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FINANCIAL MANAGEMENT & CORPORATE FINANCE-KMB204

UNIT III - SET 1
CAPITAL STRUCTURE
Meaning and Concept of Capital Structure:
The term ‘structure’ means the arrangement of the various parts. So capital structure means the
arrangement of capital from different sources so that the long-term funds needed for the business
are raised.
Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings and other long-term
sources of funds in the total amount of capital which a firm should raise to run its business.
Few definitions of capital structure given by some financial experts:
“Capital structure of a company refers to the make-up of its capitalisation and it includes all
long-term capital resources viz., loans, reserves, shares and bonds.”—Gerstenberg.
“Capital structure is the combination of debt and equity securities that comprise a firm’s
financing of its assets.”—John J. Hampton.
“Capital structure refers to the mix of long-term sources of funds, such as, debentures, long-term
debts, preference share capital and equity share capital including reserves and surplus.”—I. M.
Pandey.
Capital Structure, Financial Structure and Assets Structure:
The term capital structure should not be confused with Financial structure and Assets structure.
While financial structure consists of short-term debt, long-term debt and share holders’ fund i.e.,
the entire left hand side of the company’s Balance Sheet. But capital structure consists of long-
term debt and shareholders’ fund.
So, it may be concluded that the capital structure of a firm is a part of its financial structure.
Some experts of financial management include short-term debt in the composition of capital
structure. In that case, there is no difference between the two terms—capital structure and
financial structure.
So, capital structure is different from financial structure. It is a part of financial structure. Capital
structure refers to the proportion of long-term debt and equity in the total capital of a company.
On the other hand, financial structure refers to the net worth or owners’ equity and all liabilities
(long-term as well as short-term).
Capital structure does not include short-term liabilities but financial structure includes short-term
liabilities or current liabilities.
Assets structure implies the composition of total assets used by a firm i.e., make-up of the assets
side of Balance Sheet of a company. It indicates the application of fund in the different types of
assets fixed and current.
Assets structure = Fixed Assets + Current Assets.
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Example:

The term capitalisation means the total amount of long-term funds at the disposal of the
company, whether raised from equity shares, preference shares, retained earnings, debentures, or
institutional loans.

Importance of Capital Structure:

The importance or significance of Capital Structure:
 Increase in value of the firm: A sound capital structure of a company helps to increase
the market price of shares and securities which, in turn, lead to increase in the value of
the firm.
 Utilisation of available funds: A good capital structure enables a business enterprise to
utilise the available funds fully. A properly designed capital structure ensures the
determination of the financial requirements of the firm and raise the funds in such
proportions from various sources for their best possible utilisation. A sound capital
structure protects the business enterprise from over-capitalisation and under-
capitalisation.
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 Maximisation of return: A sound capital structure enables management to increase the

profits of a company in the form of higher return to the equity shareholders i.e., increase
in earnings per share. This can be done by the mechanism of trading on equity i.e., it
refers to increase in the proportion of debt capital in the capital structure which is the
cheapest source of capital. If the rate of return on capital employed (i.e., shareholders’
fund + long- term borrowings) exceeds the fixed rate of interest paid to debt-holders, the
company is said to be trading on equity.
 Minimisation of cost of capital: A sound capital structure of any business enterprise
maximises shareholders’ wealth through minimisation of the overall cost of capital. This
can also be done by incorporating long-term debt capital in the capital structure as the
cost of debt capital is lower than the cost of equity or preference share capital since the
interest on debt is tax deductible.
 Solvency or liquidity position: A sound capital structure never allows a business
enterprise to go for too much raising of debt capital because, at the time of poor earning,
the solvency is disturbed for compulsory payment of interest to .the debt-supplier.
 Flexibility: A sound capital structure provides a room for expansion or reduction of debt
capital so that, according to changing conditions, adjustment of capital can be made.
 Undisturbed controlling: A good capital structure does not allow the equity
shareholders control on business to be diluted.
 Minimisation of financial risk: If debt component increases in the capital structure of a
company, the financial risk (i.e., payment of fixed interest charges and repayment of
principal amount of debt in time) will also increase. A sound capital structure protects a
business enterprise from such financial risk through a judicious mix of debt and equity in
the capital structure.

