LESSON EIGT: CAPITAL STRUCTURE: PLANNING AND DESIGNING

CHAPTER OBJECTIVES

Capital Structure Management or planning the Capital

Structure

 Essential features of sound capital mix

 Factors determining capital structure

 Profitability and Capital Structure: EBIT – EPS Analysis

 Liquidity and Capital Structure: Cash Flow Analysis

 Illustrations

 Lets Sum Up

 Questions

Capital Structure Management or Planning

The Capital Structure

Estimation of capital requirements for current and future needs is important for a firm.

Equally important is the determining of capital mix. Equity and debt are the two principle

sources of finance of a business. But, what should be the proportion between debt and equity

in the capital structure of a firm is how much financial leverage should a firm employ? To

answer this question, the relationship between the financial leverage and the value of the firm

or cost of capital has to be studied.

Capital structure planning, which aims at the maximisation of profits and the wealth of the

shareholders, ensures the maximum value of a firm or the minimum cost of the shareholders.

It is very important for the financial manager to determine the proper mix of debt and equity

for his firm.

In principle every firm aims at achieving the optimal capital structure but in practice it is very

difficult to design the optimal capital structure. The management of a firm should try to reach

as near as possible of the optimum point of debt and equity mix.

Essential Features of a Sound Capital Mix

A sound or an appropriate capital structure should have the following essential

features:

(i) Maximum possible use of leverage.

(ii) The capital structure should be flexible.

(iii) To avoid undue financial/business risk with the increase of debt.

(iv) The use of debt should be within the capacity of a firm. The firm should be in

a position to meet its obligation in paying the loan and interest charges as and

when due.

(v) It should involve minimum possible risk of loss of control.

(vi) It must avoid undue restrictions in agreement of debt.

(vii) The capital structure should be conservative. It should be composed of

high grade securities and debt capacity of the company should never be

exceeded.
 (viii) The capital structure should be simple in the sense that can be easily

managed and also easily understood by the investors.

(ix) The debt should be used to the extent that it does not threaten the solvency

of the firm.

Factors Determining the Capital Structure

The capital structure of a concern depends upon a large number of factors. The factors

influencing the capital structure are discussed as follows:

1. Financial leverage of Trading on Equity: The use of long term fixed interest bearing

debt and preference share capital along with equity share capital is called financial

leverage or trading on equity. The use of long-term debt increases, magnifies the earnings

per share if the firm yields a return higher than the cost of debt. The earnings per share

also increase with the use of preference share capital but due to the fact that interest is

allowed to be deducted while computing tax, the leverage impact of debt is much more.

However, leverage can operate adversely also if the rate of interest on long-term loan is

more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the

capital structure of a firm.

2. Growth and stability of sales: The capital structure of a firm is highly influenced by the

growth and stability of its sale. If the sales of a firm are expected to remain fairly stable, it

can raise a higher level of debt. Stability of sales ensures that the firm will not face any

difficulty in meeting its fixed commitments of interest repayments of debt. Similarly, the

rate of the growth in sales also affects the capital structure decision. Usually greater the

rate of growth of sales, greater can be the use of debt in the financing of firm. On the
 other hand, if the sales of a firm are highly fluctuating or declining, it should not employ,

as far as possible, debt financing in its capital structure.

3. Cost of Capital. Every shilling invested in a firm has a cost. Cost of capital refers to the

minimum return expected by its suppliers. The capital structure should provide for the

minimum cost of capital. The main sources of finance for a firm are equity, preference

share capital and debt capital. The return expected by the suppliers of capital depends

upon the risk they have to undertake. Usually, debt is a cheaper source of

finance compared to preference and equity capital due to (i) fixed rate of interest

on debt: (ii) legal obligation to pay interest: (iii) repayment of loan and priority in

payment at the time of winding up of the company.

On the other hand, the rate of dividend is not fixed on equity capital. It is not a legal

obligation to pay dividend and the equity shareholders undertake the highest risk and they

cannot be paid back except at the winding up of the company and that too after paying all

other obligations. Preference capital is also cheaper than equity because of lesser risk

involved and a fixed rate of dividend payable to preference shareholders. But debt is still

a cheaper source of finance than even preference capital because of tax advantage due to

deductibility of interest. While formulating a capital structure, an effort must be made to

minimize the overall cost of capital.

