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• Value Maximization
• Cost Minimization
• Increase in Share Price
• Investment Opportunity
• 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 The effect of leverage on the cost of
financing under NI capital under NI approach
approach.
12/19/2018 MS 104 FINANCIAL 7
MANAGEMENT
8
IRRELEVANCE OF CAPITAL
STRUCTURE:
NOI APPROACH AND THE MM
HYPOTHESIS
WITHOUT TAXES
Suppose two identical firms, except for their capital structures, have
different market values. In this situation, arbitrage (or switching)
will take place to enable investors to engage in the personal or
homemade leverage as against the corporate leverage, to restore
equilibrium in the market.
• To determine the
levered firm's cost
of equity, ke:
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,