Nprakash 1

 Introduction
 Corporate and personal taxation
 Modifying MM propositions to account for corporate taxes
 Traditional trade-off theory, Agency theory and leverage
decision
 Asymmetric information and leverage
 Balancing agency costs with information asymmetry.

Nprakash 2
 Capital structure refers to the pattern of funding a company's long
term funding requirements.
 It represents the proportionate relationship between Debt and
Equity.
 Debt includes Debentures, Term Loans, Preference shares and
Leasing.
 Equity includes paid-up equity capital, share premium, reserves and
surplus.
 The Debt-equity mix has a bearing on the capital structure of the
company which affects the shareholder’s earnings and risk, which
in turn will affect the cost of capital and the market value of the
firm.
 Capital Structure can affect the value of a company by affecting
either its expected earnings or the cost of capital or both .

Nprakash 3
 Financing mix cannot affect the total operating earnings of a
firm, as they are determined by the investment decisions, it
can affect the share of earnings belonging to the equity
shareholders.
 The capital structure decision can influence the value of the
firm through the earnings available to the shareholders. It
can affect the value of the firm through the cost of capital.

Nprakash 4
Debt Equity
-Fixed claim -Residual claim
-High priority on -Lowest priority
payments -Not tax deductible
-Tax deductible -Perpetual or infinite life
-Fixed maturity -Management control
-No management control

Nprakash 5
 A firm should select such financing mix which maximises its
value/shareholders wealth long term.
 Theoretically, it (optimum capital structure) is the capital
structure at which the weighted average cost of capital is
minimum thereby maximising value of the firm.
 Determination of optimum capital structure is difficult
because a number of factors influence its decision.
 There is no definite model that can suggest ideal capital
structure for all business undertakings because of the varying
circumstances.
 Different industries follow different capital structures and
within an industry different companies follow different capital
structures.
 It is more of an appropriate capital structure than the
theoretical optimum capital structure.
Nprakash 6
A sound capital structure should have the following features:
 Profitability – use of leverage to obtain best advantage for

equity shareholders.
 Solvency – ensure minimum financial risk. Use of excessive

debt independent of future profitability threatens the solvency

of the firm.
 Flexibility – to meet changing requirements when needed.
 Conservatism – the future cash flows should be able to

service the debt as per schedule.

 Control - minimum risk of loss of control of the company.

The relative importance of each may differ for each firm.

Nprakash 7
 Financial Risk –
◦ Risk of cash insolvency because of an uncertainty in future
cash flows.
◦ Risk of variation in expected earnings to shareholders.
Earnings to shareholders will increase if the return on
investment is higher than the cost of debt and vice versa.
 Cost of capital - cost of a source is the minimum return
expected by its suppliers which depends on the degree of risk
(risk return). Theoretically the optimal debt equity mix for the
company is at a point where the overall cost of capital is
minimum.
Cost of Debt Cost of new Cost of
Cost of Pref. retained
Cost of Debt issue of equity
shares earnings
shares

Nprakash 8
 Cash flow ability to service debt – servicing of debts
does not merely depend on the sufficient profits, but
availability of cash. It is necessary to estimate cash flows
before deciding on the proportion of debt.
The analysis brings together the business and financial
risk of a company. It allows to address the likelihood of
insolvency and the cost therein.
 Control – balancing between dilution of control because

of more equity and financial risk arising out of variation

in expected future earnings in the use of debt.
 Flexibility – ability to change the composition in future.

Promoters often use unsecured debt to achieve flexibility.

Nprakash 9
 Size of Company – often smaller companies have to
depend on owner’s funds because of reluctance of
lenders in providing long term debt.
 Taxes – The degree to which a company is subject to

taxation is very important.

Much of the advantage of debt is tax related. If the
company pays little or no tax, debt is far less attractive
than it is for the company subject to the full corporate
tax rate.

