Capital Structure.pptx

Lecture Series on Financial Management :
Financing Decision : Capital Structure Planning &
Designing - I

Agenda
• Understanding Capital Structure Decision
• Leverage Analysis : Nature & Types
• Net Income Approach ( NI)
• Net Operating Income Approach ( NOI)
• Traditional Approach
• Modigliani & Miller Approach (MM
Approach) (With and Without Taxes)

 It is one of the important decision which
determines the proportion of Debt and
Equity in the Capital Structure of a Firm
with an objective of Maximizing Firm’s
Value.
 There are various view Points regarding
relationship between Financial Leverage
(use of debt capital) and Value of Firm.

 Leverage is a general term that refers
to an ability to multiply the effect of
some effort.
There are three measures of leverage:
 Operating Leverage,
 Financial Leverage, and
 Total/Combined leverage.

 Financial leverage refers to use of
borrowed money (debt) to multiply the
effectiveness of equity invested in a
business enterprise.
 To be leveraged / Levered means to
have debt and to be unleveraged/
Unlevered means to operate only with
equity capital.

 It is the ability of a Firm to use
Fixed Operating Cost in order to
magnify the effect of changes in
Sales on its EBIT.
 OL arises from Fixed Operating
cost like – salaries, rent,
depreciation,insurance,
advertising outlays etc.

 Operating leverage examines the effect of
change in the quantity produced/sold on
the EBIT (Earnings before Interest and
Taxes) of a firm.
 It refers to the use of fixed costs in the
operation of the firm.
 It is the firm’s ability to use fixed
operating costs to magnify the effect of
changes in Sales on its EBIT.

 Operating profit of a highly
levered firm would increase at a
faster rate for any given increase
in sales and
 it would suffer more loss than an
unlevered firm if the sales fall.

Operating
leverage
Financial
leverage
Total
lever
age

 Let Selling price be Rs. 1000/unit, Variable cost –
500/unit, Fixed operating cost Rs 200,000.Lets
see the impact of operating leverage at
quantities 500 and 600.
 20 % increase in sales, leads to 100% increase in
EBIT.
Particulars Sales- 500 units Sales- 600 units
Revenue 5,00,000 6,00,000
Variable cost - 2,50,000 - 3,00,000
Fixed operating cost - 2,00,000 - 2,00,000
EBIT 50,000 1,00,000

 Operating leverage is measured in terms
of Degree of Operating Leverage, (DOL)
DOL=
S
S
Δ
EBIT
EBIT
Δ

Operating Leverage =
OR
F
V)
Q(S
V)
Q(S



EBIT
on
Contributi

 A Company sells 1000 Unit @ Rs. 10
Per Unit . Cost of Production is Rs. 7 Per
Unit and all costs are variable.
 Company is Expecting to Increase its
Sale by 40% ;i.e. makes it 1400 Units .
 Calculate DOL and Comment

 Sales 1000 , Total Variable cost 7 Rs.Per Unit ,
Selling Price 10 Rs. Per Unit
 Existing EBIT = 1000 * ( 10-7) = Rs. 3000
 New EBIT = 1400 * ( 10-7) = Rs. 4200
 DOL =
= Rs.1200/Rs.3000 / Rs. 4000/ Rs.10000
0.4 / 0.4
= 1
S
S
Δ
EBIT
EBIT
Δ

 DOL 1 indicates absence of Operating
Leverage.
 EBIT Changes in direct Proportion to
Change in Sales
Suppose if we Change the question ??
 There is a Fixed cost of Rs. 1000
Reported in the same question in
addition to Variable Cost Reported

Particulars Existing Sales
1000 Units
Expected Sales
1400 Units
Sales @ Rs. 10 Per
Unit
Rs. 10,000 Rs. 14,000
Less : Variable Cost
@ Rs. 7 Per Unit
Rs. 7000 Rs. 9800
Contribution Rs. 3000 Rs. 4200
Less : Fixed Cost Rs. 1000 Rs.1000
EBIT Rs. 2000 Rs. 3200

DOL =
= Rs. 1200 / Rs. 2000 / Rs. 4000 / Rs.
10,000
= 0.6 / 0.4
= 1.5
S
S
Δ
EBIT
EBIT
Δ

DOL =
EBIT
on
Contributi
1000 Units
Expected Sales
1400 Units
Contribution Rs. 3000 Rs. 4200
EBIT Rs. 2000 Rs. 3200
Operating Leverage 3000/2000=
1.50
4200/3200
= 1.31

 Finex ltd. Produces exhaust fans .The price of
these fans id RS 1500/fan. The fixed cost of
production is Rs 2,00,000 , whereas the
variable cost of production is Rs. 1000 per
fan. Calculate the DOL for the production of
quantities 500 and 600 units.

 DOL(Q=500)= 500(1500-1000)/500(1500-
1000)-200000
=5.0
 DOL(Q=500)= 600(1500-1000)/600(1500-
1000)-200000
 =3.0

(1) DOL helps in determining the behavior of
EBIT when the level of output is changed.
(2) DOL measures the business risk
associated with a firm. A higher DOL implies
greater uncertainty or variability in the firm’s
EBIT and hence greater business risks.
(3) A firm can plan its production based upon
the effect of producing a particular level of
output on the DOL.

 It is the ability of a Firm to use
Fixed financial Cost (interest
expenses) in order to magnify the
effects of change in EBIT on its EPS.
 Whenever a firm has Financial
leverage ,1% change in EBIT leads to
more than 1% change in EBT.

 A firm has EBIT 50,000 ,its fixed financial cost is
30,000 and tax rate is 50%.it has 10,000 shares
outstanding. Lets see the impact of FL on EBIT
50,000 and 60,000.
 20% increase in EBIT leads to 50% increase in EPS.
 This work both ways , you can check 20% reduction
in EBIT.
Particulars Case A Case B
EBIT 50,000 60,000
INTEREST 30,000 30,000
EBT 20,000 30,000
TAX 10,000 15,000
EAT 10,000 15,000
EPS 1 1.5

 Financial Leverage measures the effect
of change in EBIT of the company on its
EPS.
DFL =
 Or Alternatively = EBIT / EBT
EBIT
EBIT
Δ
EPS
EPS
Δ

1000 Units
Expected Sales
1400 Units
EBIT Rs. 2000 Rs. 3200
Less : Interest on
Debt
Rs. 200 Rs.200
EBT Rs. 1800 Rs. 3000
Less : Tax @ 30% Rs. 540 Rs. 900
EAT Rs. 1260 Rs. 2100
No of Shares 500 500
EPS Rs. 2.52 Rs. 4.20

DFL =
= 1.68/2.52 / 1200/2000
= 0.667/ 0.60
= 1.116
EBIT
EBIT
Δ
EPS
EPS
Δ

 Given Sales Rs.100 million, Variable cost Rs.40
Million and Fixed Cost Rs.40 Million. Capital
employed of the Company Rs.80 million with debt
equity ratio 1:1. Debt carries 10% interest. Find out
the Degree of Financial Leverage?

 With the help of DFL we can study the impact of
financial leverage on the investor’s rate of return.
 DFL also helps in analyzing the risk arising as a
result of increased financial leverage. The risk
associated with increased DFL may be in the form
of :
◦ Increase in the interest rates on debts charged by
suppliers who perceive a highly financially leveraged firm
as risky.
◦ Increase in the fluctuations in the return on equity as a
result of employing more debt.


