UNIT THREE

CHAPTER TWO
CAPITAL
STRUCTURE
 Lesson 25
Chapter-8
Capital Structure
Unit 3
Financing decisions

After studying this lesson, you should be able to:

Understand the meaning and Definition of capital structure.

Understand the theoretical controversy about capital structure.
Comment on how capital structure matters: The net income Approach
Capital structure does not matter: the NOI approach

Let us have discussion on what capital structure is?

Capital structure:
Introduction:
The capital structure of a company refers to the mix of the long- term finances used by the
firm. It is the financing plan of the company. Let us take a look at the capital structure of a
company that has recently gone for public issue.

Pennar Aluminium Company Limited has gone in for a project to manufacture Aluminium
Rolled Products, Alloy conductors and Aluminium Alloys. For raising finance, the company
went in for a public issue of 19345000 Equity shares of Rs. 10 each at par and2825000
secured debentures of Rs. 200 each. The capital structure of the company was as follows:

Rs. In Lakhs
Authorized Capital 9,00,00,000 Equity shares
of Rs. 10 each 9,00,000
Issued, subscribed and paid-up capital 825.50
Present Issue
Equity shares at par 1934.50
16% Secured debenture 5650.00
Rupee term loan from institutions and banks 5060.00
Buyers Credit 1350.00
14820.00

Let us discuss the importance of capital structure decision

Importance of the Capital Structure Decision

The objective of any company is to mix the permanent sources of funds used by it in a
manner that will maximize the company’s market price. In other words companies seek to
minimize their cost of capital. This proper mix of funds is referred to as the optimal capital
structure.

The capital structure decision is a significant managerial decision, which influences the risk
and return of the investors. The company will have to plan its capital structure at the time of
promotion itself and also subsequently whenever it has to raise additional funds for various
new projects. Whenever the company needs to raise finance, it involves a capital structure
decision because it has to decide the amount of finance to be raised as well as the source from
which it is to be raised.

Capital Budgeting decision

Need for long-term sources of finance

Capital structure decision

------------------------------------------------------------------------------------

Existing capital debt-equity Dividend

Structure mix decision
---------------------------------------------

Effect on earning Effect on risks to be

per share born by investors

---------------------------------------------

Effect on cost of capital

 Optimal capital structure

Value of the firm

The capital structure controversy

From our discussion on impact of leverage on shareholder’s earnings and risk, we know that
under on favorable economic conditions, the earnings per share increase with leverage. But
leverage also increases the financial risk of the shareholders. As a result, it cannot be stated
definitely whether or not the value of the firm will increase with leverage. 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 there exist conflicting theories
on the relationship between capital structure and the value of a firm.

We know that the value of a firm depends upon its expected earnings stream and the rate used
to discount this stream. The rate used to discount earnings stream is the firm's required rate of
return or the cost of capital. Thus, the capital structure decision can affect the value of the
firm either by changing the expected earnings or the cost of capital or both. Leverage cannot
change three total expected earnings of the firm, but it can affect the residue earnings of the
shareholders. The effect of leverage on the cost of capital is not very clear. Conflicting
opinions have been expressed on this issue. In fact, this issue is one of the most contentious
areas in the theory of finance, and perhaps more theoretical and empirical work has been
done on this subject than on any other.

If leverage 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 maximises the total value of the
firm (value of shares plus value of debt) or minimizes the weighted average cost capital. Ezra
Solomon has put the question of the existence of optimum use of leverage very succinctly in
the following words.

Given that a firm has a certain structure of assets, which offers net operating earnings of
given size and quality, and given a certain structure of rates in the capital markets, is there
some specific degree of financial leverage at which the market value of the firm's securities
will be higher (or the cost of capital will be lower) than at other degrees of leverage?

All does not accept the existence of an optimum capital structure. There exist two extreme
views and a middle position. David Durand identified the two extreme views-the net income
and net operating approaches.

Net income approach:

Under the net income (NI) approach, the cost of debt and cost of equity are assumed
to be independent to the capital structure. The weighted average cost of capital de-
clines and the total value of the firm rises with increased use of leverage.

Net operating income approach:

Under the net operating income (NOI) approach, the cost of equity is assumed to
increase linearly with leverage. As a result, the weighted average cost of capital
remains constant and the total value of the firm also remains constant as leverage is
changed.

