5.

3 Capital Structure Theories

s31 Capital Structure and Optimum Capital Structure
Capital Structure: Capital Structure refers to the mix of
1.
business may be raised. so, it refers to the proportion of sources from where the Iong-term funds required in d
Debt, Preference Capital and Equity Capital.
Optimum Capital Structure: One of the basic objectives of financial
of the Firm. Capital Structure is optimum when the Firm has a management is to maximise the value or wealth
the Firm is maximum. At this combination of Equity and Debt so that the wealtn or
level, Cost of Capital is minimum and
Market Value of the Firm is maximum.

5.3.2 Capital Structure vs Financial Structure

Capital Structure Financial Structure
Refers to combination of Debt and Equity used by | Refers to all Long-Term and short term sources of funds
an Entity. capital of the Entity.
2. Comprises only long termfunds Comprises the entire Liabilities side of the Balance Sheet.
3. Forms part of overall Financial Structure Wider in scope than Capital Structure.

5.3.3 Features of appropriate Capital Structure

The following are the major features of an appropriate capital structure -
1. Profitability: It should minimize the cost of
financing, and maximise Earning per Equity Share.
2 Flexibility: The
capital structure should be such that the Company can raise funds whenever needed.
3. Conservation: The debt content should not exceed the maximunm which the Company canbear.
Sotvency: The capital structure should be such that the Company does not run the risk of becoming insolvent.
SControl: There should be minimum risk of loss or dilution of control ofthe Company.

5.3.4 MajorConsiderations in Capital Structure Planning

ne major considerations in Capital Structure Planning are (1) Risk, (2) Cost, & (3) Control. These differ for various
ponents of Capital, i.e. Own Funds &Loan Funds. Acomparative analysis is given below-
Type Risk Cost Control
Low Risk -
no question of Most expensive dividend Dilution of control Since the -

Equity repayment of capital except when expectations of Shareholders are capital base might be expanded
Capital the Company is under liquidation higher than interest rates. Also, and
Dividends are not tax-deductible.
new
shareholders public
Hence best from viewpoint ofrisk. are involved.

Slightly higher risk when comparedSlightly cheaper cost than Equity

to Equity Capital- Principal is
Preference but higher than Interest rate on
redeemable after a certain period Loan Funds. Further, Preference
No dilution
of control since voting
Capital even if dividend payment is based rights are restricted.
Dividends are not tax-deductible.
on profits.
repaidComparatively cheaper No dilution of control but some
Loan
-

High risk- Capital should be prevailing interest rates are Financial Institutions may insist
Funds as per agreement, Interest
should
be paid irrespective of profits.
considered only to the extent of on nomination of their
after tax impact. representatives as Directors.

5.7
 Financial Management and Economics for Finance-for CA INter
rddnuka S Students' Guide on
Planning
5.3.5 Other Considerations in Capital Structure
Capital Structure Planning are as under
considerations in
Risk, Cost and Control, the other
.

In addition to
is more than the rate
rate of intos
Return on Capital Employed (ROCE),
to ma: mise EPS.interest
1. Trading on When the
Equity: be used favourably on
siuch aborro
Financial Leverage can
funds rate of
or Preference Dividend,
Preference Shares may be preferred in such
uch
Company is said to be "trading on equity". Loans or
of any financing decision on EPS and ROE should be analysed carefully. situations. Thease, t e
2. Corporate Taxation: Interest on Debt is a tax- deductible expense, but dividend is not. Also, the cost .
efe
of
through borrowing is deductible in the year in which it is incurred. If it is incurred during the pre-commendsing
capitalized.
Due to tax-saving advantage, Debt has a dheaper effective cost than Preferencenent pei
can be
Capital. The impact of taxation should be carefully analysed. apital or riEoq d,t
Government Policies: Raising finance by way of borrowing or issue of Equity, is subject to policies of the e.
and its regulatory bodies like SEBI, RBI, etc. The monetary, fiscal and lending policies, as well as rules:
and r
stipulated from time to time by these bodies have to be complied with for acquiring funds through the particul
Nernmen
requirements: The applicable legal provisions should be bornme in mind while deciding iaular
about h mode
Structure. Some provisions relate to maximum limit of borrowings by a Company, approvals requiredfor F C
Investment, etc. Dred
5. Marketability: The mode of
obtaining finance depends on the marketability of the
Instruments (Debentures Bonds). In case of restrictions in marketability, it is difficult toCompany's Shares
Hence, the Company has to consider its ability to market corporate securities. obtain public sulhc
scripion.
6. Maneuverability: Here, Maneuverability means having many possible alternatives at the time of
contractingthe requirement of funds. It enables use of proper type of funds available at a expandina
enhances the bargaining power when dealing with given time, and al
prospective suppliers of funds.
7. Flexibility: It denotes the capacity of the business and its
in the business environment. The management to adjust to expected and unexpected changes
Capital
structure should provide maximum freedom to
changes at all times.
8. Timing: Proper timing of a security issue often brings substantial
market. Hence the issue should be made at the savings because of the dynamic nature of the captal
should constantly study the trend in the right time so as to minimize effective cost
of capital. The managemet
capital market and time its issue carefuly.
9. Size of Company: Small
Companies
considered less risky by Investors. Such rely heavily on Owner's Funds, while large and widely held Companies at
large Companies can issue different
10. Purpose of financing: Funds required for types of Debt Instruments or Securnue
etc. may be raised long-term
through long-term sources. But if theproductive purposes like manufacturing, setting up ne ant
facilities to employees such as funds are required for
Schools, Hospitals, etc. internal non-productive purposes, KE
11. Period of finance: Funds financing may have to be used.
Debt. If the funds are for required
for medium and
permanent requirement, it will long-term periods say 8 to 10 years may be
12.
be appropriate to
raise them by the issue or
rd hares
Nature of Investors:
Companies which enjoy stable E
Borrowings or Preference earmings and dividend with a proven track optfar
which do not have assuredShares, since they have adequate profits to pay recorome
income, should preferably rely on
difficult to attract investors towards interest fixed charges. D
may
the issue. internal resources to a
13.
large extent, >"
Requirement of Investors: Different types of securities tother
requirement. Sometimes, the investor may be are issued to
different dasses of
double options, convertibility,
security of
motivated by the options and investors cecurity,
14. Provision for future growth: Future
principal and interest, etc. advantages available wiU
considered, while planning the capital growth considerations and ould also
structure. further requirements of
capta
5.3.6 Theories explaining Capital
1. Variables: Capital Structure
Structure and Cost of Capital
(a) Theories seek to
Debt-Equity Mix, i.e. proportions of explain the
relationship between the following variabie
(b) Costs of each
component of Capital, components of capital (Debt,
(c) Impact of Leverage, Equity, etc.),
(d) Overall Cost of
(e) Capital (WACC),
Value of the Firm. and
 Structure
Cost of Capital and Capital

ive: The objective of the Firm is to choose that Debt-Equity Mix such that the Overall Cost of Capita
minimized and the value of the Firm is maximized. For this purpose, the following terms are relevan
minimiz
is
o r Ko EBT
Debt D
Interest
=
Interest (b) Value of Equity E
Residual Earnings
Value of
=

Cost of Debt Cost of Equity Ke

(a) Kd
Total Net Operating Income Value of Equity = D+E
Value of
Firm = V =

Overall Cost of Capital, ie. WACC Oorl Value of Debt +

(c) Ko
s vaue
maximize
(Ko) show an inverse relationship. Hence, the Firm seeks to
value of
im
(v nd WAL
minimising its WACC.