Nprakash 10
 Firms stage in the lifecycle :
◦ Start-ups – owner’s equity and bank debt.
◦ Expansion - investment needs will be high and will generally
look for private equity or venture capital or Issue of IPO.
◦ High Growth - firms will look for more equity issues. If using
debt, convertible debt is most likely to be used.
◦ Mature growth – the earnings and cash flows will continue to
increase reflecting the past investments. Need for investments in
new projects will decline. Funding needs will be covered by
internal accruals, debts or bonds.
◦ Decline – existing investments will continue to yield cash flows
but at a lower pace. Firms unlikely to make fresh funding and are
likely to retire existing debt and buy back stocks.
 Others : market conditions, period of finance, industry
(capital intensive).
Nprakash 11
 Typical Income Statement

   

Total Revenue    

Less Variable Costs    

Contribution    

Less Fixed Costs    

Operating
Income
Earnings before interest and tax (EBIT)    

Less Interest on Debt    

Profit Before tax (EBT or PBT)    

Less Corporate Tax    

Profit After Tax (EAT or PAT)    

Less Preference Dividend (if any)    

Equity Earnings    

   

Nprakash 12
Typical Income Statement

Total Revenue    

Less Cost of Goods Sold (COGS)    

Gross Profit    

Less Operating Costs (Salaries, rents,

administrative expenses, D&A & other
expenses)    

Operating Profit (EBIT)    

Less Interest on Debt    

Profit Before tax (EBT or PBT)    

Less Corporate Tax    

Profit After Tax (EAT or PAT)    

Less Preference Dividend (if any)    

Equity Earnings    

   
Nprakash 13
 Return on equity at various debt levels
(value in Rs.)
Debt/capital
0 percent  10 percent  20 percent  30 percent

Equity 10,000 9,000 8,000 7,000

Debt 0 1,000 2,000 3,000
Total Capital 10,000 10,000 10,000 10,000
EBIT 3,000 3,000 3,000 3,000
Interest @ 15% 0 150 300 450
PBT 3,000 2,850 2,700 2,550
Tax @ 35 percent 1,050 998 945 892
PAT 1,950 1,852 1,755 1,658
ROE (percentage) 19.50 20.57 21.93 23.68

Nprakash 14
Debt/equity ratios of some top companies (2008)
Industry   Company  D/E
Automobile 
Maruti Suzuki 0.106
Bajaj Auto 0.288
Mahindra 0.439
Tata Motors 0.574
Telecom
Bharti Airtel 0.410
Reliance Comm. 0.810
Diversified
ITC 0.019
L&T 0.358 
Grasim Ind 0.472

Pharmaceuticals 
Cipla 0.036
Dr. Reddy’s 0.074
Ranbaxy 1.273

Nprakash 15
 Risk attached to a firm can be divided into two categories –
Business risk and Financial risk.
 Business Risk arises because of the variability of EBIT. It
results from internal and external environment (business cycle,
technological obsolescence) in which the firm operates. It is
measured by calculating operating leverage. Its degree does
not differ with the use of different forms of financing.
 Financial Risk arises because of the variability of EAT. It
results from use of financial leverage – source of funds
bearing fixed returns like debt. It is associated with the capital
structure decision and the degree varies with use of different
forms of financing.

Nprakash 16
 Leverage refers to use of funds bearing fixed financial
payments like debt in the capital structure.
 Operating Leverage affects a firm’s Operating Profit (EBIT)
while the Financial Leverage affects Profit After tax (EAT /
PAT) or EPS.
 Degree of Operating Leverage is defined as “the percentage
change in the EBIT relative to a given percentage change in
sales”. It exists because of fixed costs. Example: DOL of 1.5
means for a 1% increase in sales will result in 1.5% increase in
EBIT.
% change in EBIT OR EBIT /EBIT
DOL = % change in Sales Sales/Sales

Q (S-V) OR Contribution
DOL = Q (S-V) – F EBIT
Nprakash 17
 Financial Leverage is a measure of Financial Risk.
 Degree of Financial Leverage is defined as “the

percentage change in the EPS due to a given percentage

change in EBIT”
% change in EPS EPS/EPS

DFL = % change in EBIT OR EBIT/EBIT

EBIT
Q (S-V) – F If no pref .dividend = EBT
DFL = Q(S-V) - F - I
EBIT
If preference dividend exists = EBT – ( Pref. dvd / 1-t)
Nprakash 18
 Combined Leverage :
Operating and Financial Leverages together cause wide
fluctuations in EPS for a given change in sales. If a
firm employs a high level of Operating and Financial
Leverage, a small change in the level of sales will have
a dramatic effect on EPS.

