UNIVERSITY OF CENTRAL PUNJAB

FALL 2020

FALL 2020
Course Title: Financial strategy
Course Code: IVA5833

Assignment No. 1
Name of Course Instructor: Marriam Rao

Submitted by: Amna Noor Tayyab Reg No: L1F17BSCM0021

Section: B Program: BSAF Date: 05-11-2020

Submission Date: 10-11-2020 Maximum Marks: 25

Program Objective: PO2 Course Objective: CO1 Course Learning Objective: CLO2

Assignment Topic & Details: Capital Structure

Question 1: Contrast the net operating income (NOI) approach with the Traditional approach
theory of capital structure. Explain with help of graph.
Question 2: Why might you suspect that the optimal capital structure would differ significantly
from one industry to another? Would the same factors produce differing optimal capital
structures within all industry groupings?
Question 3: What factors determine the interest rate a firm must pay for debt funds? Is it
reasonable to expect this rate to rise with an increasing debt-to-equity ratio? Why?
Question 4: What is the total-value principle as it applies to capital structure?
Question 5: If there were no imperfections in financial markets, what capital structure should the
firm seek? Why are market imperfections important considerations in finance? Which
imperfections are most important?
Question 6: What are bankruptcy costs? What are agency costs? How do they affect the
valuation of the firm when it comes to financial leverage?
1: Contrast the net operating income (NOI) approach with the Traditional
approach theory of capital structure. Explain with help of graph.
Capital Structure of a corporation refers to the composition or frame of its capitalization and it
includes all long-standing capital resources. Capital structure is the composition of a firm’s
finance consists of equity, preference, and debt. It is the combination of a firm’s everlasting
long-term financing represented by debt, preferred stock, and common stock equity.

Net operating income approach:

Net Operating Income Approach to capital structure was advocated by David Durand, believes
that the value of a firm isn't laid low with the modification of debt part within the capital
structure. This approach is exact opposite of net income approach. It assumes that the profit that
a firm derives by infusion of debt is negated by the immediate increase in the required rate of
return by the equity shareholders. With a rise in debt, the risk related with the firm, mainly
bankruptcy risk, conjointly will increase and such a risk perception will increase the expectations
of the equity shareholders. The market value of a firm is going to be same no matter the
proportion of debt. The reason of this is that any profit from the increase of cheaper debt will be
balance by a higher required rate of return on equity. Thus, the WACC and also the market
price of a firm stays fixed at any level of financial leverage.
 Use of higher debt component in the capital structure increases the risk of shareholder.
 Increase in shareholder risk causes the equity capitalization rate to increase ex higher cost
of equity
 Higher cost of equity due to cheaper cost of debt
 WACC is always constant and it depends on business risk. The Value of the firm is
calculated by using the overall cost of capital (WACC) only.
 Corporate income taxes do not exist in this. The cost of debt is constant at any level of
financial leverage and the cost of equity is larger than the cost of debt at any level of
financial leverage.
Formula:

Market value of shareholders equity is calculated by: E=V-D

The market value of the firm depends on operating income (EBIT): V = EBIT / WACC

Graph:

In other words, if we say the debt and equity is irrelevant to the market value of the firm.
Investors will claim a higher rate of return on equity to compensate for the higher risk they take.
  In this Price/rate of capital is constant
 Portion of debt increases and equity increases
 There is no effect on total cost of capital (WACC)
Traditional approach theory of capital structure:

Traditional approach is a compromise between NI and NOI. Traditional approach confirms the
existence of an optimal capital structure wherever WACC is min and worth of firm is max. the
traditional approach differs from the NOI approach as a result of it doesn’t hold that the overall
cost of capital will remain constant whatever be the degree of financial leverage. Traditional
theorists believe that up to certain purpose a firm can by increasing proportion of debt in its
capital structure reduce the cost of capital and lift market value of stock. Debt can lead the value
of capital to rise and the market value of the stock to fall. Thus, through a thoughtful mix of debt
and equity a firm can maximizes the overall cost of capital to maximizes the value of stock. The
best purpose in capital structure is one whenever overall price of capital begins to rise quicker
than the rise in earnings per share as result of application of additional debt. When the increased
cost of equity can’t be offset by the advantage of low-cost debt. Thus, overall value of capital to
keep with this approach decreases up to bound purpose remains extra or less unaffected and will
increase or rise on the way aspect a specific quantity. The Traditional Theory of Capital
Structure states that when the WACC is minimized, and also the market price of assets is
maximized, AN optimal structure of capital exists. This is achieved by utilizing a mix of both
equity and debt capital. This point occurs where the marginal cost of debt and the marginal cost
of equity are equated, and any other mix of debt and equity financing where the two don't seem
to be equated permits a chance to extend firm price by increasing or decreasing the firm’s
leverage.