Factors Determining Capital Structure:

The following factors influence the capital structure decisions:
 Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay fixed
interest liabilities. Generally, the higher proportion of debt in capital structure compels
the company to pay higher rate of interest on debt irrespective of the fact that the fund is
available or not. The non-payment of interest charges and principal amount in time call
for liquidation of the company. The sudden withdrawal of debt funds from the company
can cause cash insolvency. This risk factor has an important bearing in determining the
capital structure of a company and it can be avoided if the project is financed by issues
equity share capital.
 Risk in variation of earnings: The higher the debt content in the capital structure of a
company, the higher will be the risk of variation in the expected earnings available to
equity shareholders. If return on investment on total capital employed (i.e., shareholders’
fund plus long-term debt) exceeds the interest rate, the shareholders get a higher return.
 On the other hand, if interest rate exceeds return on investment, the shareholders may not
get any return at all.
 Cost of capital: Cost of capital means cost of raising the capital from different sources of
funds. It is the price paid for using the capital. A business enterprise should generate
enough revenue to meet its cost of capital and finance its future growth. The finance
manager should consider the cost of each source of fund while designing the capital
structure of a company.
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 Control: The consideration of retaining control of the business is an important factor in

capital structure decisions. If the existing equity shareholders do not like to dilute the
control, they may prefer debt capital to equity capital, as former has no voting rights.
 Trading on equity: The use of fixed interest bearing securities along with owner’s
equity as sources of finance is known as trading on equity. It is an arrangement by which
the company aims at increasing the return on equity shares by the use of fixed interest
bearing securities (i.e., debenture, preference shares etc.). If the existing capital structure
of the company consists mainly of the equity shares, the return on equity shares can be
increased by using borrowed capital. This is so because the interest paid on debentures is
a deductible expenditure for income tax assessment and the after-tax cost of debenture
becomes very low. Any excess earnings over cost of debt will be added up to the equity
shareholders. If the rate of return on total capital employed exceeds the rate of interest on
debt capital or rate of dividend on preference share capital, the company is said to be
trading on equity.
 Government policies: Capital structure is influenced by Government policies, rules and
regulations of SEBI and lending policies of financial institutions which change the
financial pattern of the company totally. Monetary and fiscal policies of the Government
will also affect the capital structure decisions.
 Size of the company: Availability of funds is greatly influenced by the size of company.
A small company finds it difficult to raise debt capital. The terms of debentures and long-
term loans are less favourable to such enterprises. Small companies have to depend more
on the equity shares and retained earnings. On the other hand, large companies issue
various types of securities despite the fact that they pay less interest because investors
consider large companies less risky.
 Needs of the investors: While deciding capital structure the financial conditions and
psychology of different types of investors will have to be kept in mind. For example, a
poor or middle class investor may only be able to invest in equity or preference shares
which are usually of small denominations, only a financially sound investor can afford to
invest in debentures of higher denominations. A cautious investor who wants his capital
to grow will prefer equity shares.
 Flexibility: The capital structures of a company should be such that it can raise funds as
and when required. Flexibility provides room for expansion, both in terms of lower
impact on cost and with no significant rise in risk profile.
 Period of finance: The period for which finance is needed also influences the capital
structure. When funds are needed for long-term (say 10 years), it should be raised by
issuing debentures or preference shares. Funds should be raised by the issue of equity
shares when it is needed permanently.
 Nature of business: It has great influence in the capital structure of the business,
companies having stable and certain earnings prefer debentures or preference shares and
companies having no assured income depends on internal resources.
 Legal requirements: The finance manager should comply with the legal provisions
while designing the capital structure of a company.
 Purpose of financing: Capital structure of a company is also affected by the purpose of
financing. If the funds are required for manufacturing purposes, the company may
procure it from the issue of long- term sources. When the funds are required for non-
manufacturing purposes i.e., welfare facilities to workers, like school, hospital etc. the
company may procure it from internal sources.
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 Corporate taxation: When corporate income is subject to taxes, debt financing is

favourable. This is so because the dividend payable on equity share capital and
preference share capital are not deductible for tax purposes, whereas interest paid on debt
is deductible from income and reduces a firm’s tax liabilities. The tax saving on interest
charges reduces the cost of debt funds. Moreover, a company has to pay tax on the
amount distributed as dividend to the equity shareholders. Due to this, total earnings
available for both debt holders and stockholders is more when debt capital is used in
capital structure. Therefore, if the corporate tax rate is high enough, it is prudent to raise
capital by issuing debentures or taking long-term loans from financial institutions.
 Cash inflows: The selection of capital structure is also affected by the capacity of the
business to generate cash inflows. It analyses solvency position and the ability of the
company to meet its charges.
 Provision for future: The provision for future requirement of capital is also to be
considered while planning the capital structure of a company.
 EBIT-EPS analysis: If the level of EBIT is low from HPS point of view, equity is
preferable to debt. If the EBIT is high from EPS point of view, debt financing is
preferable to equity. If ROI is less than the interest on debt, debt financing decreases
ROE. When the ROI is more than the interest on debt, debt financing increases ROE.

