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Cost
(Ko) is constant.
As the
ke
proportion of
debt increases,
ko
kd
(Ke) increases.
Debt
No effect on
total cost of
capital (WACC)
Capital Structure Theories
B) Net Operating Income
(NOI)
Capital Structure Theories
C) Traditional Approach
The NI approach and NOI approach hold extreme
views on the relationship between capital
structure, cost of capital and the value of a firm.
Traditional approach (intermediate approach) is
a compromise between these two extreme
approaches.
Traditional approach confirms the existence of an
optimal capital structure; where WACC is
minimum and value is the firm is maximum.
As per this approach, a best possible mix of debt
and equity will maximize the value of the firm.
Capital Structure Theories
C) Traditional Approach
The approach works in 3 stages
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings
will not affect WACC and the value of firm will also
stagnate.
3) Increase in debt beyond this point increases shareholders
risk (financial risk) and hence Ke increases. Kd also rises
due to higher debt, WACC increases & value of firm
decreases.
Capital Structure Theories
C) Traditional Approach
Cost of capital
Cost
(Ko) is reduces
ke
initially.
At a point, it ko
settles
But after this kd
point, (Ko)
increases, due to Debt
increase in the
cost of equity. (Ke)
Capital Structure Theories
C) Traditional Approach
Capital Structure Theories
D) Modigliani Miller Model
(MM)
MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
Further, the MM model adds a behavioural justification in
favour of the NOI approach (personal leverage)
Assumptions
o Capital markets are perfect and investors are free to buy,
sell, & switch between securities. Securities are infinitely
divisible.
o Investors can borrow without restrictions at par with the
firms.
o Investors are rational & informed of risk-return of all
securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
Capital Structure Theories
D) Modigliani Miller Model
(MM)
MM Model proposition
Proposition I
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of
operating income (i.e. EBIT) by the appropriate rate
(i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of
Debt
V(L)=V(u)=
L) Expected EBIT
Expected WACC
Proposition II
This proposition defines cost of equity. Cost of equity to a
levered firm is equal to the cost of unlevered firm in the
same risk class plus risk premium.
Ke(L) = Ke(u) + Risk Premium
= Ke(u) + [ke(u) Kd]B/S
Capital Structure Theories
D) Modigliani Miller Model
(MM)
MM Model proposition
o Asper MM, identical firms (except capital
structure) will have the same level of earnings.
o Asper MM approach, if market values of
identical firms are different, arbitrage
process will take place.
o Inthis process, investors will switch their
securities between identical firms (from levered
firms to un-levered firms) and receive the same
returns from both firms.
Capital Structure Theories
D) Modigliani Miller Model
(MM)Firm
Levered
Value of levered firm = Rs. 110,000
Equity Rs. 60,000 + Debt Rs. 50,000
Kd = 6 % , EBIT = Rs. 10,000,
Investor holds 10 % share capital
Un-Levered Firm
Value of un-levered firm = Rs. 100,000 (all
equity)
EBIT = Rs. 10,000
Capital Structure Theories
C) Modigliani Miller Model
(MM)
Return from Levered Firm:
Investment 10% 110, 000 50 , 000 10% 60, 000 6 , 000
Return 10% 10, 000 6% 50, 000 1, 000 300 700
Alternate Strategy:
1. Sell shares in L: 10% 60,000 6,000
2. Borrow (personal leverage): 10% 50,000 5,000
3. Buy shares in U : 10% 100,000 10,000
Return from Alternate Strategy:
Investment 10,000
Return 10% 10,000 1,000
Less: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Cash available 11,000 10,000 1,000
Homemade leverage: Arbitrage argument
Acc to MM, whether the firm employs debt or not, it does
not matter really.
Investors are able to substitute personal or homemade
leverage for corporate leverage.
Acc. to MM, capital structure changes are not a thing of value
in the perfect capital market world.
If the two firms are identical in each and every respects except
for their capital structures, then the total values of the two firms
must be the same.
If not, arbitrage will occur, and it will drive values of the two
firms together.
Consider the two firms, A & B, identical in every
respects except their capital structures. B has
$30,000 of 12 percent bonds.Total value =?
Co. A Co. B
O NOI $10,000 $10,000
I Interest (12%,$30,000) 0 3,600
E Earnings avail. to
common stockholders 10,000 6,400
keEquity cap. rate 0.15 0.16
S Market value of stock 66,667 40,000
B Market value of debt 0 30,000
V Total value of firm 66,667 70,000
Ko Implied overall cap rate 15% 14.3%
B/S Debt-equity ratio 0 75%
MM maintain that this situation cannot last long.
