= deals with the selection of appropriate capital structure which would help in pe present chapter pang “te value ofthe fim and minimising the overall cost of capital There are many viewpoints 4 relationship between leverage and valve ofthe frm. One schoo! of thought believes hat < relationship between value of firm and ts capital structure, On the other hand there is an Sassy song school of tought which believes tha financing mi or the combination of debt and equity ea axon te shareholders weath 20 the decson repring captal sructre rales 1m Pncag mix anor alec te tol opeaing earings of frm, ashy ae determined by Se rent deisons, butt can affect the share of earings ofthe shareholders, INTRODUCTION sa cpital structure refers to the employment of ons" | Gopi anutiredcsonisone athe pital: Dept capital important decision which decides the jor ke mixof debtand equity _propoionof debt and equ in ovr il used by a firm to finance its investment and operation capi stim of a firm with an Objective of maximizing its value. bya firm. There are two major types of cay ity capital. Capital struct Itinvolves an important decision as to how much of debt is empolyed by a firm. Employment of ases the financial risk for equity shareh per share. Hence capital structure decision is one tp ortion of debt and equity in overal value. more and more debt olders. However, at ompany’s earnings are first utilised to pay the interest on Decision on how much debtis to be a ‘ should be taken in the light ing amount iS of the criterion which Bei: ‘capital, then tax is calculated on the income after deducting fest on debt. After paying tax the remai ted among the shareholders. Therefore, in order to fullfil value of the firm. tive of wealth maximisation, capital structure should be dina way to bring the maximum value to’ the equity shareholders. the same time it also increases the of the important decision which decid Il capital structure. ofa firm with an objective of maximizing a‘enterprise. -onam “Capital structure is the "According to Weston and Brigham “Cap! sth?” long-term deb preferred ay é Gebt and equity which brings optimum capital structure. ‘There are different theories of capi the relationship of capital: relationship between value no relationship between value theories are: 4 1. NetIncome Approach. 2. NetOperating 3, Modigliani -Miller Approach. 4, Traditional Ap tions of Capital Structure Theories relationship between made: ‘Common Assump' Todicuss various theories and to understand the value of the firm , the following ‘common assumptions are 1. Thefirmemploys only wo types of capital ie. debt and equity, 2. There areno corporate taxes. 3 3 The total assets of the firm are given and there would beno changin the firm. ay 4 Theoperating profits (EBIT) of the firm are not expected tO grow: 5, Thedividend-payout-ratio is 100% ie. there arenoretained earnings. 6 ‘The business risk ofthe firm is given and constant. It is not affected 7. Allth investors have the same subjective probability distribution of tl ceamings (EBIT) fora given firm. vl 8. Thetotal financing remains constant. ‘The firm can change its capital: 4 . st the debentures by ssue of shares or by raising the debtand reducing t Inthe light of these assumpti ie it " iptions, theories of capital structure are discus these theories let us be familiar with notations and formulae used in the tt Notations and Formulae Used in the Text i 1. Market value of equity = E 2. Market value of 3. Total market value of the firm (V)=E+D 4, Total interest pay n 5. Earnings available to equity shareholders = NIconten ott nen tand tax = EBIT x re interes! _ NI © ot eat © ° paIT-I gy M gE E ett @= E D k, +(E)a alae E a Via (oez)h+(s8 ke EBIT _ 1+NI v v cost of capital (Ko) hy Bask, D ht to“ E All the above formulae are based on the assumption of no corporate taxes. INCOME (NI) APPROACH (RELEVANCE APPROACH) was given by David Durand. It suggests that there exists ppm Ht between capital structure and value of the firm. In | Net toside, a change in the capital structure causes a | nding change in the overall cost of capital and the value Hence a capital structure (proportion of debt and equity) value of firm. It is called relevance approach. This based on following additional assumptions: ‘There are no corporate taxes. The cost of debt is less than the cost of equity. The debt content in the capital-structure does not change the risk-perception of the investors. Hence cost of equity (k,) and cost of debt (k,) will remain constant. Iteimplication of the above assumptions is that as we increase the proportion of debtin the total sinicture, the weighted average cost of capital tends to decline. This is due to the fact that debt Per source of finance. With the increased use of debt having lower cost and cost of equity constant, the earnings of the shareholders and market value of the shares will increase, thereby he value ofthe firm. vif the financial leverage is reduced i, decline of debt es capital structure, the overall cost of capital will Vers, tal value of the firm will decrease. So, financial lite ngenporeant variable to the total capital structure of a leverage is zero then the overall cost of capital SB fothe cost of equity.Therefore, when a firm borrows funds then itis said tha firm sus they refr debts gearing Iieans debt marist fran al pefoman bepostve or negative The fundamental prindple of nancial overage thus increasing expected retumsto the shareholders (mea byes Aneotding ch value oft Value ing tothe Net Income (NI) Approa - veE+D é Where, V=Total market value of the firm ‘ Fe Market value ofequityand D=Market value of debt j NI _ EBIT-I 2 — 0 Se k, Overall cost of capital (ky) a or(t) =F, x wth xy ere and, are the proportion of debtand equity in capital “The approach canbe explained with the help of Example, " EBITs 300,000. The equity a ec mnom, 9% debentces dm é per NI approach Computation of the value of firm and overall cost of Value of equity (E) = a fe Value of debt (D) (given) Tolal value of the firm (V) = (E + D) EBIT _ 3,00,000 WACC(k,)= = 31,00,000 __ The WACC can also be calculated as follows: roca eae sesh -| 5,00,000 D+E]* | 5,00,000+ 26,00,000 = 0.012 + 0.084 =0.096 0r 9.6%Capital Structure, Cost of Capital and Valuation Be. debts js increased from the 5,00,000 to 8,00,000: firm and overall cost of capital (NI Approach) % | 3,00,000 64,000 | 2,36,000 | 23,60,000 | 8,00,000 31,60,000 94% with the increase in the debt content in total capital structure, value of the firm has mer oe 31,00,000 to Z 31,60,000 and WACC eclined from 9.6% to 9.4%. is reduced from & 5,00,000 to.& 2,50,000 ue of firm and overall cost of capital (NI Approach) 2 up x yoorion of debts i Computation of val 3,00,000 a io essinterest | 20.00 2,80,000 Netincome KAO 2,80,000 value of equity (E)= p49 Value of debt (D) (given) Value of the firm (V) (E + D) EBIT _ 3,00,000 WACE (ke)= == * 39,60,000 50, \ ortion of debt is reduced to % 2,50,000, the value ofthe Here we can see that when the props %30,50,000 and its WACC has increased from 9.6% to fim has gone down from %31,00,000 to 58%. Gndusions of Net Income (NI) Approach: ‘nnutsell the following conclusions can be drawn from net income approach. 