Optimal Financing Mix

A firm can use any of following five approaches to come up with the optimal mix of debt and equity
– the mix that maximizes firm value.
1. Operating Income Approach: In this approach firms specify a maximum acceptable probability
of default. We use historical data on operating income to develop a distribution of operating
income. Based on this distribution, we examine the maximum amount that a firm can borrow,
given the default probability constraint.
2. Cost of Capital Approach: Cost of capital is the weighted average of the costs of equity, debt,
and preferred stocks, where the weights are market value weights and the cost of financing are
current costs. Holding the existing investments of the firm constant, we change the proportions
of debt and equity and compute the cost of capital at each proportion. The objective is to
minimize the cost of capital, which also maximizes the value of the firm.
3. Differential Return Approach: In this we examine the effects of changing the debt ratio on the
return on equity and the cost of equity. Although both tend to increase at the debt ratio increases,
we focus on finding the debt ratio that maximizes the spread between the return on equity and
the cost on equity. By increasing the spread, we will generally increase the value per share,
though there is a danger of underinvestment a s consequence.
4. Adjusted Present Value Approach: This approach enables us to estimate the value of the firm
at different levels of debt by adding the present value of the tax benefits from debt to the
unlevered firm’s value, and then subtracting the present value of expected bankruptcy costs. The
optimal debt ratio is the one that maximizes firm value. The key additional inputs for this
approach are the probability of bankruptcy, at each debt ratio, and the total cost of bankruptcy,
including direct and indirect costs.
5. Comparison of leverage of the firm to that of similar firms: We compare a firm’s debt ratio
to the debt ratio of similar firms. Although firms often compare their debt ratios to industry
averages, these comparisons are generally not very useful in the presence of large differences
among forms within the same industry. A regression of debt ratios against underlying
fundamentals that determine leverage brings in more information from the general population of
firms and can be used to predict debt ratios for a large number of firms.

Examples: For all the following problems, unless otherwise stated, take risk free rate as 8%, market risk
premium as 5.50% and tax rate as 40%.

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 V. What is the firm’s cost of Capital (WACC)?
Ans:

Note: Cost of Equity is calculated using the formula,

KEq = [rf + x (rm – rf)] = [Risk free rate + Beta x Market risk premium].

and, Cost of Capital is calculated taking the market values of debt and equity.

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Ans: For the proposed project, total investment i.e. (Debt + Equity) = 100 million. We have found
the existing (D/E) ratio for the overall firm, on the basis of market values, as 0.50. This means, D =
33.333 million and E = 66.666 million.

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Ans: Given, tax rate = t = 0.40; we know that, LEV EquityUNLEV Equityx [1 + (1 - t) x (D/E)]; D and
E values are market values. The above equation shows that the increase in debt causes an increase in
the equity beta in view of the increased financial risk resulting from the increase in the obligated
payment on debt.

In our case, it is given that LEV Equity1.20 when (D/E) = 0.50. We use this to calculate the beta for
the firm as an unlevered one (this process is called unlevering of beta):-

UNLEV EquityLEV Equity/ [1 + (1 - t) x (D/E)] = 1.20 / [1 + (1 – 0.40) x 0.50] = 1.20 / 1.30 = 0.923.

Then we use this value of UNLEV Equityto calculate new values of LEV Equity for the changed values of
(D/E) ratios under the three different options. (This process is called Re-levering of beta). UNLEV
Equity is also known as Assets beta.

Note: the risk of the company is independent of the financing decision – only the risk of the equity
holders increases with the increased use of debt.UNLEV Equityreflects only the business risk of the
firm, whereas,LEV Equityreflects both the financial as well as the business risk of the firm.

For Option 1: Market value of equity will be (4,000 + 1,000) = 5,000 million and Market value of
debt will be (2,000 – 1,000) = 1,000 million. Hence, the (D/E)Opt 1 will be (1,000/5,000) = 0.20.

