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The cost of capital of a firm is fundamental in the decision as to whether a proposed project is acceptable. If the return from a project r! e"ceeds the cost of capital # o! then the project should be accepted. If the cash flows from the project were to be discounted at #o then the project would ha$e a positi$e net present $alue N.%.&.!. This would be profitable for the firm and will mean an increase in the present net worth. Illustration 1.1 ' firm has ()00*000 of cash a$ailable for in$estment* # o + 10,. If the compan- were to in$est the ()00*000 in a project with a return .reater than #o* then the present $alue of the firm would increase. Consider a project that will re/uire all the ()00*000 now and will return (00*000 per annum indefinitel-. Usin. i + #o + .10 the present $alue of the income stream + the IRR e/uals 11,! The present $alue of the projects inflows e"ceeds the present $alue of costs b(100*000 and this is an increase in the present $alue of the firm and the mar#et price of its shares would reflect this increase pro$ided that shareholders percei$e the situation!. The increase would be e$en .reater if # o could be reduced. In present $alue terms the $alue of the firm is at a ma"imum when the cost of capital is at a minimum. 'ttention can* therefore* be focussed on two /uestions” 1! )! Can a firm reduce #o2 If so* is there a minimum #o that can be achie$ed2
(00*000 + (000*000 .10
3ince #o is a function of the costs of the different components of capital # s* #d etc.!* it must be considered whether or not chan.in. the relati$e proportions of component capital .earin.! will affect #o. That is to sa-* is there an optimal capital structure and can a firm affect #o and its total $aluation b- chan.in. the financin. ris#2 Note #o could alwa-s be reduced if the business ris# of the firm were reduced e... if the firm were to di$ersif- into less ris#- acti$ities or if the technolo.- that a firm is wor#in. in ceased to be ris#- and became established.
s No .earin.es 6ar#et $alue of debt earnin. ris#. Initial assumptions of all models 1! )! 0! 4! 1! No ta"ation Immediate chan.from the in$estor:s point of $iew* an increase in . The strict net income approach assumes that #s and #d remain constant. ) .less than #s as debt is less ris#. ). to this approach the a$era.e cost of capital #o! declines as .mar#et $alues. earnin.earin.s distributed 'll shareholders e"pect same future earnin. 'll earnin. should lead to a decrease in #o.There are a number of different $iews on capital structures and financin.0 T89 N9T INCO69 '%%RO'C8 'ccordin.s Total mar#et $alue of firm #o is the 7'CC wei.s 5asic e/uations #d = #s = annual interest char.earin. increases.rowth in earnin.e in .than e/uit. 3ince #d is usuall. The cost of shareholders funds #s! and the cost of debt #d! are independent.s a$ailable to shareholders 6ar#et $alue of e/uit- #o = Net operatin.hted b.
s Capitali=ation rate #s! 9/uit.Illustration )..1 ' compan.is the same as the first one. 0 . This firm has a share price of )1*000 ÷ 1*@10 + (1).>.10 <<<<<<<<< )1*000 1?*000 <<<<<<<<< 0. The business ris# and 95IT of this compan.*000 <<<<<<<<< 04*100 +++++ 3a.1*@10 (10 shares and (1?*000 of 1. can also be found b.earin.>0 per share and a lower # o because of increased . Current re/uired -ields on debt + 1.earnin. debt.earnin.*000* 1. the 7'CC.*000 = >..00 <<<<<<<<< )*100 .>. NoteA >. 3o* 95IT Interest 9/uit.has (.has )*100 (10 shares* then each one is $alued at par.calculatin.*000 +++++ #o + (0.with the same capital re/uirement has onl.>.s Capitali=ation rate #s! 6ar#et $alue of debt &alue of firm (0*000 ( 0*000 .10 <<<<<<<<< )1*100 .the compan. debt with 95IT of (0*000 #s + 10.$alue 6ar#et $alue of debt &alue of firm (0*000 = ?. 'nother compan. ∴ The $alue of the firm is 95IT Interest 9/uit. (04*100 ( 0*000 410 <<<<<<<<< )*110 .
distributed with σ A = σ B = (40*000 The e"pected earnin.* remainder e/uit-.earin.s are randoml. 4 . ).earin..5 than for Compan. 's . Illustration ). Dor both companies future earnin. The debt ser$ice cost interest! + (00*000 p.asA k ks ko kd gearing This approach su.The net income approach can be demonstrated .' + (?0*000 Compan.ests that .5 + (10*000 (?0*000 B 00*000! 3hareholders earnin.capital 9 95IT! + (?0*000 B D95T + (100*000 C @.reater relati$e dispersion for Compan.' coefficient of $ariation!.es increase. increases so financial ris# increases because the fi"ed char.raphicall.s ha$e .5A 9 95IT! + (?0*000 B all e/uit. should be ma"imi=ed.s of shareholders are Compan.a.) Two companies ha$e the same 95IT but different capital structures Compan.'A Compan.1 The traditional &iew The traditional $iew is that there is an optimal capital structure.
