, Rs 7 lakh (Rs 1,05,000/0.15). Alternatively, it can be determined with
reference to equation 15.
(Brt/r) = Bt (15)
where t = Corporate tax
r = Rate of interest on debt
Bt = Amount of debt = 0.35 Rs 20 lakh = Rs 7 lakh
It may be noted that value of levered firm (as shown by equation 14) reckons
this tax shield due to debt.
The implication of MM analysis in this case is that the value of the firm is
maximised when its capital structure contains only debt.
19-40
Traditional Approach
The traditional approach is mid-way between the two
extreme (the NI and NOI) approaches. The crux of this
approach is that through a judicious combination of
debt and equity, a firm can increase its value (V) and
reduce its cost of capital (k
0
) upto a point. However,
beyond that point, the use of additional debt will
increase the financial risk of the investors as well as
of the lenders and as a result will cause a rise in the
k
0
. At such a point, the capital structure is optimum.
In other words, at the optimum capital structure the
marginal real cost of debt (both implicit and explicit)
will be equal to the real cost of equity.
19-41
Example 6
Let us suppose that a firm has 20 per cent debt and 80 per cent equity in its capital
structure. The cost of debt and the cost of equity are assumed to be 10 per cent and
15 per cent respectively. What is the overall cost of capital, according to the
traditional Approach?
Solution
The overall cost of capital (k
0
) = k
i
i.e. 0.10 (20 / 100) + k
e
i.e. 0.15 (80 / 100) = 14%
Further, suppose, the firm wants to increase the percentage of debt to 50. Due to the
increased financial risk, the k
i
and k
e
will presumably rise. Assuming, they are 11 per
cent (k
i
) and 16 per cent (k
e
), the cost of capital (k
0
) would be: = 0.11 (50 / 100) + 0.16
(50 / 100) = 13.5%
It can, thus, be seen that with a rise in the debt-equity ratio, k
e
and k
i
increase, but, k
0

has declined presumably because these increases have not fully offset the
advantages of the cheapness of debt.
Assume further, the level of debt is raised to 70 per cent of the capital structure of
the firm. There would consequently be a sharp rise in risk to the investors as well as
creditors. The k
e
would be, say, 20 per cent and the k
i
14 per cent. The k
0
= 0.14 (70 /
100) + 0.20 (30 / 100) = 15.8%
The overall cost of capital has actually risen when the firm tries to employ more of
what appeared, at the previous debt-equity ratio, to be the least costly source of
funds, that is, debt. Therefore, the firm should take into account the consequences
of raising the percentage of debt to 70 per cent on the cost of both equity and debt.
19-42
Example 7
Assume a firm has EBIT of Rs 40,000. The firm has 10 per cent
debentures of Rs 1,00,000 and its current equity capitalisation rate is
16 per cent. The current value of the firm (V) and its overall cost of
capital would be, as shown in Table 12.
TABLE 12 Total Value and Cost of Capital (Traditional Approach)
Less: Interest (I) 10,000
Earnings available to equityholders (NI) 30,000
e
) 0.16
Total Market value of equity (S) = NI/k
e
1,87,500
Total Market value of debt (B) 1,00,000
Total value of the firm (V) = S + B 2,87,500
Overall cost of capital, k
0
= EBIT/V 0.139
Debt-equity ratio (B/S) = (Rs 1,00,000 Rs 1,87,500) 0.53
19-43
The firm is considering increasing its leverage by issuing additional
Rs 50,000 debentures and using the proceeds to retire that amount of
equity. If, however, as the firm increases the proportion of debt, k
i

would rise to 11 per cent and k
e
to 17 per cent, the total value of the
firm would increase and k
0
would decline as shown in Table 13.
e
) 0.17
e
1,38,235
Total Market value of debt (B) 1,50,000
0
= EBIT/V 0.138
Debt-equity ratio (B/S) 1.08
19-44
Let us further suppose that the firm issues additional Rs 1,00,000 debentures
instead of Rs 50,000 (that is, having Rs 2,00,000 debentures) and uses the
proceeds to retire that amount of equity. Due to increased financial risk, k
i

