AFM 1

Addition syllabus SV - Subscription value

 Cost of capital RV – Redemption Value
 Capital structure

Cost of capital
1. Cost of debt
a. Irredeemable: Kd = I(i-t)/sv
Sv= net proceeds
= issue price – flotation cost
b. Redeemable: Kd = I(i-t) + Rv-sv/n //Rv + sv/2
Rv + sv/2 Average value

2. Cost of preference shares

a) Irredeemable
KP= PD/SV x (1+DDt)
b) Redeemable
KP= PD(1+DDT) + (RV-SV)/n// RV+SV/2

3. Cost of equity (ke)

a) Dividend – growth (Gordan’s formula)
Ke = d1/po + g
D1= expected dividend at the end of the year
Po= cmp
G = growth rate g = b*r
D1= D0 + =G B =balance profits (returns)
R =ROE

b) Dividend (Gordon’s)
Ke = d1/po

c) Earning – price approach

PE – price earnings ratio
Ke=EPS/MPS = 1/ PE ratio

d) CAPM Approach
Ke = Rf Rf = 6%
8% debt 10%ps eso25%
Risk premium (Rm-Rf)

4% 19%
2%
ne
R = rf + β(rm-rf)
Some common assumption

 There are only two sources of finance.

 Total capital employed should remain the same.
 Increase in equity will be used to retire debts and increase in debt will be used to
retire equity.
 EBIT remains constant.
 There are no corporate taxes and no transaction cost.
 There are no retained earnings as entire profits are paid as dividends i.e. DPR
(dividend pay of ratio) = 100%
V=d+s v=value of firm
D= debt and s=equity
D= interest/kd kd= i/sv
S=net income/ke ke=d1v/mp
Mp=NI/Ke
V=e.b.i.t/ ko

Theory 1: Net income theory

This theory was proposed by Durand.
According to this theory, the capital structure of a firm affects the value of the firm.
Thus, a change in financial leverage of the firm will lead to corresponding change in WACC as
well as the value of the firm.
If financial leverage of the firm increases
a) WACC decreases.
b) Value of the firm will increase.
c) Market price of the equity share increases.
Assumption of theory
1. To 6 common assumptions
7. Kd < ke
8. Kd and ke remain constant.
Example 1
Suppose a company has 24,000 Equity shares and some amount of Debentures. It has
an EBIT of $500.000 and pays interest of $200,000 on its Debentures. its kd = 12.5%
and kp= 10%
EBIT 500,000
Less Interest 200,000
Net Income (N.I) 300,000

Equity [N. I. /ke = 300,000 / 12.5%] 2,400,000

Debt [200,000 / 10%] 2,000,000
Total Market Value of Firm (V) 4,400,000
WACC = EBIT/V = 500,000/4,400,000 = 11.36%
MV of Equity Shares = 2,400 000/24 000 = $100
Suppose the company issues new Debentures of $10,00,000 and with the proceeds buys back its
equity shares @ MP of $100
No. of shares bought back = 1,000,000/100
= 10,000 shares
Balance number of equity shares = 24,000 - 10,000 = 14,000
E.B.I.T. 500,000
Less: Interest [10% of 3,000,000] 300,000
N. I. for Equity Shareholders 200,000
Equity [ N.I. / k, = 2,00,000 / 12.5%] 1,600,000
Debt 3,000,000
Total Market Value of Firm (V) 4,600,000
WACC = EBIT/V = 500,000/4,600,000 = 10.87%
MV of Equity Shares = 1,600,000/14,000 = $114.29

Theory 2 : Net operating income theory

This theory was also proposed by prof. Durand.
According to this theory, value of the firm is unaffected by the capital STRUCTURE. Whatever
maybe degree of leverage, the total value of the firm remains constant.
  If the financial leverage of the firm increases
a) WACC remains constant.
b) Value of firm will remain constant.
c) Market price of the equity share remains constant.
d) Cost of equity will increase with leverage, but since the debt, which is
cheaper source of finance increases, the increase in ke of set-off by the
decrease in cost of debt.
Assumption of theory
1. 6 common assumptions
7. Kd < ke
8. Kd and ko remain constant.