% change in EBIT X % change in EPS

DCL = % change in Sales % change in EBIT

= % change in EPS OR Contribution

% change in Sales Profit before tax
Nprakash 19
 Capital budgeting Decision
◦ Replacement
◦ Modernisation
◦ Expansion
◦ Diversification
 Funding Decisions
◦ Internal sources
◦ Debt
◦ External equity
 Capital Structure Decision
◦ Existing Capital Structure
◦ Payout Policy
◦ Desired Debt-Equity Mix
 Effect on Return Effect on Cost of Capital
 Effect on Risk Value of the firm

Nprakash 20
 Capital structure theories explain the theoretical
relationship between Capital Structure, Overall Cost
of Capital (Ko) and Valuation (V).

The 4 important theories of capital structure :

1. Net Income Approach (NI)
2. Net Operating Income Approach (NOI)
3. Traditional Approach
4. Modigliani Miller Approach (MM)

Nprakash 21
Kd = I / MVd where Kd is cost of debt, I is annual
interest charge, MVd is market value of debt
Ke = E/MVe where Ke is cost of equity, E is equity
earnings and MVe is market value of equity
Ko = EBIT/V where V is market value of firm or the
weighted average cost of capital
Alternatively
Ko = Kd (MVd/(MVd+MVe) + Ke(MVe/MVd+MVe)

Nprakash 22
 NI approach suggested by Durand states that the
weighted average cost of capital (Ko) of a firm is
dependent on its capital structure. A firm can change its
value and cost of capital through a judicious mix of
Debt and Equity.
 If the degree of financial leverage as measured by the

ratio of Debt- Equity is increased, the weighted

average cost of capital will decline, while the value of
the firm as well as the market value of equity will
increase. The reverse will hold good if the Debt-
Equity is decreased.

Nprakash 23
Assumptions in NI Approach
1. No Taxes - there are no corporate taxes.
2. Kd < Ke - the cost of debt is less than the cost of equity.
3. No change in risk - there is no change either in the cost of
debt or equity.
 The cost of debt and cost of equity being constant, increased use
of debt (increase in leverage) will increase equity earnings and
thereby market value of the equity shareholders.
 With a judicious mix of debt and equity, a firm can evolve an
optimum capital structure which will be the one where the value
of the firm is the highest and the overall cost of capital will be
the lowest. At this level, the market price per share will be the
maximum.
 If the firm uses no debt at all - means that the financial leverage
is zero, the overall cost of capital will be equal to the equity
capitalisation rate (cost of equity).
Nprakash 24
Effect on…. Effect of increase Effect of decrease
in Leverage in Leverage
Weighted Average Cost Decreases : because Increases : because of
of Capital ( Ko) of advantage disadvantage
associated with use of associated with the
relatively less use of relatively more
expensive debt expensive equity

Total Value of firm (V) Increases : because of Decreases : because

decrease in Weighted of increase in
Average Cost of Weighted Average
Capital Cost of Capital

Nprakash 25
 Ke
.10
Cost of Capital

Ko
Kd
.05

O
Degree of Leverage

Nprakash 26
Value of the Firm (NI Approach)
Rs.
Net Operating Income (EBIT) 50,000
Less Interest on Debentures (I) 20,000
Earnings available to equity holders (NI) 30,000
Equity Capitalisation rate (K e) 0.125
Market Value of Equity (Mve) NI/Ke = 30,000/0.125 2,40,000
Market value of Debt (MVd) 2,00,000
Total Value of Firm (V) 4,40,000

Overall Cost of Capital (Ko) EBIT/V= 50,000/440,000 11.36%

Nprakash 27
Value of the Firm (NI Approach)
Rs.
Net Operating Income (EBIT) 50,000
Less Interest on Debentures (I) 30,000
Earnings available to equity holders (NI) 20,000
Equity Capitalisation rate (K e) 0.125
Market Value of Equity (Mve) NI/Ke = 20,000/0.125 1,60,000
Market value of Debt (MVd) 3,00,000
Total Value of Firm (V) 4,60,000

Overall Cost of Capital (Ko) EBIT/V= 50,000/460,000 10.86%

The use of additional debt has caused the total value of the firm to increase from
Rs. 4,40,000 to 4,60,000 and the overall cost of capital has decreased from
11.36% to 10.86%