Categorisation of Theeories: These theories can be broadly classified into two categories Debt-
Structure (i.e.
a)Theories which suggest that Capital Structure (i.e. (b) Theories which suggest that Capital
Debt-Equity Mix) affects WACC, not affect WACC,
Equity Mix) does
WACC Theoriess
i.e. Variable WACC Theories i.e. Constant
Approach (NI Approach) 1. Net Operating Approach (NOI Approach)
Income
1. Net Income
& M Approach)
2. Traditional Approach |2. Modigliani and Miller Approach (M

in Structure Theories
5.3.7 General Assumptions Capital
in Structure Theories
Thefollowing are the general assumptions Capital
1. The Fim has a perpetual life (i.e. Going Concern).
two sources of funds viz. Debt and Equity. (No Preference
Share Capital).
2. There are only
of the Firm (i.e. Capital Employed) is constant. (No change in Capital
Employed). However, Debt-
3 Total Assets
done by
Equity mix can be changed. This can be
-

Shares or
(a) either by borrowing Debt to repurchase (redeem) Equity
debt.
(b) by raising Equity apital to retire (repay)
mix decision. (No change in Fixed Costs
or
Business Risk is constant and is not affected by the financing
Operating Risks).
5. The Firm earns Operating Profits and it is expected to grow. (No Losses).
[Note: Operating Profits =EBIT]
6. There are no corporate or personal taxes. (No taxation).
100% Dividend Payout Ratio). (No Retained
7. All Residual Earnings are distributed to Equity Shareholders (i.e.
since there is no Taxation and Preference Dividend.]
Earmings). [Note: Residual Earnings EBT,
=

difference in Investors
8. The Investors have the same subjective probability distribution of expected earnings. (No
Debt and Equity Investors.]
expectations). [Note: Investors refer to both
9. Cost of Debt Ka (referred to as Debt Capitalisation Rate) is less than Cost of Equity Ke (referred to as Equity

Capitalisation Rate) (i.e. Low Cost Debt).

5.3.8 Net Income Approach

NET INCQME APPROACH
This Theory advocates maximum possible Ke
borrowing in order to minimize WACC and
haximise the value of the Firm.

en ROOCE> Interest Rate on Debt, Financial

Leverage works favourably, and hence use or
ebt Funds is justified. The Gearing/ Trading on
favourable to Equity
cry effect will be
Shareholders. Debt-Equity Mix, i.e. % of Debt in Capital
Constant
1. Ka and Ke: Use of debt content does not change the risk perception of Investors (i.e. both Sunnliers of
constant at all levels of Debt-Equity Mix,
Debt and Equity Investors). Hence, Ka and Ke remain
2. Low-Cost Debt: Debt is a cheaper source ofthe
finance than Equity due to Investors risk expectations (and also tax
saving effect.) Use of cheaper debt
total
funds in structure will reduce the
capital WACC, as Debt oercentan
Creases in the Total Capital Structure.

5.9
 and Economics for Finance-
For CA Inter
Management
on Financial
dS Students' Guide Will decline with every incro-
of Financial Leverage
increases, WACC crease in the
Favourable DFL: As the Degree
o
content in Total Funds Employed. EBIT the Value of Firm will increase for every declin
4. Effect on Firm Value: Since Value
of Firm WACC
Jcing the Value
thereby reducing Valio.
NK
will happen, 1.e. WACC WIll increase of
Where debt content is reduced, the
reverse the Fim
value and lower its Ko (WACC) by increasing tho
can increase its
5. Maximum Use of Debt: Thus, a Firm the use of total or maximumm
debt in the capital structure. Thus,
Net Income Approach suggests
mum at a point where
Value of the Firm will be maximu ACC ssible
WACC is
debtof
financing, for minimising
i.e. point of maximum debt.
the cost of capital.
minimum,
Income Approach for determining WACC involves the following steps
Application: Theapplication of Net Procedure
Step =EBIT less Interest on Debt Funde
1 Determine EBIT (Net Operating Income) and EBT (Net Income). EBT
EBT EBT
2 Compute Market Value of Equity (E) Cost of Equity Ke
Interest Interest
Compute Market Value of Debt (D)
3 Cost of Debt Kd
Compute Market Value of Firm (V) =E+ D Market Value of Equity +Market Value of Debt.
EBIT
5 Compute Overall Cost of Capital (Ko)
Value of Firm

5.3.9 Net Operating Income Approach

1. Increase in Ke: Ka (Debt Capitalisation Rate) remains constant at various levels of Debt-Equity Mix. However, as Debt
content increases, the expectations of Equity Investors also increases, due to higher financial risk. Therefore, Ke (Equity
Capitalisation Rate) increases as percentage of debt in Capital Employed increases.
d
2 Set-off Effect: Increase in financial risk causes the Equity Capitalisation Rate to increase. Thus, the advantage
using low-cost debt is set off exacty by increase in Equity Capitalisation Rate, i.e. Ke.
3. Constant Ko: Due to the set-off effect of low Ka advantage vs. increasing Ke disadvatage, the Overall Cost af Cape
(Ko) remains constant for all degrees of Debt-Equity mix.

Market Capitalisation:
(a) The market (investors in Debt as well as Equity) capitalises the value of the Firm as a whole, witnout ggiving
importance to the Debt-Equity mix. Hence Overall Cost of Capital is constant.
ostof
(b) The Market Value ofthe Firm is ascertained by capitalising the Net Operating Income (EBIT) at the Overa
ence,
Capital Ko, which is constant. The Market Value of the Firm is not affected by Debt-Equity mix change n
distinction between Debt and Equity is irrelevant.
mix
5. Optimum Capital Structure: Since WACC is constant at all levels, every debt-equity mix is as good as any ou
There is no optimum capital structure. Every capital structure is optimal one.

NET OPERATING INCOME THEORY

This Theory states that WACC i.e. Ko, is
constant. The Market Value of the Firm is not
affected by debt-equity mix change.

The advantage of using low-cost debt is set off

by increase in Ko. Every debt-equity mix is an
optimal one since Ko and Market Value will be
constant at all levels.
Debt-Equity Mix i.e. % of Debt in Capital
Application: The application of Net Operating Income theory in determining Ke involves the following stepsS

5.10
 Cost of Capital and Capital Structure

Step
Procedure
Determine EBIT (Net operatin9 Income) and EBT (Net Income). EBT =EBIT less Interest on Debt rur ds
Compute Market Value of Firm (V) EBIT EBIT
2 WACC No
Compute Market Value of Debt (D) Interest Interest
3 Cost of Debt Kd
Compute Market Value of Equity (E) V-D = Market Value of Firm (Less) Market Value of Debt.
Compute Cost of Equity Capital (Ke) EBT EBT
5 Value of Equity E
Note: Under Net Income Theory, the approach is V = E + D, in order to compute Ko. However, under Net Operating inco
Theory, the approach is E =V- D, in orderto compute Ke

5.3.10 Traditional APproach/Theory

1. Change in Risk Perceptions: As debt contet increases, the Firm's financial risk increases, causing increase in the
be taken
expectations of Equity Investors and therefore rise in the Cost of Equity Capital K. Also additional loans
a can

only at a higher rate of interest. So Cost of Debt Kg also rises beyond a certain leve! of debt content.

