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²  :  


f
by ² ony. The oher (F
rm L)

evered:

f
nanced pary by equ
y, and pary by deb. The )od

an
)
er
heorem saes ha he vaue of he  o f
rms
s he same.

Ú


 
{

 



where, 3 
  
      = pr
ce of buy
ng a f
rm
composed ony of equ
y, and 3

 
   = pr
ce of buy
ng a f
rm
ha
s composed of some m
of deb and equ
y.
To see why h
s shoud be rue, suppose an
nvesor
s cons
der
ng buy
ng one of he
wo f
rms U or L. Insead of purchas
ng he shares of he evered f
rm L, he coud
purchase he shares of f
rm U and borrow he same amoun of money + ha f
rm L
does. The evenua reurns o e
her of hese
nvesmens woud be he same.
Therefore he pr
ce of L mus be he same as he pr
ce of U m
nus he money
borrowed +, wh
ch
s he vaue of L's deb.
Th
s d
scuss
on aso car
f
es he roe of some of he heorem's assump
ons. We have

mp
c
y assumed ha he
nvesor's cos of borrow
ng money
s he same as ha of
he f
rm, wh
ch need no be rue
n he presence of asymmer
c
nforma
on or
n he
absence of eff
c
en markes.
{

 



Propos

on II w
h r
sky deb. As everage (D/E)
ncreases, he WA44 (k0) says
consan.

c
c


ëc ˜ 
   

 









ëc ˜0 






 

ëc ˜ 
   

 



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ëc + / 




 


A h
gher deb o-equ
y ra
o eads o a h
gher requ
red reurn on equ
y, because of he
h
gher r
sk
nvoved for equ
y-hoders
n a company w
h deb. The formua
s der
ved
from he heory of we
ghed average cos of cap
a (WA44).
These propos

ons are rue assum
ng he foow
ng assump
ons:

ëc no axes ex
s,
ëc no ransac
on coss ex
s, and
ëc Ind
v
duas and corpora
ons borrow a he same raes.

These resus m
gh seem
rreevan (afer a, none of he cond

ons
s me
n he rea
word), bu he heorem
s s
 augh and sud
ed because
 es us someh
ng very

mporan. Tha
s, cap
a srucure maers prec
sey because one or more of hese
assump
ons
s v
oaed. I es us where o ook for deerm
nans of op
ma cap
a
srucure and how hose facors m
gh affec op
ma cap
a srucure.

Ú

 
{

 



Where,

ëc 3

 
  

ëc 3 
 
   
 
ëc  + 

 


 

+

ëc he erm  + assumes deb
s perpeua
Th
s means ha here are advanages for f
rms o be evered, s
nce corpora
ons
can deduc
neres paymens. Therefore everage
owers ax paymens. D
v
dend paymens are non-deduc
be.
{

 



c

c
 Where,

ëc 
   

 









ëc 0 






 

ëc + 
   


 



 






ëc + / 




 



ëc  

 

The same rea
onsh
p as ear
er descr
bed sa
ng ha he cos of equ
y r
ses
w
h everage, because he r
sk o equ
y r
ses, s
 hods. The formua
however has
mp
ca
ons for he d
fference w
h he WA44. The
r second
aemp on cap
a srucure
ncuded axes has
den
f
ed ha as he eve of
gear
ng
ncreases by repac
ng equ
y w
h cheap deb he eve of he WA44
drops and an op
ma cap
a srucure does
ndeed ex
s a a po
n where deb

s 100%.
The foow
ng assump
ons are made
n he propos

ons w
h axes:

ëc corpora
ons are axed a he rae  on earn
ngs afer
neres,
ëc no ransac
on coss ex
s, and
ëc
nd
v
duas and corpora
ons borrow a he same rae
)
er and )od
g
an
pub
shed a number of foow-up papers d
scuss
ng
some of hese
ssues.
The heorem was f
rs proposed by F. )od
g
an
and ). )
er
n 1958.