1 - m * . Value of the firm: According to this approach, a firm can increase its value by increasing the ture. This is because of the assumption Boron of debtor degree of leveregein the capital stru ‘ sone, Pproach that cost of debt (k,) ‘and cost of equity (k,) are constant and debt is a cheaper Legit finance (k, < k,). Increased use of debt will continue to increase the earnings available E tity shareholders aid value of the firm, However, the value of firm will continue to increase ee rate of retum on investment is higher than the cost of debt. Psat 2st of equity (k,): The debt content in the capital stare does not change the risk n of the investors. Hence the cost of equity will remain constant.3. Overall cost of capital : With increased debt Proportion or financial leverage, the overall cost of Also this is i capital (K,) would keep on declining. s Decause of the factthat k,and k,areconstantandki< 5 k,. This is illustrated in figure 9.1. Gee 4. i i : rding to this Optimum capital structure a rau capil approach, a firm will have its ; structure when it has 100% debt contents. This . based on the assumption that rate of return 0} investment is more than cost of debt. However 1f 100% debtis theoritical ‘optim: ital structure o! e Seer pecause there caot be 100% debt firm and Leverage (3) some element of equity is must for every corporate Fig. 9.1. Leverage ‘ firm. Hence with a judicious combination of debt (NI egal mee Wim can have a optimum capital, = and equity, @ A minimum and value of the firm is maximum. structure where k, is minim Important Note taxes, However, questions are asked in examinations, orate tax rate is given and students are ud When tax effect is incorporated in NI A\ ae (EBIT -1)(1-t) Bess alse of BY O)S k ea INIApproach assumes no corporate ional examinations) where corp incorporate effect of tax in NI Approach. Market value of Debts (D) = k(l-1) and peer ae eens TR Overall cost of capital (K,) will only be calculated by the following formula: K, =K,xW,+K,(1-#) xW, 93 NETOPERATING INCOME (NOI) APPROACH (IRRELEVANCE APPROACH) This approach is also suggested by Durand. This is just opposite /APoraina tan of the net income Approach. This is also called Irrelevance | (NO) A approach. According to this approach capital structure decision | decision of the firm is independent and does not exert any influence on | anddoes the value of the firm or the overall cost of capital. Any change | in the leverage or debt content in the total capital structure does ©" not bring about any change in the value ofthe firm and the cost of capital. The market value cll firm is calculated by capitalising the net operating income at the overall cost of capital, which considered to be constant. This approach is based on the fact that the earning . operating income) of the investment made by the firm is constant. It canmot change because oft change in source of finanace. The capital structure will not have any impact on the earning Pols” of the assets. Earning capacity of the firm is basically influenced by the business risk. Hene® value of the firm remain constant irrespective of the debt-equity mix employed by the fm 7xpot OP erating income approach is based on following assumptions: cost of capital remains constant. ; ‘ the firm as a whole and thus capitalize th i pets f eh . le total earnings of the firm to O he jn eyo! the firm as a whole. The split between debt and equity is not relevant. e at debt (ky) is constant. of , pe ore end more debt es capital structure increases the risk of the shareholders qe™ ats in the increase in the cost of equity capital (k,). So, the net effect is that the sremployins debt are completely taken away by increase in cost of equity (k,). Ey wt its are no taxes. ao Reccccing to this approach value of the firm can be calculated as follows: = Ee “ According to NOI Approach the market . , -Value of the firm is calculated by qe value ofthe frm © capitalising the net operating income: rings before interest and taxes __ atthe overall cost of capital, which is ) k aa cost of capital fa ee Oe ee vy 2 ity is a residual value whicl i et value of eae LA eae ES REC 2 abStane by deducting the total E=V-D E= Market value of equity y=Market value of firm D=Market value of debt seqity h) can be calculated by using the following formula: ‘e Ree x or k= hy + (hy-k)E Wlapproach states that there is nothing like optimum capital structure. The total value of ‘remains constant irrespective of the change in debt-equity mix. Therefore, the market value iiae will nt change due to the content of more or less debt in capital structure i. capital ‘decision is irrelevant to the value of the firm. The theory can be explained with the help 2 2. The net operating income (EBIT) of a firm is ¥ 2,00,000. The overall capitalization The firm is having 8%, % 3,00,000 debentures outstanding, What is the value of the Saulty capitalization rate according to NOI Approach if debt declines to ¥ 2,00,000 and debt is raised to % 4,00,000? Computation of Value of firm and cost of equity (k,) % 2,00,000 10% = 2,00,000 20,00,000 0.10 3,00,000 17,00,000 Capital Structure, Cost of Capital and Valuation000 24,000 1 17,00,000 v-D ‘Alternatively, 3,00,000, > 0,10 + 0.02(0 Ds 30+ (040-008) 470,000 ke Kh WE sines to € 200,000 Re 1. Tithe pooper putational of firm a eBT sealization rate (Ko) overali capital 2,00,000 N=” 00 Market value of he firm (V) =, qoxalvalve ot debt(O) Trea vate toqut ()=10-0) mT -1 BB capitalization rate «) =D” -7,0,000=16,000- = aa Equity 70,00,000-2,00,000 18, m proper of deta 140000 firm and cost of equity (N Computation fo Value of BIT Overall capitalization rate, (k) Market value of the frm (V)= “710 Market value of debt (0) Market value of equity (E)=(V-D) 2,00,000-32,000, — EBIT-I Equity capitalization rate (t= “yp ~ 20,00,000=4, 00,000 Comments: When the debt is % 3,00,000, k, is 10.35%. When £2,00,000,k, also comes down to 10.22% and when the debt pro $Bogos pio 103% Te value oh fim remains sane S598 wba chungein riko te shareholders as esl fa change d will be changing linearly with change in debt proportion. Conclusions of Net operating Income (NOI) Approach Implications of net operating income approach can be concluded 1. Value of the firm: According to net operating income v ‘on. its capital structure (Debt ity Ener eg ermt tot or to the eaming potential of the assets it has inv affected by the operation of its production and sales activities and eeital structure is not relevant in determinat ence cap! . Hel nt at all patterns of debt equity mix, es ai constai ital: Th k) of equity resulting a he MY ancial Tis increas ity (k,). The cost of ly offset the benefits wi st of eg to exact sin debt capital. This will cost of capital constant. This call c 9.2 Cost k. jn figure 9-2- of ? Capital ith increased debt contents,“ eof the firm, financial“ “* M# areholders increases thereby he cost of equity and vice-versa. fore c changes linearly with the ain debt proportion. ital structure: As per this £ firm does not depend on ‘ . structure and overall cost of Fle 9.2 soaeee pane Come Core ‘ remains constant at all proach - equity mix. all capital structure | — an ° Degree of Leverage can be optimum capital structures. Important Note no corporate taxes. However, questions are asked in examinations [Approach assumes TO Cons) WHETeC professional examinations) where corporate tax rate is given and students are expected is incorporated in NOI Approach teeffect of taxin NOI Approach. Ive the question according to MM approach with taxes whit dlater in the present chapter. ‘MM approach is considered _a i NOI taxes willno longer be approach like MMfapproach with With tax effect in place NOL Capital Structure, Cost of Capital and Valuation Ree ion of the value of the firm. e overall cost of capital wil ci ‘ ‘apital will remaii fi of hit increase contents of debt which isa CHOY SiN Of Nae Phe ae : per source of finance, the ri , the risk Therefore this approach does not suggest