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According to NI approach
both the cost of debt and the
cost of equity are independent
of the capital structure; they
remain constant regardless of
how much debt the firm uses.
As a result, the overall cost of
capital declines and the firm
value increases with debt.
This approach has no basis in
reality; the optimum capital
structure would be 100 per
cent debt financing under NI
approach. The effect of leverage on the cost of
capital under NI approach
Traditional Approach
6
IRRELEVANCE OF CAPITAL
STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES
MM Approach Without Tax:
10 Proposition I
MM’s Proposition I is
that, for firms in the same
risk class, the total market
value is independent of
the debt-equity mix and is
given by capitalizing the
expected net operating
income by the
capitalization rate (i.e.,
the opportunity cost of
capital) appropriate to that
risk class.
MM’s Proposition I: Key
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Assumptions
Perfect capital markets
Homogeneous risk classes
Risk
No taxes
Full payout
The cost of capital under MM
12
proposition I
Net Operating Income (NOI)
13
Approach
According to NOI approach the value of the firm
and the weighted average cost of capital are
independent of the firm’s capital structure. In the
absence of taxes, an individual holding all the debt
and equity securities will receive the same cash
flows regardless of the capital structure and
therefore, value of the company is the same.
MM’s approach is a net operating income
approach.
Arbitrage Process
14
RELEVANCE OF CAPITAL
STRUCTURE:
THE MM HYPOTHESIS UNDER
CORPORATE TAXES
19
Suppose two firms L and U are identical in all respects except that firm L
is levered and firm U is unlevered. Firm U is an all-equity financed firm
while firm L employs equity and Rs 5,000 debt at 10 per cent rate of
interest. Both firms have an expected earning before interest and taxes (or
net operating income) of Rs 2,500, pay corporate tax at 50 per cent and
distribute 100 per cent earnings as dividends to shareholders.
21
You may notice that the total income after corporate tax is Rs 1,250 for the
unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered
firm L’s investors are ahead of the unlevered firm U’s investors by Rs 250.
You may also note that the tax liability of the levered firm L is Rs 250 less
than the tax liability of the unlevered firm U. For firm L the tax savings
has occurred on account of payment of interest to debt holders. Hence, this
amount is the interest tax shield or tax advantage of debt of firm L: 0.5 ×
(0.10 × 5,000) = 0.5 × 500 = Rs 250. Thus,
Value of Interest Tax Shield
22
The attractiveness of borrowing depends on corporate tax rate, personal tax rate
on interest income and personal tax rate on equity income.
The advantage of borrowing reduces when corporate tax rate decreases, or when
the personal tax rate on interest income increases, or when the personal tax rate
on equity income decreases.
A firm will stop borrowing when (1 – Tpd) becomes equal to (1 – Tpe) (1 – T).
Thus, the net tax advantage of debt or the interest tax shield after personal taxes
is given by the following:
Corporate and Personal Tax Rates
in India
29
It is now widely accepted that the effect of personal taxes is to lower the
estimate of the interest tax shield.
Miller’s Model
32
With more and more debt, the costs of financial distress increases and
therefore, the tax benefit shrinks. The optimum point is reached when
the marginal present values of the tax benefit and the financial distress
cost are equal. The value of the firm is maximum at this point.
Agency Costs
39
Shareholders–Managers conflict
1. Capital mix
2. Maturity and priority
3. Terms and conditions
4. Currency
5. Financial innovations
6. Financial market segments
Framework for Capital
Structure:
44
The FRICT Analysis
Flexibility
Risk
Income
Control
Timing
APPROACHES TO ESTABLISH
TARGET CAPITAL STRUCTURE
45
The firm should employ debt to the point where the marginal
benefits and costs are equal.
This will be the point of maximum value of the firm and
minimum weighted average cost of capital.
The difficulty with the valuation framework is that managers
find it difficult to put into practice.
The most desirable capital structure is the one that creates the
maximum value.
Cash Flow Analysis
48