leverage decision

1. Nprakash
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2. 
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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.
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3. 
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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 .
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4. 
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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.
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5. Debt
-Fixed claim
-High priority on
payments
-Tax deductible
-Fixed maturity
-No management control
Equity
-Residual claim
-Lowest priority
-Not tax deductible
-Perpetual or infinite life
-Management control
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6. 
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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.
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7. 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.
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8. 
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.
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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
Cost of new
Cost of Debt
Cost of Pref.
Cost of Debt
shares
retained
earnings
issue of equity
shares
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9. 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.
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10. 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.
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11. 
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.
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Others : market conditions, period of finance, industry
(capital intensive).
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12. 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
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13. 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
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14. Return on equity at various debt levels
(value in Rs.)
Debt/capital
0 percent
Equity
10,000
Debt
0
Total Capital
10,000
EBIT
3,000
Interest @ 15%
0
PBT
3,000
Tax @ 35 percent 1,050
PAT
1,950
ROE (percentage) 19.50
10 percent
20 percent
30 percent
9,000
1,000
10,000
3,000
150
2,850
998
1,852
20.57
8,000
2,000
10,000
3,000
300
2,700
945
1,755
21.93
7,000
3,000
10,000
3,000
450
2,550
892
1,658
23.68
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15. Debt/equity ratios of some top companies (2008)
Industry
Automobile
Company
D/E
Maruti Suzuki
Bajaj Auto
Mahindra
Tata Motors
0.106
0.288
0.439
0.574
Bharti Airtel
Reliance Comm.
0.410
0.810
ITC
L&T
Grasim Ind
0.019
0.358
0.472
Cipla
Dr. Reddy’s
Ranbaxy
0.036
0.074
1.273
Telecom
Diversified
Pharmaceuticals
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16. 
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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.
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17. 
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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
DOL =
Q (S-V)
Q (S-V) – F
OR
Contribution
EBIT
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18. 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
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DFL =
% change in EBIT
DFL =
Q (S-V) – F
Q(S-V) - F - I
OR
EBIT/EBIT
EBIT
If no pref .dividend = EBT
EBIT
If preference dividend exists = EBT – ( Pref. dvd / 1-t)
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19. 
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
% change in Sales
Contribution
Profit before tax
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20. 
Capital budgeting Decision
◦
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Replacement
Modernisation
Expansion
Diversification
Funding Decisions
◦ Internal sources
◦ Debt
◦ External equity
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Capital Structure Decision
◦ Existing Capital Structure
◦ Payout Policy
◦ Desired Debt-Equity Mix
 Effect on Return
 Effect on Risk
Effect on Cost of Capital
Value of the firm
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21. 
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)
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22. 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)
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23. 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 DebtEquity is decreased.