Trading on Equity:
Trading on equity is the financial process of using debt to produce gain for the residual owners.
The practice is known as trading on equity because it is the equity shareholders who have only
interest (or equity) in the business income.
The term owes its name also to the fact that the creditors are willing to advance funds on the
strength of the equity supplied by the owners. Trading feature here is simply one of taking
advantage of the permanent stock investment to borrow funds on reasonable basis.
When the amount of borrowing is relatively large in relation to capital stock, a company is said
to be ‘trading on this equity’ but where borrowing is comparatively small in relation to capital
stock, the company is said to be trading on thick equity.
Effects of Trading on Equity:
Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any
fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share
(EPS) by operation of trading on equity larger the magnitude of debt in capital structure, the
higher is the variation in EPS given any variation in EBIT.
Effects of trading on equity can be explained with the help of the following example.
Example:
Prakash Company is capitalized with Rs. 10, 00,000 dividends in 10,000 common shares of Rs.
100 each. The management wishes to raise another Rs. 10, 00,000 to finance a major programme
of expansion through one of four possible financing plans.
Then management
A) may finance the company with all common stock,
B). Rs. 5 lakhs in common stock and Rs. 5 lakhs in debt at 5% interest,
C) all debt at 6% interest or
D) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with 5-4 dividend.
The company’s existing earnings before interest and taxes (EBIT) amounted to Rs. 12,00,000,
corporation tax is assumed to be 50%
Thus, when EBIT is Rs. 1,20,000 proposal B involving a total capitalisation of 75% common
stock and 25% debt, would be the most favourable with respect to earnings per share. It may
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further be noted that proportion of common stock in total capitalisation is the same in both the
proposals B and D but EPS is altogether different because of induction of preferred stock.
While preferred stock dividend is subject to taxes whereas interest on debt is tax deductible
expenditure resulting in variation in EPS in proposals B and D, with a 50% tax rate the explicit
cost of preferred stock is twice the cost of debt.
Solution:
Impact on trading on equity, will be reflected in earnings per share available to common stock
holders. To calculate the EPS in each of the four alternatives EBIT has to be first of all
calculated.

Proposal A Proposal B Proposal C Proposal

Rs. Rs. Rs. D Rs.

EBIT 1,20,000 1,20,000 1,20,000 1,20,000

Less; ------ 25,000 60,000 ---------

interest

Earnings 11,20,000 95,000 60,000 1,20,000

before
taxes

Less; 60,000 47,100 30,000 60,000

taxes @
50%

Earnings 60,000 47,500 30,000 60,000

after
taxes

Less; 25,000 ------ -------- ---------

Preferre
d stock
dividend

Earnings 60,000 47,500 ,30,000 35,000

available
to equity
share
holders

No. of 20,000 15,000 10,000 15,000

common
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shares

EPS Rs. 3.00 3.67 3.00 2.33

Optimum Capital Structure of a Firm

An optimum capital structure has such a proportion of debt and equity which will maximise the
wealth of the firm. At this capital structure the market price per share is maximum and cost of
capital is minimum.
E. F. Brigham defines—”the optimum capital structure strikes that balance between risk and
return which maximises the price of the stock and simultaneously minimizes the firm’s overall
cost of capital.”
Generally speaking, a sound optimum capital structure is one which:
 Maximises the worth or value of the firm.
 Minimizes the cost of capital.
 Maximises the benefit to the shareholders by giving best earning per share and maximum
market price of the shares in the long-run.
 Is fair to employees, creditors and others.
Features of an Optimum Capital Structure:
The features of an optimum capital structure:
 Simplicity: All businessmen are not educated. A complicated capital structure may not
be understood by all; on the contrary it may raise suspicions and create confusion. A
capital structure must be as simple as possible.
 Profitability: An optimum capital structure is one which maximises earning per equity
share and minimizes cost of financing.
 Solvency: In a sound capital structure, content of debt will be a reasonable proportion of
the total capital employed in the business. As a result, it has minimum risk of becoming
insolvent.
 Flexibility: The capital structure of a firm should be such that it can raise funds as when
required.
 Conservatism: The debt content in the capital structure of a firm should be within its
borrowing limits. It should be free from the risk of insolvency.
 Control: The capital structure should be designed in a such a way that it involves
minimum risk of loss of control of the firm.
 Optimal debt-equity mix: Optimal debt-equity mix in the capital structure of a company
would be that point where the weighted average cost of capital is minimum. Optimum
debt- equity proportion establishes balance between owned capital and debt capital. The
firm should be cautious about the financial risk associated with the maximum utilisation
of debt.
 Maximisation of the value of the firm: An optimum capital structure makes the value of
the firm maximum.

