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Analysis
How do we want to finance our firm’s assets?
Distinguish between financial structure and
capital structure.
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’ Financial
Equity
Structure
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Capital
Structure
Why is Capital Structure Important?
Break even point in both the options to get the EBIT will be:
[(1-T) EBIT] / number of shares in plan 1 (N1) = [(1-T)(EBIT -Interest]/ Number
of shares in plan 2 (N2)
Capital Structure Theory:
•Excess financial risk put the firm into
bankruptcy cost and to use little financial
leverage results in an undervaluation of
the firm’s shares in the marketplace.
•Financial manager must know how to
find the optimal financial leverage use
What is the Optimal Capital
Structure?
In a “perfect world” environment
with no taxes, no transactions
costs and perfectly efficient
financial markets, capital
structure does not matter.
This is known as the
Independence Hypothesis of
capital structure: firm value is
independent of capital structure.
Analytical Setting:
•Investment policy and dividend policy are
held constant throughout the discussion
•Firm retains none of its current earnings
•Corporate income is not subject to any
taxation (removed later)
•Capital structure consists of only debt and
equity. Degree of financial leverage is by
retiring the debt or repurchase of equity
(More…)
•The expected values of EBIT of all investors
are identical for each firm
•Securities are traded in perfect or efficient
financial markets
Theories:
1) Extreme Positions View
• Independence Hypothesis (NOI Theory by D. Durand)
• Dependence Hypothesis (NI Theory by D. Durand)
2) Moderate View
This is not to say that the markets really
behave in strict accordance with either
position.
The point is to identify polar positions on
how things might work.
1) Independence Hypothesis
Firm value does not depend
on capital structure.
Firm’s composite cost of capital and
common stock price are both independent
of the degree of financial leverage.
•Independence hypothesis- if the capital
structure has no impact on the total market
value of the firm, then the value of the firm is
arrived by capitalizing (discounting) the
firm’s operating income (EBIT) . Therefore
this hypothesis is called Net Operating
Income.
•Value of equity is the residual value
Independence Hypothesis
Cost of
Capital kc = cost of equity
kd = cost of debt
ko = cost of capital
kc .
0% debt financial leverage 100%debt
Independence Hypothesis
Cost of
Capital
If we have an all-equity
financed firm, what is
the cost of capital?
kc .
financial leverage
Independence Hypothesis
Cost of
Capital
If we have an all-equity
financed firm, the cost of
capital is just the cost of
ko=kc . equity.
financial leverage
Independence Hypothesis
Suppose we begin adding debt
Cost of financing at a cost of kd.
Capital
kc
kd
financial leverage
Independence Hypothesis
Suppose we begin adding debt
Cost of financing at a cost of kd.
Capital
kd is lower than kc, so what
should happen to the cost
of capital?
kc
kd kd
financial leverage
Independence Hypothesis
kc
kd kd
financial leverage
Independence Hypothesis
financial leverage
Independence Hypothesis
Increasing leverage causes the
kc
Cost of cost of equity to
Capital rise.
kc
kd kd
financial leverage
Independence Hypothesis
Increasing leverage causes the
kc
Cost of cost of equity to rise.
Capital
What will
be the net effect
on the overall cost
kc of capital?
kd kd
financial leverage
Independence Hypothesis
The cost of capital does kc
Cost of not change. Leverage has
Capital no effect on the cost
of capital and
therefore,
kc ko
kd kd
financial leverage
Independence Hypothesis
The cost of capital does kc
Cost of not change. Leverage has
Capital no effect on the cost
of capital and
therefore, it has no effect on
the value of the firm.
kc ko
kd kd
financial leverage
Independence Hypothesis
In a “perfect markets”
environment, capital
structure is irrelevant. In
other words, changes in
capital structure do not
affect firm value.
The EBIT of the firm is expected to be Rs1 lakh and
the company has debt of Rs3 lakhs in its capital
structure. The cost of debt is 10% and the over all cost
of capital is 12.5%.
If the company change the debt equity ratio and now
increased the debt capital to Rs5 lakhs. Find the value
of firm under IH/NOI approach
Mv of debt 300000 Mv of debt 500000
cost of capital 12.50% cost of capital 12.50%
cost of debt 10.00% cost of debt 10.00%
EBIT 100000 EBIT 100000
interest 30000 interest 50000
EACS 70000 EACS 50000
mv of firm 800000 mv of firm 800000
mv of debt 300000 mv of debt 500000
mv of equity 500000 mv of equity 300000
cost of equity 0.14 cost of equity 0.166667
•Firm’s cost of equity will rise at precisely the
same rate as the earnings and dividends do.
•Use of financial leverage brings a change in the
cost of common equity large enough to offset the
benefits of higher dividends to investors. This will
keep the composite cost of funds constant.
•Independence Hypothesis says, one capital
structure is as good as any other, the financial
officers should not waste time searching for an
optimal capital structure.
Dependence Hypothesis
(NI Theory)
kc kc
kd kd
financial leverage
Dependence Hypothesis
because
Cost of of the tax benefit
Capital associated with
debt financing.
kc kc
kd kd
financial leverage
Dependence Hypothesis
So, what will happen to the
Cost of cost of capital as leverage
Capital increases?
kc kc
kd kd
financial leverage
Dependence Hypothesis
kc
kc
ko
kd kd
financial leverage
The EBIT of the firm is expected to be Rs1 lakh and the
company has debt of Rs3 lakh in its capital structure.
The cost of debt is 10% and cost of equity is 13%.
If the company wants to change the debt equity ratio by
increasing debt capital to Rs5 lakhs, what will happen to
the value of the firm
kc
kd
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
The cost of debt increases as the
Cost of
proportion of debt increases. At
Capital
some point, the capital markets
will consider any new debt
kc excessive, and therefore much
kd
riskier.
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
Increasing debt also increases
Cost of
the cost of equity since the
Capital
equity becomes
riskier.
kc kd
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
Increasing debt also increases kc
Cost of
the cost of equity since the
Capital
equity becomes
riskier.
kc kd
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
At first, the cost of capital falls. kc
Cost of
Why?
Capital
kc kd
ko
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
Because the cost of equity is not kc
Cost of
rising enough to offset the
Capital
low after-tax cost of
debt.
kc kd
ko
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
At higher debt levels, the higher kc
Cost of
costs of debt and equity cause
Capital
the cost of capital to
increase. ko
kc kd
kd
financial leverage
Moderate Position with Bankruptcy
and Agency Costs
kd
financial leverage
Modigliani-Miller Approach:
0 20 20 8 12 12
5 15 20 8 13.33 12
10 10 20 8 16 12
15 5 20 8 24 12
20 0 20 8 - 12
With corporate tax;
Suppose the tax rate is 40% and the all other
things are constant only the EBIT is changed
from 2.4 to 4 lakhs
When the firm has 0 debt but it pays tax, so its value will be:
V(U) = EBIT(1-T)/Ke(U)
Now if the firm uses 10 lakhs of debt in the world of tax we see by
proportion I that the total market value rises to 24
V(L)=V(U)+TD
= 20+(10*.4)= Rs24 lakhs So the value of equity = 24-10=14
We can also find the cost of equity of the firm and the WACC at a
debt level of 10 lakhs.
= 12+(12%-8%)(1-.4)(10/14) = 13.71%
This beta is to be used in CAPM to get the cost of equity and that the
over all cost of capital is to be calculated taking the weight and
component costs