 This theory says that for any company or investment there is an optimal mix of debt and
equity financee that minimizes the WACC and max value. The optimal capital structure
occurs where the marginal cost of debt is adequate to the marginal cost of equity. The
cost of either debt or equity financing vary with reference to the degree of leverage.
 Cost of equity remains stable or grows slightly with a rise within the debt ratio to a
definite limit after which it begins to grow rapidly. Cost of debt remains stable with a rise
within the debt ratio to a definite limit after which it begins to grow.

Cost of capital is reducing initially. At point it settled after this Ko increases due to increase in
equity. The capital of the firm is represented by equity only, its WACC is equal to the cost of
equity as financial leverage increases, WACC decreases until the marginal cost of debt is less
than marginal cost of equity.
Calculation of WACC: WACC = kd × wd + ke × we

2: Why might you suspect that the optimal capital structure would differ
significantly from one industry to another? Would the same factors produce
differing optimal capital structures within all industry groupings?
An optimal capital structure is the best mix of debt and equity financing that maximizes a
company's market value and minimizing its cost of capital. Minimizing the WACC is one way to
optimize for the lowest cost mix of financing.
 D/E vary across industries because some industries are more capital intensive than others
 The financial sector has one of the highest debts and equity but this is not indicative of
high risk, just the nature of the business.
 The debt-to-equity (D/E) ratio measures how much of a business's operations are
financed through debt versus equity.
 A higher D/E ratio indicates that a company is financed more by debt than it is by its
wholly-owned funds.
 Depending on the industry, a high D/E ratio can indicate a company that is riskier.

Different industries experience different business environments. Consequently, these

circumstances can cause differences in the capital structure. In a growth industry, the need for
new investments and increased debt capital can be larger than in a mature industry. Capital
structures can vary significantly by industry.  Cyclical industries like mining( price to net asset,
price to cash flow, total acquisition cost etc.) are often not suitable for debt, as their cash flow
profiles can be unpredictable and there is too much uncertainty about their ability to repay the
debt. Other industries, like banking and insurance, use huge amounts of leverage and their
business models require large amounts of debt. Debt ratio is negatively related to profitability,
growth, and age, while asset structure and company size are positively related.
One of the major reasons why this vary is the capital-intensive nature of the industry. Capital-
intensive industries, such as oil and gas refining or telecommunications, require significant
financial resources and large amounts of money to produce goods or services. The D/E ratio
measures the proportion of how a company finances its operations with debt versus equity. Each
industry has a different parameter of what constitutes a good or bad D/E ratio based on their
capital requirements and revenue-generating capabilities. The optimal capital structure becomes
the search for the WACC, because when the WACC is minimized, the value of the
company/shareholder wealth is maximized so each company has its own values of shares or
position in market so this resulted different in every firm or industry.
Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world
optimal capital structure. What defines a healthy blend of debt and equity varies according to the
industries involved, line of business, and a firm's stage of development, and can also vary over
time due to external changes in interest rates and regulatory environment.