For Option 2: Market value of equity will be (4,000 - 1,000) = 3,000 million and Market value of
debt will be (2,000 + 1,000) = 3,000 million. Hence, the (D/E)Opt 2 will be (3,000/3,000) = 1.00

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For Option 3: Market value of equity will be (4,000 - 3,000) = 1,000 million and Market value of
debt will be (2,000 + 3,000) = 5,000 million. Hence, the (D/E)Opt 3 will be (5,000/1,000) = 5.00

LEV Equity 1UNLEV Equityx [1 + (1 - t) x (D/E)] = 0.92 x [1 + (1 – 0.4) x 0.20] = 1.0304

LEV Equity 2UNLEV Equityx [1 + (1 - t) x (D/E)] = 0.92 x [1 + (1 – 0.4) x 1.00] = 1.472

LEV Equity 3UNLEV Equityx [1 + (1 - t) x (D/E)] = 0.92 x [1 + (1 – 0.4) x 5.00] = 3.68.

Ans to first three questions

Cost of Equity is calculated using the formula,

KEq = [rf + x (rm – rf)] = [Risk free rate + LEV Equity x Market risk premium].
KEq 1 = [8 + 1.0304 x 5.5] = 13.69
KEq 2 = [8 + 1.472 x 5.5] = 16.12
KEq 3 = [8 + 3.68 x 5.5] = 28.31.
Cost of debt is after tax, kDebt x (1 – t) :-
kDebt 1 = 11 x (1 – 0.40) = 6.60
kDebt 2 = 13 x (1 – 0.40) = 7.80
kDebt 3 = 18 x (1 – 0.40) = 10.80.
Weighted Average Cost of Capital, WACC = kDebt x [D / (D +E)] + kEquity x [E / (D +E)]
WACC 1 = 6.60 x (1/6) + 13.69 x (5/6) = 12.51
WACC 2 = 7.80 x (1/2) + 16.12 x (1/2) = 11.96
WACC 3 = 10.80 x (5/6) + 28.31x (1/6) = 13.72
The cost of capital (WACC), which is 13.06% i.e. [WACC 0 = kEquity 0 = [8 + 0.92 x 5.5] = 13.06]
when the firm is unlevered, decreases as the firm initially adds debt; it gradually reaches a minimum
and then again starts to increase again. The optimal debt ratio is obtained at the minimum value of
WACC.

Current market value of the firm, V0 = Rs. 6,000 million with current cost of capital as
12.13%. Also current stock price = Rs. 80 per share.
WACC 0 = 12.13; and, WACC 1 = 12.51; WACC 2 = 11.96; WACC 3 = 13.72.
Change in the market value of the firm = Current Market Value x [Change in Cost of
Capital / New Cost of Capital]
Change in the market value of the firm = V0 x [(WACC 0 - WACCi) / WACCi] :-
Change in the market value of the firm for option 1 = 6,000 x [(0.1213 – 0.1251) / 0.1251] =
(-180) m
Change in the market value of the firm for option 2 = 6,000 x [(0.1213 – 0.1196) / 0.1196] =
86 m

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 Change in the market value of the firm for option 3 = 6,000 x [(0.1213 – 0.1372) / 0.1372] =
(-693) m
Change in Stock Price = [Increase (Decrease) in the market value of the firm / Number
of Shares Outstanding]: -
Increase (Decrease) in Stock price for Option 1 = [(-180) m / 50 m] = Rs. (-3.60), decrease.
Increase (Decrease) in Stock price for Option 2 = [86 m / 50 m] = Rs. 1.72, increase.
Increase (Decrease) in Stock price for Option 3 = [(-693) m / 50 m] = Rs. (-13.86), decrease.
Change New Firm Value Debt New Value of Change New Stock Price
in the = [ 6,000 – Change Valu Equity in the = [Rs. 80 –
Firm in Firm Value] e = [New Firm Stock Change in the
Value Value – Debt] price Stock Price]
Optio (-180) m 5,820 m 1,000 4,820 m Rs. (- Rs. 76.4
n1 m 3.60)
Optio 86 m 6,086 m 3,000 6,086 m Rs. 1.72 Rs. 81.72
n2 m
Optio (-693) m 5,307 m 5,000 5,307 m Rs. (- Rs. 66.14
n3 m 13.86)
Note: The change in the firm value will mean that the debt ratios computed above will also change.

Because, the cost of capital (WACC) is 11.96% i.e. lowest for option 2, even taking the current
capital structure (with 12.13%) into account.

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Ans: