Professional Documents
Culture Documents
Capital Structure Dicisions
Capital Structure Dicisions
Capital Structure Dicisions
Increase in leverage
Decrease in leverage
Value of
Increase (since K0 is decreased)
firm
Leverage means using borrowed funds. In above table since you are borrowing funds so
that must be cheaper. This is assumed.
6. Steps involved in calculating the weighted average cost of capital under Net income
approach:
a. MV of equity share =
b. MV of debt =
Net income
Ke
Interest
rate of interest
NOI
K0
interest
interest rate
Net income
Value of equity
Net incomeinterest
Value of equity
Traditional Approach
9. Traditional approach:
a. Traditional approach is intermediate of NI and NOI approach. Since it considers both
the approaches.
b. The calculation and steps involved in this approach are same as NI approach.
Modigilani and Millar approach
10.MM approach:
a. According to this approach, K0 is independent of its capital structure. That means by
changing the debt equity ratio, a firm cannot change its value and cost of capital.
b. If two firms are identical in all aspects except for the degree of leverage, firms will
have different MV so the arbitrage will start.
c. Assumptions:
i. There is perfect capital market.
ii. Homogenous risk class.
iii. No taxes
iv. All investors have same expectations.
v. Company has 100% payout ratio.
d. Criticism:
i. There is no perfect market.
ii. Arbitrage may fail.
iii. Existence of corporate tax.
11.Before starting the problem, calculate the total value of Unlevered firm and Levered firm::
a. Calculation of total value of unlevered firm when there are no taxes:
i. Value of unlevered firm = NOI / Ke
ii. In case of unlevered firm, there is no debt so the question of K d doesnt arise
thats Ke = K0
b. Calculation of value levered firm when there are taxes:
i. Value of levered firm can be calculated only when the taxes are given.
ii. Value of unlevered firm when there are taxes = (NOI taxes) / K e
iii. Value of levered firm = Value of unlevered firm + tax saving ( tax paid on
debt)
When there are no taxes
Particulars
1.
2.
3.
4.
5.
6.
NOI
Less : Interest
NI
K0
Total Value of firm (NOI / K0)
Less: MP of debt (Interest /
rate)
7. MP of Equity
8. Ke ( NI / MP of equity)
Particulars
1. Value of unlevered firm (NOI (1
t) / Ke)
2. Add: tax saving on interest on
debt
3. Total value of firm (1+2)
4. Less : MP of debt (interest /
rate)
5. MP of equity (3 4)
6. Ke (NOI interest)(1 tax) / MP
of equity
Amou
nt