any optimum capital mother with the assumption of corporate taxes MMApproach without the Assumption of Taxes f Approach has provided a Bea to the NOL behavioural ‘Approach through “Arbitrage Process".iM hypothesis supports thatthe vale of fi © independent O01 given set of assumptions this approach maintains that the valle OF capital doesnot change with change in © ‘Assumptions: The MM approach based on ae tT dividend payout ares £ personal leverage (homemade leverage 5, Perfect substitution of same cost of capital. i : 6. There are no corporate faxes. However, this assumption was MIM approach describes the relationship between capital st value of the firm on the basis of three propositions. These are dis Proposition I: The overall cost of capital (&) and value ofthe firm capital structure of the firm ie i, and V are constant. According to ‘are alike in every respect except that one uses debt (levered firm) (aslevered fm) then the market values ofboth the firms wil be eg v,=V; Even if these two firms differs in their valuation in the short while other is overvalued) then arbitrage process (the basis ofthis proposi bring the market prices of their shares equal. Hence firm's values Ws « Proposition Il: The cost of equity capital (,) is equal to the capi stream plus a premium for financial risk, Financial risk increases a : debt content in the capital-structure. This results an increase in k,. with increasing debts contents in capital structure the cost of equity offset the use of a less expensive source of funds represented by debt. and its overall cost of capital constant, The cost of equity of differential of overall cost ofall equity firm (k,) and cost of debt (F,) would be in debt equity ratio. This can be expressed in following k, (Levered firm) =f, + (k=) = , Proposition II: The cut off rate for investment] urposes will be Ws indepen fhe ype of suc wheter dbl req fo Sane provides a guideline for optimum investment policy, Therefore, for wealth, the firm should use its WACC as cut off rate, Arbitrage-Process: According to the ise a os tbe one a Soren mix in its capital-structure, So the total value of the remain same irrespective of change in its financing-mix.toan This is ‘al tt puy the shares in Capital Structure, Cost of Capital and Valuation ted a behavioural justification for this. This justification is called Arbitrage- act of buying a security in one market having lower price and selling it in higher price so that the market price of the security becomes equal in both the ciple of arbitrage has been used under MM Approach to explain that the value of vine evered) and one not employing debts (unlevered) will be equal irrespective of so because the investors of overvalued firm will sell their shares, take in the undervalued firm in order to obtain the same return on smaller vying and selling pressure will continue til the market price in both the markets jel can be explained better with the help of an example. , The are two firms L. Ltd, and U. Ltd. These firms are alike in all respects except that je, ther“ arm and has 10% debenture of % 50,00,000 in its overall capital structure of hand, U. Ltd. is an unlevered firm and has only equity funds. Both ne EBIT of € 15,00,000 and equity capitalization rate (k,) of 20%. Market values aM modi nthe other me ia 1 ns AV A” of these firms are as follows: Wt of capital! L Ltd, & uuee e 1,00,000 EEN essinterest ao Net profit (NI) Sa auity capitalization rate (k,) Ee NI Value of equity (E)= 75,00,000 I value of debt (D) = (given) 50,00,000 2 Jotal value (V)=E+D jan eo WAC, (ko) = eT 15% aa Ltd higher market value (V) and lower k, as compared to U. Ltd.. Atitrage process. Let us discuss the arbitrage process : nth debe Though, both the L. Ltd. and U. Ltd. have same EBIT of & 15,00,000 and same k, of 20% but still However, according to MM hypothesis this position will not persist for long period due to _ Suppose an investor holds 10% equity share capital of L. Ltd. (over valued firm). The value of lisinvestment is € 5,00,000 i.e. 10% of % 50,00,000 . Out of profits of % 10,00,000 of L. Ltd., he is pi to% 100,000 (i.e. 10% of € 10,00,000) and is getting a return of 20% (k,) on his investment = he wants to increase his earning , so he decides to shift his holdings from L. Ltd. (over firm) to U. Ltd. (under valued firm). He disposes off his holdings in L. Ltd. for ® 5,00,000. 10 buy 10% of shares in U. Ltd. (ie. 10% of 75,00,000) he takes a personal loan @ 10% of an sl '0%5,00,000 (i.e. 10% of the debt of the L. Ltd.).As an investor of L.Ltd.he is comfortable tion ect L.Ltd,,so his risk level will not alter after this borrowing. Only difference now is the investor is levered because he has created a personal leverage (Homemade bY borrowing @ 5,00,000 from the market. Infact, he has replaced the corporate leverage i Personal leverage at the same rate of interest keeping his risk level intact.Now funds equal to % 10,00,000(® 5,00,000+% 5,00,000). He invests % 7,50,000 to buy 10%i b ih him € 250,000. Ass harchlding in U1. ae stil left with hi net aoe cam te same EDIT of € 15,0000) 1, Profit available from U Ltd. 50,000 {or of net prof a Lass interest P sable ( Personal loan @ 1 on )) 5000. 100,000 100,000- ‘Net return «vector is getting the same return of & 1,00,000 from U, 4 wvhich he on evn as an investor of L. Ltd. However, 9,000 left with him for investment elsewhere, Thus, his | pert pcome may now be more than & 1,00000 (inelusive of some income on the investment of & 2,50,000). Moreover, his risk level ig ¥ The MM approach argues that the opportunity to earn extra retur Jnvestors as wel. This will increase the sales of shares of L. Ltd. The ine Ltd. will bring their prices down and the demand for the shares of U, This sling and purchasing pressure will bring prices of shares in ty resultin same market value of both the firms. Hence the value of the le their cost of capital would be same. The table 9.1 summarises the | 4, Investor's existing postion in L. Ltd, (levered frm) with 10% equi | (@) investment Value (10% of750,00,000) (6) Dividend income (10% of €10,00,000) 2. Total funds available with investor before swapping from L.Ltd, to U.Ltd. | (@)Own funds ¢ | (p) Borrowed fund (10% of & 50,00,000) | 3. Investor's poston in U.Lid after swapping from L.Ltd (@) Investment made (purchase of 10% equityholding) (6) NetIncome: Dividend income (10% of ®15,00,000) Less Interest payable (10% on €5,00,000) io (c) Surplus funds available (or reduction in outlay) for investment el (¥ 10,00,000 -€7,50,000) or Investor's positon in Ud after shifting from L. Ltd fhe invests all the (2) Investment made (6) Netincome; Dividend income es ee 750,00, Less interest payable (10% on €5,00,000) (©) Surplus funds available } * 10,00,000Capital Structure, Cost of Capital and Valuation =e ., jn Table 9.1 shows that an investor can earn more income if he shifts his fo U. Lid (under valued firm), Other investors will follow the same process, to Ud and thereby price of shares of U. Ltd. On the other hand, due to selling of L Ltd. (over valued firm) will decline. This process will continue as race the investment amount and get the same return. Beyond this point, it investors to get the extra benefits by shifting from any of the firm. This is as int. This 4 the eat dies a of the two firms as well as their overall cost sii e same. SO, according e \ypothesis, the total value of a levered firm en ac an unlevered firm and the reverse is also true. ‘ e DE cst value of ma unlevered firm is more than levered firm): 3 Reve pothesis the total investment value of a firm employin debts (levered) and gt? the MIM anlevered) will be equal irrespective of their capital Sr atewe Viet value than the unlevered firm then the arbitrage process will set in and will bring the see the firms equal Butwhat happens when value of unlevered firm is more than * aifthe value of unlevered firm is more than the value of levered firm then the arbitrage Feperate in reverse direction. The invester of unlevered firm (overvalued firm here) will a and acquire same proportion of equity and debts of levered firm This will give ors for a Tower investment outlay.The surplus funds can be invested elsewhere to earn erstand reverse arbitrage process, let us take the following example. To und earnings and other information of L.Ltd. and U.Utd.are given below: e the shares “3. Tnemarket values, Ltd, | ULLtd. ¢ er 15,00,000 | — 15,00,000 | Less nterest (10% on € 50,00,000) 5,00,000 cf Net proft (N!) 000 76,00,000 Equity capitalization rate (k,) 25% 16% | NI Value of equity E)= 4, 40,00,000 | _1,00,00,000 I | Value of debt(D)= %, (given) 50,00,000 = Total value (V) = E +D 90,00,000 | 1,00,00,000 WACC, (kg) = at 16.67% | 18% how an invester holding 10% equity in U.Ltd can be benifited by the arbitrage process. U. Ltd, have same EBIT of & 15,00,000 but still U. Ltd. has red to L. Ltd. . Since value of unlevered firm is more in the reverse direction will set in and this will bring . ‘The investor having 10% equity holding in U.Ltd. ed and overvalued firm) will dispose off his holding and acquire same proportion (10% ue tuity and debts of L.Ltd.(levered and undervalued firm). This will give him same returns pao stment outlay-The surplus funds can be invested ‘elsewhere to earn extra returns. arbitrage process in reverse direction is shown in following table : Though, both the L. Ltd. and4 Jnvestorseieting poston n UL. (ulevered fm) wth 10% eq {@) Investment Velve( 10%: peat income (10% of €15,00, \2 Trae ete verre srg Fon WoL 4 q (Onan 10.000 sling of au Pel ingin UL) Investor Ltd after swapping Ls ; : @ a aad ecnasedt1hequytokingand 10%debs) Eauitty (10% of '240,00,000) Debis (10% on ¥50,00,000) ‘Net Income: © aseencone (0% 100,000) Interest income (10% on 85,00,000) y {¢)Surplus funds available (or reduction in outlay) for investment el (€ 10,00,000 - %9,00,000) or % | _ Ivestor's position in U.Ltdfter swapping from L.Ltd. fhe invests al th (@)Investment made| Corse Equity (1/9 of €40,00,000) Debts (1/9 of €50,00,000) (0)Net income: Dividend income (1/9 of %10,00,000) Interestincome (10% on 555,556) d (c) Surplus funds avaiable (or reduction in outlay) for investmentel ‘The valuation of the frm as per MM Approach (without taxes) Approach. However itcan again be concluded that: ¥ Value oflevered (Vand unlevered firm (V,) will besame: VA ae _ naVr 2, aT ofboth the firms (anevered and levered) is assumed as. * Qserall capitalization rate (ky) of both levered and Suess 4 cones in cpl stuctre i neste &, of unlivered firm = EBI ‘ _ K, of levered firm = EBIM-1 The, fevered frm can also be caleated aa (Levered firm) k =k + (k -4) 2 fe firm) k, =h, + hy 2 ‘nie oven cs of apo the evered fos an FO k=, xu,+k x, (wlof MM Approach (without Taxes) sions the MM approach of irrelevance of capital structure (without taxes) is similar e only difference between the two is that MM approach give behavioural ol aPP"* this irrelevance based on the principle of arbitrage. Main points of this approach tion tion of corporate taxes can be summed up as follows: um re the firm : As per this approach (without assumption of taxes), the value of firm is wali? OF 4 by its capital structure. The value of the levered firm and unlevered firm will be pat atic“, = V,, However if the value of two firms, identical in every respect differs in short ie the process of arbitrage will start and bring the value of two firms to equilibrium conclusion of : t of capital: Under the ’ he Ee no fee the cost of capital of ptiom, and unlevered firm will be same this will be equal to the cost of equity ane ity capitalization rate) of all equity (equity von The cost of equity in all firm will therateofreturnonassetsemployed Capital Pr with the increase in leverage, the cost of Ko, ke ke ty will increase due to financial risk dby the investors. This will exactly offset Pe benefit of cheaper cost of debt to keep the cost of both levered and unlivered firm int This is ilwstrated in figure 93. ° =r of equity: The cost of equity capital (k,) Fig. 9.3 Leverage and Cost of Capital al to the capitalization rate of a pure (MM Approach without Taxes) y stream plus a premium for financial Financial risk increases as we introduce more and more debt content in the capital-structure. increasing debts contents in capital structure the cost of equity of levered firm rises just to the use of a less expensive source of funds represented by debt. This keeps the value of mm and its overall cost of capital constant. The cost of equity of levered firm would increase inearly (as shown in figure 9.3) by the differential of overall cost of all equity firm (k,) and cost ‘debt (k,) and the proportion of increase would be in debt equity ratio ie. Cost ko ka k, (Levered firm) = k, + (k, ~ k,) 2 ce, cost of equity depends upon overall cost of all equity firm (k,), cost of debts (k,) and equity ratio. wm capital structure: Like NOI approach, there is no capital structure which can be lescribed as optimum capital structure under MM approach also. The value of the firm and ne overall cost of capital of either levered or unlevered firm is not affected by capital structure. “tee capital structure is irrelevant to the value of the firm. 2 tal Evaluation of the MM Model él can be critically evaluated on the following aspects: istic Assumptions: As per the MM model it is proved that the weighted average cost of '8 unaffected by the change in debt and equity mix. But it may not be true because debt is a Capital Structure, Cost of Capital and Valuation MEL‘Fundamentals of Financial Management heaper source of finance than equi. pet Te ae any benef ‘of debt in the capital structure i$ Mie by te ta mn a atl ‘i vill rema said that the value ees ee in the light of assump oa debt wn Erna ofthese asstimptions like pee all-equity firm. These co" weve which MM hypothessis based Howe a aon, debtor g 5, free & same pone of earnings ithe operation of “Arbitrage Pr, fe ca form of divider : Wi basis of MM 2. Substitution of sonal and corporate levera is ss i ge are isbased onthe assum PA past critical assumption of MM hypothesis. The wha teach other. Infact this is h St : Process” is based on the fact that personal borowing can substitute for ¢ i ver, this is not true because of the following reasons: 6 Difeet Terms and Conditions ofthe Lenders: The terms & conditions of theo, Fending to individuals and corporates, Anindivigual cannot borow athe sane atwhicha firm can borrow because a fim havingbettercreditstanding inthe in better position to borrow at lower interest rate. Because of high cost of bo individual investor, the “Arbitrage Process” will notbe effective and thevalueotie n wwillnot reach equilibrium level. (i) Unlimited Liability: When an investor takes personal loan to investin the: ‘unlimited liability towards the Jender. As an investor fine firm, he creates = liability was limited to the ‘amcunt of capital invested. In view of the creation of Iiability with the risk of attachement of personal assets in case of default, an inves be willing to create personal leverage. (ii), No initial personal leverage: Arbitrage profess assumes that an investor is not hay initial personal leverage. This may not be true (io) Higher leverage capacity of firm: Firms have higher leverage capacity as comp Jeveragecapacity of the individuals. An individual's capacity to borrow is limited. Bomowings individual involves cumbersome process as they ave to undergo a lot of formas inconveniences. 