Debt-Equity Mix vs Cost: Ka and Ke vary with change in Debt-Equity mix. However, increase in Cost of Equity is
more steeper and higher than increase in cost of debt.
3. Initial Leverage Effect: Debt is a cheaper source of finance than equity due to tax saving effect and investor's risk
of
expectations. Use of cheaper debt funds in total capital structure will reduce Ko initially. This
is because the benefits
cheaper debt may be so large that even in off-setting the effect of increase in cost of equity, the WACC may go down.
4. Set-Off Effect: As more debt is employed, the risk perceptions of Equity Investors and Ke may increase. However, Ka
may still remain constant, causing WACC to remain constant due to set-off effect, i.e. advantage of low-cost debt is
set-off exactly by the disadvantage of increasing cost of equity.
5. Subsequent Risk Effect: However, beyond an acceptable limit (called as the Optimal Point), the Cost of Debt Kd
and Cost of Equity Ke start rising. This is because of the high financial risk associated with the Firm. The increasing Ke
owing to increased financial risk and increasing Ka makes the Overall Cost of Capital Ko to increase.
6. Optimal Capital Structure: The Firm should strive to reach theoptimal capitalstructure andmaximiseits total value
through a judicioususe of both debt and equity in the capital structure. At the optimal capital structure the overall cost
of capital will be minimum and the value of the Firm is maximum.

TRADITIONAL THEORY
Ke Phase I II III

Constant Constant Increases

Ka
Ko
gradually.
Constant Increases
Ke Increases
faster than Kd
Kd Declines and may
Ko Declines remain constant. Increases.
Reason Low Cost Advantage of Ka and Ke
III Optimal Point for Ko Low Cost Ka is both increase,
Phase I Ka pulls
move set-off by
Capital ment
down Ko causing K, to
Debt-Equity Mix i.e 9% of Debt in increase in Ke. increase.
Application: The computation of Ko is the same asthat of Net Income Approach, except that Ke and Ka differ for differe
rees of Debt-Equity mix. The least WACC should be selected for the optimal Capital Structure.

.3.11 Modigliani and Miller Approach

This
This Approach is a refinement of the Net Operating Income Approach. The basic theory is essentialy the same
dtional propositions are made.

5.11
 for Finance-
and Economics
Management
Financial
Rate (Ka) re remains constant at
Padhuka's Students' Guide on
Debt
Capitalisation
t Vario various
c o n t e n t increases due to

1. Behaviour of Ka and Ke: Ka is

always
less than

Capitalisation
Ke.
Rate Ke
increases
as debt
higher finandalleve
Equity
Debt-Equity mix. However, sell securities. They
and higher expectations of Equity Investors.
free to buy and well:
Investors hekre
are

informe
Investors
costs. The
Markets are perfect. transaction

Perfect Market: The apital are no

2 securities. There
n and return on all type ofsame terms as the Firms
d0.
about the risk
restrictions on the
borroW without risk classes. They belong to this
dass
cah
"homogenous

Risk Classification: Firms can be classified into

investors' perceptions). if th
3.
risk characteristics (as per the
pECted earnings have identical different risk categories, The :

Investors expect different

L,
returns for the return exper higher the tie
Risk-Return Relationship: for a certain risk category
another category
the higher M is considered
is the return as For
expectation. moreexample,
riskier than L, the return expectation for that ategory willis 15%
More

than 15% (say 21%).

i.e. the higher the risk, the higher the return. Rt.
Constant WACC: Risk and Return are directly related,
the same category have the same risk and have
constant expected return. For every risk category fco category (consistingmd
number of Firms), the expected return of all investors (i.e.
Debt and Equity) is the same.

6. Market Capitalisation:
(a) The market (Investors in Debt as well as Equity) capitalises the value of the Firm as a whole, withot e
importance to the debt-equity mix. Hence Overall Cost of Capital is constant for all degrees of debt-equity mi
()
The Market value of the Fim is ascertained by capitalising the Net Operating Income (EBIT) at the
Capital Ko, which is constant. The Market Value of the irm is not affected by debt-equity mix
Overall as
change.
Optimum Capital Structure: Since WACC is constant at all levels, every
There is no optimum capital structure. debt-equity mix is as good as any other ma
Every capital structure is an optimal one
8.
MODIGLIANI AND MILLER APPROAC
WACC vs Debt
Equity Mix: The Total Cost of
Capital of a Fim (i.e. WACC or Ke) is Ke
of its methods and level of independent
Equity Mix is not
financing. Hence, Debt-
relevant for
determining WACC.
9 WACC= Ke at 0% Debt: Since Risk Prermiun
constant, WACC at 0% Debt WACC is
shouid be the same as (i.e. 100% Equity)
WACC at any other
percentage of debt. Hence WACC
Firm isfinanced purely by Ke when the =

Firm equals the Equity. So, WACC of a 8

stream of its dassCapitalisation
of risk.
Rate of pure
equity
Propositions: Modigliani and Miller Debt-Equity Mix i.e. %of Debt in Caplidl
A
Constant WACC: The Total make the following
Total Market Value of the Market Value of Firmpropositions-
and its Cost a
Income) at discount rate Firm is given by
a of
Capital are
considered capitalising
stream ofindependent of t
the
B. K. K, + Premium for
= appropriate for its risk expected Net Operat
Risk: class. operating earnings
Risk. The The Cost of Equity (Ke) is
premium for Financial
eases in such a manner Financial Risk equal to
exactiyincreases
as to
Cost of Equity
off-set with
the use of more debt Capitalisation
content
Rate of Pure Equity
Stream
phs

less As a resu

expensive source ofin the

=

C.
Investment- Financing
WACC+Risk Premium. capital structure
debt funds.
of financing.
Hence every ecisions: The
So, Ke Ko+ Debt
Fauity Mix is not relevant for estment
invest cut off
rate for (Ko- Ka)
Equity (Ko-Ka)
Capital proposal can be investment emae
D. Leverage Adju
djustment: Budgeting decisions.evaluated at the purposes i s completely independe m sD e t

the same
the
risk class. Financial
ss. In case
leverage effect. Hence Leverage has
such Firms no
rate
applicable for such type
Arbitrage willhad differentimpact on
market market values.
substitute values, which remain
Wnich constant for .
ms

personal leverage investors

for will remain
buy
Shares andset
hares
corpor ai
rporate leverage.
 Cost of Capital and
Capital Structuree

bet'n Cost
6.3.12
Relationship
of Equity & Fin.Leverage as per M&M Proposition
of pure eqe
nposition: Modigliani and Milerargue that the Cost of Equity (K.) is equal to the Capitalisation
a m plus a premium ror inancial risk. The financial risk increases with more debt content in the
Rate
Capital S t r u c t u r e . As
strear

creases in a manner to offset exactly the use of less expensive source of debt funds. Hence, Overall Cost
esult, Ke increases

constant.
is
of Capital on
When the Debt Content in (trading
rage:
Financial Leverag Capital Structure increases, the financial leverage
mity) operates favourably, particularly when the Firm's ROCE is high. However, Equity Shareholders are enn
f residual income only (i.e after meeting interest payment, taxes, if any, and Preference Dividend, duy
ce, at
Hence, at higher levels of debt, the risk perception of Equity Shareholders increases.
off Effect: The advantage of using low-cost debt is set off by the disadvantage of rising Cost of Equity
Set-
3encethe Overall Cost of Capital remains constant. The increase in the Cost of Equity is defined by the Risk Premiu
hence