4. Minimisation of Risk: A firm’s capital structure must be developed with an eye towards

risk because it has a direct link with the value. Risk may be factored for two

considerations: (a) the capital structure must be consistent with the business risk,

and (b) the capital structure results in certain level of financial risk. Business risk may be

defined as the relationship between the firm's sales and its earnings before interest and

taxes (EBIT). In general, the greater the firm's operating leverage – the use of fixed
 operating cost – the higher its business risk. Although operating leverage is an important

factor affecting business risk, two other factors also affect it – revenue stability and cost

stability. Revenue stability refers to the relative variability of the firm's sales revenue.

Firms with highly volatile product demand and price have unstable revenues that result in

high levels of business risk. Cost stability is concerned with the relative predictability of

input price. The more predictable and stable these inputs prices are, the lower is the

business risk, and vice-versa. The firm's capital structure directly affects its financial risk,

which may be described as the risk resulting from the use of financial leverage. Financial

leverage is concerned with the relationship between earnings before interest and taxes

(EBIT) and earnings per share (EPS). The more fixed-cost financing i.e., debt (including

financial leases) and preferred stock, a firm has in capital structure, the greater its

financial risk.

5. Control: The determination of capital structure is also governed by the management

desire to retain controlling hands in the company. The issue of equity share involve the

risk of losing control. Thus in case the company is interested in – retaining control, it

should prefer the use of debt and preference share capital to equity share capital.

However, excessive use of debt and preference capital may lead to loss of control and

other bad consequences.

6. Flexibility: The term flexibility refers to the firm’s ability to adjust its capital structure to

the requirements of changing conditions. A firm having flexible capital structure would

face no difficulty in changing its capitalization or source of fund. The degree

of flexibility in capitals structure depends mainly on (i) firm’s unused debt

capacity, (ii) terms of redemption (iii) flexibility in fixed charges, and (iv) restrictive

stipulation in loan agreements.

 If a company has some unused debt capacity, it can raise funds to meet the sudden

requirements of finances. Moreover, when the firm has a right to redeem debt and preference

capital at its discretion it will able to substitute the source of finance for another, whenever

justified. In essence, a balanced mix of debt and equity needs to be obtained, keeping in view

the consideration of burden of fixed charges as well as the benefits of leverages

simultaneously.

7. Profitability: A capital structure should be the most profitable from the point of view of

equity shareholders. Therefore, within the given constraints, maximum debt financing

(which is generally cheaper) should be opted to increase the returns available to the

equity shareholder.

8. Cash Flow Ability: The EBIT – EPS analysis, growth of earnings and coverage ratio are

very useful indicator of a firm’s ability to meet its fixed obligations at various levels of

EBIT. Therefore, an important feature of a sound capital structure is the firm’s ability to

generate cash flow to service fixed charges.

At the time of planning the capital structure, the ratio of net cash inflows to fixed charges

should be examined. The ratio depicts the number of times the fixed charges commitments

are covered by net cash inflows. Greater is this coverage, greater is this capacity of a firm to

use debts an other sources of funds carrying fixed rate of interest and dividend.

9. Characteristics of the company: The peculiar characteristics of a company in regards to

its size, nature, credit standing etc. play a pivotal role in ascertaining its capital structure.

A small size company will not be able to raise long-term debts at reasonable rate of

interest on convenient terms. Therefore, such companies rely to a significant extent on the

equity share capital and reserves and surplus for their long-term financial requirements.
In case of large companies the funds can be obtained on easy terms and reasonable cost by

selling equity shares and debentures as well. Moreover the risk of loss of control is also less

in case of large companies, because their shares can be distributed in a wider range. When

company is widely held, the dissident shareholders will not be able to organize themselves

against the existing management, hence, no risk of loss of loss of control. Thus, size of a

company has a vital role to play in determining the capital structure.

The various elements concerning variation in sales, competition with other firms and life

cycle of industry also affect the form and size of capitals structure. If company’s sales are

subject to wide fluctuations, it should rely less on debt capital and opt for conservative

capitals structure. A company facing keen competition with other companies will run the

excessive risk of not being able to meet payments on borrowed funds. Such companies

should place much emphasis on the use of equity than debt, similarly, if a company is in

infancy stage of its life cycle, it will run a high risk of mortality. Therefore, companies in

their infancy should rely more on equity than debt. As a company grows mature, it can make

use of senior securities (bonds and debentures).

Capital Structure of a New Firm: The capital structure a new firm is designed in the

initial stages of the firm and the financial manager has to take care of many considerations.