earin. due to increased ris# to debt holders. This implies there is an optimal capital structure. It can be show . increases financial ris# and #s will* therefore* increase with .5 + (10*000 + 0.1 Coefficient of $ariation for Compan.asA (40*000 (40*000 1 .? The financial ris# of Compan. The traditional $iew follows the net income approach in that it su..The dispersion of income + business ris# The dispersion of shareholders earnin.reater.earin. effect on #o until a certain point is reached when the increase in #s is such as to increase #o.incorporates an increase in #d at a certain le$el of ..earin.earin.' + (?0*000 + 0.ained from increased .ests there is a benefit to be .5 is .s + financial ris# Coefficient of $ariation for Compan.raphicall.earin.* but this increase is not sufficient to offset the . 8owe$er* increased . The traditional model usuall.
e.e cost of capital of the compan-F and the total $alue of the firm remains unchan.sufficient to offset the effect of the increased importance of #d so #o is constant.ed with chan. The increase in #s is e"actl. The total $alue of the firm & is . has an 95IT of (.asA k ks ko kd gearing 'll capital structures are optimal.1 Dirm R.constant and is not sensiti$e to small chan.The ..1) or 1).. #o remains constant.es in the . #d + >.00*000.0>1) = .e of . This can be shown . where #o is fairl. to this approach* there is no optimal capital structure.i$en b-A &= 95IT + (.es in the financin.1. The financin.earin.*000*000 #o The $alue of debentures + (4*000*000 Thus e/uit.C. mi" does not effect the a$era.0 T89 N9T O%9R'TINE INCO69 '%%RO'C8 'ccordin. 1*000*000 @ . There is debt of (4 million in the capital structure.*000*000 − ( 4 m " . Illustration 0. and 7'CC #o! + 10.raphicall.is worth (1*000*000 #s = .earin. 0. i.raph demonstrations that there is a ran. mi".
1) = 10.00*00 = + (. income approach is the beha$ioural model de$eloped b.eared. as before! .offset use of cheaper debt Re/uired rate of return for in$estment is independent of the financin.101) " 4 m = 10.eared with 1. &alue of the firm is still (.s constant Initial assumption of no ta"es Dirms can be classified into Ge/ui$alent ris#: classes.liani and 6iller. ar. decision.0>1 + (1 m " .1 The 6odi.10 The $alue of e/uit. income approach that #o is constant.uments in fa$or of the net operatin.a is un.liani B 6iller 6odel One of the leadin. Their propositions are 1! )! 0! Total mar#et $alue of firm is independent of capital structure #s increases to e"actl. #o . . (. m.) a! Two companies ' H 5! ha$e identical capital re/uirements of (100*000.0>1! = 10. Compan5 is 00. Illustration 0. > .. m If debt is increased to (1 million* #o remains constant.6odi. 6odi.7'CC = (4 m " . as & = 95IT (.m 0.oes upA #s = #o = .0>1 + . 4m 1 m " . debtF Compan.m. m < 1 m " . Their model has some crucial assumptionsA 1! )! 0! 4! Capital 6ar#ets are perfect B 'll in$estors ha$e perfect cost<free information 9"pected future earnin.liani and 6iller fa$or the net operatin.1).
and in$est in compan. shares in 5 and bu-in. them in '.' in the followin.5 will ta#e ad$anta.earin.liani B 6iller ar.earnin. . of a compan. i..satisfied with the ris# of a 00.5 .e and will ha$e the effect of decreasin.e.ue that the abo$e situation is not stable. him total funds of (10*@0@. wa-A 3tep I 3tep II < 8e will sell his shares in compan.sellin. for the corporate . the mar#et $alue of shares in ' suppl. the mar#et $alue of shares in 5 and increasin. N.5 10*000 >*100 <<<<<<<<<<< 4)*100 .5 and reali=e (0?*@0@. < 8e will borrow (11*000 at 1. Note that he owns 10. of compan.that is 00.' Net operatin.i$es an e/ual # o in both companies. This process will continue until the share prices stabili=e at a $alue that . . 8e will now substitute a personal . .i$es him a return of (4*)10 10. This has a mar#et $alue of (0?*@0@* and .0. (110*000 (10@*0@4 + (11*000 (10*@0@ ? .i$in. 100*000 Compan.eared in the same proportion as compan.Compan. of (4)*100!.10 <<<<<<<<<< 100*000 < <<<<<<<<<<< (100*000 10*000 10@*0@4 6id. ' shareholder in compan. + 10*000 < <<<<<<<<<<< 10*000 .i$es him* b.11 <<<<<<<<<<< 0?@*0@4 110*000 <<<<<<<<<<< (10@*0@4 = .earin. Illustration 0.5.) b! 'ssume that a shareholder owns 10.s + assumed e/uit. 8e is now .5. income Debt interest 9/uit. of 00..earin.capitali=ation rate 6ar#et $alue of e/uit6ar#et $alue of debt 6ar#et $alue of firm #o + 10*000 = 10.5.e of the better share price the lower # o for compan.eared and is presumabl.and demand function!. This process is called arbitra.