would rise to 12.5 per cent and k
e
to 20 per cent, the total value of the firm
would decrease and k
0
would rise as is clear from Table 14.
e
) 0.20
e
75,000
Total Market value of debt 2,00,000
0
= EBIT/V 0.145
Debt-equity ratio (B/S) (Rs 2,00,000 Rs 75,000) 2.67
19-45
Increased Valuation and Decreased Overall Cost of Capital
During the first phase, increasing leverage increases the total valuation of the firm
and lowers the overall cost of capital. As the proportion of debt in the capital
structure increases, the cost of equity (k
e
) begins to rise as a reflection of the
increased financial risk. But it does not rise fast enough to off set the advantage of
using the cheaper source of debt capital. Likewise, for most of the range of this
phase, the cost of debt (k
i
) either remains constant or rises to a very small extent
because the proportion of debt by the lender is considered to be within safe limits.
Therefore, they are prepared to lend to the firm at almost the same rate of interest.
Since debt is typically a cheaper source of capital than equity, the combined effect
is that the overall cost of capital begins to fall with the increasing use of debt.
Example 7 has shown that an increase in leverage (B/S) from 0.53 to 1.08 has had
the effect of increasing the total market value from Rs 2,87,500 to
Rs 2,88,235 and decreasing the overall capitalisation rate from 13.9 to 13.8 per
cent.
Constant Valuation and Constant Overall Cost of Capital
After a certain degree of leverage is reached, further moderate increases in
leverage have little or no effect on total market value. During the middle range,the
changes brought in equity-capitalisation rate and debt-capitalisation rate balance
each other. As a result, the values of (V) and (k
0
) remain almost constant.
The effect of increase in leverage from zero, on cost of capital and valuation of the
firm, can be thought to involve three distinct phase.
19-46
Decreased Valuation and Increased Overall Cost of Capital
Beyond a certain critical point, further increases in debt proportions are not
considered desirable. They increase financial risks so much that both k
e
and k
i
start
rising rapidly causing (k
0
) to rise and (V) to fall. In example 7, the effect of an
increase in B/S ratio from 1.08 to 2.67 is to increase (k
0
) from 13.8 to 14.5 per cent
and to decrease (V) from Rs 2,88,235 to Rs 2,75,000.
A numerical illustration, given in Table 15 and its graphic presentation in Fig. 4
further help to clarify the relationship between leverage and cost of capital. They
present hypothetical changes similar to those envisaged by the traditional
approach and examine the effect of leverage on the individual variables. We have
assumed, in addition to other assumptions already stated at the beginning of the
chapter, that given capital market conditions, the company can repurchase its own
shares. The face value of a share is Rs 10 and that of debentures Rs 100 each. The
symbols used in Table 15 have the same meaning as explained at the beginning of
the chapter.
Table 15 as well as Fig. 4 reveal that with an increase in leverage (B/V) from zero to
0.27, the market value of the firm increases (from Rs 1,000 to Rs 1,111) and the
overall cost of capital declines from 10 to 9 per cent (Phase I). With further
increases in leverage from 0.27 up to 0.54, there is no change either in (V) or in (k
0
);
both the values remain constant, that is, Rs 1,111 and 9 per cent respectively
(Phase 2). During Phase 3, with an increase in the ratio beyond 0.54 up to 0.79,
there is a decrease in market value of the firm (from Rs 1,111 to Rs 1,013) and an
increase in (k
0
) (from 9 to 9.4 per cent), suggesting that the optimal leverage lies
within the range of 0.27 to 0.54 debt-equity ratio.
19-47
TABLE 15 Leverage, Capitalisation Rates and Valuationa
B k
i
(%)
EBIT I NI
(EBIT-I)
k
e
(%)
Numb
er
of
share
s
Amou
nt of
shares
(book
value)
S
(NI
k
e
)
Mark
et
value
per
share
V
(B +
S)
k0
%
L1
(B/
S)
L2
(B/V)