Theories of Capital Structure

Theories of Capital Structure (Relevance and Irrelevance theories)
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The capital structure decision can affect the value of the firm either by changing the expected
earnings or the cost of capital or both.
The objective of the firm should be directed towards the maximization of the value of the firm
the capital structure, or average, decision should be examined from the point of view of its
impact on the value of the firm.
If the value of the firm can be affected by capital structure or financing decision a firm would
like to have a capital structure which maximizes the market value of the firm. The capital
structure decision can affect the value of the firm either by changing the expected earnings or the
cost of capital or both.
If average affects the cost of capital and the value of the firm, an optimum capital structure
would be obtained at that combination of debt and equity that maximizes the total value of the
firm (value of shares plus value of debt) or minimizes the weighted average cost of capital.

David Durand views, Traditional view and MM Hypothesis are tine important theories on capital
structure.

 David Durand Theories on Capital structure :

The existence of an optimum capital structure is not accepted by all. There exist two extreme
views and a middle position. David Durand identified the two extreme views – the Net income
and net operating approaches.

1. Net income Approach (NI)( Relevance Theory) : Net Income theory was introduced by
David Durand. According to this approach, the capital structure decision is relevant to the
valuation of the firm. This means that a change in the financial leverage will
automatically lead to a corresponding change in the overall cost of capital as well as the
total value of the firm. According to NI approach, if the financial leverage increases, the
weighted average cost of capital decreases and the value of the firm and the market price
of the equity shares increases. Similarly, if the financial leverage decreases, the weighted
average cost of capital increases and the value of the firm and the market price of the
equity shares decreases.
Assumptions of NI approach:
 There are no taxes
 The cost of debt is less than the cost of equity.
 The use of debt does not change the risk perception of the investors

Relationship between degree of financial leverage and cost of equity capital, cost of debt and
overall cost of capital as per NI approach has been exhibited in figure given below. The degree
of leverage D/V is plotted along the horizontal axis and the percentage rate for Ke Kd and K0is
plotted on the vertical axis of the graph.
The graph is based on the information given in Illustration 1. As the Kd, and Ke are assumed to
remain constant, both the curves are parallel to the X-axis. As the degree of leverage increases
the weighted cost of capital, Ko decreases and tends to approach the cost of debt Kd.
The optimal capital structure is the one at which total value of the firm is highest and the cost of
capital the lowest. Market price of shares at the point will be the maximum. This structure can be
traced to the right side of figure given below. Under the NI approach a firm will have the
maximum value and the lowest cost of capital when it is all debt financed.
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Illustration
Excellent Manufacturing Company expects to earn net operating income of Rs. 1, 50,000
annually. The Company has Rs. 6.00,000 8% debentures. The cost of equity capital of the
Company is 10%. What would be the value of Company? Also calculate overall cost of capital.
Solution:

Now assume that the management raises the amount of debt from Rs. 6,00,000 to Rs. 12,00,000
and uses the proceeds so obtained to repurchase stock.
Presuming that the cost of debt remains constant, value of the company will be as shown
below:
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A perusal of the above calculation will show that as the amount of debt increases from Rs.
6,00,000 to Rs. 12,00,000 value, of the company rises from Rs. 16,20,000 to Rs. 17,40,000 and
overall cost of capital declines from 9.3% to 8.6.%.

Let us now assume that the amount of debt decreases from Rs. 6,00,000 to Rs. 3,00,000 and the
Company issues new shares worth Rs. 75,000 to retire the debentures.

Impact of change in financial leverage on cost of capital and value of the firm as will be
under:

It is to be noted from the above that with decrease in debt from Rs. 1,50,000 to Rs. 75,000,
overall cost of capital rises from 9.3% to 9.6% and total value of firm declines from Rs.
16,20,000 to Rs. 15,60,000. In sum, as per NI approach increase in ratio of debt to total
capitalisation brings about corresponding increase in total value of firm and decline in cost of
capital.
On the contrary, decrease in the ratio of debt to total capitalisation causes decline in total value
of firm and increase in cost of capital.
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2. Net Operating income Approach (NOI) ( Irrelevance theory) : According to Net

Operating Income Approach which is just opposite to NI approach, the overall cost of
capital and value of firm are independent of capital structure decision and change in
degree of financial leverage does not bring about any change in value of firm and cost of
capital.