3: What factors determine the interest rate a firm must pay for debt funds? Is
it reasonable to expect this rate to rise with an increasing debt-to-equity ratio?
Why?
The D/E ratio is an important metric. It is a measure of the degree to which an organization is
finances its operations through debt versus wholly-owned funds. The debt-to-equity (D/E) ratio
compares organizations total liabilities to its shareholder equity and can be used to measure how
much leverage a company is using. A debt-to-equity ratio measures the amount of debt a
company uses to fund its business for every dollar of equity it has. The risk of defaulting on, or
being unable to repay, your debt increases as your debt-to-equity ratio rises. The debt-to-equity
ratio measures an organizations debt relative to the value of its net assets; it is most often used to
gauge the extent to which a corporation is taking on debt as a means of leveraging its assets. A
high debt/equity ratio is often associated with high risk; it means that a corporation has been
aggressive in financing its growth with debt.
One of the main factors used to determine the interest rate of a firm for debt funds is Debt Equity
ratio. The Debt Equity ratio relates the amount of a firm’s debt financing to its equity. To
calculate the debt equity ratio, divide a firm's total liabilities by its total shareholder equity both
items are found on organizations balance sheet. The organizations capital structure is the driver
of the debt-to-equity ratio. The more debt a company uses, the higher the debt-to-equity ratio
will be. Yes, it is reasonable to expect this rate to rise with an increasing debt-to-equity ratio. A
high debt equity ratio is considered risky for lenders and investors because it suggests that the
company is financing a significant amount of its potential growth through borrowing.
If a lot of debt is used to finance growth, an organization could potentially generate more
earnings than it would have without that financing. If leverage increases earnings by a higher
amount than the debt’s cost (interest), then shareholders should expect to benefit. However, if the
cost of debt financing outweighs the increased income generated, share values may decline. The
cost of debt can vary with market conditions. For equity capital, this cost is determined by
calculating the rate of return on investment shareholders expect based on the performance of the
broader market and the instability of the company's stock. The cost of debt capital, on the other
hand, is the interest rate lenders charge on the borrowed funds.
Interest rates mainly influence a company's capital structure by affecting the cost of debt capital.
Companies finance actions with either debt or equity capital . Short-term debt tends to be cheaper
than long-term debt and it is less sensitive to shifting interest rates, the second company’s
interest expense and cost of capital is higher. If interest rates fall, long-term debt will need to be
refinanced which can further increase costs. Rising interest rates would seem to favor the
company with more long-term debt, but if the debt can be redeemed by bondholders it could still
be a disadvantage.

4: What is the total-value principle as it applies to capital structure?

The Valuation Principle states that we can use market cost to determine the value of an
investment chance to the firm. the total value of a firm, in a perfect capital market, is equivalent
to the market value of the total cash flows which is shaped by its assets and is not affected by its
choice of capital structure. Total value principle for financial perfect capital markets in which
financial transactions neither add nor destroy value, but instead signify a repackaging of risk
(and therefore return). It suggests that any financial transaction that seems to be a good deal in
terms of adding value either is likely too good to be true or is operating some type of market
imperfection.
Modigliani and Miller (M&M) is Believer that the relationship between financial leverage and
the cost of capital is explained by the NOI approach. Provide behavioral justification for a
constant ko over the entire range of financial leverage possibilities. Total risk for all security
holders of the firm is not altered by the capital structure. Therefore, the total value of the firm is
not altered by the firm’s financing mix. Total market value is not altered by the capital structure
M&M assume an absence of taxes and market imperfections. Investors can substitute personal
for corporate financial leverage. In theory, debt financing offers the lowest cost of capital due to
its tax deductibility. However, too much debt increases the financial risk to shareholders and the
return on equity they require. Thus, companies have to find the optimal point at which the
marginal benefit of debt equals the marginal cost.
MM proved their result by arguing that, in perfect capital markets, the total cash flow paid out to
all of a firm’s security holders is equal to the total cash flow generated by the firm’s assets.
Therefore, by the Law of One Price, the firm’s securities and its assets must have the same total
market value. Thus, as long as the firm’s choice of securities does not change the cash flows
generated by its assets, this decision will not change the total value of the firm or the amount of
capital it can raise.