He is required to assess and evaluate not only the present requirement of capital funds but

also the future requirements. The present capital structure should be designed in the light of a

future target capital structure. Future expansion plans, growth and diversifications strategies

should be considered and factored in the analysis.

Capital Structure of an Existing Firm: An existing firm may require additional capital

funds for meeting the requirements of growth, expansion, and diversification or even

sometimes for working capital requirements. Every time the additional funds are required,

the firm has to evaluate various available sources of funds vis-à-vis the existing capital
structure. The decision for a particular source of funds is to be taken in the totality of capital

structure i.e., in the light of the resultant capital structure after the proposed issue of capital or

debt.

Evaluation of Proposed Capital Structure: A financial manager has to critically evaluate

various costs and benefits, implications and the after-effects of a capital structure before

deciding the capital mix. Moreover, the prevailing market conditions are also to be analysed.

For example, the present capital structure may provide a scope for debt financing but either

the capital market conditions may not be conducive or the investors may not be willing to

take up the debt-instrument. Thus, a capital structure before being finally decided must be

considered in the light of the firm’s internal factors as well as the investor's perceptions.

Profitability and Capital Structure: EBIT – EPS Analysis

The financial leverage affects the pattern of distribution of operating profit among

various types of investors and increases the variability of the EPS of the firm. Therefore, in

search for an appropriate capitals structure for a firm, the financial manager must analyse the

effects of various alternative financial leverages on the EPS.

Given a level of EBIT, EPS will be different under different financing mix depending

upon the extent of debt financing. The effect of leverage on the EPS emerges because of the

existence of fixed financial charge i.e., interest on debt financial fixed dividend on preference

share capital. The effect of fixed financial charge on the EPS depends upon the relationship

between the rate of return on assets and the rate of fixed charge. If the rate of return on assets

is higher than the cost of financing, then the increasing use of fixed charge financing (i.e.,

debt and preference share capital) will result in increase in the EPS. This situation is also

known favourable financial leverage or Trading on Equity.

 On the other hand, if the rate of return on assets is less than the cost of financing, then

the effect may be negative and therefore, the increasing use of debt and preference share

capital may reduce the EPS of the firm.

The fixed financial charge financing may further be analysed with reference to the

choice between the debt financing and the issue of preference shares. Theoretically, the

choice is tilted in favour of debt financing because of two reasons: (i) the explicit cost of debt

financing i.e., the rate of interest payable on debt instruments or loans is generally lower than

the rate of fixed dividend payable on preference shares, and (ii) interest on debt financing is

tax-deductible and therefore the real costs (after-tax) is lower than the cost of preference

share capital.

Thus, the analysis of the different capital structure and the effect of leverage on the

expected EPS will provide a useful guide to select a particular level of debt financing. The

EBIT-EPS analysis is of significant importance and if undertaken properly, can be an

effective tool in the hands of a financial manager to get an insight into the planning and

designing the capital structure of the firm.

Limitations of EBIT-EPS Analysis: If maximization of the EPS is the only criterion for

selecting the particular debt-equity mix, then that capital structure which is expected to result

in the highest EPS will always be selected by all the firms. However, achieving the highest

EPS need not be the only goal of the firm. The main shortcomings of the EBIT-EPS analysis

may be noted as follows:

(i) The EPS criterion ignore the risk dimension: The EBIT-EPS analysis ignores as to

what is the effect of leverage on the overall risk of the firm. With every increase in

financial leverage, the risk of the firm and therefore that of investors also increase.
 The EBIGT-EPS analysis fails to deal with the variability of EPS and the risk return

trade-off.

(ii) EPS is more of a performance measure: The EPS basically, depends upon the

operating profit which in turn, depends upon the operating efficiency of the firm. It is

a resultant figure and it is more a measure of performance rather than a measure of

decision-making.

These shortcomings of the EBIT-EPS analysis do not, in any way, affect its value in

capital structure decisions. Rather the following dimensions may be added to the EBIT-EPS

analysis to make it more meaningful.

The Risk Considerations: The risk attached with the leverage may be incorporated in the

EBIT-EPS analysis. The financial manager may start by finding out the indifference level of

EBIT (i.e., the level of EBIT at which the EPS will be same for more than one capital

structure). The expected value of EBIT may then be compared with this indifference level of

EBIT. If the expected value of EBIT is more than the indifference level of EBIT, then the

debt financing is advantageous to the firm. The more is the difference between the expected

EBIT and the indifference level of EBIT, greater is the benefit of debt financing, and so

stronger is the case for debt financing.