Under the net operating income (NOI) approach, the cost of equity is assumed to increase
linearly with average. As a result, the weighted average cost of capital remains constant and the
total of the firm also remains constant as average changed.
Thus, if the Nl approach is valid, average is a significant variable and financing decisions have
an important effect on the value of the firm, on the other hand, if the NOI approach is correct,
then the financing decision should not be of greater concern to the financial manager, as it does
not matter in the valuation of the firm.

The market value of the firm is determined by the following formula:

V = NOI ( EBIT) / KO

The crucial assumptions of the NOI approach are:

 The firm is evaluated as a whole by the market. Accordingly, overall capitalisation rate is
used to calculate the value of the firm. The split of capitalisation between debt and equity
is not significant.
 Overall capitalisation rate remains constant regardless of any change in degree of
financial leverage.
 Use of debt as cheaper source of funds would increase the financial risk to shareholders
who demand higher cost on their funds to compensate for the additional risk. Thus, the
benefits of lower cost of debt are offset by the higher cost of equity.
 The cost of debt would stay constant.
 The firm does not pay income taxes.
Thus, under the NOI approach the total value of the firm as stated above is determined by
dividing the net operating income (EBIT) by the overall capitalisation rate and market value of
equity (S) can be found out by subtracting the market value of debt (D) from the overall value of
the firm (V). In other words.
S=V–D
The cost of equity and equity capitalization rate can be calculated as follows
Ke = EBIT – Interest / S
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The relationship between financial leverage and K0, Ke and Kd, has been graphically depicted in
figure above. It may be noted from the above figure that curve K0 and curve Kd, are parallel to
the horizontal axis because K0, and Kd, remain constant under all the circumstances. But
Ke shows rising tendency with increase in the amount of debt in capitalisation.
Illustration
Canon Manufacturing Company has annual net operating income of Rs. 150000. The Company
has Rs. 6,00,000 8% debentures. The overall cost of capital of the Company is 10%. What would
be the value of the Company?
Solution:
Value of Canon Company has been computed as below:

Let us now assume in order to assess the effect of leverage on value of firm that the Company
increases the amount of debt from Rs. 6,00,000 to Rs. 12,00,000. The value of the firm and cost
of equity capital will be as shown above.
It may be noted from the above that increase in amount of debt from Rs. 6.00,000 to Rs.
12,00,000 has not brought about any change in the total value of the Company but cost of equity
capital has shot up from 11.33% to 18%.

What would happen under NOI approach if the amount of debt declines from Rs. 6,00,000 to Rs.
3,00,000 ? The value of the company in that case will be, as shown below. A perusal of the table
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will show that as the amount of debt decreases from Rs. 6,00,000 to Rs. 3,00,000 while value of
the firm remains at Rs. 15,00,000 as it was earlier cost of equity capital has declined from
11.33% to 10.5%.

In sum, change in degree of financial leverage does not cause any change in value of the firm but
cost of equity capital certainly responds to such change. Since overall cost of capital remains
constant for all degrees of financial leverage, there is no unique optimal point in capital structure.
It implies that capital structure decision has no relevance to valuation of the firm.

3. Traditional Approach:
While the above two approaches represent extreme views about the impact of financial leverage
on value of firm and cost of capital, traditional approach offers an intermediate view which is a
compromise between the NOI and NI approaches.
This approach resembles the NI approach when it argues that the value of the firm can be
increased and cost of capital can be reduced by the judicious mix of debt and equity share capital
but it does not subscribe to the view of NI approach that the value of the firm will increase and
cost of capital will decrease for all the degrees of financial leverage.
Further, the traditional approach differs from the NOI approach because it does not hold the view
that the overall cost of capital will remain constant whatever be the degree of financial leverage.
Traditional theorists believe that up to certain point a firm can by increasing proportion of debt in
its capital structure reduce cost of capital and raise market value of the stock.
Beyond the point further induction of debt will lead the cost of capital to rise and market value of
the stock to fall. Thus, through a judicious mix of debt and equity a firm can minimise overall
cost of capital to maximise value of stock. They opine that optimal point in capital structure is
one where overall cost of capital begins to rise faster than the increase in earnings per share as a
result of application of additional debt.
Traditional view regarding optimal capital structure can be appreciated by categorizing the
market reaction to leverage in following three stages:
 Stage I: The first stage starts with introduction of debt in the firm’s capital structure. As
a result of the use of low cost debt the firm’s net income tends to rise; cost of equity
capital (Ke) rises with addition of debt but the rate of increase will be less than the
increase in net earnings rate. Cost of debt (Ke,) remains constant or rises only modestly.
Combined effect of all these will be reflected in increase in market value of the firm and
decline in overall cost of capital (K0).
 Stage II: In the second stage further application of debt will raise costs of debt and equity
capital so sharply as to offset the gains in net income. Hence the total market value of the
firm would remain unchanged.
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 Stage III: After a critical turning point any further dose of debt to capital structure will
prove fatal. The costs of both debt and equity rise as a result of the increasing riskiness of
each resulting in an increase in overall cost of capital which will be faster than the rise in
earnings from the introduction of additional debt. As a consequence of this market value
of the firm will tend to depress.
The overall effect of these stages suggests that the capital structure decision has relevance to
valuation of firm and cost of capital. Up to favorably affects the value of a firm. Beyond that
point value of the firm will be adversely affected by use of debt.
The traditional view of optimal structure is set forth graphically in figure given below