 Total leverage comprises both operating and
financial leverage.
 It is the product of DOL and DFL and is
expressed as:
C.L. = DOL * DFL
Or
% Change in EPS/ % Change in Sales
Or
Contribution / EBT

 A Company has Sales of Rs. 10,00,000,
Variable Cost 20% on Sales
 Fixed Cost – Rs 2,50,000
 10% Debentures of Rs. 5,00,000
Calculate Different Types of Leverages

Sales 10,00,000
Less : Variable Cost 2,00,000
Contribution 8,00,000
Less : Fixed Cost 2,50,000
EBIT 5,50,000
Less : Interest @ 10 % 50,000
EBT 5,00,000

Sales 10,00,000
EBIT 5,50,000
EBT 5,00,000
Operating Leverage = Contribution / EBIT
= 8,00,000 / 5,50,000
= 1.45

Sales 10,00,000
EBIT 5,50,000
EBT 5,00,000
Financial Leverage = EBIT / EBT
= 5,50,000 / 5,00,000
= 1.10

Sales 10,00,000
EBIT 5,50,000
EBT 5,00,000
Combined Leverage = Contribution / EBT
= 8,00,000 / 5,00,000
= 1.60

Combined Leverage = D.O.L. X D.F.L.
1.45 X 1.10
1.595
or 1.60

 DTL measures the change in EPS
for a given change in the quantity
produced.
 DTL helps in measuring the total
risk in the form of variability in
EPS caused by an error in
forecasting Q.

O.L. = % Change in EBIT / % Change in Sales
Or O.L. = Contribution / EBIT
F.L. = % Change in EPS/ % Change in EBIT
Or F.L. = EBIT / EBT
C.L. = O.L. X F.L.
Or C.L. = Contribution /EBT

 Operating Leverage of a Firm = 3
 Financial Leverage of the Firm = 2
 Combined Leverage = 6
Required :
1. If the Firm Wants to Double its EBIT ,How much
Change in Sales will be needed ( in %) ?
2. If the Firm Wants to Double its EPS ,How much
Change in EBIT will be needed ( in %) ?
3. If the Firm Wants to Double its EPS ,How much
Change in Sales will be needed ( in %) ?

Desired Change ( in % ) / Concerned
Leverage
1. 100 / 3 = 33.33%
2. 100/ 2 = 50 %
3. 100/6 = 16.66%

 The relationship among Capital
structure, Cost of capital and
Value of Firm had always been
one of the most debated issue in
financial management.

Basic Formulae for Value of Firm
V= EBIT/ Ko

We have to find an answer to the
following question:
 Whether Capital Structure decision is
relevant to the firm’s Value or Not ?
 To answer this question there are
several opinions /approaches having
different opinion and justification for
their opinion.

 Broadly speaking, there are four
Approaches to capital structure and
they can be grouped into two
categories;
 the one which says that capital
structure decision is relevant to the
firm’s value and
 the other which says that capital
structure decision is not relevant to
the firm’s value.

Relevant to the Firm’s
Value
Not Relevant to the
Firm’s Value
1.Net Income Approach
( NI Approach)
1.Traditional Approach
1.Net Operating Income
Approach ( NOI)
2.Modigliani & Miller
Approach (MM
Approach) (With and
Without Taxes)

As per this approach, capital structure
decision is relevant to the firm’s
Value.
It says that any change in capital
structure will bring change in overall
cost of capital (Ko) and value of the
firm.

NI Approach is based on following
assumptions :
 No Tax is there.
 Cost of Debt ( Kd) is less than cost of
equity ( Ke).
 Use of Debt have no impact on risk
perception of investors.

Formulae given by the NI Approach :
V= E+D
Where V= Value of Firm
E= Market Value of Equity
D= Market Value of Debt
Market Value of Equity (E) = NIATEH/Ke
Net Income Available to Equity Share holders/ Ke
Market Value of Debt (D) = Interest/Kd
Ko = EBIT / V

Q.1 A Company has an expected annual Net Operating
Income of Rs. 1,00,000 on equity rate of 10% and is having
6% Debentures of Rs. 5,00,000.
 Calculate value of Firm as per NI Approach. Also
calculate Overall cost of Capital.
 If the firm assumes to employ the debt of Rs. 7,00,000
in place of Rs. 5,00,000 what would be the value of firm
and WACC.
 If the firm assumes to employ the debt of Rs. 3,00,000,
what would be the value of firm and WACC.
 Use Net Income Approach to answer these questions