4, Institutional Restrictions: Many institutions such as insurance companies, mutual commercial banks are not allowed to use personal leverage and buy the shares of an unleve Therefor, te option ofs witching from levered firm to unlevered 4. Transaction Costs: The assumption of no transaction costs under MM approach snot In actual practice transaction costs has to be paid by investors at time of buying ands scourities. The transaction costs will affect the net proceeds realised by selling stars investors have to invest more amount again in undervalued firm than his presenti earn the same return. 5, Corporate-Taxes: The MM model is based on the assumption that there are nO OORT This assumption is also unrealistic because we find that in every’ economy’ remove it imposed on the eamings of the business firms. However this assumption Was q MM Approach. 9.4.2 MM Approach when Taxes are Assumed Proposition I: If we introduce corporate taxes then definitel} ly, P bs distributed among equity shareholders as compared t0 unlevered Frm nthe oF uctibility ofthe intrest payments The effective cost of debt will be 1 a thelevered fim willy jem. TiCapital Structure, Cost of Capital and Vatuation Eas te, The value of the levered firm (V)) would be higher than the nount equal to the present value of the tax saving due to The persent value of the tax saving is equal to the levered also known as tax shield of debt. Hence ax penrefi sty fir W.) by an am firmcest payment: | Liane Pee. This is © ander MM approach with taxes MIA Approach urder ares states tt e v, =V,+Dt value of tha levered fern wild be orlistat higher than the value of he univers fimby an arrourt enue athe procert value of the tax saving due to the valve taxdeductibilty of interest paymert. unt This tax saving is also known as tax Am 0° shield of debts. oo mean be calculated as follows jever@ os EBIT( af (All equity firm, hence k, = k,) fi alue of the firm (V) - Value of debts (D) goo ot equi Of . b Gameee le jth increase in the debt proportion in the capital structure, the cost of equity of IE: With incr the increase in financial risk perceived by equity shareholders. However, sed nit would have risen in the absence of axes. Iwill rise by the differentia leet Cguity frm (K,) and the cost of debts (,) and proportion of increase would be ‘Bt to equity ratio. However, its overall cost of capital will be lower. value of de ‘ N_ GBIT-p-9 aqanyorteverea fim’ =p > 2 bon gamers: D k,(Levered firm) =, + (hy) A= g rst of capital of all equity firm (required rate of return) is wre tax fof levered firm can be calculated by using the followit cy (1—t) x Wj +k, x w, 6s seat ectpemarke ively, D and w,= 4, Two firms X and Y are identical in all respects except the degree of leverage. Firm X ‘debenture of % 6 lakh, while firm Y is unlevered. Both of them earn same earnings before and tax of 2 1 lakh each, The equity capitalisation rate is 10% and the tax rate is 50%. the market value of two firms as per MM Approach. Firm X@ Firm ¥@ 1,00,000 4,00,000 '36,000 _ “64,000 400,000 32,000 50,000 32,000 50,000eae Therefore, as per the MM ‘contains debts. However, the exces payment of interest and principal, increased Conclusions ‘of MM's irrelevance approach of capital structure ( jons of MM's irrelevance approach of capital ee taxes can be summed up as follows: 4. Value of firm: The market value of the levered firm sill be higher than that of unlevered firm by an amount equal to the present value of tax saved, This is illustrated in figure 9-4. capital: The overall cost of the capital will decrease with the increase in the debt contents in capital structure of the levered firm. Though increased leverage will result in higher cost of equity due to more: financial risk but present values of the tax saved on account of employment of debt will be higher than rise in the cost of equity. Hence employment of debts will help in decreasing, overall cost of capital for levered firm as shown in figure 95. 3. Cost of Equity: With increase in the debt portion in the capital structure, the cost of equity of levered firm will rise due to the increase in financial risk perceived by equity co. shareholders. However, it will rise ata lesserrate of then it would have risen in the absence of taxes, Capital Itwill rise by the differential of overall cost ofall ‘nM equity firm (K,) and the cost of debts (k,) and proportion of increase would be (1-1) times the market value of debt to equity erall Cost of Levered fi Overall cost of v k, (Levered firm) = k, + (k,~k,) (1-1) x 2 Optimum Capital Structure: Increase in leverage will result in higher valuation of the firm and also decrease nee optimum capital structure will be at 100% debt level. use a corporate firm will always have some element of 95 TRADITIONALAPPROACH : The two approaches like the NI a 4 jpproach and the NOI approach approach suggests that use of debt affects the overall cost of capil Jaat capital structure is irrelevant to the tion of the firm. Critical analysis of the a nat the assumptions on which the MM that # ests pot seems to be realistic. Therefore, Sst trough ajrsceam nef ct does ie re equity | can increase: dot mgested middle path betvcen NIand | yalsg and easy ten a overall cost of capital chsuggests that like the NI approach, cost al PP of the firm are not independent of capital structure. However, it suggests that seg valve Tot increase for all degrees of leverage. Wiyeyond a certain degree of leverage fh, that Pe overall cost of capital increases of 2208). vn the total value of the firm. ditional approach is that through a and equity the firm can increase its total eptjuce the overall cost of capital. The reason yper source of finance in comparison to the : Seen ‘we replace equity with debt then the Sapa Wher ill go down. If the firm further raises Bot OP. then the financial risk ofthe firm would egal] Mareholders would ask a higher-equity ge an “gto bear the additional financial risk caused : debt in the ea Bee oe ® i may not be hi er than the benefits es oct dn the capital structure, ive further increase the debt-content in capital senthe financial risk wil increase and cost of equity will rise toa new level. The creditors company would feel insecure and they will demand higher interest rate. Therefore, use of eyond a certain point will raise the weighted average cost of capital. Therefore, up level of leverage, the use of debt will favourably affect the value of the firm but above a use of debt will start adversely affecting it. At this level of debt equity ratio, the capital- ‘soptimum. Also, at this level, overall or composite cost of capital will be minimum. 