It may be noted from figure that the cost of capital curve (K e) is saucer shaped where an optimal
range is extended over the range of leverage. But cost of capital curve need not always be saucer
shaped. It is possible that stage 2 may not exist at all and instead of optimal range we may have
optimal point in capital structure. This possibility is shown in figure 14.4.
Thus, cost of capital curve may be V shaped which suggest that applications of additional debt
in capital structure beyond a point will result in an increase in total cost of capital and fall in
market value of the firm. This is an optimal level of debt and equity mix which every firm must
endeavour to attain.

The following illustration will explain the traditional approach:

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Illustration :
Sneh Steel Ltd. is expecting a net operating income of Rs. 3,00,000 on a total investment of Rs.
20,00,000. The equity capitalisation rate is 10 percent, the firm has no debt; but it would increase
to 11 percent when the firm substitutes equity capital by issuing debentures of Rs. 6,00,000 and
to 12.5 percent when debentures of Rs. 10,00,000 are issued to substitute equity capital.
The management expects that it will have to pay interest @ 5% to raise an additional debt of Rs.
6,00,000 and @ 7% to raise an additional debt of Rs. 10,00,000. What would be the overall cost
of capital and market value of the firm under the Traditional Approach?
Solution:

Evaluation of the Traditional Approach:

The traditional model discussed above shows that the cost of capital would tend to increase and
market value of the firm would tend to decline as the firm becomes more risky as a result of
financing operations with debt capital.
Although there is no convincing empirical evidence to support the traditional model intuition and
practice as evidenced by the behaviour of supplier of capital as well as by the finance manager
seem to suggest that there is indeed a limit to which a firm can assume debt without increasing
its cost of capital.
To exceed certain limits of debt an acceptable range tends to increase both the cost of debt and
cost of common stock because the risk tends to increase.