5: If there were no imperfections in financial markets, what capital structure

should the firm seek? Why are market imperfections important
considerations in finance? Which imperfections are most important?
MM proved their result by arguing that, in perfect capital markets, the total cash flow paid out to
all of a firm’s security holders is equal to the total cash flow generated by the firm’s assets.
Therefore, by the Law of One Price, the firm’s securities and its assets must have the same total
market value. Thus, as long as the firm’s choice of securities does not change the cash flows
generated by its assets, this decision will not change the total value of the firm or the amount of
capital it can raise. Even if investors prefer an alternative capital structure to the one chosen by
the firm, MM demonstrated that the firm’s capital structure is still irrelevant because investors
can borrow or lend on their own and achieve the same result With perfect capital markets, a
firm’s WACC is independent of its capital structure and is equal to its unlevered equity cost of
capital. If there were no imperfections in the market firm increases its leverage, its debt and
equity costs of capital both increases, but its weighted average cost of capital remains constant
because more weight is put on the lower cost debt.
Market imperfections generate costs. Understanding these costs gives us insight regarding the
total costs of transactions, where to place them, or whether to make them at all . An imperfect
market refers to any economic market that does not meet the hard standards of the hypothetical
perfectly or purely competitive market. A perfect market is characterized by perfect
competition, market equilibrium, and an unlimited number of buyers and sellers. That’s why
market imperfections are considered important in finance. With perfect capital markets, a firm’s
WACC is independent of its capital structure and is equivalent to its unlevered equity cost of
capital. Because unlevered equity is equivalent to a portfolio of debt and levered equity. With
perfect capital markets, financial transactions neither add nor destroy value, but instead represent
a repackaging of risk (and therefore return). It implies that any financial transaction that appears
to be a good deal in terms of adding value either is likely too good to be true or is exploiting
some type of market imperfection. Imperfections can and do change over time. The degree of
existing imperfections varies, new imperfections appear, and existing imperfections disappear.
The simplest example is taxes, Tax rates change, new taxes are imposed, and (much less
commonly) disappear entirely.
Imperfect markets are characterized by having competition for market share, high barriers to
entry and exit, different products or services, and a very small number of buyers and sellers.
Perfect markets cannot exist in the real world; all real-world markets are imperfect markets.
Market structures that are categorized as imperfect include monopolies, oligopolies,
monopolistic competition, monopsonies, and oligopsony’s. Some examples of imperfect
markets:
 Monopolies and oligopolies: An organization could have established a monopoly, so
it can charge prices that would normally be considered too high. The same situation
arises in an oligopoly, where there are so few competitors that there is no point in
competing on price.
 State intervention: Governments may intervene in a market, usually to set prices
below the actual market level (such as by subsidizing the price of oil). When this
happens, an excessive quantity is purchased. The reverse situation can also occur,
where a government imposes such high regulatory barriers that few companies are
allowed to compete.
 Monopolistic Competition: In monopolistic competition, there are many sellers who
offer similar products that can't be substituted. Businesses compete with one another and
are price makers, but their individual decisions do not affect the other.
 Monopsony and Oligopsony: These structures have many sellers, but few buyers. In
both cases, the buyer is the one who manipulates market prices by playing firms against
one another

6. What are bankruptcy costs? What are agency costs? How do they affect the
valuation of the firm when it comes to financial leverage?
Bankruptcy costs:
The more debt a company takes on the more it risks being unable to meet its financial obligations
to creditors. A high leverage firm is more vulnerable to a decrease in profitability. Therefore, a
highly leverage firm has a higher risk bankruptcy.
The way to measure the bankruptcy cost is to multiply the probability of bankruptcy by the
expected cost of bankruptcy.
Agency costs:
Agency costs are internal costs incurred due to competing interest of shareholders and the
management team (agents). Expenses associated with resolving disagreements and managing the
relationship are referred to as agency costs. We can say that it refers to conflict between
shareholders and their company’s managers. The shareholder wants the manager to make
decisions which will increases the share value. Managers prefer to expand and increase salaries
which may not necessarily increase share value.
how do they effect the valuation of firm?
Bankruptcy usually happens when a company has far more debt than it does equity. While debt
in a company's capital structure may be a good way to finance its operations, it does come with
risks. Companies use debt and equity achieve an optimal capital structure to finance their
operations. Financing with debt can decrease a company's tax liabilities, but taking on too much
debt can increase the level of risk to shareholders, as well as the risk of bankruptcy. Bankruptcy
costs, which include legal fees, can erode a company's overall capital structure. Higher costs of
capital and an raised degree of risk in order, increase the risk of bankruptcy. As the company
adds more debt to its capital structure, the company's WACC increases beyond the optimal level
which cause increase in bankruptcy costs.
Debt investors take less risk because they have the first claim on the assets of the business in the
event of bankruptcy.  For this reason, they accept a lower rate of return and, thus, the firm has a
lower cost of capital when it issues debt compared to equity. Equity investors take more risk, as
they only receive the residual value after debt investors have been repaid.  In exchange for this
risk, investors expect a higher rate of return and, therefore, the implied cost of equity is greater
than that of debt. Leverage is positively related to firms’ value before reaching to the optimal
level of capital structure. bankruptcy costs tend to rise at an increasing rate with financial
leverage on other hand Agency Costs associated with monitoring management to ensure that it
behaves in ways consistent with the firm’s contractual agreements with creditors and
shareholders.