Nprakash 28
Value of the Firm (NI Approach)
Rs.
Net Operating Income (EBIT) 50,000
Less Interest on Debentures (I) 10,000
Earnings available to equity holders (NI) 40,000
Equity Capitalisation rate 0.125
Market Value of Equity (Mve) NI/Ke = 40,000/0.125 3,20,000
Market value of Debt (MVd) 1,00,000
Total Value of Firm (V) 4,20,000

Overall Cost of Capital (Ko) EBIT/V= 50,000/420,000 11.90%

The decrease in the leverage has increased overall cost of capital and has
reduced value of the firm

Nprakash 29
 NOI approach states that weighted average cost of
capital of a firm (Ko) is independent of its capital
structure.
 A firm cannot change its value (V) and cost of capital

through any change in the mix of Debt and Equity.

 As per NOI approach, there is nothing like an optimum

capital structure. Rather every capital structure is an

optimal one.

Nprakash 30
 Constant Kd – the debt capitalisation rate is constant.
 Constant Ko – The weighted average cost of capital (Ko) is
constant for all degree of debt equity mix since business risk on
which Ko depends is assumed to remain constant.
 No Split – the market capitalises value of a firm as a whole. The
split between debt and equity is not important.
 Neutralisation – increase in the proportion of debt in the capital
structure will lead to increase in the financial risk of equity
shareholders. The advantage associated with the use of the
relatively less expensive debt in terms of explicit cost is exactly
neutralised by the implicit cost of debt represented by the
increase in the cost of equity capital.
 No Taxes – there are no corporate taxes.
Nprakash 31
Effect on…. Effect Effect of Increase in Leverage
Equity Increase Increase in the proportion of Debt in the capital
Capitalisation structure will lead to increase in the financial
Rate (Ke) risk of equity shareholders. To compensate for
the increased financial risk, the shareholders
would expect a higher rate of return on their
investments.
Weighted Remain Advantage of using less expensive Debt in
Cost of Constant terms of explicit cost is exactly neutralised by
Capital (Ko) the implicit cost of debt represented by the
increase in the cost of equity capital.
Total Value of Remain Since Ko remain constant.
the firm (V) Constant

Nprakash 32
Effect on…. Effect Effect of decrease in Leverage
Equity Decrease Decrease in the proportion of Debt in the capital
Capitalisation structure will lead to decrease in the financial
Rate (Ke) risk of equity shareholders. For the decreased
financial risk, the shareholders would expect a
lower rate of return on their investments.
Weighted Remain Disadvantage of using less expensive Debt in
Cost of Constant terms of explicit cost is exactly neutralised by
Capital (Ko) the advantage in terms of decrease in the
implicit cost of debt represented by the decrease
in the cost of equity capital.
Total Value Remain Since Ko remain constant.
of the firm Constant
(V)
Nprakash 33
 Ke
Cost of Capital (per cent)

. Ko

Kd

O
Degree of Leverage

Nprakash 34
 This approach is also known as Intermediate approach as it takes
a midway between NI approach (the value of firm is dependent of
the degree of financial leverage) and the NOI approach (the value
of the firm is independent irrespective of the degree of financial
leverage).
Basic Propositions of Traditional Approach
1)Upto a reasonable limit of leverage, the cost of debt (Kd) plus
the increased cost of equity (due to the use of debt) will be less
than the cost of equity (Ke) (in case of only equity financing).
As a result, the overall cost of capital (Ko) is decreased and the
value of the firm (V) increases.
At this limit, the capital structure is optimum since the overall
cost of capital is the least and the value of the firm is
maximum.
Nprakash 35
2)Beyond the reasonable limit of leverage, the cost of debt
(Kd) plus the increased cost of equity (Ke) (due to the use of
debt) will be more than the cost of equity (in the case of
equity financing only) since the financial risk of the equity
shareholders and the suppliers of debt also start increasing.
As a result the overall cost of capital (Ko) increases and the
value of the firm (V) decreases.

Nprakash 36
 Ke
Stage II
Cost of Capital (per cent)

Ko
.