EBIT Rs. 1,00,000
Less : Interest on
Debentures @ 6% Rs. 30,000
NIATEH Rs. 70,000
Ke = 10%
Market Value of Equity (E) = NIATEH/ Ke
70,000 / .10 = Rs. 7,00,000
30,000/0.06 = Rs. 5,00,000
V = E + D
Rs. 7,00,000 + Rs. 5,00,000 = Rs.
12,00,000
Ko = EBIT / V
1,00,000 / 12,00,000 * 100
= 0.083333 * 100 = 8.33 %
Situation I

EBIT Rs. 1,00,000
Less : Interest on
NIATEH Rs. 58,000
Ke = 10%
58,000 / .10 = Rs. 5,80,000
42,000/0.06 = Rs. 7,00,000
V = E + D
Rs. 5,80,000 + Rs. 7,00,000
= Rs. 12,80,000
Ko = EBIT / V
1,00,000 / 12,80,000 * 100
= 0.0781 * 100 = 7.81 %
Situation II

If the firm assumes to employ
the debt of Rs. 3,00,000, what
would be the value of firm and
WACC ?

EBIT Rs. 1,00,000
Less : Interest on
NIATEH Rs. 82,000
Ke = 10%
82,000 / .10 = Rs. 8,20,000
18,000/0.06 = Rs. 3,00,000
V = E + D
Rs. 8,20,000 + Rs. 3,00,000 = Rs.
11,20,000
Ko = EBIT / V
1,00,000 / 11,20,000 * 100
= 0.0892 * 100 = 8.92 %
Situation III

Situation I With a Debt
of Rs. 5,00,000
Situation II With a Debt
of Rs. 7,00,000
Situation III With a Debt
of Rs. 3,00,000
E = Rs. 7,00,000 E = Rs. 5,80,000 E= Rs. 8,20,000
D = Rs. 5,00,000 D = Rs. 7,00,000 D = Rs. 3,00,000
V = Rs. 12,00,000 V = Rs. 12,80,000 V = Rs. 11,20,000
Ko = 8.33% Ko= 7.81% Ko = 8.92%

 Net Operating Income Approach ( NOI) :
This approach is entirely opposite to NI
Approach.
 It believes that value of firm is not
affected by capital structure changes.
According to it the advantage of debt is
affected by the increase in equity
capitalization rate.

 There are no corporate Taxes
 The debt equity mix does not affect
the overall cost of capital.
 The increase in debt changes the risk
perception of shareholders.
 Cost of Debt is Constant.

 Formulae given by the NOI Approach :
1. Value of Firm = EBIT / Ko
2. Value of Equity (E) = V – D
3.Rate of Equity Capitalization ( Ke) = EBIT-
Interest/ V- D


 The Net Operating Income of a company is Rs.
1,00,000. The overall capitalization rate is 10%.
The Outstanding debt is Rs.2,00,000 with 8% as
cost of Debt. What will be the value of firm and
Rate of Equity capitalization if
 A) Debt increases from Rs. 2,00,000 to Rs.
3,00,000
 B) Debt decreases by Rs.1,00,000
 Use NOI approach to answer these questions.

Situation I Situation II Situation III
V = EBIT/Ko
1,00,000/.10
Rs. 10,00,000
V = EBIT/Ko
1,00,000/.10
Rs. 10,00,000
V = EBIT/Ko
1,00,000/.10
Rs. 10,00,000
8 % Debentures Rs.
2,00,000
8 % Debentures Rs.
3,00,000
8 % Debentures Rs.
1,00,000
E = V –D
10 Lakhs – 2Lakhs
= 8 Lakhs
E = V –D
10 Lakhs – 3Lakhs
= 7 Lakhs
E = V –D
10 Lakhs – 1Lakhs
= 9 Lakhs
Ke = EBIT-Int / E
84000/8 Lakhs
= 10.50 %
Ke = EBIT-Int / E
76000/7 Lakhs
= 10.85 %
Ke = EBIT-Int / E
92,000/ 9 Lakhs
= 10.22 %

It is a compromise between NI
and NOI approach.
It states that cost of capital
decreases within reasonable
limit of debt and then
increases with the leverage.