5, The following estimates of cost of debt and equity capital (after tax) have been given levels of debt-equity mix: Value of the Firm x Degree of Leverage Fig. 9.6 Leverage and Value of Firm (Traditional Approach) ° NS ara Debt as Percentageage of Total Cost of Debt Cost of Equity Capital Employed (%) (%) 0 60 11.0 10 6.0 11.0 | 20 60 15 | 30 65 120 40 70 125 50 15 13.5 60 80 155 the optimal debt-equity mix for the company by caleulating composite cost of capital.ae deb ye optimum Perc compose cost of capital is least ie Conclusions of the Traditional Approach of Cost of Capital, Capital Stra 3 ‘and Value the Firm The conclusion of the traditional ap| summaries as follows: 1. Value of the firm: With the increase in debt the value of the firm will rise. This is pecause of the fact that debt is a cheaper source of finance because of it’s tax deductibility. This situation will continue up to a certain proportion ‘of debt in capital structure. Beyond this level, the equity shareholder will perceive greater degree of financial risk resulting in their increased expectations and higher cost of equity. This will result in increase in overall cost of capital and hence a decline in the value of the firm. This is illustrated in figure 9.6. The value of the firm is snaximum at point ‘O’ (degree of leverage) Cost of equity: Though the cost of equity rises with every increase in debt proposton, the advantage of debt will be more than the of equity, But beyond a certain proportion of debt in capital structure, the cs increase rapidly and will offset the benefits of the use of further debts, t-equity mix is the combination where debt j s least ie, 10.30%. tis soy, proach can be — n 3. in cepital structure, the overall cost of capital decrease initially because debtb sae ae than equity. But beyond a certain level of debts, the € cee A return because of their increased financial risk. Vius will ‘ pene eric wil offset the advantage of cheaper cost of debt When the Babe Peo 9 seraty Jevel then the cost of further debts will also ina Waray increase in overall cost of capital. This is illustrated inf é pre Carte Structure: According to traditional approach, there exists 478 - The overall cost of capital cccreases initially with inereased eS 4,Capital Structure, Cost of Capital and Valuation Tila nore K, 18 lowest, the value of the firm will be maximum, The debtequity nown as optimum capital sturcture, At this point marginal cost of debt inal cost of equity. Point ‘O’ in figures 9.6 and 9.7 shows the proportion y capital structure, 4g point W! e Pent 18 be eo evs ** person and TY or tl so con® pe vidend . - erate fOr dividend and interest income are same then the investors would be indifferent meg their income as dividend or interest, However ifthe provision of taxation ae forbotn types of income (interest and dividend) then he may not be indifferent between funds as debt investor or equity investor, In India the dividends are not taxable up to a hands of the shareholders but interest is subject to tax. optimum al Tax Liability of an Investor: While deciding the degree of leverage 4 firm ne tax liability of the investors who receives their income either in the form of Lele slat iracture isa mix of different sources of finance (debt and equity) in the total capitalization of a Ist decision is one of the important decision which decides the proportion of debt and ity in overall capital structure of a firm with an objective of maximizing ts value. ‘of debt and equity which brings maximum value to the firm is called optimum capital fre four theories of capital structure (i) Net Income Approach (NP) (it) Net Operating Income (NOD (iii) Modigliani and Miller Approach (MM Approach) (v) Traditional Approach. (ND) Approach suggests that there exists arclationship between capital structure and value firm, Itassumes equity capitalization rate is constant and increasing debt propurtion will reduce ‘cost of capital and increase the value of the firm. g to Net Operating Income (NOI) Approach capital structure decision of the firm is dent and does not exert any influence on the value of the firm or the overall cost of has provided a behavioural justification to the NOI Approach through “Arbitrage refers to an act of buying a security in one market having lower price and selling it in ‘market having higher price. suffers from many shortcomings basically because of its unrealistic assumptions of {competition in capital market, substitution of corporate leverage with personal leverage, absence tion costs, no corporate taxes etc. ditional approach has suggested a middle path between NI and NOL approach, The crux of this oach is that through a judicious use «f debt and equity, the firm can increase its total value and ‘can reduce its overall cost of capital,ae «earnings of €3,00,000, The on ; 1, Acompany has eaorinr ently the cost of equity capital of TS.MIMQ borrowed at the rate ft cost of capital using Net Income Aj firm and the overall ¢ i valuation of firm as per Net Income App ess Drerest renolders (NI) ity ——" 2,55,000 marvet valve of eQUIDNE) = NI/Ke= “430% Market vaive of debt (0) ote! value ofthe firm (V) = ) (EBT ‘Overall cost of capital 7s +D) 3,00,000 26,25,000 ~ 148 MMustration 2. A company has EBIT of € 4,00,000. The capital structure £500,000 borrowed at the rate of 8%. Cost bf equity capital is 12%. Find (@ Total value of the firm and overall costef capital using Net Income (@ Value when debt is increased by € 2,00,009. 2 (@ Value when debt is decreased by € 2,00,0 ee: Solution: Statement Showing Value of the Firm (Net Income ———————7EE - i Particulars Existing Debt 000 E EBsIT 4,00,000 ce Less interest 40,000 ise s ‘Eamings for shareholders (NI) 3,60,000 i 344, y Cost of equity (k,) 12% eg ms Market value of equity (E) = M/k, 30,00,000 Market value of debt (D) (given) 5,00,000 Value of the firm (V) = (E + D) 35,00,000 | | Overall cost of capital (37) 11.4% 2 a Therefore, from the above, it can be observed that the increase in firm and decrease in the overall cost of capital and vice-versa. Illustration 3, Two firms X and Y are identical in all res} s ts including, has issued 10% debentures of 18 lakh while Y has peo only equity. interest and taxes on their total assets of & 30 lakh.Capital Structure, Cost of Capital and Valuation § 7U/ rate of 50 percentage and capitalization rate of 15 percentage for an all equity firm. mmpanies X and Y using net income approach [B. Com (Hons) Dethi University, 2003 & CA (F) Nov. 1994] Valuation as per Net Income Approach < 2,10,000 2,10,000 18% 14,00,000 18,00,000 32,00,000 Jon. ABC Ltd. has all equity capital structure with a cost of capital of 15%. The company decides 90,000, 12% debt and use the proceeds to retire equity. The expected level of EBIT is % 90,000 which ‘remain unchanged. Assuming net income approach assumptions are applicable, calculate value |debt and the value of firm before and after change in capital structure. Also calculate weighted of capital after the change. a . [B. Com (H), Delhi University 2005 (R)] ‘Statement of computation of value of firm as per NI approach and WACC z Particula Allequity Equity + Debt 90,000 90,000 Nil 24,000 90,000 66,000 15% 15% 6,00,000 4,40,000 Nil 2,00,000 600,000 6,40,000 15% 14.06% class and are identical in all respects except that company ‘company R does not use debt. firm has & 9,00,000 debentures carrying 10 percentage rate of interest. Both the firms earn 20 profit on their total assets of € 15 lakh, The company is in the tax bracket of 35 percentage ‘rate of 15 percentage on all equity shares. ired to compute the value of S Ltd, and R Ltd. using Net Income approach.6. Acomany has annual net operating income oF8 5 lah ization rateis 10%. You are required to calculate the val : g to Net Operating Income Approach, What will be lization rate if the debenture debt is inc Ho eautyshercoldr Ni) \ E=(V-0j2 =-0i=(6900000 409000)r avin EE ing tONet Operating income A 7 eco PPrOAch; J g. company hts an EBIT of ¢ 39 rowed atthe rate Of 8% Fina ge ne here ost of capital 12.5% The company has debt phow change in debt by & 3,009,099 i Company using NOI approach and show using, hevelnpacton teat of Say capital ofthe company. Valuati [B.Com (#4), Sem - V, Delhi Univ. Nov. 2013] “i ‘on of firm as per NOT Approach : ae oa When Cebt increases | When Debt Decreases 3 by 83.00.00 by %3,00,000 ess | " SE) 8,00,000 2,00,000 see 5) 8% 8% in Skea 300,000 290000 | italisaticn ratte (k,) .