In case, the expected EBIT is less than the indifference level of EBIT, then the probability

of such occurrence is to be assessed. If the probability is high, i.e., there are more chances

that the expected EBIT may fall below the indifference level of EBIT, then the debt financing

is considered to be risky. If, however, the probability is negligible, then the debt financing

may be opted.

Debt Capacity: Whenever a firm goes for debt financing (howsoever big or small), it

inherently opts for taking two burdens, i.e., the burden of interest payment and the burden of
repayment of the principal amount. Both these burdens are to be analysed (i) from the point

of view of liquidity required to meet the obligations, and (ii) from the point of view of debt

capacity.

The profits of the firm’s vis-à-vis the burden of debt financing should also be analysed. The

debt capacity or ability of the firm to service the debt can be analysed in terms of the

coverage ratio, which shows the relationship between the EBIT and the fixed financial

charge. The higher the EBIT in relation to fixed financial charge, the better it is. For this

purpose, Interest coverage ratio may be calculated as follows:

Interest Coverage Ratio = EBIT/Fixed Interest Charge

Liquidity and Capital Structure: Cash Flow Analysis

A finance manager, while evaluating different capital structure, should also find out

the liquidity required for (i) interest on debt (ii) repayment of debt, (iii) dividend on

preference share capital, and (iv) redemption of preference share capital. The requirement of

liquidity should then be compared with the cash availability from operations of the firm as

follows:

1. Debt Service-Coverage Ratio: In the Debt Service Coverage Ratio (DSCR), the

cash profits generated by the operations are compared with the total cash required for the

service of the debt and the preference share capital i.e.,

2. Projected Cash Flow Analysis: The firm may also undertake the cash flow

analysis for the period under consideration. This will enable the financial manager to assess

the liquidity capacity of the firm to meet the obligations of interest payments and the
repayment of principal obligations. A projected-cash budget may be prepared to find out the

expected cash inflows and cash outflows (including interest and repayments). If the inflows

are comfortably higher than the outflow, then the firm can proceed with the debt financing.

EBIT-EPS Analysis versus Cash flow Analysis (i.e., Profitability versus Liquidity): In the

EBIT-EPS analysis, it has been pointed out that a financial manager should evaluate a capital

structure from the point of view of the profitability of equity shareholders. A capital structure

which is expected to result in maximisation of EPS should be selected. Financial leverages at

different levels are considered so as to find out their effect on the EPS.

On the other hand, in the cash flow analysis, the liquidity side of the leverage is

stressed. A capital structure should be evaluated in the light of available liquidity. The firm

need not face any liquidity problem in debt servicing.

Under these two analyses, the different aspects of the capital structure are evaluated.

The EBIT-EPS analysis stresses the profitability of the proposed financing mix and analyses

it from the point of view of equity shareholders. The cash flow analysis looks upon a

financing mix and stresses the need for liquidity requirement of debt financing and thus, it

emphasizes the debt investor.

Financial Distress

An increase in debt thus increases the probability of financial distress. The financial

distress is a situation when a firm finds it difficult to honor its commitment to the

creditors/debt investors. With reference to capital structure, the financial distress refers to the

situation when the firm faces difficulties in paying interest and principal repayments to the

debt investors. Financial distress arises when the fixed financial obligations of the firm affect

the firm's normal operations. There are many degrees of financial distress. One extreme
degree of financial distress is the bankruptcy, a condition in which the firm is unable to meet

its financial obligation and faces liquidation. The firm should try to achieve a trade-off

between the costs and benefits of debt financing. The cost being the financial distress and the

benefits being the interest tax-shield. The financial manager must weigh the benefits of tax

savings against the cost of financial distress in the form of increasing risk. The cost of

financial distress is reflected in the market value of the firm and can be measured therefore,

through its effect on the value of the firm. Lower levels of leverage will have little effects,

but as the financial leverage increases, the cost of financial distress increases and the market

value of the debt as well as the equity falls.

In view of the cost of financial distress, the market value of the firm may not be as

much as it could have been in absence of such costs. Thus, the value of the firm is:

Value = Value (fall equity firm) + Present value of tax-shield – Present value of cost of

financial distress.