Stage III
Stage I
Kd

O
Degree of Leverage

Nprakash 37
 Stage I Increasing Value : Ke either remains constant or increases
slightly with debt. Ke does not increase fast enough to offset the
advantage of low-cost debt. During this stage Kd remains constant.
Ko decreases with increasing leverage and value of firm V also
increases.
 Stage II Optimum Value : Beyond stage I any subsequent increase
in leverage have a negligible effect on Ko and hence value of the
firm. Increase in Ke due to the added financial risk just offsets the
advantage of low cost debt. Within this range, at a specific point
Ko will be minimum and the value of the firm will be maximum.
 Stage III Declining Value : Beyond the acceptable level of leverage,
the value of the firm decreases with leverage as Ko increases with
leverage. Investors perceive a high degree of financial risk and
demand a higher equity capitalization rate which exceeds the
advantage of low-cost debt.
Nprakash 38
 Franco Modigliani and Merton Miller (M & M) revolutionized the financial
world when they published their article “The Cost of Capital, Corporation
Finance and the Theory of Investment” in The American Economic
Review in June 1958.
 Prior to their landmark study, the "traditional approach" to capital structure
maintained that there was an optimal level of debt that a company should
have.
 In other words, according to the traditional approach, there was one "best"
debt-to-equity ratio for a company and Managers should identify this point
and not deviate from it.
 M & M wrote their groundbreaking article when they were both professors at
the Graduate School of Industrial Administration of Carnegie Mellon
University. Miller and Modigliani were set to teach corporate finance for
business students despite the fact that they had no prior experience in corporate
finance.
 Modigliani was awarded Nobel Prize in 1985 for this & other contributions
and Miller got Nobel Prize in Economics in 1990.
Nprakash 39
 According to MM Approach, the weighted average cost of capital
(Ko) is independent of its capital structure. It does not change with
the change in the proportion of debt to equity in the capital structure.
 The value of a firm depends on the earnings and risk of its assets
(business risk) rather than the way in which the assets are financed.
Cost of Capital ( %)

Ko

O
Degree of Leverage
Nprakash 40
1. Investment opportunities of the firm remain fixed. Corporate real
investment and operating decisions are not affected by capital structure.
2. Perfect Capital Markets – (a) securities are infinitely divisible,
(b) investors are free to buy/sell, (c) investors can borrow without any
restrictions at the same rate as companies (d) no transactions costs (e)
investors are well informed about the risk & return and they behave
rationally.
3. Same Expectations - All investors have the same expectation of firm’s
future earnings (EBIT) and volatility of these earnings with which to
evaluate the value of firm.
4.Homogeneous Risk class - The business risk of a firm can be measured
and firms can be grouped into distinct business risk classes.
5.Debt is risk free and the interest rate on debt is the risk free rate.
6.The dividend payout is 100%.
7.There are no taxes (modified later).

Nprakash 41
There are 3 basic propositions of MM approach.
1)The overall cost of capital (Ko) and the value of the firm (V)
are independent of its capital structure. The Ko and V are
constant for all degrees of leverage for both levered and
unlevered firms.
2) Ke is equal to the capitalisation rate of a pure equity stream +
a premium for financial risk equal to the difference between
the pure equity capitalisation rate (Ke) and Kd times the ratio
of debt to equity. Ke increases in a manner to offset exactly
the use of a less expensive source of funds represented by
debt.
3) The cut-off rate for investment is completely independent of
the way in which an investment is financed.

Nprakash 42
 The market value of a firm depends upon its expected net operating
income (EBIT) and the overall capitalisation rate Ko or the
opportunity cost of capital.
 Since the capital structure can neither change the firm’s EBIT nor its
operating risk, the values of levered or unlevered firms ought to be the
same.
 The firm’s capital structure merely indicates how EBIT is divided
between shareholders and bondholders.
 It is the magnitude and riskiness of EBIT and not the partitioning
between shareholders and bondholders that determines the market
value of the firm.
 Whether you cut a pizza (EBIT) into six slices or eight does not
increase the size of the pizza. The same is also true of companies.
 Companies can make money by good investment decisions
and not by good financing decisions.

Nprakash 43
 Firms with identical EBIT and business risk (operating), but different
capital structure should have the same firm value.
 Value of a levered firm = Value of unlevered firm
VL = VU
Value of firm = Net Operating Income = NOI
Firm’s opportunity cost of capital Ko
 Both Net Operating Income and firm’s opportunity cost are assumed to
be constant at all levels of financial leverage.
 For a levered firm, the expected net operating income (EBIT) is the
sum of the income of shareholders and the income of debt holders.
 The average rate of return required by all security holders in a levered
firm is the firm’s weighted average cost of capital Ko.
 In the case of unlevered firm, the entire net operating income is the
shareholder’s net income & hence its WACC is equal to cost of equity.

