6885-15-8Q AID: 63238 | 21/05/2020

A company can either have an All-Equity structure or Debt-Equity structure. The value of the
company is equal to Value of Debt and Value of its equity. A public held company raises
funds through issue of Commercial Papers, Non-Convertible Debentures and Preferential and
Common Allotment of Equity. A privately held company is backed by Venture Capitalists,
Private Equity Funds and promoter holdings.

A company raises capital by borrowing money from banks, lenders or issuing preferential
shares and common stock for the purchase of inventory, equipment or even land. Debt or loan
is used to finance the company’s need for expanding asset base, introduce new products etc.
because it's a less expensive way of raising funds. But, when a company uses debt financing,
it has to keep a collateral – which is generally assets of the company i.e. land, equipment or
goodwill. Creditors have legal claims against the collateral, which is why debt financing is
also termed as a financial leverage.

Although, borrowing funds is less expensive than raising capital through equity – but it
involves financial risk. When a company is unable to pay interest payment and principal
payments to the lender, it results a default risk, a credit risk and liquidity risk – when a
company defaults on loan payments – it drastically affects the stock price of the company.
Shareholders face risk against this volatility in prices. And creditors rely on company’s
liquidity to provide for debt servicing and loan repayment – resulting in increased risk from
this leverage. Credit Risk becomes worrisome for the management because it becomes
difficult for the company to source funds through debt (because of high risk of defaults).

Let us assume that,

Market value of the firm’s outstanding equity is given by E
Market value of the firm’s outstanding debt is given by D
Cost of Capital on firm’s levered equity is given by Re
Cost of Capital on firm’s debt is given by R d
Cost of Capital on firm’s unlevered equity is given by R u

According to M&M Proposition II, Re is given by -

D
Re =Ru + ´ (Ru - Rd )
E
 As leverage increases, D rises and E falls
D
 E rises
 Reason: Debt Holders get firm’s first, least risky cash flows
 Re increases as leverage increases, the stockholders are left with increasingly risky cash-
flows