Example 2
Suppose a company has 20,000 Equity shares and some amount of Debentures. It has an EBIT of
$500,000 and pays interest of $200,000 on its Debentures.
Given Ko = 12.5% and Kd= 10%

E.B.IT. 500,000
Less Interest 200,000
Net Income (N.I) 300,000
Market Value of Firm [EBIT/ ko = 500,000|12.5%] 4,000,000
Less: Debentures [200,000/10%] 2,000,000
Equity = V -D 2,000,000
WACC = EBIT/V = 500,000/4,000,000 = 12.50%
MV of Equity Shares = 2,000,000/20,000 = $100
Cost of Equity = 300,000/2,000,000 = 15%
Suppose the company issues new Debentures of $1,000,000 and with the proceeds buys back its
equity shares @ MP of $100
No. of shares bought back = 1,000,000/100
= 10,000 shares
Balance number of equity shares = 20,000 - 10,000 = 10,000
E.B.I.T. 500,000
Less: Interest [10% of 3,000,000] 300,000
N.I. for Equity Shareholders 200,000
Market Value of Firm [500,000/12.5%) 4,000,000
Less: Debentures 3,000,000
Equity = V -D 1,000,000
WACC = EBIT/V = 500,000/4,000,00 = 12.50%
MV of Equity Shares = 1,000,000/10,000 = $100
Cost of Equity = 200,000/1,000,000 = 20%

Observation
1) WACC has remained the same at 12.5%
2) MP of equity shares has remained the same at $100.
3) Value of the firm has remained the same at $4,000,000.
4) Cost of equity has increased from 15% to 20%

Theory 3: Millers Modigliani Theory

According to miller and Modigliani two companies which are in the same business, with the
same business risk, same capital employed, and same operating profit should have the same
market value.
They argue that value of the company depends upon the profitability and the way the assets
of the company are used.
The value of the company does not depend upon the way the assets of the company are
financed.
If such similar companies do not have the same market value, then the investors will, make it
same by the process of arbitrage
Assumption of the theory
1) To 6. Common assumption
7. capital market is perfect
8. All investors are rational
9. An investor can substitute corporate debt by personal debt

Arbitrage Process
Normally “arbitrage process” is a process by which similar product having different prices in
different markets at the same time are brought to equilibrium, in this case M&M state that if
two companies are similar as to their operating list type of product etc. then they should
have the same value also. If not, then the process of arbitrage will bring about equilibrium as
follows:
 Shareholders of the overvalues company will sell their shares and buy the shares of
the Undervalued company, this will increase the demand purchase of undervalues
company. Thereby increasing the market value of its shares. On the other hand,
supply of overvalues company shares when increased resulting in a decline in the
market value.
The investors will replace corporate debt by taking personal loan to maintain same
level of financial leverage. The investor will enjoy the benefits of arbitrage range by
switching over, this will continue till there is befit in switching over.
When the benefit stops, it will be found that both the companies are in equilibrium.

Example 3
The following is the data regarding two companies X and Y belonging to the same equivalent
risk class.
X y
Number of Ordinary Shares 90,000 150,000
Market Price per share $1.20 $1.00
6% Debentures $60,000 NIL
Profit Before Interest $18,000 $18,000
All profit after debentures interest is distributed as dividends.
Explain how under Modigliani & Miller approach, an investor holding 10% of shares in
company X will be better off in switching his holding to company Y?

STEP 1:
Shareholder holding 10% stake in Company X will sell off his shares. Amount realised is
$10,800.

STEP 2:
Shareholder will borrow $ 6,000 [10% of 60,000] @ 6% interest p.a. to have same leverage
as before. Therefore, total amount with shareholder
= 10,800 + 6,000
= $16,800

STEP 3:
The total amount of $16,800 will then be used to purchase the shares of Company Y
S1 per share.
So, proportion of investment in Co Y
= 16,800/1,50,000 x 100
= 11.2%
 Co. Co.
M.V of equity share 108,000 150,000
6% Debenture 60000
168,000 150,000
E.B.I. T 18000 18000
(-) Interest (3,600)
N.I for ESH/Dividend 14,400 18,000

CO.X (Before) CO. Y(After)

Dividend Received 1,440 2,016
[10%*14,400] [11.2%*18,000]
Interest on loan @ 6% on (360)
60,000
1,440 1,656

Arbitrage Gain = 216

The above process will continue till the price of the two firms come to a common
equilibrium

Example
Two companies A n B belong to the same risk class. Two firms are identical in every aspect
except the firm A has 10% Debentures. The valuation of two firm is as follows:
A B
NOI 2,250,000 2,250,000
Interest on debt 150,000
Earnings to ESH 2,100,000 2,250,000
MV of Equity 15,000,000 18,000,000
MV of Debt 1,500,000
Total MV of the firm 16,500,000 18,000,000
Show the arbitrage by which an investor who holds shares $2,250,000 in company B will be
benefited by investing in company A