Nprakash 44
 Size of the corporate pie = PV of cash flows

Any Other
ratio of
Debt to
Equity

50% Debt 20% Debt

100% Equity
50% Equity 80% Equity

Nprakash 45
 When a waitress asked Yogi Berra (Baseball Hall of Fame Catcher for
the New York Yankees) whether he wanted his pizza cut into four pieces
or eight, Yogi replied: ‘Better make it four; I don’t think I can eat eight.’
Yogi’s quip helps convey the basic insight of Modigliani and Miller
(M&M). The firm’s leverage choice ‘slices’ the distribution of the firm’s
future cash flows in a way that is like slicing a pizza. M&M recognize
that if you fix a company’s investment activities, it’s like fixing the size
of the pizza; no information costs means that everyone sees the same
pizza; no taxes means the IRS (Internal Revenue Service) gets none of
the pie; and no ‘contracting’ cost means nothing sticks to the knife. And
so, just as the substance of Yogi’s meal is unaffected by whether the
pizza is sliced into four pieces or eight, the economic substance of the
firm is unaffected by whether the liability side of the balance sheet is
sliced to include more or less debt.
 Source: Michael J Barclay et al. (1995).

Nprakash 46
 Since equity investors bear financial risk in addition to business
risk, cost of equity will be more than the cost of debt.
 MM argue that an increase in financial leverage increases the
systematic risk (of the firm’s stock) that equity investors have to
bear.
 Being risk averse, equity investors will demand a corresponding
increase in the return on equity. The increase in the cost of
equity will exactly offset the effect of lower cost of debt.
 Likewise, decrease in financial leverage will not increase the
WACC, as the reduction will result in an offsetting decrease in
the cost of equity due to lower systematic risk. So the weighted
average cost of capital is the same at all debt levels.

Nprakash 47
Miller (1991) explains the intuition for the Theorem with a simple analogy.
“Think of the firm as a gigantic tub of whole milk. The farmer can sell the
whole milk as it is. Or he can separate out the cream, and sell it at a
considerably higher price than the whole milk would bring.” “The
Modigliani-Miller proposition says that if there were no costs of separation,
(and, of course, no government dairy support program), the cream plus the
skim milk would bring the same price as the whole milk.” The essence of the
argument is that increasing the amount of debt (cream) lowers the value of
outstanding equity (skim milk) – selling off safe cash flows to debt-holders
leaves the firm with more lower valued equity, keeping the total value of the
firm unchanged. Put differently, any gain from using more of what might
seem to be cheaper debt is offset by the higher cost of now riskier equity.
Hence, given a fixed amount of total capital, the allocation of capital
between debt and equity is irrelevant because the weighted average of the
two costs of capital to the firm is the same for all possible combinations of
the two.

Nprakash 48
 The WACC is independent of leverage in an MM world
without taxes.
 How you finance a project is only a matter of detail. It has no
bearing on firm value. If a project is unviable with one
package of securities, it’ll be unviable with any other package
of securities.
 A firm should look for making money by good investment
decisions and not by good financing decisions.
 ROE might increase with leverage but so does cost of equity.

Nprakash 49
 As per MM, the total risk of all security holders of a firm is
not altered by changes in its capital structure.
 Therefore, the total value of the firm should be the same
regardless of its financing mix.
 This is supported by the presence of arbitrage in the capital
markets.
 The value of two or more firms with same risk class in the
same industry should be the same even with different capital
structures; otherwise, arbitragers will enter the market and
drive the values of the two firms together.

Nprakash 50
 Company U Companuy L
Net Operating Income (EBIT) 1,00,000 1,00,000
Less Interest on Debentures 15,000
Earnings available to equity holders (NI) 1,00,000 85,000
Equity Capitalisation rate 0.10 0.11
Market Value of Equity (Mve) NI/Ke 10,00,000 7,72,727
Market value of Debt (MVd) 3,00,000
Total Value of Firm (V) 10,00,000 10,72,727

Implied Overall Capitalisation rate (Ko) EBIT/V 10.00% 9.33%

Debt-to-equity Ratio (%) 0 38.80%

Nprakash 51
 According to MM, this situation cannot continue, as arbitrage will drive
the total values of the two firms together and will bring prices to
equilibrium.
 Company L cannot command a higher total value simply because it has a
different financing mix than Company U.
 MM argue that investors in company L are able to obtain the same amount
of return with no increase in financial risk by investing in Company U.
Moreover they are able to do this with smaller investment outlay.
 The investors will sell their shares in Company L and buy shares in
company U. This arbitrage will continue until Company L shares declined
in price and company U shares increased in price enough so that the total
value of both companies are same.

