Net income approach- effect of leverage on

cost of capital
 MODIGLIANI- MILLER APPROACH
• The basic theorem states that, under a certain
market price in the absence of taxes, 
bankruptcy costs, agency costs, and 
asymmetric information, the value of a firm is
unaffected by how that firm is financed.
 In the absence of taxes
• This theory proves that the cost of capital is
not affected by the changes in the capital
structure.
 ASSUMPTIONS
• Perfect Capital Market.
• 100% dividend payout ratio
• Homogeneous risk class
• Investors act rationally
• No taxes.
• X Ltd. Has no debt. EBIT= Rs 24 Lacs. There are
no taxes. It pays all its income as dividends. If
the company borrows debt @ 8%. Money
raised by selling debt would be used to retain
common stock. Equity shareholders demand a
rate of 12%, if no debt is used.
Determine( assuming a debt of Rs 1 crore)
market value of firm, Market value of
equity,and leverage cost of equity).
• Market value of firm- EBIT/Ke
• Value of Equity- V- D
• Leverage of Cost of Equity- Ke+(Ke – Kd)
 When taxes are assumed to exist.
• This theory proves that the value of firm will
increase or cost of capital will decrease with
the use of debt.
• A co. has an EBIT of Rs 1 lakh. It expects a
return on its investment @ 12.5%. Find out
the value of firm according to MM approach.
• Value of firm- EBIT/ Ko
• MM Approach Without Tax: Proposition I
 MM’s Proposition I states that the firm’s value
is independent of its capital structure. With
personal leverage, shareholders can receive
exactly the same return, with the same risk,
from a levered firm and an unlevered firm. Thus,
they will sell shares of the over-priced firm and
buy shares of the under-priced firm until the
two values equate. This is called arbitrage.
• MM’s Proposition II
 The cost of equity for a levered firm equals the
constant overall cost of capital plus a risk premium that
equals the spread between the overall cost of capital and
the cost of debt multiplied by the firm’s debt-equity
ratio. Forfinancial leverage to be irrelevant, the overall
cost of capital must remain constant, regardless of the
amount of debt employed. This implies that the cost of
equity must rise as financial risk increases.
• Copyright © 2008, Dr Sudhindra Bhat