STEP 1:
Sell shares of Co. B for $2,250,000 [12.5% stake]

STEP 2:
Buy 12.5% of shares of Co. A $1,875,000
Buy 12.5% of Debentures of Co. A $187,500
$2,062,500

STEP 3:
Surplus = 2,250,000 - 2,062,500 = $187,500

Co. A Co. B
Dividend received 281,250 262,500
[2,250,000*12.5%] [12.5%*2.1m]

Interest received on 18,750

debentures

281,250 281,250

By investing in co B the investor was 281250. Now by switching over to co A, he gests the
same amount of 281,250. But he has a surplus of 187,500 which will earn additional income
and that will be the investor’s gain
If corporate taxes exist (MM Theory)
Valuation under NOI approach
i. Vu = NOI (1-t) / Ke
ii. VL = VU + D * t
iii. Ko = Kd(D)/VL + Ke(S)/VL
Explanation of VL = Vu+ D * t
According to MM Theory, if taxes are introduced, since interest on debt is a tax-
deductible expenditure, the effective cost of borrowing is less than the rate of interest
as per agreement.
Therefore, a levered firm will have a greater value than an unlevered firm. Thus, value of
a levered firm will exceed that of an unlevered firm by an amount equal to the levered
firm's debt as multiplied by rate of tax.
Example
Suppose the EBIT of two companies U and Lis $1,000,000. They are similar in all respects
except that Co. L uses 15% Debt of $ 2,000,000. The rate of tax is 30%. Value of Co. U is
$5,000,000. What is value of Co. L?

Co.L CO. U
EBIT 1,000,000 1,000,000
LESS: INTEREST 300,000
NPBT 700,000 1,000,000
LESS: Tax @ 30% 210,000 300,000
Income available for ESH 490,000 700,000
Income available foe debt 790,000 700,000
and ESH

Benefit for stakeholders in the levered company exceeds by $90,000, and the debt of
the levered company is permanent. So, the benefit accruing is also going to be
permanent.
Therefore, advantage to stakeholders of levered company will be 90,000/15% =
$600,000
But 2,000,000 * Tax Rate 30% = 600,000
Le. Debt of levered company x tax rate = 600,000
Value of levered Firm = Value of Unlevered Firm + Benefit of leverage
= 5,000,000 + 600,000
= $5,600,000

C
When considering the proposed course of action of taking the company to a full listing
on an international stock exchange, the CFO should take into account several ethical
considerations:

1. Transparency and Disclosure: The CFO should ensure that all relevant information
about the company's financial performance, risks, and prospects is accurately and
transparently disclosed to potential investors. This includes providing complete and
truthful financial statements, as well as disclosing any potential conflicts of interest or
related party transactions.

2. Fair Treatment of Shareholders: The CFO should ensure that the interests of all
shareholders, including minority shareholders, are protected and that they are treated
fairly in the listing process. This includes ensuring that the listing process does not
unduly benefit certain shareholders at the expense of others.

3. Insider Trading and Market Abuse: The CFO should ensure that all employees and
stakeholders involved in the listing process are aware of and comply with laws and
regulations related to insider trading and market abuse. This includes not using any non-
public information for personal gain or sharing such information with others who may
use it for trading purposes.

4. Corporate Governance: The CFO should consider the impact of the listing on the
company's corporate governance structure. This includes ensuring that the company has
appropriate board composition, independent directors, and effective internal control
systems to safeguard the interests of shareholders and stakeholders.

5. Social and Environmental Responsibility: The CFO should consider the company's
social and environmental impact and ensure that it complies with relevant regulations
and standards. This includes disclosing any potential environmental risks or liabilities
associated with the company's operations.

6. Impact on Employees: The CFO should consider the potential impact of the listing on
employees, such as changes in ownership structure, potential job losses, or changes in
employee benefits. It is important to ensure that employees are treated fairly and their
rights are protected throughout the listing process.
7. Reputation and Public Perception: The CFO should consider the potential impact of
the listing on the company's reputation and public perception. This includes assessing
any potential negative consequences or controversies that may arise from the listing
and taking appropriate measures to mitigate them.

It is important for the CFO to carefully consider these ethical considerations and ensure
that the proposed course of action aligns with the company's values and
ethical standards.