Y
 
Y 

Y 
Assume a perfec cap
a marke (no ransac
on or bankrupcy coss; perfec

nforma
on); f
rms and
nd
v
duas can borrow a he same
neres rae; no axes; and

nvesmen dec
s
ons aren' affeced by f
nanc
ng dec
s
ons. )od
g
an
and )
er
made wo f
nd
ngs under hese cond

ons. The
r f
rs 'propos

on' was ha he vaue
of a company
s
ndependen of
s cap
a srucure. The
r second 'propos

on' saed
ha he cos of equ
y for a everaged f
rm
s equa o he cos of equ
y for an
uneveraged f
rm, pus an added prem
um for f
nanc
a r
sk. Tha
s, as everage

ncreases, wh
e he burden of
nd
v
dua r
sks
s sh
fed beween d
fferen
nvesor
casses, oa r
sk
s conserved and hence no exra vaue creaed.

c
c
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Y

 
4os of equ
y = @
sk free rae of reurn + Prem
um expeced for r
sk
a
 
The expeced reurn (or requ
red rae of reurn for
nvesors) can be cacuaed w
h he
Ed
v
dend cap
a
a
on modeE, wh
ch
s

c c
Tha equa
on
s aso seen as: Expeced @eurn = d
v
dend y
ed + growh rae of
d
v
dends.c
Y


 


 

The cap
a asse pr
c
ng mode (4AP))
s used
n f
nance o deerm
ne a heore
cay
appropr
ae pr
ce of an asse such as a secur
y. The expeced reurn on equ
y
accord
ng o he cap
a asse pr
c
ng mode. The marke r
sk
s normay characer
ed
by he ȕ parameer. Thus, he
nvesors woud expec (or demand) o rece
ve:

c
Where:
a = The expeced reurn for a secur
y



















The expeced r
sk-free reurn
n ha marke (governmen bond y
ed)

M

















The sens

v
y o marke r
sk for he secur
y


















The h
sor
ca reurn of he sock marke/ equ
y marke

½









The r
sk prem
um of marke asses over r
sk free asses.

V 



ëc The expeced reurn (%) = r

sk-free reurn (%) + sens

v
y o marke r
sk *
(h
sor
ca reurn (%) - r
sk-free reurn (%))

ëc Pu anoher way he expeced rae of reurn (%) = he y

ed on he reasury noe
coses o he erm of your pro5ec + he bea of your pro5ec or secur
y * (he
marke r
sk prem
um)

he marke r
sk prem
um has h
sor
cay been beween 3-5%
ëc
Y  
The mode saes ha
nvesors w
 expec a reurn ha
s he r
sk-free reurn pus he
secur
y's sens

v
y o marke r
sk 
mes he marke r
sk prem
um.

c

c
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c
c
 14% Debenures 3,00,000 0.15
11% Preference 1,00,000 0.05
Equ
y 16,00,000 0.80

„ „

c
c c


 
c c c

c c
cccccccccccccccccccccccccc c


  
 
     
 

 


 
  


 

½
„

c
c c  c 



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c
c c


c 

c
c
 4acua
on of g: I can be observed from he pas rends of EPS ha

s grow
ng
a an annua compound rae of 10%. For exampe,

Us
ng Tabe, we f
nd ha he presen vaue facor of 2.36 a he end of 9h year
s
oba
ned when he
neres rae
s 10%.




cc
c

 

c½c 
c c½ c
c½ c

Deb 0.15 0.0833 0.0125

Preference 0.05 0.1200 0.0060

Equ
y 0.80 0.1500 0.1200

)arg
na cos of cap
a 0.1385

c
c
ñ The marg
na cos of cap
a ()44)
s he we
ghed average cos of new cap
a.
The f
rm woud ma
na
n
s ex
s
ng cap
a srucure. Therefore, new cap
a
woud be ra
sed
n propor
on o he ex
s
ng cap
a srucure.

Y The company can spend he foow

ng amoun w
hou
ncreas
ng
s ))4 and
w
hou se
ng he new shares:

ý 
  
½

½ý

  


ý
 



The ord
nary equ
y (rea
ned earn
ngs
n h
s case)
s 80% of oa cap
a. Thus

+ If he company spends more han @s 1,47,500 ,

 w
 have o
ssue new shares.
The cos of new
ssue of ord
nary shares
s:

The marg
na cos of cap
a
n excess of @s. 1,47,500
s:

c

c
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