 This approach believes that through
a proper use of debt-equity
proportions ,a firm can increase its
total value and result by reduce its
overall cost of capital.
 It believes that there is no optimum
capital structure but it can be at an
optimum level in a range.
Note : Formulae used in NI approach is used
for Traditional Approach as well.

A Company has EBIT of Rs. 3,00,000. It has an
outstanding debt of Rs. 12,00,000 at a cost of
10% and cost of equity ( Ke) is estimated to be
15%.
Required :
1. Determine the current value of Firm using
Traditional Approach.
2. Determine the Ko

EBIT Rs. 3,00,000
Less : Interest on
Debentures @ 10 % Rs. 1,20,000
NIATEH Rs. 1,80,000
Ke = 15%
1,80,000 / .15 = Rs. 12,00,000
1,20,000/0.10 = Rs. 12,00,000
V = E + D
Rs. 12,00,000 + Rs. 12,00,000 = Rs.
24,00,000
Ko = EBIT / V
3,00,000 / 24,00,000 * 100
= 0.125 * 100 = 12.50 %

 In the same problem suppose the firm is
considering to issue share capital of Rs.
4,00,000 in order to redeem Debentures of
Rs. 4,00,000. Kd is expected to be the same,
however, Ke is estimated to become 13% due
to decline in leverage.
 Will you recommend this proposal. Use
Traditional Approach to answer.

EBIT Rs. 3,00,000
Less : Interest on
Debentures @ 10 % Rs. 80,000
NIATEH Rs. 2,20,000
Ke = 13%
2,20,000 / .13 = Rs. 16,92,308
80,000/0.10 = Rs. 8,00,000
V = E + D
Rs. 16,92,308 + + Rs. 8,00,000
= Rs. 24,92,308
Ko = EBIT / V
3,00,000 / 24,92,308 * 100
= 0.1203 * 100 = 12.30 %

 Since the Value of Firm has
Increased from Rs. 24,00,000
to Rs. 24,92308 and
 Ko has also declined from
12.50% to 12.03 %, hence
Proposal should be accepted

 This approach supports NOI approach
relating to cost of capital and degree of
leverage. It maintains that the WACC is
not affected with the proportion of debt
to equity on the capital structure.
 MM approach offers behavioral
justification for this statement (through
Arbitrage process).

 Overall cost of Capital (Ko) and Value of
enterprise are independent of its capital
structure. Ko and V are constant for
different degrees of leverage.
 Ke increases in a manner to offset the use of
sources of funds represented by the less
expensive means of debt.
 The Cut-off rate is independent of the way
in which investment is financed. WACC is
used as a Cut off Rate.

 There are perfect capital markets.
(Means investors are free to buy and
sell securities).
 Individuals can borrow at the same
terms & conditions as firms can.
 All investors have same expectations
and awareness to the value of firm.
 Dividend payout ratio is 100%.

 There are no taxes.
 Business risk is equal among all
firms with similar operating
environment.
 There are no transaction costs. Every
investor has the freedom to switch
from one firm to another without any
restrictions or costs of making the
change.

 This approach justifies its opinion by
the way of Arbitrage & Reverse
Arbitrage process.
 Note : The process of shifting from
one firm to another will continue till
value of both the firms becomes
equal.

 Arbitrage refers to an act of buying a
security in one market having lower Price
and selling it in the other market having
higher Price.
 The same principle of Arbitrage has
been used in MM Approach to explain
that the value of Levered and Unlevered
firm will be equal irrespective of their
capital structure.

