BASICS and TERMINOLOGY

COST OF EQUITY COST OF DEBT WACC Leveraged firm and Unleveraged firm 

Ke Kd

BASICS and TERMINOLOGY
FOR FINANCIAL LEVERAGE- EPS, ROE  FOR CAPITAL STRUCTURE THEORIES- IMPACT

ON THE VALUE OF A FIRM
  

VALUE = VALUE AS EQ + VALUE AS DEBT

VALUE = NET EARNINGS  Ke/WACC

NET INCOME APPROACH
Financial Plan

Unlevered

Levered

1. Earnings before interest and taxes, EBIT 1000 2. Less: interest, INT Ke Value of the equity Kd
Value of the debt Value of the firm WACC 10000 .10

1000 150 850 .10
? .05 3000 ? ?

0 .10
10000

3. Profit before taxes, PBT = EBIT – INT 1000

NET INCOME APPROACH
Financial Plan

Unlevered

Levered

1. Earnings before interest and taxes, EBIT 1000 2. Less: interest, INT Ke Value of the equity Kd
Value of the debt Value of the firm WACC 10000 .10

1000 150 850 .10
8500 .05 3000 11500 .087

0 .10
10000

3. Profit before taxes, PBT = EBIT – INT 1000

Net Income (NI) Approach
  Assumptions:

o No taxes o No financial risk o Kd < Ke o  The optimum capital structure would be 100 per cent debt financing under NI approach.
  Criticism

C ost

ke, ko

ke

kd

ko kd

D ebt

This approach has no basis in reality.
.

5

TRADITIONAL APPROACH
Financial Plan

DEBT INCR

1. Earnings before interest and taxes, EBIT 2. Less: interest, INT 3. Profit before taxes, PBT = EBIT – INT Ke Value of the equity Kd
Value of the debt Value of the firm WACC

1000 450 550 .15
? .07 ? ? .095

TRADITIONAL APPROACH
Financial Plan

DEBT INCR

1. Earnings before interest and taxes, EBIT 2. Less: interest, INT 3. Profit before taxes, PBT = EBIT – INT Ke Value of the equity Kd
Value of the debt Value of the firm WACC

1000 450 550 .15
3667 .07 6248 9910 .095

Traditional Approach
 Assumptions:

o Same as Net Income Approach except that there is a financial risk.

C ost ke

 Initial rise in Ke is less than gain by issuing debt with lower Kdbut at higher stages Ke rises more.   So there is an Optimum capital structure where Ko is the lowest.

ko

kd

D ebt

8

NET OPERATING INCOME APPROACH
Financial Plan

Unlevered

Levered

1. Earnings before interest and taxes, EBIT 1000 2. Less: interest, INT Ke Value of the equity Kd
Value of the debt Value of the firm 10000 10000

1000 150 850

0

3. Profit before taxes, PBT = EBIT – INT 1000

10000 .010

WACC/ OPPURTUNITY COST OF CAPITAL .010

Net Operating Approach
 Assumptions

Income

(NOI)

o Perfect capital market o No taxes o NOI and Opportunity cost is constant for all levels. o o No optimum capital structure exists. o o

C ost ke

ko kd

D ebt

10

MM Approach Without Tax: Proposition I
 Assumptions

o Perfect capital market o Investors can borrow at the same rate corporate can. o Same expectations about operating profits. o Same Business Risk o No taxes.
  No optimum capital

C ost

ko

D ebt M M 's P r o p o s i ti o n I

structure explained through operation al arbitrage process using home made

11

M&M- operational Arbitrage
Financial Plan

Unlevered

Levered

1. Earnings before interest and taxes, EBIT 1000 2. Less: interest, INT Ke Value of the equity Kd
Value of the debt Value of the firm WACC 10000 .10

1000 150 850 .10
8500 .05 3000 11500 .087

0 .10
10000

3. Profit before taxes, PBT = EBIT – INT 1000

M&M – PROPOSITION II
Financial Plan

Levered

Unlevered

1. Earnings before interest and taxes, EBIT 2. Less: Interest, INT 3. Profit before taxes, PBT = EBIT – INT Ke Value of the equity Kd
Value of the debt Value of the firm WACC/ OPPURTUNITY COST OF CAPITAL

1000 0 1000 .10
10000 -

1000 150 850 ?
.05 3000

10000 .010

10000 .010

M&M’s Proposition II
 Assumptions : same   But Rise is Ke= Fall in
C ost ke

WACC due to lower rate debt.


ko

kd

D ebt M M 's P r o p o s i t i o n I I

14

M&M – WITH TAXES
Unlevered levered

1. Earnings before interest and taxes, EBIT 2. Less: Interest, INT 3. Profit before taxes, PBT = EBIT – INT Taxes @ 50 % Profit after tax

1000 0 1000 500 500 500
10000

1000 150 850 425 425 425+150=575
11500

Amount to EQ and Debt holders

Value of the equity and Firm (u)
Value of firm (L)= V (u) + P V of tax shield (TD)

-

S o , 1 0 0 % d e b t Fa vo u ra b l . b u t fo r ta p p i g o p p o rtu n i e s e n ti a n d re m a i i g fl xi l i sh o u l n o t b e 1 0 0 % a s su g g e ste d n n e b e t d b y M &M

M & M (WITH TAXES)
Maximum value of firm

Market Value of The Firm

PV of interest tax shields

Value of unlevered firm

Optimum capital struture 100% Debt

Then why is there not an inclination of firm towards DEBT?

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