in compan. for corporate .be less attracti$e.e occurs across firms with different ris#. as companies at the same cost. This is the same as he was recei$in.5 but he now has (0*@0@ a$ailable for consumption. costs are .ainst the 6odi.nificant a . )! 0! The percei$ed ris#s of personal and corporate .ests that the arbitra.uments a.. 0! 4! Capital mar#ets are perfect..her than corporate costs.on corporate debt.not wor# perfectl1! If there is a possibilit. 0. 'r. 'll propositions can be illustrated b.10. ma.e process ma.eared firm ma.earin. Dirms can be classified into e/ui$alent ris# classes.eneral e/uilibrium anal-sis where arbitra.earin. The beha$ioral model su.be different because of limited liabilit.i$e him a return of (1*000 from which he must pa.ain from the process and at that point # o will be identical in both companies.unli#el-. This will .earin. This is $er.e proof of the 6<6 thesis is not dependent on e/ui$alent ris# classes.earin.the arbitra. There are no transaction costs in the arbitra. . %ersonal borrowin.enerall. a net return of (4*)10.'* which will cost (10*000.e process.e process will continue until no shareholder can ma#e a .his debt interest of (>10 lea$in. 'll in$estors ha$e access to perfect* cost<free information. NoteA it is possible to demonstrate that the arbitra. In perfect mar#ets if the firm is li/uidated all assets are reali=ed with =ero costs.hi.of ban#ruptc. The crucial factor is the assumption of rational in$estors who will substitute personal .and if these costs are si.liani B 6iller 6odel 'ssumptions 1! )! 3hareholders can obtain the same personal .3tep III < 8e will bu. of compan.) 'ssumptions and criticism of the 6odi..liani B 6iller position These are based on reasons wh. .
6odi. corporation ta" into the model # o can be lowered b.law.are too .be precluded from Gpersonal: borrowin.ar. must lower # o and increase the $alue of the firm.earin. The . 10 .introducin.earin..earin.earin. the total $alue of the firm cannot be altered throu. 7hen . 9"treme Eearin.eneral. In$estors do not ha$e access to perfect* cost<free information.ni=e that b..to the contention that shareholders became relati$elless ris#<a$erse with e"treme . rate to offset the increase in #d.uin.the .earin. debt so the .ainst corporation ta".o$ernment is subsidi=in.e.4! 1! @! Transaction costs restrict arbitra.reater the debt the .a hi.es and the ris#ier the loan. Therefore .0 The Introduction of Ta"ation 7hen corporate ta"ation is introduced into the models #d must be decreased as debt interest is allowed a.reater the subsid. 6<6 den.h .. 6an.in to beha$e in a manner consistent with Ghomemade: .authorities object stron. bthe articles or b. that the.l.her interest rate on debt.reater the $alue of the firm. as there are enou. The.liani B 6iller are on much wea#er . 6odi.earin.and the . case.reater the .h mar#et participants at the mar. The 6<6 approach is most $ulnerable at e"treme le$els of .earin. 9ffecti$el. the lower the co$era. their thesis for the e"treme ..earin.est that as lon.round in defendin.e of fi"ed char.su..earin. reaches a certain le$el #d will rise as debt in$estors e"pect the firm to pa. 9$en if #d rises* 6<6 maintain the #o will be constant because #s will increase at a decreasin. 3ome institutional in$estors ma. The implication of this is that a firm should ma"imi=e its debt.liani B 6iller reco.the importance of these criticisms b.. 0.
or shares at per can be issued to raise the finance re/uired. raisin. 'n 9. 11 .earin.&. and the rate of corporation ta" to be used is 10.%. One other factor which influences the capital mi" is the attitude of companmana.er should carefullconsider the implications of issuin.s per share 9%3! of possible capital structures.5..ement.%roponents of the traditional model ar. The implication is that debt funds are simpl.of e"aminin.s per share.earin. ta"<allowances as a subsid-* # o can be reduced b. The 6odi.s before ta" is estimated to be (000*000 p.with an increase in financial ris#.s before ta" and interest for $arious capital structures.es in the financin.0 CONCIU3ION3 ON C'%IT'I 3TRUCTUR9 In the absence of perfect capital mar#ets and with the e"istence of corporate ta"es* an optimal structure is implied b.in the capital structure would . the actual mar#et $alue of a compan-:s shares* the financial mana.ain on wea#est .earin. mi". O$er a fairle"tensi$e ran.round for e"treme . 't present the entire capital comprises e/uit.earin.I.is b. imposed b. and the 9arnin. 't different le$els of earnin.less sensiti$e to chan. 1.1 Dirm 8. Itd. B 9.increasin.0 95IT B 9. are considerin.earin.ar. ()00*000 for a new project. ' li#elle$el of earnin.will percei$e a decrease in their job securit. 'N'IJ3I3 One wa. one t-pe of capital as opposed to another.ement will tend to put constraints on the le$el of .liani B 6iller should feel uncomfortable: &an 8orne!.e of .e"aminin.introducin.#o will rise.s* different combinations of debt and e/uit.et debt ratio: that does not $iolate an.this is a position with which 6odi.earin.both the 6<6 and the traditional $iew. debt or e/uit.%. 3ince 9%3 is usuall. 's emplo-ees* mana.refused be-ond a certain point. GCertainl.liani B 6iller reco.3. .creditors..liani B 6iller thesis is a. the effect on earnin. and the. chart shows .ni=e that b. It is estimated that either debt at ?. Decisions on the optimum le$el of debt will differ from firm to firm and should in$ol$e considerations of the firm:s future strate.ies and e"ternal factors li#e the rate of inflation.3.T.limits on . #o is relati$el.of (?00*000 in shares of (1 each.an important factor in determinin.a.ue that a firm should aim for a Gtar.i$e different earnin. as the.ue that e"treme .raphicall. 6odi. 4.the relation between 9. This implies that #o would rise be-ond this point and that there is an optimal capital structure. must increase financial ris# and e$entuall.%. Illustration 1.3. the /uestion of issuin.
ure* usin. ). It can be seen that the brea#e$en point in the abo$e chart is at an 95IT fi.ure of (?0*000. 1..can be arri$ed at b.her 9%3* while below this fi.i$es a hi.s per share 'n 95ITK9%3 chart can now be drawn.calculatin.her 9%3.11 95IT Interest C ?.i$e a =ero 9%3. Dor e/uit.1>>1 9/uit( 000*000 < <<<<<<<<< 000*000 110*000 ++++++ 1*000*000 .ure* use of e/uitresults in a hi.i$e the same 9%3. The Gstartin. Dor debt 95IT + 1@*000 the amount of the debt interest! when 9%3 is =ero. debt . The point where the two lines cross each other is the brea#e$en or indifference point.9arnin.95IT + 0* when 9%3 is =ero.s per share under the two alternati$es at an 95IT le$el of (000*000! would beA Debt ( 000*000 1@*000 <<<<<<<<< )?4*000 14)*000 ++++++ ?00*000 . point: for debt and e/uit. Ta" C 10. Number of shares in issue 9arnin. 't 95ITs of o$er this fi. the re/uired 95IT under both alternati$es to . this can be confirmed as followsA 1) . 't this point* both debt and e/uit.
00 Number of shares in issue 9%3 The brea#e$en point can also be calculated al. The probabilit. @0*000 1@*000 <<<<<<<<< 44*000 ))*000 <<<<<<<<< ))*000 +++++ ?00*000 . Ta" C 10. The increase in the financial ris# of the business b.Debt 95IT Interest C ?. " < 1@! ?00 ?00 " B 0! ?00 " B 0! ?00 " " 1*000 " B 1@! 1*000 " B 1@*000 1@*000 ?0 It should be noted that 95IT B 9%3 anal-sis ta#es onl.ures in (:000!.er:s decision to introduce debt in the capital structure.)>1 9/uit@0*000 < <<<<<<<<< @0*000 00*000 <<<<<<<<< 00*000 +++++ 1*000*000 .ebraicall. " < 0! 1*000 Debt + + + + + 10.the e"plicit costs of debt into account.ta#in. 9/uit10. 10 .fi.of future profits bein. on debt should also be considered. abo$e a brea#e$en point would also effect the financial mana.