Example: suppose a rational investor owned 1 percent of Company L worth

Rs.7727 (market value of equity) and also invested in debt of Rs.3,000.
 He will sell his stock in Company L for Rs. 7727

Nprakash 52
 Borrow Rs. 3000 at 5% interest. This personal debt is equal to 1% of the
debt of the Company L – his previous proportional ownership of the
company.
 Buy 1% of the shares of U, for Rs. 10,000.

Prior to these transactions, the investor’s expected return on the investment in

Company L was 11% on Rs. 7727 investment, or Rs. 850. His expected
return on investment in Company U is 10% or Rs. 1,000 on investment of
Rs. 10,000. From this return he must deduct the interest charges on his
personal borrowings. The net rupee return is :
Return on investment in Company U is Rs. 1000
Less interest (Rs. 3000 @5%) Rs. 150
Net Return Rs. 850
Thus the rupee return is Rs. 850 is the same as it was for his investment in
Company L. However his cash outlay of Rs.7000 (Rs. 10,000 less
borrowings of Rs. 3,000) is less than Rs. 7727 invested in company L .
Because of the lower investment, the investor would prefer company U.
In essence, the investor is able to lever the stock of the unlevered firm by
taking personal debt. The investor is engaged in personal or homemade
leverage as against the corporate leverage to restore equilibrium in the
market.

Nprakash 53
Nprakash 54
 MM hypothesis that the value of the firm is
independent of its debt policy is based on the critical
assumption that corporate income taxes do not exist.
 However, since corporate taxes is a reality, interest

paid to debt holders is treated as a deductible expense

and is an advantage to the firm.
 In 1963, MM modified their argument to show that

value of the firm will increase with debt due to the tax
shield on interest charges and the value of the levered
firm will be higher than the unlevered firm.

Nprakash 55
Income Firm U Firm L
Net operating income 2500 2500
Interest 0 500
Taxable income 2500 2000
Tax @ 50% 1250 1000
Pat 1250 1000
Dividend to shareholders 1250 1000
Interest to debt holders 0 500

Total income to investors 1250 1500

Interest tax shield 0 250

Relative advantage of debt 1500/1250 1.20

Nprakash 56
 Interest Tax shield = T x Interest
= T x Kd D

Present value of interest tax shield = Corporate Tax rate X interest

Cost of Debt

Using the formula the PVINTS of the levered firm is 0.50 X 5,000
= Rs. 2,500
Value of the unlevered firm = After-tax Net operating income
Unlevered firm’s cost of capital

Value of levered firm = Value of unlevered firm + PV of tax

shield
Nprakash 57
 When the corporate tax rate is positive (t >0) the value of the
levered firm will increase continuously with debt.
 Theoretically, value of the firm will be maximised when it
employs 100% debt as shown in the chart.

Vl
Value

Value of
interest tax
shield
Vu

Leverage

Nprakash 58
 MM’s revised view of recognising corporate tax
suggests that a firm can increase its value with
leverage.
 Optimum capital structure is reached when the firm

employs almost 100% debt.

 However, in practice firms do not meet almost all of its

capital requirement by debt nor are the lenders ready to

lend beyond certain limits which is decided by them.

Nprakash 59
Nprakash 60
Nprakash 61
Unlevered Firm
With No Tax With Tax
Total Market Value of Vu = NOI/Ke Vu = NOI (1-t) /Ke
Unlevered Firm (Vu)
Overall Capitalisation Ko = Ke (since no debt) Ko = Ke (since no debt)
rate

Nprakash 62
Levered Firm
With No Tax With Tax
Total Market Value of Vl = Vu Vl = Vu+Dt
Levered Firm (Vl)
Equity Capitalisation Rate Ke = NOI-Interest Ke = NOI – Interest – Tax
(Ke) Vl - D Vl -D

Overall Capitalisation Rate Ko = NOI Ko = (NOI – I) (1-t) + I

(Ko) Vl Vl
D = Debt amount
t = tax rate

Nprakash 63
Nprakash 64
 Optimal Capital Structure is a trade-off between interest
tax shields and cost of financial distress (bankruptcy).
 This theory suggests that firms trade-off tax shields and

bankruptcy costs and move towards an optimal debt ratio.