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24. 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).
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25. Effect on….
Effect of increase
in Leverage
Effect of decrease
in Leverage
Weighted Average Cost Decreases : because
of advantage
of Capital ( Ko)
associated with use of
relatively less
expensive debt
Increases : because of
disadvantage
associated with the
use of relatively more
expensive equity
Total Value of firm (V) Increases : because of
decrease in Weighted
Average Cost of
Capital
Decreases : because
of increase in
Weighted Average
Cost of Capital
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26. Cost of Capital
Ke
.10
Ko
Kd
.05
O
Degree of Leverage
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27. Value of the Firm (NI Approach)
Rs.
50,000
20,000
30,000
0.125
2,40,000
2,00,000
4,40,000
Net Operating Income (EBIT)
Less Interest on Debentures (I)
Earnings available to equity holders (NI)
Equity Capitalisation rate (K e)
Market Value of Equity (Mve)
NI/Ke = 30,000/0.125
Market value of Debt (MVd)
Total Value of Firm (V)
Overall Cost of Capital (Ko)
EBIT/V= 50,000/440,000
11.36%
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28. Value of the Firm (NI Approach)
Net Operating Income (EBIT)
Less Interest on Debentures (I)
Earnings available to equity holders (NI)
Equity Capitalisation rate (K e)
Market Value of Equity (Mve)
NI/Ke = 20,000/0.125
Market value of Debt (MVd)
Total Value of Firm (V)
Rs.
50,000
30,000
20,000
0.125
1,60,000
3,00,000
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%
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29. Value of the Firm (NI Approach)
Rs.
50,000
10,000
40,000
0.125
3,20,000
1,00,000
4,20,000
Net Operating Income (EBIT)
Less Interest on Debentures (I)
Earnings available to equity holders (NI)
Equity Capitalisation rate
Market Value of Equity (Mve)
NI/Ke = 40,000/0.125
Market value of Debt (MVd)
Total Value of Firm (V)
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
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30. 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.
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31. 
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.
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32. Effect on….
Effect
Equity
Increase
Capitalisation
Rate (Ke)
Weighted
Cost of
Capital (Ko)
Effect of Increase
in Leverage
Increase in the proportion of Debt in the capital
structure will lead to increase in the financial
risk of equity shareholders. To compensate for
the increased financial risk, the shareholders
would expect a higher rate of return on their
investments.
Remain
Advantage of using less expensive Debt in
Constant terms of explicit cost is exactly neutralised by
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
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33. 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
risk of equity shareholders. For the decreased
Rate (Ke)
financial risk, the shareholders would expect a
lower rate of return on their investments.
Weighted
Cost of
Capital (Ko)
Remain
Disadvantage of using less expensive Debt in
Constant terms of explicit cost is exactly neutralised by
the advantage in terms of decrease in the
implicit cost of debt represented by the decrease
in the cost of equity capital.
Total Value
of the firm
(V)
Remain Since Ko remain constant.
Constant
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34. Cost of Capital (per cent)
Ke
.
Ko
Kd
O
Degree of Leverage
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35. 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.

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36. 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.
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37. Ke
Cost of Capital (per cent)
Stage II
Ko
.
Stage III
Stage I
O
Kd
Degree of Leverage
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38. 
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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.
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39. 
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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.
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40. 
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
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41. 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).
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42. 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.
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43. 
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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.
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44. 
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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.
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45. 
Size of the corporate pie = PV of cash flows
Any Other
ratio of
Debt to
Equity
100% Equity
50% Debt
50% Equity
20% Debt
80% Equity
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46. 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).
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47. 



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.
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48. 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.
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49. 



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.
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50. 



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.
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51. Net Operating Income (EBIT)
Less Interest on Debentures
Earnings available to equity holders (NI)
Equity Capitalisation rate
Market Value of Equity (Mve)
NI/Ke
Market value of Debt (MVd)
Total Value of Firm (V)
Implied Overall Capitalisation rate (Ko) EBIT/V
Debt-to-equity Ratio (%)
Company U
Companuy L
1,00,000
1,00,000
15,000
1,00,000
85,000
0.10
0.11
10,00,000
7,72,727
3,00,000
10,00,000
10,72,727
10.00%
0
9.33%
38.80%
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52. 



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
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53. 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.

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54. Nprakash
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55. 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.

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56. 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
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57. 
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
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58. 
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
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59. 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.

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60. Nprakash
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61. Nprakash
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62. Unlevered Firm
Total Market Value of
Unlevered Firm (Vu)
Overall Capitalisation
rate
With No Tax
Vu = NOI/Ke
With Tax
Vu = NOI (1-t) /Ke
Ko = Ke (since no debt)
Ko = Ke (since no debt)
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63. Levered Firm
Total Market Value of
Levered Firm (Vl)
Equity Capitalisation Rate
(Ke)
Overall Capitalisation Rate
(Ko)
With No Tax
Vl = Vu
With Tax
Vl = Vu+Dt
Ke = NOI-Interest
Vl - D
Ke = NOI – Interest – Tax
Vl -D
Ko =
Ko = (NOI – I) (1-t) + I
Vl
NOI
Vl
D = Debt amount
t = tax rate
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64. Nprakash
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65. 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.

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66. Nprakash
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67. 




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.
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68. 






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.
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69. 
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
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70. 
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.
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71. 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
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72. 
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.
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73. 
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
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74. 
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.
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75. 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
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76. 
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.
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