£ 3% el 0 (ko) 128% 125% 125% | | (est) } : | jet oft firm (V) = =i 24,00,000 24,00,000 24,00,000, | | eit value of debt (D) 00,000 8,00,000 2,00,000 | ! Be ve ofeqly (E)=(v-D) 19,09,000 16,00,006 22,00,000 | hee) 40k 31,000 16,000 | fargo shareholder (EBIT-) | 2600 2,36,000 284,000 13.68% 14.75% 12.91% | be L | 4h: boveilustation, we observe that the change in debt: ‘in the total caput} structure does isthe total market value ofthe firm, The cost of equity increas with the increase in propcition of debt he cpital structure, = 9. ‘Two companies are identical in all respects except that X L bere of 129, ’v whereas Y Ltd. haz no debt in its capital structure. The wt Ho 15.0000 on which the companies have earnings of 20%. You are O Glas value of companies and ky using NI approach taking kas 18%, 4 Cate value of companies and k, using NOI approach taking fy as 18%, ~mpare the results an i f the two approaches. Tesults and comment on the aifferences o! pp 1B. (Com (H Dek as debt of 5,00,009 borrowed sets of both the companies lired to do the following: Iniversity 2076)eenserer of France Management 3 a eee. i 22,00,000 i 200 '2,0,000 "1% EArt 2% (1-045) = 44%) “qa7é2 x 0044 + 0.5238% O.11 = 0.92085% 00575 007855 or 7.86% costof capital of YL, (unlevered frm) willbe =F,» Earp: emze tr Eng tavaes Wi) foveal cost of 4 pe fe sion 11. ‘L’ Ltd. and “U" Ltd. are identical except that “L’ Lid. has issued 10% debentures of Merete thon) =(E8T) x) wile ‘U Ltd, has only equity in their capital strcture. Both the fms have operating profit of Marae Ry) osume capitalisation rate of 15% forall equity firm, le ofthe two firms using Net Operating income (NO approsch. 18. Conte, Dei Unio 2015) ‘Valuation as per Net Income Approach + Aboconpute the overcast of capt Lessin \ Soliton: Valuation sible equity shareholder (i) 3 er Approach with axa, 2 eM Denia. 2015 Snr ae Cosco (ier) 4on0 atl equity(E)=NI/hy e 00000 Ath of 80) (en) a 300 “ola cna fim (¥) =(€ +0) =a ODO 45% | AEM. x 100=13.04% ST «100 mono00 oe inde InN Approach pus oh fm ener ond dere wih 230000 + 2000000 x a5 * 33.0000 + 900000 = & 42.09000 ieBe Ceptal Stucture, Cost of Capital andy Ea 5. Com company ¥ does 5 Th 0 ete 15. Com le compa levered firm has 8900000, cay seve feng am 27 Obra ra on al ct oS ee TE captalsaton ae of 5% foram ate sms X and Y using Net Income (NI) approach, can em sng Net Ope nse ND apc, syiod 1p tote ( forfims Xana, fe perena . Ps ths fms hasan pina capa oe a In exnngntoe x is nee [ gant Note Nand NO! Appin ssn a une 22 a nee sors where corpora a8 in and ee pores se im does rot charge wines indo aah pone is tn vedaterincperng eee neo ves are denial except that ALIS. has a debt of pf gms Xand Y using Net Income (approach, remeees rctre. The total assets ofboth the oa re debe in its capital Peasy earns 2% return. Find the valge a aM ean rae sare Le £20000 on Whi ne (NOI Approwch Equity capi scone! areal os of opt i pe = exes 30 0000 3.00000 00m sn Apc Wie Tear asad eng Olt Si NON eng teva fhe im, a eve = | Cation of BIT = 2,00,000%-22 os 208 sone por a-t - smo = x sartcdersN eee aus vit of uneveed fem Let) = EOD = SOOT 5a iS fea U lex 18% i. wo heer fim (ALid) =, #DE a aa Vale of unlevred frm D = Vale of deb f= Ta Hem ston © & aa os 1358353 + 10,00 (050) = ® 1833.33 — pa wae fa latin Oval Cost Cpl of Lid sng NOUMM Approach pe ayer poss Ro - Gy Galeton of value of firm 3s per NOT approach (MM with axe) dastiat Approach 38,0001 oy cam sled emt) = BIEN, SIME py LessTx() bo vesupneein a ‘le of levered firm (XL&d)=V,+Dt-> 1300000 + 900000 « 035 Manto) = 1300000 + 315000 = 161500 leesvvsct tO) a 1500000 + 31500 Vie ctEaty) Bi ok 2s per NI approach: Be ee }=15 x 222. op0 035) 220 of Aig, « mings for equity shareholderes _ 1,50,000 a HolX ed =k x, +k 1) am) = 15% x 5 380,00 B 8,33,333, = 754% + 323% = 107% fALtd =, x14 54 8:33,338 4 KOfAL «xt, 5+ TS 18% (Alterac ky OMOEA eV <1, = 15% : ; wal ' UNM Appresh Si 5 04H 018 = 00227 ODI = DAR tow cone ing NOG em Be Note Ovenlles of capt of Li, anlevered fim) willbe =k, = 15% ‘ae ofthe fem (v [As caleulated in par i) ofthe quest ee ; Less Value of debt(0) > T7500 ‘ave of auity ()pe Te ene te ereoxcept that SLA has debt of pn OT etl en oa Se otal assets ofboth the compe ca tO eon Oe De i ses sing NT=ppronch a5Suming as 155 og tol Ld Uslevetd em) assy, oem) sing NOT/ MM appro ator of the COM eset a ess Ta 60) | 2.80;800 = 15% eat eee 1872000 ar vse easy l=, ise 1) rasan) =D) recat car) * pemokds-000d 13720 400,000, tes 15x BRS «1 0400 * 272,000 nm (Caan of alse sper NOI approach (MM Approach with taxes) enIT(-1) _ 500,0001-040) _ «29 900m0 k, = 15% = ‘Value of levered firm (S Ltd) = V, + Dt =» 20,00,000 + 4,00,000(0.40) = 21,6000 (kin sf Ove Cat Cpt of La. sing NOUMM Approch: t ‘nedtetmicarane ach lo Less Value of debt (D). ; Naess => 12.35925% + 08451%= ‘Valu of unlevered firm (R Ltd) = ee ee a 1H Sepustunds avaiable (reduction in outlay forinvestment elsewhere equtystacblders , 20080. 91595 «1595% earings SS 17,60,000 be 17,60,000 acy 0,4) x 00-000. ; is.ud ater fl 1) 041 1595 69,099 “A 04) OO a 48 +48 %x 0.1852 > 19% +089 % = 13.89% 215.95 %x 081 sg the data epardng Ovo companies Aand B Explain using the MM approach, how an in switching his holding to company B. {B.Com(H), Delhi Une. 2017] e 15,000 15,000 15,000 4,000, 11,000 equity shareholders oe out, Company Ail dstbute®1,000as dividend tots shareholders whereas Company ear het rite 15.4 jerthe investor would be benefitted by selling his sharesin Company Aand buying B torsells 125% of his holding (10,000 shares) in Company A, then he will realize 11,000 clean at @ 8% of € 6.250 (12.5% of 250,000) and out of the total cash of © 17.250 Lio fe purchases 125% of shares of Company B £15,000 shares for €15000 (15000 1.00) nition of Investor in Company A (Before switching over to Company B) t mesinent Valve (12.5% of €88,000(80,000 * 1.10) 11,000 F Ducens recived (125% 0 & 17,000) 1375 Position of investor in Company B After switching over from Company A) Oy Fncaaiate {11,000 + 6250 (12.5% ot € 50.000) 17250 1D) nesirert made (Purchase of 12.5% equityholding) 15.000 Netlacome: Duidend income (12.5% of £15,000) 1875 1375 Less Interest payable (8% on & 6,250) 500 (£17,250 - 15,000) = € 2,250 ’.dent of the proportion of is indepen which the total value g i equibeum ec jason oan investor who holds 10% ein 3 environ) : w vase fy of his investment will be 10% of € 93,750 ie. % 9,375. Assuming 100? (11500 of company 8, he is entitled for & 1,500 as his share o ‘he decides to shit his holdings from company B (overvalued) fo disposed off his holdings in company B for &9,375, But to buy 10 20060) betes personal loan @ 12.5% paa. of & 12,000 (ie: tbl copany Asan investor of company B, hei a 5, so his risk level will not alter after this borrowing. Only diff Troops ered because hehas created a personal leverage (ho momo the mat Infact, he has replaced the corporat Pesonlleege atthe same rte of interest keeping his overall Oi tobuy 1% shar fe 1 eam same Eto acta Aare asfolows, get company A(D% of € 390) : es 4 sete (25% co st pay Outlet 1500 Jing same return of 1,500 from —— iy B However, he has € 1375 eh withhagee how be more than & 1,00 (including some nement bbe summarized inthe following ible,“ ™* O* aiton in Comapny B (levered fi) wth 105 = st (10% 0f 893,750) eae rca (103%0F8 15,000) ale wth nvestorbefor swapping fam Conapny jo Fe ¢ oon vi (10%0f €120,000), 9375 sin Comapry A