Illustration 1: Alpha company is contemplating conversion of 500 14% convertible bonds of

Ksh..1,000 each. Market price of bond is Ksh. 1,080. Bond indenture provides that one bond

will be exchanged for 10 share. Price earnings ratio before redemption is 20:1 and anticipated

price earnings ratio after redemption is 25:1.Number of shares outstanding prior to

redemption are 10,000. EBIT amounts to Ksh. 2,00,000. The company is in the 35% tax

bracket. Should the company convert bonds into share? Give reasons.
Solutions:

Present Position After Conversion

EBIT Ksh.200,000 Ksh.200,000

Less interest @ 14% 70,000 ---

1,30,000 2,00,000

less tax @35% 45,500 70,000

Number of share 10,000 15,000

EPS Rs. 8.45 Rs. 8.67

P E Ratio 20 25

Expected market Price Rs. 169.00 Rs. 216.75

The company may opt for conversion of bonds into equity shares as this will result in

increase in market price of share from Rs.169 of Rs.216.75.

Lets Sum Up

 The relationship between capital structure, cost of capital and value of firm has been one

of the most debated area of financial management.

 Factors determine capital structure are control, flexibility, characteristic of company,

profitability, cash flow ability, cost of capital, minimization of risk, trading leverage.
 Two basic techniques available to study the impact of a particular capital

structure are (i) EBIT –EPS Analysis which studies the impact of financial leverage on

the EPS of the firm and (ii) Cash Flow Analysis which emphasizes the liquidity required

in view of particular capital structure.

 Different accounting ratios such as interest coverage ratio and debt service coverage ratio

may be ascertained to find out the debt capacity of the firm and the cash profit generated

by the firm which may be used to service the debt.

 The financial manager should also take care of the financial distress which refers to the

situation when the firm is not able to met its interest / repayment liabilities and may even

face a closure.

CAPITAL STRUCTURE THEORIES

a) THE NET INCOME APPROACH (NI)

The essence of the NI approach is that the firm can increase its value or lower the overall cost

of capital by increasing the proportion of debt in the capital structure. The crucial assumption

of this approach are:

(a) The use of debt does not change the risk perception of the investor. Thus Kd and Ke

remain constant with changes in leverage.

(b) The debt capitalization rate is less than equity capitalization rate (i.e. Kd < Ke).

The implications of these assumptions are that with constant Kd and Ke, increased use of debt,

by magnifying the shareholders earnings will result in a higher value of the firm via higher

value of equity. The overall cost of capital will therefore decrease. If we consider the equation

for the overall cost of capital,

 D
Ko = Ke - ( Ke - K d)
V

Ko decreases as D/V increases because Ke and Kd are constant as per our assumptions and
Kd is less than Ke.

This also implies that Ko will be equal to Ke if the firm does not employ any debt (i.e. when
D/V = 0) and that Ko will approach Kd as D/V approaches

This argument can be illustrated graphically as follows.

b) NET OPERATING INCOME (NOI) APPROACH

The critical assumptions of this approach are:

 i.The market capitalizes the value of the firm as a whole.

ii.Ko depends on the business risk. If the business risk is assumed to remain constant, then Ko

will also remain constant.

iii.The use of less costly debt increases the risk of the shareholders. This causes Ke to increase

and thus offset the advantage of cheaper debt.

iv.Kd is assumed to be constant.

v.Corporate income taxes are ignored.

The implications of the above assumptions are that the market value of the firm depends on the

business risk of the firm and is independent of the financial mix. This can be illustrated as

follows:

C) TRADITIONAL APPROACH TO CAPITAL STRUCTURE

The traditional approach to the valuation and leverage assumes that there is an optimal

capital structure and that the firm can increase total value through the judicious use of

leverage. It is a compromise between the net income approach and the net operating

income approach. It implies that the cost of capital declines with increase in leverage

(because debt capital is cheaper) within a reasonable or acceptable limit of debts and then

increases with increase in leverage.

The optimal capital structure is the point at which Ko bottoms out. Therefore this

approach implies that the cost of capital is not independent of the capital structure of the

firm and that there is an optimal capital structure. Graphically this approach can be

depicted as follows:
 The traditional approach has been criticized as follows:

(a) The market value of the firm depends on the net operating income and the risk

attached to it, but not how it is distributed;

(b) The approach implies that totality of risk incurred by all security holders of a firm

can be altered by changing the way this totality or risk is distributed among the

various classes of securities. In a perfect market this argument is not true.

The traditional approach however has been supported due to tax deductibility of interest

charges and market imperfections.