Arbitrage
Process
Levered Firm
Un-Levered
Firm
Arbitrage
An Investor Switching

Reverse Arbitrage
Process
Un- Levered Firm
Levered
Firm
Reverse
Arbitrage
An Investor Switching

 The profit from arbitrage may
either be in the form of :
1. Increased Income from Same
Level of Investment or
2. Same Income from Less
Investment

 Two companies U and L belong to same risk
class. These two firms are identical in all
respect except that company U is unlevered
while company L has 10% debentures of Rs.
5,00,000.
 The other relevant data regarding their
valuation and capitalization rates are as
follows :

Particulars Company
‘L’
Company
‘U’
EBIT 1,00,000 1,00,000
Less : Interest 50,000 Nil
Earnings available to equity
holders
50,000 1,00,000
Equity Capitalization Rate 0.16 0.125
Market Value of Equity 3,12,500 8,00,000
Market Value of Debt 5,00,000 Nil
Total Market Value 8,12,500 8,00,000
Overall cost of Capital (Ko) 0.123 0.125
Debt-Equity Ratio 1.6 -

 An Investor Mr. A is holding 10%
equity shares of Company L. Show
the arbitrage process and amount
by which he could reduce his outlay
through the use of Leverage.
 According to Modigliani & Miller,
when will this arbitrage process
come to an end ?

 Voting Power Should not
change. Means the investor
should hold the same % of
Shares in the other Company.
 The Revenue Income should
not decrease.

Present Position
in Company ‘L’
Prospective Position
in Company ‘U’
Capital Position :
10% of M.V. of Equity i.e.
Rs. 3,12,500 * .10 =
Rs. 31,250
Capital Required :
10% of M.V. of Equity i.e.
Rs. 8,00,00 * .10 =
Rs.
80,000
Less : Sale Proceed of
Shares in L Ltd.
Rs. 31,250
Remaining Rs.
48,750
To be borrowed @ 10%
Arbitration is
Possible

Revenue Position in L
Ltd:
10% of NIATEH i.e.
50,000 *.10 = Rs.
5000
Revenue Position in U
Ltd.
10% of NIATEH i.e.
1,00,000 *.10 = Rs.
10,000
Less : Interest Paid on
borrowed fund @ 10%
Rs. 4875
Effective Revenue
= Rs. 5125
Arbitration is Profitable

 According to MM , this process
of switching from Levered firm
to Unlevered firm will continue
till the value of both the firms
becomes equal .

It is defined as the use of
leverage by investors in
their own portfolio to adjust
the leverage choice given by
the firm (which is known as
corporate leverage.)

 MM Approach, at a later stage
introduced with the effects of Tax
in two identical firms.
 These two firms are similar in all
aspects, except that one firm is
levered and the other is unlevered
to find out the advantage of Debt.

 According to it Value of firm
will increase and cost of
capital will decrease
(leverage) with the
introduction of taxes.
 Since the Interest is tax
deductible, Levered firm will
have greater value.

VU = EBIT ( 1-t) / Ko
VL = VU + Dt
Where
VU = Value of Unlevered Firm
VL = Value of Levered Firm
D = Debt,
t= Tax Rate
Ko = Ke or WACC

 Companies X & Y are in the same risk class and
are identical in every respect except that
company X uses debt while company Y does
not.
 The levered firm has Rs. 9,00,000 debentures
carrying 10% rate of Interest.
 Both the firms earn 20% operating profit on
their total assets of Rs. 15 lakhs.
 Assume perfect capital markets, rational
investors and so on; a tax rate of 35% and
capitalization rate of 15% for an all equity
company.

 Compute :
(i) Value of each firms using Net Operating Income
Approach ( NOI)
(ii) Overall cost of capital for firms X & Y
(iii) Which of these two firms has an optimum
capital structure using NOI Approach and Why ?