Ke =
Ko + Risk Premium.
Hence,

5.3.13 Arbitrage under M& M Approach

argue that there is difference in the market values of different Firms in the same risk class.
Modialiani and Miller
no
use of debt in capital structure has no impact on Market
Values. Ineir
They consider that Financial Leverage or
reasoning is as under
will
Same Risk = Same Ko
= Same Market Value: Companies in different industries may have different risks, which
1. will have the
in the risk category
result in their earnings being capitalised at different rates. However, Companies
same

same expected earnings (EBIT). This EBIT will be capitalised at the

WACC (for that risk category) and hence Market
Values of all Companies in the same risk category (i.e. same WACC) will also be the same.
if the Market Values (as
2. Buying and Selling Effect: In the same risk category (i.e. return expectation is the same),
represented by Market Price per Share i.e. MPs) of different Companies were to be different, investors in the high MPS5
is because, in the capital market, the
Company will sell their holding and buy the Shares of low MPS Company. This
rational movement should be "buy at low prices and sell at high prices".
3. Movement in Share Prices: The buying and selling spree of Investors will lead to increase in demand of the low
MPS Company's Shares, causing its share price to increase. Similarly, due to sale of holdings, the price of high
MPS Company's Shares will fal.
4. Arbitrage: This movement in Share Prices will continue till both Companies' Share Prices settle at a constant. This is
attributed to the arbitrage effect. Through the above procedure, investors will move from a Leveraged Firm to
Unleveraged Firm and vice-versa,through the process of arbitrage. This will cease only when total Market Vaiues of
both Firms are the same.
. No Leverage Effect: The arbitrage effect nullifies the effect of leverage that the Companies may possess. Hence, it is
not possible for the Companies in the same risk clasS, to affect their market values and therefore their overall
capitalisation rate by use of leverage.
6. Constant Market Value and WAcC: Thus, for a Company ina particular risk class, the total Market Value must be
Same, irrespective of level of Debt in the Company's capital structure.

14Effect of Taxation on Value of Firm, under M &M Approach

1. Tax Saving: When Taxes are paid on Corporate Income, use ofDebt Funds isadvantages due to the tax-saving effect
of Interest Payment. Equity Dividends and Retained Earnings are not "deductible" as an expense for taxation purposes.

2.
Eff
Sect of Tax Saving: When Corporate Taxation is included in the analysis-
and (b) Overall Cost of Capital will decrease.
(a) Value of the Firm will increase,
3. ax Shield: The effect of Tax Saving can be identifled from the following relationships
a) Total Earnings in Levered Firm = Total Earnings in Unlevered Firm Interest on Debt xTax Rate. [Here Total
carnings =
EAT +Interest, i.e. the Earnings
available for Equity and Debt-holders.]
(6) Value of the Levered Firm will be greater than that of the Unlevered Firm, to the extent of the Tax Shield, Hence
value of Levered Firm = Value of Unlevered Firm+ Debt
x Tax Rate. nce,

5.13
 Financial Management
and ECOnoi
uka S Students' Guide
on
Leverage ane
d Fims Require
relationship
between the Financial
relationship-
Effect: The following
4. with Tax is given by the
a n d Ko relationship with Corporate
Taxes = Required Rate of Return to Equity Share
Keturn to Equity
Shareholders
Ke
= Required of
Rate Return for an olders
all-Equity Firm
Ko Portion of
Debt in Capital Structure
=

D in Capital structure
Portion of Equity
Ke Ko +(1-Tc) (Ko- Ka), where E
=

= Corporate Tax
Rate
Tc Lenders
= Required Rate of Return to
Ka

Company l and Uboth have a EBIT (Net Operating lncome) of 10,00,000 each. Company L has 10% Debt in theof40% ta
lustration:
Funds to the tune of T
40,00,000. Both Companies are in 18,00.00
Company
Equity of 22,00,000.Tax
U employs Equity
available to Investors. bracke
of
EXplain the effect Shield on the Total Earnings

Particulars
CompanyL (Levered)
10,00,000
Company u(Unlevery
EBIT 1,80,000 10,003
Interest on Debt at 18%
Less 8,20,000
EBT
3,28,000
10,0,0
Less: Tax Expense at 40% 4,00 05
4,92,000 6,00,0
EAT
6,72,00
Total Income of Equity & Debt (EAT +Interest)
the following relationship
6,00,0
Difference in Total Earnings of Equity
and Debt Investors is given by
Unlevered Firm + Interest on Debt xTax Rate.
in Levered Fim Total Earnings in
=
Total Earnings
6,00,000(7 1,80,000 x 40%)
Thus, F 6,72,000 =

llustration:
not use any Debt in its Capital Structure, Q 7 80.08 while has
There are two Firms P and Q which are identical except P does
Firms have EBIT of 2,60,000 p.a. and the Capitalization Rate isT
9% Debentures in its Capital Structure. Both the N
Firms according to M&M Hypothesis.
Assuming Corporate Tax 30%, calculate the Value of these
Particulars Computation
EAT 2,60,000x (100%-30%) 18,20,0M
1. Value of Unlevered Firm (P) =

Capitalisation Rate 10%

2,40,00
Debt Tax Rate T 8,00,000 x 30%
2. Tax Shield of Levered Firm x
=

20,60,0
3. Value of Levered Firm (Q) =Value of Unlevered Firm + Tax Shield (1+2)

Mustration: strucbe

ALid and B Lid are identical in every respectexceptCapitalStructure. A Lid does not employ Debt in is capi
whereas B Lid employs 12% Debentures amounting toR 10 Lakhs. Assuming that
(a) All assumptions of M-M model are met. cEBIT is 2,50,000 and
(b) The income-Tax Rate is 30%. dThe Equity Capitalization Rate of ALtd Is z
Calculate the Average Value of both the Companies and find the Weighted Average Cost of Capital for both the Congo

Solution:
EAT of A Ltd (Pure Equity Firm) = EBIT x (100% - Tax Rate) = R 2,50,000 x (100% - 30%) = 5,000.
1,75,00
1
EAT
2. Value of A Ltd (Pure Equity, i.e. Unlevered Firm) =

Equity Capitalisation Rate

=
1,75,000
20%
z s,75,000
3. Value of B Ltd (Levered Firm) =
Value of Levered Firm + (Debt x Tax Rate)
-
t8,75,000+(T 10,00,000 x 30%) = 11,75,000
4. Weighted Average Cost of Capital is as under
A Ltd (Pure Equity Firm) Equity =

Capitalisation Rate given 20%. Mix.)

B Ltd (Levered Firm) 20%% (Since,
=
M&M Approach is
applicable, WACC is constant irrespecuv
5.14
 and Capital Strudture
Cost of Capital
Alternati K,of B Ltd may be computed as under.
EBIT
2,50,000 Value of the Firm (as per WN 3 above) 711,75,000
Interest (12% on 10 Lakhs) 10,00,000
L e s s
1,20,000 Less: Market Value of Debt ( Debentures given)
EBT 1,30,000 Market Value of Equity 71,75,000
Tax 30% EAT 91,000 52.00%
Less: 39,000 Cost of Equity Ke Value of Equity 1,75,000
8.40%
EAT
91,000 Cost of Debt K 12 x (100%-30%)
of B Ltd Ko = (Ka x Wa) + (Ke x W) = 8.4% x 0 , 0 0 0 52% x 1,75000 = 14.89%
WACC of
11,75,000 11,75,000

s3.15 Criticisms of Modigliani and Miller Approach

Modigliani and Miller Theory is criticised on the following grounds-
The assumption of as transacuon
1. perfect
market is not practical. In the real world, various imperfections exist, such
costs for purchase and sale of securities, differential rates of interest, etc.
calculated
2 The argument nullifies the effect of leverage is not valid. Investors do not behave in such
that arbitrage
and rational way in switching from leveraged to unleveraged Firm or vice-versa.
a

3The theory presumes the availability of free and upto date information on all aspects of the Company's functioning. in
not
practice, investors have little or no knowledge about the Company's operations. Their dealings in shares are based
only upon the information on hand, but on other considerations also.