2.4 THE MODIGLIANI-MILLER (MM) HYPOTHESIS

The MM, in their first paper (in 1958) advocated that the relationship between leverage

and the cost of capital is explained by the net operating income approach. They argued

that in the absence of taxes, a firm's market value and the cost of capital remains invariant

to the capital structure changes. The arguments are based on the following assumptions:

(a) Capital markets are perfect and thus there are no transaction costs.

(b) The average expected future operating earnings of a firm are represented by

subjective random variables.

(c) Firms can be categorized into "equivalent return" classes and that all firms within a

class have the same degree of business risk.

(d) They also assumed that debt, both firm's and individual's is riskless.

(e) Corporate taxes are ignored.

Proposition I
The value of any firm is established by capitalizing its expected net operating income (If Tax

=0)

VL = VU = EBIT = EBIT

WACC KO

1. The value of a firm is independent of its leverage.

2. The weighted cost of capital to any firm, levered or not is

(a) Completely independent of its capital structure and

(b) Equal to the cost of equity to an unlevered firm in the same risk class.

Proposition II

The cost of equity to a levered firm is equal to

(a) The cost of equity to an unlevered firm in the same risk class plus

(b) A risk premium whose size depends on both the differential between the cost of

equity and debt to an unlevered firm and the amount of leverage used.

D
K el = K eu + Risk premium = K eu + ( K eu - K d )
E

As a firm's use of debt increases, its cost of equity also rises.

The MM showed that a firm's value is determined by its real assets, not the individual securities

and thus capital structure decisions are irrelevant as long as the firm's investment

decisions are taken as given.

This proposition allows for complete separation of the investment and financial decisions. It

implies that any firm could use the capital budgeting procedures without worrying where

the money for capital expenditure comes from.

The proposition is based on the fact that, if we have two streams of cash, A and B, then the

present value of A +B is equal to the present value of A plus the present value of B.

This is the principle of value additives. The value of an asset is therefore preserved regardless

of the nature of the claim against it. The value of the firm therefore is determined by the assets

of the firm and not the proportion of debt and equity issued by the firm.

The MM further supported their arguments by the idea that investors are able to substitute

personal for corporate leverage, thereby replicating any capital structure the firm might

undertake. They used the arbitrage process to show that two firms alike in every respect except

for capital structure must have the same total value. If they don't, arbitrage process will drive

the total value of the two firms together.

Illustration

Assume that two firms the levered firm (L) and the unlevered firm (U) are identical in all

important respects except financial structure.

Firm L has Sh 4 million of 7.5% debt, while Firm U uses only equity. Both firms have EBIT of

Sh 900,000 and the firms are in the same business risk class. Initially assume that both firms

have the same equity capitalization rate Ke(u) = Ke(L) = 10%.

Under these conditions the following situation will exist.

Firm U

Value of Firm U's Equity = EBIT - KD = 900,000 - 0

 Ke 0.1

= Sh 9,000,000

Total market value = Du + Eu

= 0 + 9,000,000
= Sh 9,000,000

Firm L

Value of Firm L's Equity = EBIT - KdD = 900,000- 0.075(4,000,000)

Ke 0.10

= Sh 6m

Total market value = DL + EL

= 4m + 6m
= Sh 10,000,000

Thus the value of levered firm exceeds that of unlevered firm. The arbitrage process occurs as

shareholders of the levered firm sell their shares so as to invest in the unlevered firm.

Assume an investor owns 10% of L's stock. The market value of this investment is Sh 600,000.

The investor could sell this investment for Sh 600,000, borrow an amount equal to 10% of L's

debt (Sh 400,000) and buy 10% of U's shares for Sh 900,000. The investor would remain with Sh

100,000 which he can invest in 7.5% debt. His income position would be:

Sh Sh
Old income 10% of L's Sh 600,000 equity income 60,000
New income 10% of U's income 90,000
Less 7.5% interest on 400,000 (30,000) 60,000
 Plus 7.5% interest on extra Sh 100,000 7,500
Total new investment income 67,500
The investor has therefore increased his income without increasing risk.

As investors sell L's shares, their prices would decrease while the purchaser of U will push its

prices upward until an equilibrium position is established.

Conclusion:

Taken together, the two MM propositions imply that the inclusion of more debt in the capital structure

will not increase the value of the firm, because the benefits of cheaper debt will be exactly offset by an

increase in the riskiness, and hence the cost of equity.

MM theory states that in a world without taxes, both the value of a firm and its overall cost of capital are

unaffected by its capital structure.