1 2 3 (Rs) 4 (Rs) 5 (Rs) 6 7 8 (Rs) 9
(Rs)
10
(Rs)
11
(Rs)
12 13 14
0 4.0 100 Nil 100 10.0 100 1,000 1,000 10.00 1,000 10.2 0 0
100 4.0 100 4.0 96 10.0 90 900 960 10.67 1,060 9.4 0.1
0
0.09
200 4.0 100 8.0 92 10.3 80 800 893 10.16 1,093 9.1 0.2
2
0.18
300 4.2 100 12.6 87.4 10.8 70 700 810 11.57 1,111 9.0 0.3
3
0.27
400 4.5 100 18.0 82 11.5 60 600 711 11.85 1,111 9.0 0.5
6
0.36
500 5.0 100 25.0 75 12.3 50 500 611 12.22 1,111 9.0 0.8
2
0.45
600 5.5 100 33.0 67 13.1 40 400 512 12.80 1,111 9.0 1.1
7
0.54
700 7.0 100 49.0 51 14.0 30 300 364 12.13 1,064 9.4 1.9
2
0.65
800 8.5 100 68.0 32 15.0 20 200 213 10.65 1,013 9.9 3.7
6
0.79
19-48
12
11
10
9
8
7
6
5
4
3
2
1
M
a
r
k
e
t

V
a
l
u
e

(
R
s
)

Degree of Leverage (L
2
) [(B / (B + S)]
Y
i
e
l
d
s

K
e
,

k
i

a
n
d

k
0

(
%
)

Figure 4: Leverage and Cost of Capital (Traditional Approach)

0
0.1 0.2 0.3 0.5 0.6 0.7 0.8 0.9 0.4

k
e

In practice, it may not be possible to determine the minimum overall cost of capital. Therefore, a diagrammatic
presentation is useful as it depicts a range over which the cost of capital is minimised. The (k
0
) curve developed in
Fig. 4 is a fairly shallow saucer with a horizontal section over the middle ranges of leverage (0.27 to 0.54). The firm
should not go to the left or to the right of the saucer part of the curve.
19-49
x
Y
0
K
e
,

k
i

a
n
d

k
0

(
%
)

Figure 5: Leverage and Cost of Capital (Traditional Approach)
k
e

k
0

k
i

The traditional view on leverage is commonly referred to as one of U shaped cost of
capital curve (as shown in Fig. 5). In such a situation, the degree of leverage is optimum at
a point at which the rising marginal cost of borrowing is equal to the average overall cost
of capital. For this purpose, marginal cost of a unit of debt capital consists of two parts: (i)
the increase in total interest payable on debt; (ii) the amount of extra net earnings
required to restore the value of equity component to what it would have been under the
pre-existing capitalisation rate before the debt is increased.
19-50
Thus, in Table 15, the marginal cost of borrowing the seventh to Rs
100 units of funds is Rs 19 or 19 per cent. It is determined as follows:
(i) Increase in total interest payable (I) Rs 16
Rs 49 (when B is Rs 700) Rs 33 (when B is 600)
Plus: (ii) Increase in net income required for shareholders 3
(When the value of a share is Rs 12.13, the
required earnings are Rs 51.
Therefore, to maintain the value of share at Rs 12.80, the earnings are
Rs 54 i.e. (Rs 12.80 / Rs 12.13) x Rs 51; thus, the increased earnings
required is Rs 3).
Since the marginal cost of debt is 19 per cent, while the over all cost
of capital is 9 per cent, the use of more debt at this stage is
imprudent. In other words, a mix of debt of Rs 600 with equity capital
of Rs 400 provides the optimum combination of debt and equity and
optimum capital structure.
19-51
SOLVED PROBLEMS
19-52
SOLVED PROBLEM 1
Company X and Company Y are in the same risk class, and are identical in
every respect except that company X uses debt, while company Y does not.
The levered firm has Rs 9,00,000 debentures, carrying 10 per cent rate of
interest. Both the firms earn 20 per cent operating profit on their total assets of
Rs 15 lakhs. Assume perfect capital markets, rational investors and so on; a tax
rate of 35 per cent and capitalisation rate of 15 per cent for an all-equity
company.
(a) Compute the value of firms X and Y using the Net Income (NI) Approach.
(b) Compute the value of each firm using the Net Operating Income (NOI)
Approach.
(c) Using the NOI Approach, calculate the overall cost of capital (k
0
) for firms X
and Y.
(d) Which of these two firms has an optimal capital structure according to the
NOI Approach? Why?
19-53
Solution
(a) Valuation under NI approach
Particulars Firm X Firm Y
EBIT
Less: Interest
Taxable income
Less: Taxes
Earnings for equity holders
e
)
Market value of equity (S)
Market value of debt (B)
Total value of firm (V)
Rs 3,00,000
90,000
2,10,000
73,500
1,36,500
0.15
9,10,000
9,00,000
18,10,000
Rs 3,00,000