4. Modigliani-Miller (M-M) Approach (Irrelevance theory)

Modigliani and Miller presented rigorous challenge to the traditional view. This approach closely
resembles with NOI approach. According to this approach, cost of capital and so also value of
the firm remain unaffected by leverage employed by the firm.
Modigliani and Miller argued that any rational choice of debt and equity results in the same cost
of capital under their assumptions and that there is no optimal mix of debt and equity financing.
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The independence of cost of capital argument is based on the hypotheses that regardless of the
effect of leverage on interest rates the equity capitalisation rate will rise by an amount sufficient
to offset any possible savings from the use of low-cost debt.
They contend that cost of capital is equal to the capitalisation rate of a pure equity stream of
income and the market value is ascertained by capitalizing its expected income at the appropriate
discount rate for its risk class.
So long as the business risk remains the same, the capitalisation rate (cost of capital) will remain
constant. Hence as the firm increases the amount of leverage in its capital structure the cost of
debt capital remaining constant the capitalisation rate (cost of equity capital) will rise just enough
to offset the gains resulting from applications of low-cost debt.
Thus, the essence of the M-M approach is that for firms in the same risk class the total value of
the firm and the overall cost of capital are not dependent upon degree of financial leverage. The
K and V remain constant for all degrees of financial leverage and value of the firm is found out
by capitalizing the expected flow of operating income at a discount rate appropriate for its risk
class.
Assumptions of M&M approach
 There are perfect capital markets.
 Investors behave rationally.
 No investors are large enough to effect the market price of shares.
 There are no taxes.
 The expected earnings of all firms have identical characteristics.
 All earnings are distributed to shareholders.
 The cut off point of investments in a firm is capitalization rate.
M-M’s argument is based on a simple switching mechanism what is called ‘arbitrage’.
Arbitrage Process:
M-M’s approach holds the view that the market value of two firms which are identical in all
respects except for the difference in the pattern of financing will not vary because arbitrage
process will drive the total values of the two firms together.
Rational investors according to M-M will use arbitrage in the market to prevent the existence of
the two assets in the same class and with same expected returns from selling at different prices.
The arbitrage process is an act of buying an asset in one market and selling it in another to take
advantage of price differentials in the two markets. This process is essentially a balancing
operation which would not allow two securities of the identical quality being sold at different
prices in two markets. M-M applied the ‘arbitrage’ argument to explain their view.
According to them because of the operation of the arbitrage process the total value of two firms
which are similar in all respects except that one firm is levered and the other is unlevered will not
be different. The investors of the levered firm whose value is higher will liquidate their holdings
and buy the shares of the unlevered firm whose value is lower.
This will benefit the investors because they will be able to earn the same return with same
perceived risk at relatively lower outlay. This behaviour of the investors will result in rise in the
share prices of the firm whose shares are being sold. This process will continue till the market
prices of the two homogeneous firms become identical.
The investors are as indicated above assured of the same return with identical risks but at lower
outlay by the arbitrage process. This is possible because the investors would borrow in the
proportion of the degree of leverage present in the firm.
The use of debt by the investor for arbitrage is called “home-made’ or “Personal” leverage. The
following illustration will explain how arbitrage process will drive value of two firms of the
same risk class together.
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Illustration
Two firms A and B falling in the identical risk class have net operating income of Rs. 2,00,000
each. Firm A is an unlevered concern having all equity but Firm B is levered concern as it has
Rs. 10,00,000 of 10% bonds outstanding. The equity capitalisation rate of firm A is 12.5% and of
firm B is 16.0%.
Solution:

It may be noted from the above that the total value of firm B which is levered is higher than the
unlevered firm A. However, this state of affairs cannot exist for a long time as the rational
investors according to M-M approach will substitute personal leverage for corporate leverage
and adjust their portfolios to take advantage of price differential and thereby improve their
earnings.
This behaviour of the investors will bring about the values of the two firms to an identical level.
The arbitrage process will work as under:
Suppose a rational investor owns 10 percent shares of Firm B. He thus holds shares worth Rs.
62,500 (10% of Rs. 6,25,000) and his earnings will amount to Rs. 10,000 (10% of Rs. 1,00,000).
He will liquidate his holdings of Firm B and use the proceeds to buy shares of Firm A.
Since firm A is unlevered the investors’ investment will be exposed to relatively less risk. He
will borrow additional funds equal to his share in the Firm B’s debt on his personal account. In
other words, he will substitute personal leverage (home made leverage) for corporate leverage.
Thus, by making personal borrowing the investor is introducing leverage in capital structure of
firm A. In our example the investor will borrow Rs. 1, 00,000 at 10% interest.
The investor would then buy 10 percent shares of Firm A the unlevered one for Rs. 1,60,000.
Before the above dealings the investor’s expected return on his investment in Firm B was 16
percent on a Rs. 62,500 investment or Rs. 10,000. His expected return on investment in Firm A
is 12.5 percent on a Rs. 1,60,000 investment or Rs. 20,000.
Out of this return he will have to pay interest on the debt taken by him leaving Rs. 10000 as his
net return as calculated below:
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We thus find that the investor is getting a net return of Rs. 10,000 from his investment in firm A,
the same amount which he was getting earlier from firm B. But investment outlay defrayed by
him to get a return of Rs. 10,000. From firm A is Rs. 60,000 which is less than the Rs. 62,500
investment in Firm A. Because of this benefit the investor would always prefer to invest in firm
A.
The behaviour of a large number of investors described above will cause drop in share prices of
firm B and rise in that of firm A. This arbitrage process will continue till the opportunity of
making same amount of return with investment outlay exists. At the point where there will be no
such opportunity the total value of the two firms will be identical.
This point is known as equilibrium point. The cost of capital of both the firms would also be the
same. In view of this investors would not be bothered about capital structure of the firm. They
can offset the leverage benefit of the firm with their own. The end result of the switching over
process is depicted graphically in figure