5.3.16 Pecking Order Theory

1. Donaldson's Approach:
a) This Approach suggests that the Firm should use low-cost funds in order to minimize WACC and maximize its value.
() According to this theory, to minimize overall cost, the order of raising finance should be - () Intermal Cash
Accruals, (i) Additional Debt, and (il) Aditional Equity. This is because Issue Cost of Internally Generated Funds is
the least, and the Issue Cost of Equity is the highest.
(c)Therefore, a Frm should rely as much as possible, on internally generated funds. If these funds are not sufficient,
the Firm will move to additional debt and then to additional equity.

2. Myers' Approach:
)Myers has suggested that a Frm follws a "modified pecking order" in their approach tofinancing
(b) Heavy reliance on intermally generated funds is attributed to asymmetric information relating to the Capital Market,
where issue of Equity Shares is interpreted in the Market, as bad news. So, the theory argues that a Firm will be
motivated to issue Equity Shares only when share markets are undeveloped.
c)The use of internal finance ensures that there is a regular source of finance, which is in tune with the Company's
expansion programmes and long-term budgets. If funds over and above intenal cash accruals are required, the
Firm will first resort to additional borrowings. Further issue of Equity Shares will be the last resort for financing.
3. General Points: The Pecking Order Theory of Capital Structure has the folowing aspects-
a) Low Dividend Payout Ratio, i.e. a sticky dividend policy,
(6) Preference for using internally generated funds,
()Aversion to the issue of Equity Shares, which will be the last resort for financing.

5.3.17 Trade Off Theory

. Cost Benefit Analysis: In the context of Capital re Plann the Trade Off Theory focusses on the use of Debt
Financeupto the Optimum Level bybalancing the Cost of Debt, with the Benefits of Debt. For this purpose -
Costs of Debt Financeinclude- Benefits of Debt Finance include-
(a) Explicit Cost of Debt (Interest Expense), (a) Saving/ Reduction in Agency Costs [See Chapter 1],
(6) Cost of Financial Distress which include (b) Tax Benefits/ Saving due to Interest Expense,
Bankruptcy Costs and Non-Bankruptcy Costs. (c) Leveraging Effect of Debt usage on EPS and MPS.

5.15
danuka's Students' Guide on Financial Management and Economics for Finance-For CA Inter
2. Vpe of Financial Distress Costs: A Firm experiences Financial Distress when the Firm is unable to cope i
Debtholders' obligations. If the Firm continued to fail in making payments to the Debtholders, the Firm can eveh the
insolvent. So, Cost of
Financial Distress will comprise
aDirect Costs, e.g. Administrative and Legal Cost of Insolvency Proceedings, Loss due to Sale of Assets at .
than Current Prices, etc. lower
(b) Indirect Costs,
them, Cost of
eg. Cost of Employees leaving, Cost of Customers paying lower than due from them,
Ders demanding disadvantageous payment terms, Cost of Investors/ Managers / Shareholders, Costs due
Bondholder/Stockholder infighting, etc. to
(c)
and Costs, caused by dispute of interests among themanagement of the Firm, Debtholders and Stockholer
Shareholders-Managers conflict and Shareholders-Debtholders conflict, at the time of insolvency proceedings
In the Graph,
the Top Curve indicates the Tax Shield Gains of
Debt Financing,
PV of Bankruptcy Costs
the Bottom Curve indicates the Tax Shield Gains of
Debt Financing (-)Costs of Bankruptcy, and
the Gap between the Curves indicate the PV of
Bankruptoy Costs, or the Cost of Financial Distress. PV of Intere_t Tax Shields
Optimum DE
Hence, Trade Off Theory suggests that Optimum Debt
Level (D/E mix) is the point at which there is a trade
off between the Interest Tax Shield and Bankruptcy, by Value of UnleveredPirm
balancing Costs and Benefits of Debt.
Debt-Equity Mix i.e. % of Debt in Capital
 7. Capital Structure Theories
Computation of Income to Debt and Equity Holders
5
There are two Firms Company A and B having Net
whereas Company A is all Equity Company. Debt
Operating Income of R 15,00,000 each. Company B is a Levered Company
employed by
both the Companies is 25%. Calculate Earnings available for Company
B is of 7,00,000@ 11%. The Tax Rate
applicable to
Equity and Debt for both the Firms.
Solution:
Particulars (Amounts in )
Company A Company B
Net Operating Income =
EBIT
15,00,000 15,00,000
Less: Interest on Debt (11% of 7,00,000) = Income for Debt holders
77,000
Profit before Taxes
15,00,000 14,23,000
Less: Tax@25%
3,75,000 3,55,000
Profit After Tax =
Earnings available in Equity Holders 11,25,000 10,67,250
Total Earnings available to Equity Holders+ Debt holders 11,25,000 +Nil 10,67,250 +77,000
11,25,000 11,44,250
Terence in Total Earnings of Equity and Debt Investors is given by the following relationship-
Total Earnings in Levered Firm Total Earnings in Unlevered Firm + Interest on Debt xTax Rate.
=

Thus, 11,44,250 = R 11,25,000+(7 77,000 x 25%)

Net Income Approach-Valuation of Firm

he following data relates to four Firms-
A B C
EBIT
Firm D
2,00,000 3,00,000 5,00,000 6,00,000
Irnterest 20,000 60,000
16%
2,00,000 2,40,000
tquity Capitalization Rate 12% 15% 18%
Ass
SSuming that there are no taxes and Interest Rate on Debt is TU6, erermine tne Value and WACC of each Firm usina
Net income Approach. What happens if Firm A borrows z Lakns at i0x to repay Equity Capital?

5.43
Padhuka's Students' Guide on Financial Management and Economics for Finance For CA Inter

Solution: B
Firm A C|
EBIT 2,00,000 7 3,00,000 T5,00,00o
2,6,4000,080
Less: Interest T 20,000 T 60,000 R2,00,000
EBT = Net Income 1,80,000 2,40,000 7 3,00,00o

Ke (given)
12% 16% 15% 3,60,0
Value of Equity (E) =
EBT 18h
15,00,000 15,00,000 20,00,000
Ke
20,00,00
Value of Debt (D) = nterest [Note: Kd 10%] 2,00,000 T6,00,000 20,00,000
Kd
24,00,00
Value of Firm (V) =(E+D) 17,00,000 21,00,000 40,00,000 44,00,000
EBIT
Ko = WACC 11.76%o 14.29/% 12.50%
Value of Firm 13.64%
When Firm Aborrows 2 Lakhs at 10% interest rate, to repay Equity Capital, the efifect on WACC willbe as under-
Particulars Before After
EBIT (given) 2,00,000 T 2,00,000
Less: Interest 20,000 40,00
EBT Net Income 1,80,000 71,60,000
12%
Ke(9iven) 12%
Value of Equity (E) =
EBT
15,00,000 7 13,33,333
Ke
Value of Debt (D) = Note: Kd = 10%]
Kd 2,00,000 4,00,00

Value of Firm (V) =(E +D) 17,00,000 17,33,33

EBIT
Ko =
WACC =
11.76% 11.54%
Value of Firm
Under Net Income Approach, increase in Debt content leads to increase in Value of Firm & decrease in WACC.