Value of Unlevered Firm i.e.
Company ‘ Y’
VU = EBIT (1- t) / Ko
= 3,00,000 ( 1- 0.35) / 0.15
= 1,95,000 / 0.15
= Rs. 13,00,000

Value of Levered Firm i.e. Company
‘ X’
VL = VU + Dt
Rs. 13,00,000 + Rs. 9,00,000 X
0.35
Rs. 13,00,000 + Rs. 3,15,000
= Rs. 16,15,000

Ko of Company ‘X’ :
Value of the Firm = Rs.16,15,000
Value of Debt = Rs. 9,00,000
Value of Equity = V- D
= Rs.
7,15,000

Since the firm Y has only Equity and Ke = 15 %
..hence Ke = Ko i.e. 15 %
Firm X : ( Levered Firm)
Kd = I ( 1- t) = 10% ( 1-0.35) = 6.5%
Ke= NIATEH / Value of Equity
1,36,500 / V-D 16,15,000-9,00,000
1,36,500 / 7,15,000 * 100 = 19.09 %
Rs. 3,00,000 – Int 90,000 = 210,000 – Tax @ 35% ( 73,500)
= Rs. 1,36,500

Source Amoun
t
Specific
Cost
Product
10 %
Debentures
9,00,000 6.5% 58,500
Equity
Share
Capital
7,15,000 19.09 % 136493.50
Total 16,15,000 1,94,993.5
0
WACC = Total of Product / Total of Amount * 100
= 1,94,993.5 / 16,15,000 * 100
= 0.120739 * 100
= 12.07 %

 Levered Firm i.e. Company X has
an optimum Capital Structure
because it has higher Value of Rs.
16,15,000 and lower Ko of 12.07
% as compared to that of Y Ltd to
be Rs. 13,00,000 and Ko of 15%
respectively .

 Point to ponder??
 Given the fact, that Debt is the cheapest
source of finance (which is possible due to
the deductibility of Interest as per the
provisions of relevant tax laws.)
 why don’t firms go for 100% debt for their
capital requirements?

 The disadvantages emanating from the debt
which is popularly grouped as ‘Financial
Distress’.
 Financial distress arises when a firm is not
able to make payment of interest/principal to
debt holders.

 Firm’s Continuous failure to make payments to debt
holders may result into the insolvency of the firm.
 For a given level of operating risk, financial distress
exacerbates with the increase in debt.
 (With the higher level of operating risk and higher
debt, the probability of financial distress becomes
much greater.)

 Insolvency of firms involves direct as
well indirect costs.
 The expected costs of insolvency raises
the lender’s required rate of return which
in turn affects the market value of equity
negatively.

 Cost of Insolvency as the proceedings of
insolvency involve cumbersome process.
 The conflicting interest of Creditors and
other stakeholders can delay the
liquidation of assets

 and further the physical conditions of assets, which
become in-operative due to commencement of
liquidation process, may deteriorate over time and reduce
their NRV ( Net Realizable Value).
 Eventually the assets are sold out at distressed prices
which cause loss to the company.
 Insolvency also causes high legal and administrative
costs.

 In a financially distressed firm:
 The morale of employees is adversely affected and their
productivity declines.
 Customers get concerned about the quality and after-sale
services
 Suppliers curtail supplies
 Shareholders start withdrawing their investments by
selling –off their shares
 And Managers expropriate the resources of firms.

Since financial distress reduces the value of the firms,
the value of a levered firm is calculated as follows :
Value of Levered Firm = Value of Unlevered firm +
PV of Interest Tax Shield(PVINTS) – PV of Financial
Distress
Or VL = Vu + Dt – PVFD

 The Capital structure of the firm is
determined as a result of the tax benefits and
the costs of financial distress.
 The Present value of Interest Tax Shield (ITS)
increases with every increase in borrowings
and so does the cost of financial distress.
 Since the Cost of Financial Distress are very
nominal at moderate level of debt, the value
of firm increases with debt.

 With more and more debt the costs of
financial distress increases and therefore, the
tax benefit shrinks.
 The Optimum point is reached when the
marginal present value of ITS is equal to
marginal cost of financial distress. The
Value of firm is maximum at this point.

Capital Structure.pptx

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