Ke = Cost of Equity
Cost of Capital

K0 = Overall cost
of Debt

Kd= Overall Cost of

Debt

Degree of Leverage
MM Theory of Irrelevance
Thus, on the basis of arbitrage Modigliani and Miller conclude that the financing decision does
not matter in maximisation of market price per share. In their words, “the market value of any
firm is independent of its capital structure and is given by capitalizing its expected return at the
rate appropriate to its (risk) class.”
Limitations of the M-M’s theory which have been brought to fore from time to time are as
under:
 M-M’s theory seems to have ignored the vital fact that business risk is a function of the
degree of financial leverage. If a firm fails to service the debt during the loan periods it is
very likely to collapse and will therefore not survive to reap the benefits of leverage
during the loan periods. Further, bank policy involves high costs and the probability of
the firm having to bear these costs tends to rise with leverage.
 M-M’s argument that there is no difference between personal and corporate leverage does
not hold true in actual practice. In fact, investors prefer corporate leverage to personal
leverage in view of greater risk exposure in personal leverage than in corporate leverage.
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 Higher interest rates on individual than corporate debt and stiffer margin regulations in
the case of personal borrowing further make the investors loath to-wads personal
leverage. Modigliani and Miller have answered these charges by pointing out that the
existing practices justify their assumptions.
 Another objection hurled against the MM’s proposition is that it is unrealistic to assume
that there are no restrictions on institutional investors in respect of their dealing in
securities. In real life situations, many institutional investors are not allowed to engage in
the ‘home made leverage’ that was described.
 Furthermore the Reserve Bank of India regulates margin requirements in respect of
different types of loans and stipulates the percentage of advances under a margin loan. As
a result, a significant number of investors cannot substitute personal leverage for
corporate leverage.
 It is also unrealistic to presume that there are no transaction costs. In actual practice,
leverage security dealers have to incur brokerage underwriting commission and similar
other costs in buying and selling corporate securities. Consequently, effectiveness of the
arbitrage mechanism may be impeded. Arbitrage will take place only up to the limits
imposed by transaction costs after which it is no longer profitable. As a result, the
leveraged firm could have a slightly higher total value.
 The assumption of no corporate tax is basically wrong. Nowhere in the world corporate
income has been untaxed. As a matter of fact, everywhere taxation laws have provided
for deductibility of interest payments on debt for calculating taxable income. If this is so,
debt becomes relatively much cheaper means of financing and the finance manager is
naturally encouraged to employ leverage.
For that very reason debt may be preferred to preferred stock. In view of this controversy,
Modigliani and Miller in their subsequent paper admitted that given the tax factor over-all cost of
capital can be lowered as more leverage is inducted in capital structure of the firm.
Consequently, the total market value of the firm also increases with rising leverage.
5. The M-M Approach and Corporate Taxes:
As stated above. Modigliani and Miller modified their earlier stand and accepted the proposition
that the value of the firm will increase and overall cost of capital will decline because of tax
factor. Since interest on debt is tax deductible expense item effective cost of debt will be much
less than the rate of interest.
Consequently, a levered firm would have greater market value than an unlevered firm.
Specifically, M-M state that the value of the levered firm would exceed that of the unlevered
firm by an amount equal to the levered firm’s debt multiplied, by the tax rate.
Thus, the value of the levered firm can be found with the help of the following formula:
VI = Vu+ Dt ………
VI = Value of levered firm
Vu = Value of unlevered firm
D = Amount of borrowing
T = tax rate
The above equation implies that the market value of a levered firm is equal to the market value
of an unlevered firm in the same risk class plus the discounted present value of the tax saving
resulting from tax deductibility of interest payments.
Illustration
Two firms A and B are homogeneous in all respects except that Firm A is unlevered and Firm B
is levered with Rs. 1,20,000 at 5% bonds. Both the firms earn Rs. 30,000 before tax income. The
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after-tax capitalisation rate is 10%. The corporate tax rate is 50%. Calculate the market value of
the two firms.
Solution:

M-M’s recognition that value of the firm having leverage in its capital structure will be higher
than the unlevered firm because of tax factor implies that a firm can reduce its cost of capital and
raise its value of incorporating more and more doses of debt. Thus, so as to have optimal capital
structure a firm must have only debt in its capital structure.
But in real life situations this is not true because excessive reliance on debt financing would
expose the firm to greater financial risk. With the result that cost of capital beyond certain debt
limit tends to go up in correspondence with increase in doses of debt and value of the firm would
fall.
In view of this, optimal capital structure would be the one which has desired amount of debt
determined at a point or range where the overall cost of capital is minimum and not the one with
cent-percent debt. M-M recognise this fact that extreme leverage lands the firm in great financial
risk and therefore suggest that a firm should adopt ‘target debt ratio’ so as not to violate limits of
leverage imposed by creditors.
There is thus a safe limit for use of debt and firms should make use of debt upto this limit.