44. Net Operating Income Approach

ta
Alpha Limited and Beta Limited are identical except for Capital Structures. Alpha has 50% Debt and 50% Equity, whereas
has 20% Debt and 80% Equity. (All percentages are in Market-Value terms). The Borrowing Rate for both Companies iso
no-tax world, and capital markets are assumed to be perfect.
d the
) f you own 2% of the Stock of Alpha, what is your return if the Company has Net Operating Income of R3,60.000a
Overall Capitalization Rate of the Company, Ko is 18% ? (6) What is the Implied Required Rate of Retun on Equity oesi
Beta has the same Net Operating Income as Alpha. () What is the Implied Required Equity Return of Beta?( Wny
differ from that of Alpha?

Solution: Note: Net Operating Income Approach (with Constant Ko) is applicable since (a) Companies are loe
Capital Markets are perfect, (c) no tax. Beta(
Particulars
Alpha (R)
1. Value of Firm (F) =
EBIT 3,60,0000 20,00,000 3,60,000 - 20,00,0
Ko 18% 18% 4,00,000

20% 1 6 , 0 0 , 0 0 0
2 . Value of Debt (D) 50% 10,00,000
VALUE OF Equity = F-D
3. 10,00,000 360,000

4.
Net Operating Income =PBIT 3,60,000 32,000

5. Interest on Debt (8% on Debt) 80,000 3,28,000

6. NetIncome EBT for ESH (4-5) 2,80,000 20.59%

7. Ke Implied Required Equity Return 28%

(3)

5.44
 Cost of Capital and Capital Structure
Note:

Income to Shareholder for 2% Stock in Alpha 2% of 2,80,000 7 5,600.

2. Ke of Beta Company is lower because Beta uses Debt in its Capital Structure. Under the Net perau a ne

approach, the decdine in required Equity isReturn offsetsexactly the disadvantage of ot employing
of "cheaper" Debt Funds, thus overall
so much in the way
Ko Constant.

M&M Approach
One-Third of the total Market Value of Hari Limited consists of Loan Stock, which has a cost of 10%. Another Company, Guru
Limited, is identical in every respect to Hari Limited, except that its Capital Structure is all-equity, and its Cost of Equity is 16%
According to Modigliani and Miller, if we ignored taxation and tax relief on Debt Capital, what would be the Cost of Equity of
Hari Limited?

Solution:
As per Modigliani and Miller, if there are no taxes, the two Firms Hari and Guru should have equal WACC.
Since Cost of Equity of Sansui (Pure Equity Firm) is 16%, its WACC is also 16%, and the WACC for Hari also will be the
same at 16%.
Cost of Equity of Hari Ltd is given by the following computation -

Under M&M Approach, Ke= Ko+ = 16%+x (16% - 10%) = 19%o.

Ea iKo-Ka) 2
Note: 1/3 of Total Funds is financed by Debt. Hence, Ratio between Debt and Equity is 1:2.

46. NOI &M&M Approach-Computation of Ko RTP

ABC Ltd adopts Constant-WACC Approach, and believes that its Cost of Debt and Overall Cost of Capital is at 9% and 12%
respectively. If the ratio of the Market Value of Debt to the Market Value of Equity is 0.8, what Rate of Retum do Equity
Shareholders earn? Assume that there are no taxes.

Solution: Constant Ko means the use of NOI or M&M Approach. Under M &M Approach, Ke = Ko + Risk Premiunm.

From M & M Approach, we have So, K= Ko+ Debt (K-Ka) = 12% + [80% x (12% - 9%6) = 14.40%%.
Equity

47. M&M Approach-Leveredvs Unlevered Firms M17

PNR Ltd and PXR Ltd are identical in every respect except Capital Structure. PNR Ltd does not employ Debts in its Capital
Structure whereas PXR Ltd employs 12% Debentures amounting to R 20,00,000.

The following additional information is given-

Income Tax Rate is 30% The Equity Capitalization Rate of PNR Limited is 20% and
All assumptions of Modigliani - Miller Approach are met.
EBIT is 5,00,000

Calculate-(1) Value of both the Companies, (2) Weighted Average Cost of Capital for both the Companies.

Solution: 1. Computation of Value of Firms

(a) Value of Unlevered Firm (PNR) = Value of Equity only
EBITx (100% Tax) 5,00,000x(100%0-300) =
7 17,50,000 [Note: Post-tax EBIT is taken here.]
Ke 20%
(b) Value of Levered Firm (PXR) =Value of Unlevered Firm + (Value of Debt x Tax Rate)
= 7 17,50,000 (as above) +(R 20,00,000 x 30%) =
7 23,50,000
2. Computation of WACC of Firms
Particulars (Unlevered)PNR (Levered) PXR
EBIT 75,00,000 75,00,000
Less: Interest on Debt (7 20,00,000x12%) 2,40,000
5.45
Padhuka's Students' Guide on Financial Management and Economics
for Finande-For CA Inter

(Unlevered)PNR
EBT
Tax at 30%
Particulars
5,00,000
71,50,000
(Levered)P
250 M
Less:
EAT 3,50,000 78000
Value of Firm (V) (as computed above) 17,50,000
Nil
1,23,852,0000
Less: Value of Debt (D)
Value of Equity (E) = (V) - (D)
T 17,50,000 20,0 0
Cost of EquityValue of
EAT
20.00%
3,50,00
Equity 52.00%
Cost of Debt Nil 12% x
(100% -30%) =
84
(8.4%x 20,00,000
WACC= (Ka Xx)+(K ) x 20% 23,50,000(52%x 3,50,000
23,50,000 14.89

48. M&M (with taxes)-Levered vs Unlevered Firm

M12
RES
Ltd is an all Equity financed Companywith a Market Value of 25,00,000 and Cost of Equity, Ke 21%. The Comu
wants to buy-back Equity Shares worth 5,00,000 by issuing and raising 15% Perpetual Debt ofthe sameamount.Rateofta
=

may be taken as 30%. After the capital re-structuring and applying MM Moc (with taxes), you are required to calculate-
0 Market Value of RES Ltd.
)Cost of Equity Ke
(i) Weighted Average Cost of Capital and comment on it.

Solution: Given, Value of Unlevered Firm (given)

So, EAT of Unlevered Firm
=

7
25,00,000, and Cost of Equity (K-) =21%
=
25,00,000x 21% =7 5,25,000
EBT of Unlevered Firm T5,25,000 = R 7,50,000 EBIT also.
100% -70%
Profit Statement

EBIT
Particulars (amountsin) Pure Equity Debt and Equity
7,50,000 7,50,00
Less: Interest (R 5,00,000 x 15%) 75,00
Nil
EBT 6,75,000
7,50,000
Less Tax at 30% 2,02,50
EAT
2,25,000 4,72,500

Income to Debt 5,25,000

Holders plus Income Available to Shareholders (EAT+Debt) 5,25,00o
5,47,500

After Restructuring:
1. Market Value of Levered Firm =
Market Value of Unlevered Firm
(Debt x Tax Rate)
+ =
MV of ULF+ Tax si
=
25,00,000+(5,00,000 x 30%) =? 26,50,0000
EAT
2. Cost of Equity (Ke) =
Value of
4,72,500 21.98%o
Equity 26,50,000 5,00,000
3 of Capital (K,) is as under
Cost
Component
WACC