3,00,000
1,05,000
1,95,000
0.15
13,00,000

13,00,000
( ) ( )
cent per 15
y
o
K Similarly,
cent per 12.1
16,15,000 Rs
7,15,000 Rs
0.191
e
k
16,15,000 Rs
9,00,000 Rs
.065
d
k
ox
K (c)
16,15,000 Rs (0.35) 9,00,000 Rs 13,00,000 Rs
X
V
13,00,000 Rs
0.15
0.35 - 1 3,00,000 Rs
Y
V
Approach NOI under Valuation (b)
=
= + =
= + =
= =
(
|
.
|
\
|
19-54
Working Notes
EBIT Rs 3,00,000
Less: Interest 90,000
Taxable income 2,10,000
Less: Taxes 73,500
NI 1,36,500
V as determined in (ii) 16,15,000
B 9,00,000
S (V B) 7,15,000
K
e
= (Rs 1,36,500/Rs 7,150,000) = 19.1 per cent or k
e
= k
0
+ (k
0
k
d
) B/S
= 12.1% + (12.1% - 6.5%) 9,00,000 / 7,15,000 = 19.1%
k
d
= 0.10 (10.35) = 6.5 per cent
(d) Neither firm has an optimum capital structure according to the NOI
Approach. Under the MM assumptions, the optimum capital structure requires
100 per cent debt.
19-55
SOLVED PROBLEM 2
The two companies, U and L, belong to an equivalent risk class. These two
firms are identical in every respect except that U company is unlevered while
Company L has 10 per cent debentures of Rs 30 lakh. The other relevant
information regarding their valuation and capitalisation rates are as follows:
Particulars Firm U Firm L
Net operating income (EBIT) Rs 7,50,000 Rs 7,50,000
Interest on debt (I) 3,00,000
Earnings to equityholders (NI) 7,50,000 4,50,000
e
) 0.15 0.20
Market value of equity (S) 50,00,000 22,50,000
Total value of firm (S + B) = V 50,00,000 52,50,000
Implied overall capitalisation rate (k
0
) 0.15 0.143
Debt-equity ratio (B/S) 0 1.33
(a) An investor owns 10 per cent equity shares of company L. Show the
arbitrage process and the amount by which he could reduce his outlay
through the use of leverage.
(b) According to Modigliani and Miller, when will this arbitrage process come
to an end?
19-56
Solution
(a) Arbitrage process
(i) Investors current position (in firm L)
Dividend income Rs 45,000
Investment cost 2,25,000
(ii) He sells his holdings of firm L for Rs 2,25,000 and creates a
personal leverage by borrowing Rs 3,00,000 (0.10 Rs 30,00,000
debt of firm L).
The total amount with him is Rs 5,25,000. Income required to break
even would be:
Dividend income (L firm) 45,000
Interest on personal borrowing (0.10 Rs 3,00,000) 30,000
75,000
(iii) He purchases 10 per cent equity holdings of the firm U for Rs 5,00,000.
Dividend income (U firm) (0.10 Rs 7,50,000) 75,000
Amount of investment 5,00,000
He will reduce his outlay by Rs 25,000 through the use of leverage.
(b) According to Modigliani and Miller, this arbitrage process will come to an end
when the values of both the firms are identical.

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