ater swapping fom ComapnyB : “a sos : recta (purchaser 10% equlyhllng) se pejand nome (107%01% 30,000) e Hossinterest payable (12.5% on 12,000) oa pustunds avaiable (or reduction in outlay) for investinent (¢ 24,375 € 20,000) analysis shows that an inves A (under valued firm). Other! se the share price of Comapny A. O be Comapny B (over valued firm) will jpreduce the investment amount and for the investors to get the extra benefits am point. This is the level where total ft ial would be same. This process isae - ofFnancal Management —s X and Y belong to the same risk di ie 7. Te no ere of €12,000. The following ingen 8 Capital Structure, seis ings and other information aus, eanmings and tion of U. Ltd. and Li. are given below tin 17. TEIOE ST ebenture ing apt cn YS 125 formation soy, EEL 3 | Feprirgrene ences) 2 onto end Matin Mea & few is 2 ete valu of 0 TT fm wl be beter off switching his ha Sh a na ig a BS 23% shares of Oe end 1 ge res came wa aes ar glia te ) NETO) ean whens = % if 15% 164% Sietion [a eueren EET 9 sa et a ice 317) ih and L Lid ave same eaing of € 9000 but stl U. Lid nacre once) oth enpredi Li fae vais of sieve te ed Ua ee een (sate revene eon ‘will et in and this wil bring the market values ofboth arias ety it Pr ator holding 10% equity U.Ltd (unlevered and overvalued firm) will dispose gaya Feet epee ea) andes Lid ieee nerd co ae fora lower investment outly.The surplus fands canbe invested elsewhere NI a sae! arvavecteasty E)* g, ig gretinsame SP aeitrage proces in the reverse direction is shown in the folowing table: Meet avert it) eT Effectof Reverse Arbitrage: in ULI. unlevered fe) with 10% equty-holdng: encpmton fiesrin company YL sen overed EP 00) eee rat pkngin Company =10% of € 927500 = ¢ 99730 ete a €,00) ay Share ofearings in Company Y =10% of € 150,000 = € ed prams win ves beer swaping tom Lid. t0L Li soo | 1,000 fom seing of equity hoding In UIs) | Stes for obirage Process od | ;nLLtdter swapping fom Utd * Inorderto have the 10% holding in company X (, 10% of 20,000) investors wil nner ston (0 Pao 10% of debts of € 120000) at same rate of interest Le, 125% heed aaa (prose of 10% equtyholding and debts) ee ——— we wrk = (10% on 825. 7 ‘Ownfands by sighs holding infirm Y) 9 | genome , Z 25 ee roe funds at 25% ate f intrest) 120 eee ne (0% 7:00) = ‘Total funds 238 Inerestincome (8% on £2,500) 200 00, 0 (iStetatnd avalable (or reduction in outlay) for investment elsewhere td. Presently undersaled fi: (t6000-"5 500) Poson of investor ater shifting from firm Y Ltd to X Lt Win € 213750 nis hand he wl buy shares in Company X for & 2,000 (10% hoi, Fis shar of earnings in Company X (10% of &3,00,000) ad es interest on borrowings (12.5 % of € 120,000) id lysing from ULLtd. to Ltd, he will earn same income a Ud to LL, he will eam same income of € 90, But ei hing 500 “Sepa cach with him tives elsewhere Hence he is beriited. : 50 7 18. The lowing fe shit hisoldng from company ¥ (levered) o company X (unlevered) he wile 2M ad 3g information is availble for Y Ltd. and Z Ltd. Compute the equilibrium spany ¥ (levered) to company X (\ y lsewhe equity capitalization rate of the two companies assuming (j) there is no income tax (jf) the of 15,00. But atthe same time he will have surplus f a ime he will have surplus funds of € 13750 to bein if a rte is 12% (0) Aig proces wl cometoanend when market price ofthe shares ofboth4a Management Fundamentas com Saas eon ae a find ut the equilib ee! Baa [apices ee °&©q fs s | cg | = ET (aut vues) sain tbo tm ee 420) Manteve oot) 210-0) wer say wea re) 10000 1,078)" F590 | us eee a _ Fam Lid. having debt in its capital structure has higher k, equal mee companies Uand belong tan equivalent ikea. These ofa oon Uinlevered while company Les 10% dena caplizaonsota ana ‘acep that U company spat te ober relevant information regarding the valuation a Yue 1.20000 12% 10,00000 280,000 7,80,000 100,000 | 139% t013.39%, wan Oe Capital Stucture, Cost of Capita ang. i shares of company L. Show the arbite Peace Proce an sss enn eh tin EP em de when wil this arbitrage process come oan en? ro Modi! {18.Com (H) Dethi University 2012 sitar, peti cat Tan gata choke =n ce a ete holding in company U (ie, 17% of 500000) investors will have to borow to no 0,000) a same Fate of interest ie, 10% phon ‘ : in firm L) se eaing hisholding pete ons rate of intrest) wns afer shifting fom frm LL to U Ltd Prevent undervalued fr nr wil buy shares in Company U for € 500,000 (10% holding). espn hand Company U (10% of 750,000) 75,000 en owing (10% of 300.00) 30,000 dese 45.000 sotings from company (levered) to company U anlevered) he wil ea the same aon at at hese me e wil have Surplus fads of € 25,00 fo be invested oe Bee agin oly = (8525 00-5 00.00) = 25,0 Fe jcus wil come to an end When market price ofthe shares ofboth the firms become equal. peers and Y are similar except that firm X is unlevered, while Y has 300,00 of 6% ir, Fen ming tax rate at SO%, net operating income (EBIT) at 50,000 andthe cost of bata the value ofboth the firm, ifthe MM assumptions are met (a) value ofthe hen dothis represent equilibrium value? Ifnot how will equilibrium be reached ? md K pean. t (pec ulevered firm (XLtd): Vy = —Z— = aa 250,000 E im (YL Y= tes soe ream | Tam) Year fm 0 Ltd) Vy =Vy+ D1 instanton) —— ee Pee ee ioe | “a {item is 400000 whereas i is given as 84.20.0000 itis overvalued by £20,000 To bring apes 2s tearm arbitrage process will be followed: t Markt value of equty(E)= a S000.) al ‘Mie frm () (given) 420,000 es ‘lasValue of debt 300,000 asta ct) oe, 3.0.00 eet a se | Meeniy ad ‘Overat coptzation rate (k,) a 5 50,000 Debt-equty rato (DIE) mye loerest 18,000Capital Structure, Cost of Capa ang “eine fm 2 aveot BAV 0S Soe am aay — a a aa tequy Sharhade > 9 np = a ‘ ae * °26,00,006, =O otis, etme a ceo me tch-pnw eo Fas can get sae earnings by selling his holding infirm Y ang 20,00,000 : ent i cee OH of € 250/00) i,m X's shares for ¢ “asia = 00226 + 0.0622 = 0.0848 or 8.45% eaten of avon Fm elo ithing oe sg a $3000 Te re = (etvestmer Vue (10% of 120.000) Se cient value ofthe firm using the traditional valuation approach, {eyDvidend received (10%of& 16,000) ‘an he adioal valaton pad Postion of Investor in Fim X(After switching over from Fim yy“ (eyvesient ade (Purchase of 10% equiyholing) (0) Natincome: ‘vidend income [10% of €50,000(1-)] Less Interest payable (6% on £15,000) te oe capitalization rate ky igo isu captal of € 40,00 inorder to redeem 00000 deb affected. However, the firms cost of equity apa wi a a Tecorimend this proposal? = e tim valle or reduction in outlay) or investment elsewhere 3,00,000 a Soe stOg) Tm 1,20,000 He had € 77/00 at his disposal. He has invested ¥ 25,000 in firm X and i earing sae ergs avalble for equity shareholders Fanta 34 Bets having 2000 as left over funds to be invested elsewhere. SN en 00) ad 2, Companies U and Lar dential in every respect except that Unlove wnt NI 'EBIT of both firms is 6 lakh and tax rate is 35%, Equity capitalisation ra etevae of equity (E)= 5 +12,00,000 | thereof ah fem scoring 0 MM APP tna wttvn tO) me ya oe 00,000 |market value of firm (V) = (E + D) ‘Solution: ‘Value of the Firm as per MM Approach (with taxes) ‘2 ) 24,00,000 Company — Unlevered firm @) Effect of Redempti er 00000 a oss = eles fon .00.000, —_ or 600,000 Yetrme LossTax@ 35% 2,10,000 esjcapaisation rate (k,) amings valle for equity shareholiers(N) | _Cse0007 | Nett alu of equity (= 222.000 Value of Ualevered frm (U) with taxes patieoteat(0) = matt value of frm (V) = (E+D) 4-3 | 300000 123% & 24,00,000 to & 24,92,308. ‘elu of levered firm (L) with taxes SS