Debt
5,00,000 19% Ka
Individual Cost
15% x (100% - 30%) = 10.5%
1.995%

17.804%
Equity 21,50,000 81%
Total Ke (as above) =21.98% 19,799%

26,50,000 100%

Comment: At
K i sr e d u c e d

present the Company is all equity financed. healin

to 19.799% and Ke Would increase So, Ke Ko 21%. However after = =

of the Company. from 21% to 21.98%. Reduction in re-strucru

Ko and increase in Ke is good ror u
 Structure
Cost of Capital and Capital

Arbitrage under M&M Approach

relating to two
data
t Companies Karna Ltd and Arjun Ltd, belonging to the same risk class, are as under -
The Arjun Ltd
Particulars
Shares
Karna Ltd 1.50,000
Number of Equity 90,000 7 1.00
Share
Market Price per 1.20
NIL
6%Debentures 60,000 18,000
Proftbefore Interest 18,000 ni
if he switcnes
There are no taxes. Bheem is
an Investor holding 10% stake in Karna Ltd. What is the benefit/ loss to Bheem,
holding to Arjun Ltd? When will this arbitrage process end?
Solution: Arbitrage process under M&M Approach operates as under
Step Description Debt holding in
Dividends, Bheem will sell off his Equity and
Since both Companies have same Market Values and
Karna Ltd, and get the following amounts
= 7 10,80o
10% of 90,000 =9,000 Shares at 1.20
(a) Sale of Equity Shares: = 76,000
sold at Face Value
(b) Sale of Debentures: 10% of T 60,000 = of
wll purchase Shares of Arjun Ltd at 7 1 per Share. Number
With the above total amount of 16,800, Bheem
16,800= 16,800 Shares, which constitutes 16,800= 11.2% stake in Arjun Lrd.
2 Shares purchased =
1 1,50,000
11.2% = 7 2,0165
R 18,000 x
Arjun Ltd (i.e. no Debt) EBT 11.2%
=
x =
Income from
Income from Karna Ltd (before the arbitrage process)
(from Equity & Debt holding)
Less: =(71,440)
10% x(7 18,000-6% of 60,000)
10% of EBT =10% x(EBIT - Interest)
=

10%x (6% of 60,000)

=(7 360)
on Debentures
=

10% ofInterest Arjun Ltd to Ltd = 7 2166

Additional Income to Bheemby switching over from Karna the
over from one Company
to another in the above manner,
Investors also) switch the Market Value
When Bheem (and hence other of preference of Investors), and
of Karna Ltd tends to decline (due to lack will end only when the
Market Value of Equity demand for its Shares). This process
increase (due to higher
of Equity of Arjun Ltd tends to
Market Values of both the Companies are the same.

Firm
Personal Taxes on Value of in
Leverage, Corporate and and Taxes
50 M&M-Effect ofhas 30,00,000 and a 40% Tax Rate. ts Required Rate on Equity
Earnings before Interest of
Tushara Company
the absence of borrowing is 18%.
what is the ofthe value Company in an MM world
1.In the absence of Personal Taxes,
with 70,00,000 in Debt.
with 40,00,000 in Debt (c) Stock income is 25%, and the
a) with no leverage (b) Personal Tax rate on Common
Taxes now exist. The Marginal for each of the three debt
2. Personal as well as Corporate the value ot the Company
Debt Income is 30%. Determine
on
Marginal Personal Tax rate answers differ?
alternatives in Part. Why do your

Solution:
1.Without Personal Taxes:
EAT 30x(100%- 40o)z100 Lakhs.
(a) Value of Unlevered Firm Ke
of Tax Shield on Debt (i.e. Debt x Tax
Firm + Value
40,00,000 in Debt
=
Value or Unievered
(b) Value of Firm with Lakhs = 7 128 Lakhs.
100 Lakhs+ 40% on 7 70Firm is able to
increase Its value in a
linear manner with more Debt.
Rate) =
the
Note: Due to the Tax saving effect,

2. Effect of Personal Taxes: EAT 30x (100%-40o) = z 100 Lakhs.

(a)Valueof Unlevered
Firm =

Ke Ke
Debt
40,00,000 in
(6) Value of Firm with
7
Post Tax Equity Income of Shareholders x Debt
+(1 Income of Debt holders
Firm Post Tax Debt
=
Value of Unlevered

5.47
Padhuka's Students' Guide on Financial Management and Economics for Finance - For CA Inter
-

100 Lakhs +(1 - (1 0.40)(1 0.25) )x 40 Lakhs

1-0.30
Where,
= R 100 Lakhs + 14.29 Lakhs = 114.29 Lakhs. 0.40 Corporate Tax
(c) Value of Firm with 70,00,000 in Debt 0.25 Personal Tax Rate on Equity
Inee
= R100 Lakhs (1- (10.40)(1-0.25)
1-0.30
)x 70 Lakhs
0.30 Personal Tax Rate on ncome
Debt Incom
ome
= R 100 Lakhs + 25.00 Lakhs = R 125.00 Lakhs.

Note:
The presence of Personal Taxes reduces the Tax advantage associated with Corporate Debt. Also, if the
Tax on Stock Income is less than that on Debt Inocome, the Net Tax Advantage to Debt is positive. Asa Persona
Taxes, orresult,
the Value of the Firm rises with more Debt, but not as rapidly as if there were no Personal
Personal Tax Rate on Stock and Debt Income were the same. f the

51. Arbitrage when Value of Levered Firm is more than Value of Unlevered Firm
There are two Firms N and M. having same Earnings before Interest and Taxes, ie. EBIT of 20.000. Fim M is a ered
Company having a Debt of 1,00,000@ 7% Interest Rate. Cost of Equity of Company N is 10% and of CompanyMis 11,50
Explain how arbitrage process will be carried on in this case.

Solution
Particulars Unlevered Firm N
Levered Firm M
NOI (i.e. EBIT) 20,0000 20,000
Value of Debt (D) 7 1,00,000
NOI - Interest
Value of Equity (E)
Cost of Equity
20,000- Nil
10%
= 2,00,000 20,000-7,000
11.5%
= R 1,13,043
Value of Firm (F) = Value of Equity (E) + Value of Debt (D)
2,00,000 2,13,043
Suppose an Investor X has 10% Share in Levered Company M. Therefore, Investment in 10% of Equity of Levered Company
M 10% x ? 1,13,043 =7 11,304.30. On this Investment, the Investor is entitled to a Return / Income = 10% of Earnings
for Equity Holders 10% of (T 20,000- 7,000) = T 1,300.

Arbitrage Process will operate as under (Moving from Firm M to Firm N)

(a) Sell the 10% Share of Levered Firm for 7 11,304.30, and borrow 10% of Levered Firms Debt i.e. 10% of 1,00,00,
and invest the money, i.e. 10% in Unlevered Firms Stock.
(b) Total Resources (Money) available = R 11,304.30 + 10,000 7 21,304.30, but investment in unlevered CompanyN=
10% of 2,00,000 = 7 20,000

Note: Surplus Cash available = 21,304.30 (Less) 20,000 71,304.30

(c) Return obtained now = 10% EBIT of Unlevered Firm (Less) Interest to be paid on Borrowed Funds

=
10% of 7 20,000 (-) 7% of R10,000 2,000 7,00 =
7 1,300
lus
Result: The Return of F1,300 is the same as was obtained earlier in Firm M. However, we now have 1,304.30 SUrp
money available. Thus, we are better off by doing arbitrage.

52. Arbitrage when value of Unlevered Firm is more than the Value of Levered Firm. st of
There are two Firms U and L having same NOI of 20,000, Firm L is a levered Firm having Debt of 1,00,000 7%, ana
Equity of U& Lare 10% and 18% respectively. Show how arbitrage process will work in this case.