 The firms stop borrowing when the present value of

bankruptcy costs exceeds the present value of tax shields.

 Profitable firms that can avail tax shields will borrow

relatively more than the less profitable firms.

 Studies conducted in US and elsewhere do not support

this hypothesis as profitable firms borrow less.

Nprakash 65
Nprakash 66
 When a company is new, it is likely to be financed entirely with equity,
so its average cost of capital is the same as its cost of equity (10% for
0/100 debt/equity ratio).
 As the company grows, it establishes a track record and attracts the
confidence of lenders. As the company increases use of debt, the
company's debt/equity ratio increases and the average cost of capital
decreases.
 The company starts substituting cheaper debt for the more expensive
equity, thereby decreasing its overall cost.
 As the company's debt/equity ratio keeps increasing, the cost of debt
and the cost of equity will increase.
 Lenders will become more concerned about the risk of the loan and
will increase the interest rate on its loans.

Nprakash 67
 Equity shareholders will become more concerned about default on the
loans (bankruptcy risk- losing their investment) and will insist on a
higher rate of return to compensate them for the higher risk.
 Since both the cost of debt and equity increases, the average cost of
capital will also increase.
 This results in a minimum point on the Average cost of capital curve.
 If the company move far to the left-side of the curve, the cost of equity
is higher and it would be better to borrow debt and buyback shares to
reduce the cost.
 If the company move to the right-side of the curve, it is perceived as
risky and therefore reduce debt by issuing more equity.
 There is a range of debt/equity ratios that will allow the company to
stay in the shallow portion of the curve.
 This gives flexibility to the company in choosing debt/equity ratio
within the range explained as Optimal Range.
Nprakash 68
 The pecking order theory suggests that there is an
order of preference for the firm of capital sources
when funding is needed.

 The firm will seek to satisfy funding needs in the

following order:
◦ Internal funds
◦ External funds
 Debt
 Equity

Nprakash 69
 There are three factors that the pecking order theory
is based on and that must be considered by firms
when raising capital.

1. Internal funds are cheapest to use (no issuance costs) and

require no private information release.

2. Debt financing is cheaper than equity financing.

Nprakash 70
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmetric information, investors may
make inferences about the value of the firm based on the
external source of capital the firm chooses to raise.
 Equity financing inference – firm is currently overvalued
 Debt financing inference – firm is correctly or undervalued

Nprakash 71
 The pecking order theory suggests that the firm will first use
internal funds. More profitable companies will therefore have
less use of external sources of capital and may have lower
debt-equity ratios.

 If internal funds are exhausted, then the firm will issue debt
until it has reached its debt capacity .

 Only at this point will firms issue new equity.

 This theory also suggests that there is no target debt-equity

mix for a firm.

Nprakash 72
 The pecking order theory suggests that there is an
order of preference for the firm of capital sources
when funding is needed.

 The firm will seek to satisfy funding needs in the

following order:
◦ Internal funds
◦ External funds
 Debt
 Equity

Nprakash 73
 There are three factors that the pecking order theory
is based on and that must be considered by firms
when raising capital.

1. Internal funds are cheapest to use (no issuance costs) and

require no private information release.

2. Debt financing is cheaper than equity financing.

Nprakash 74
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmetric information, investors may
make inferences about the value of the firm based on the
external source of capital the firm chooses to raise.
 Equity financing inference – firm is currently overvalued
 Debt financing inference – firm is correctly or undervalued

Nprakash 75
 The pecking order theory suggests that the firm will first use
internal funds. More profitable companies will therefore have
less use of external sources of capital and may have lower
debt-equity ratios.

 If internal funds are exhausted, then the firm will issue debt
until it has reached its debt capacity .

 Only at this point will firms issue new equity.

 This theory also suggests that there is no target debt-equity

mix for a firm.

Nprakash 76