Arbitrage will occur very soon, which will drive the values
of two firms together.
Company B cannot command a higher total value simply
because it has a financing mix different from company As.
Investors in Company B would move to Company A because
they get the same return with less capital outlay.
The arbitrage process will be ceased when the values of the
two firms would be identical.
Arbitrage steps:
If you are a rational investor who owns 1 percent of the stock
of Company B, the levered firm, worth $400, you should:
[ Class Exercise]
Students are requested to show arbitrage proof.
1. Sell the stock in Company B for $400.
2. Borrow $300 at 12 percent interest. This personal debt is equal
to 1 percent of the debt of Company B - proportional
ownership.
3. Buy 1 percent of the shares of Company A for $666.67.
Return?
Return in Company B: 16% of $400 = $64.
Return in Company A: 15% of $666.67 = $100
Less interest:12% of $300 = 36
Net return 64
Cash outlay?
Outlay in Company B:1% of $40,000 $400
Outlay in Company A:1% of $66,667.67 $666.67
Less Personal debt 300.00
Net outlay 366.67
Here you have saving of $33.33
M&M with Corporate Taxes
=B Kd TC
Kd B TC
PV TC B
Kd
This represents the increase in the value in the levered firm over the
unlevered firm.
30
M&M Proposition I (with Corporate Taxes)
VL = V U + T C B
31
The Value of a Levered Firm Under
MM Proposition I with Corporate Taxes
Value of
the firm
(VL )
VL = VU + TC B
VU VU
32
M&M Proposition II (with Corp. Taxes)
Proposition II (with Corporate Taxes)
This proposition is similar to Prop. II in the no tax
case, however, now the risk and return of equity
does not rise as quickly as the debt/equity ratio is
increased because low-risk tax cash flows are
saved.
Some of the increase in equity risk and return is
offset by interest tax shield
Ke(L) = Ke(U) + (B/S)(1-TC)(Ke(u) - Kd)
B
ke ( L) Ke(u ) (1 TC ) [ K e (u ) K d ]
S
r0
B S
K 0(WACC ) K d (1 TC ) Ke
BS BS
rB
Debt-to-equity
ratio (B/S)
34
Corporate taxes
The advantage of debt in a world of corporate
taxes is that interest payments are tax deductible.
Consequently, total amount of payments available
for both debt holders and stockholders is greater
if debt is employed.
Suppose the EBIT are $2000 for companies X &
Y, and they are alike in every respect except in
leverage.
Co. Y has $5,000 in debt at 12 percent interest.
Assume corporate tax rate is 40 percent.
Co.X Co.Y
EBIT $2,000 2,000
Less interest (12%, $5000) 0 600
Profit before taxes 2,000 1,400
Taxes @40% 800 560
Income avail. to stockholders 1,200 840
38
Millers Model with Corporate and
Personal Taxes
(1 - Tc)(1 - Ts)
VL = VU + 1 B
(1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
39
Tc = 40%, Td = 30%,
and Ts = 12%.
(1 - 0.40)(1 - 0.12)
VL = VU + 1 B
(1 - 0.30)
= VU + (1 - 0.75)B
= VU + 0.25B.
(1-tc)(1-tps)
PV of tax shield= 1- -------------------- B
1-tpd
If tps & tpd are taxed at the same rate, then PV of tax shield would be
TcB.
Suppose the marginal corporate tax rate is 35 percent, the marginal
personal tax rate on debt income is 30 percent, and the market
value of debt is $1 million.
If the marginal personal tax rate on stock income is 28 percent, PV
of tax shield would be $331,429.
If the personal tax rate on stock income is 0.20
instead of 0.28, then:
(1-.35)(1- .2)
PV of tax shield= 1- ------------------ $1million
1 - 0.3
= $257,143.
If tps=0.32, then PV of tax shield would be
$369,000.
Conclusions with Personal Taxes
Use of debt financing remains advantageous, but benefits are less than
under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in equilibrium, the tax rates of
marginal investors would adjust until there was no advantage to debt.
44
Effect of Bankruptcy Cost
45
Incentive issues and Incentive cost
Costs of
Market Value of The Firm
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt
Financial signaling & Asymmetric information
48
Investors understand this, so view new stock sales as a
negative signal.
50
Firms use internally generated funds first, because there are no flotation
costs or negative signals.
If more funds are needed, firms then issue debt because it has lower
flotation costs than equity and not negative signals.
If more funds are needed, firms then issue equity.