Solution: Levered Firm

Particulars Unlevered Firm U 20,000
NOI (i.e. EBIT) 720,000D 1,00,000
Value of Debt (D)
NOI - Interest 20,000 7,000 72,222
Value of Equity (E) =
Cost of Equity
20,000-NII = 7 2,00,000 18%
10%
1 , 7 2 , 2 2 2

Value of Firm (F) =Value of Equity (E) + Value of Debt (D) 2,00,000

5.48
 and Capital Structure
Cost of Capital
estorX has 10% Share of Unlevered Firm 'U' ie. Investment of 10% of 2.00,000 = 7 20,000, and Return
se an Invest

on
on 20,000. Incom
20,000. Income (Return) =
10% of Earnings available for Equity Holders 10% 20,000
0.
at10% x
L,0
r ae
ge Process
will operate as under
(Moving from-

Firm U to Firm L):

sell the Shares in Unlevered Firm for R 20,000, and buy 10% Shares of Levered Firm's Equity plus Debt
(a)
O) Total Investment in Levered Firm = 10% o fEquity+ 10% of Debt - (72,222 x 10%) + (1,00,000x 10%) = 1 i 4 6 4 2.
f Total Resources available on sale = R 20,000, whereas Investment is only 7 17,222.

Note: Surplus Cash avallable ={ 20,000- 17,222 = T2,778.

d)Return obtained now is as under -
7% on Debt of 10,000 700
10%on Equity i.e. 109% Eamings availablefor Equity holders, i.e. (10% x 13,000) 1,300
TotalRetum 2,000
Result: The Return of 2,000 is the same as was obtained earlier in Firm U. However, we now have 2,778 Surplus rno
available. Thus, we are better off by doing arbitrage.

RTP
53. Effect of Debt Funding on Value of Equity Shares-WACC not affected by Gearing
Dividend of 7 1,20,000 has
Zeta Ltd is presently financed entirely by Equity Shares. The current Market Value is 7 6,00,000. A
just been paid. This level of dividend is expected to be paid indefinitely. The Company is thinking of investing in a new project
Ihe
involving an outlay of R 5,00,000 now and is expected to generate Net Cash Receipts of 1,05,000 per annum indefinitely.
consideration-
project would be financed by issuing7 5,00,000 Debentures at 18% Interest Rate. Ignoring tax
1. Calculate the Value of Equity Shares &the gain made by Shareholders, if the Cost of Equity rises to 21.6%
2 Prove that the Weighted Average Cost of Capital is not affected by gearing.

Solution: 1. Presentke DPS

MPS 1,20,000 209%, Since there is no Debt, Present Ko 2090
6,00,000
2. Effect of new Project 7 1,05,000
EBIT
Less: Interest on Debt
(18%) 90,000
Surplus available for Dividends 15,000
Add: Existing Dividend 1,20,000
Total Dividend to Equityholders 1,35,000
DPS 1,35,000
So, New Market Value of Equity =K 21.6% T6,25,000o

Less: Existing Market Value of Equity 6,00,000

Gain to Equity Shareholders 725,000
3.Computation of WACCunder new Capital Structure (Market Value Weights)
Component Individual Cost WACC
Debt 44.44% Ka = Interest Rate only(notax) = 18.00% 8.00%
5,00,000
Ke (revised) (given) 21.60% 12.00%
Equity 6,25,000 55.56% 20.00%
Total 11,25,000 100.00% WACC K% =|
Thus, WACC is not affected by gearing. The advantage of borrowing is set-off by increase in Ke from 20% to 21.60%.

modes of Financing- Traditional Theory

4 Optimum Capital Structure-Effect of different N 15
RST Lidisexpecting an EBIT of T4 Lakhs for .Y. 2015-16. Presenty theCompanyis financed entirely by Equity Share Capital
oft 20 Lakhs vith Equity Capitalization Rate of 16%. The Company is contemplating to redeem a part ofthe capitai by
introducing Debt Financing. The Company has twO options to ralse Debt to the extent of 30% or 50% of the Total Fund.

tis expected that for Debt Financing upto 30%, theRate ofnterestwillbe 0% and Equity Capitalization Rate will increase to
7%. If the Company opts for 50% Debt, then the Interest Rate will be 12% and Equity Capitalization Rate will be 20%,

5.49
 For CA Inter
s Students' Guide on Financial Management and Economics for Finance
You are required to compute the Value of the Company and its Overall Cost of Capital under diferent options, and
which is the best option. and also stae
Solution:
Plan Present: 0% Debt Plan 1: 30% Debt Plan 2:
Debt Nil 6,00,000 50% Debr
Equity Capital (given at Present Level) 20,00,000 14,00,00o 10,00,00
Total Assets 20,00,000 20,00,000 10,00,000
EBIT
7 4,00,000 74,00,000 20,R04,00,0
0,000
Less: Interest at 10% & 12% under Plan 1 & 2 60,000
EBT F 4,00,00D0 3,40,0000 71,20,000
Ke 16% 17%
72,80,000
20%
EBT
Value of Equity (E) Ke 25,00,000 20,00,000
14,00,00
Add: Value of Debt (D) (taken at Book Value) 6,00,000
Value of Firm = V = (E +D)
T 25,00,000 26,00,000
710,00,000
EBIT
24,00,0
Ko = WACC =
16.00% 15.38% 16.67%
Value of Firm
Inference:The Fim should opt for Plan 1, i.e. 30% Debt, being the Optimum Capital Structure. This is the pointatwhie
WACC is minimum, and Value of the Firm is maximum.

8. Miscellaneous llustrations
55. Rights Share Valuatior
Pioneer Ltd has issued 15,000 Equity Shares of 10 each. The current Market Price per Share is 37. The Com has a plan
to make a Rights Issue of one New Equity Share at a price of 25 for every five Shares held. You are requiredto -
1. Calculate the Theoretical Post-Rights Price per Share.
2. Calculate the Theoretical Value of the Rights alone.
3. Show the effect of the Rights Issue, on the wealth of a Shareholder who has 1,000 Shares, assuming he sells the entre nghs
4. Show the effect if the same Shareholder does not take any action and ignores the issue.

Solution:
1. Theoretical Post Rights Price per Share =

= (Old Number of Shares xTotal

= Old Market Price)+ (Rights Shares xRights Price)-(5x 37)+(1x 25) 35
Number of Shares (5+1)
2 Theoretical Value of Rights = Post Rights Price per Share Cost of Rights Share = 35-F 25 = 7 10o

3. Wealth of Shareholder:
Before Rights Issue After Rights Issue
1,000 Shares at 37 35,000
7 37,000 1,000 Shares at 7 35

Add: Sale of Rights Nil Add: Sale of Rights000 Shares x 10 2,000

5 Shares
737,000
Total 7 37,000 Total oss

If the Shareholder ignores the Rights Issue (i.e. he ncither subscribes to Rights Issue, nor sells his Rights), there is a
due to dimunition in value to the extent ofT 2,000 (7 37,000 35,000).

NM

56. EVA using Cost of Capital

incomeon
Consider a Firm that has existing assets in which it has capital invested of 7 100 Crores. The aftert atax
x operating
operating
oany

assets-in-place is 15 Crores. The Return on Capital Employed of 15% is expected to be sustained in perpetuity, anace
has a Cost of Capital of 10%. Estimate the present value of Economic Value Added (EVA) to the Firm from its assels-l

5.50
 Structure
Cost of Capital and Capital

Solution:
1.OperatingProfit after Tax 15 Crores
Narmal Return on Capital =
Capital Employed x WACC =
100 x 10°%
10Crores
Added (EVA) 5 Crores
3.Economic
Value (1- 2)
=

EVA 5 Crores 50 Crores

4. Since this
EVA iS Sustained till perpetuity, Present Value of EVA= Cost of Capital 10%

Important Theory Questions