Traditional approach:

According to this approach, the cost of capital declines and the value of the firm
increases with leverage up to a prudent debt level and after reaching the optimum
point (minimum cost of capital or maximum value of the firm), coverage causes the
cost of capital to increase and the value of the firm to decline.

Thus, if NI approach is valid, leverage 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 great concern to the financing
manager, as it-does not matter in the valuation of the firm.

Modigliani and Miller (MM) support:

 The NOI approach by providing basically consistent behavioral justifications is in its
favor. They deny the existence of an optimum capital structure. Between the two
extreme views, we have the middle position or intermediate version advocated by the
traditional writers. Thus, there exists an optimum capital structure at which the cost of
capital is minimum. The logic of this view is not very sound. The MM position
changes when corporate taxes are assumed. The interest tax shield resulting from the
use of debt adds to the value of the firm. This advantage reduces when personal
income taxes are considered.

Assumptions and Definitions

In order to grasp the elements of the capital structure and the value of-the firm or the cost of
capital controversy properly, we make the following assumptions:

Firms employ only two types of capital: debt and equity.

The total assets of the firm are given. The degree of leverage can be changed by
selling debt to repurchase shares or selling shares to retire debt.
Investors have the same subjective probability distributions of expected future
operating earnings for a given firm.
The firm has a policy of paying 100 per cent dividends.
The operating earnings of the firm are not expected to grow.
The business risk is assumed to be constant and independent of capital structure and
financial risk.
The corporate and personal income taxes do not exist. This assumption is relaxed later
on. In our analysis of capital structure theories, we shall use the following basic
definitions:

S = Market value of ordinary shares

D = Market value of debt
V = Total market value of the firm (S + D)
NOI= X = Expected net operating income, i.e., earnings before interest and taxes
(EBIT)
INT = Interest charges (i.e., kd D)
 NI = Y = Net income or shareholders' earnings (EBIT - INT) when corporate taxes do
not exist.

The capitalisation rates or costs associated with the different earnings stream and the value of
different securities can be defined as follows:

Debt
INT
Cost of debt = kd =
D

INT
Value of debt = D =
kd
Equity

DIV1
Cost of equity = ke = +g
P0

DIV1 EPS1
+0 = (when DIV = EPS. then g = Q)
P0 P0

Where DIV1 is dividend per share and EPS is earnings per share next year, P current market
price per share and g growth rate. When a firm distributes all earnings as dividends, the cost
of equity can also be calculated as follows:

NOI − INT NI X − K d D
Ke = = =
V −D S S

Weighted Average cost of capital.

Ko = Ke [s/v] +Kd [d/v]

Total Value of the firm:

 V = (S+D) = NOI/Ko.

Capital structure Theories:

I. CAPITAL STRUCTURE MATTERS: THE NET INCOME APPROACH

The essence of the net income (NI) approach is that the firm can increase its value or lower
the Overall cost of capital by increasing the proportion of debt in the capital structure. The
crucial assumptions of this approach are:

The use of debt does not change the risk perception of investors; as a result, the
equity-capitalization rate, ke and the debt-capitalisation rate, ke remain constant with
changes in leverage. . The debt-capitalisation rate is less than the equity-capitalisation
rate (i.e. kd < ke).
The corporate income taxes do not exist.
The first assumption implies that, if ke and kd are constant, increased use of debt, by
magnifying the shareholders' earnings, will result in higher value of the firm via
higher value of equity. Consequently, the overall, or the weighted average cost of
capital, ko, will decrease. The overall cost of capital is measured by Equation (4):

X NOI
Ko = =
V V
It is obvious from Equation (4) that, with constant annual net operating income (NOI), the
overall Cost of capital would decrease as the value of the firm, V, increases. The overall cost
of capital, kO Can also be measured by Equation (6):

D
K O = K e − (k e − k d )
V

In Equation (6), as per the assumptions of the NI approach, ke and kd are constant and kd is
less than k . Therefore, k will decrease as DN increases. Equation (6) also implies that the
overall cost of capital, ka, will be equal to ke if the firm does not employ any debt (i.e. DIV=
0), and that ko will approach k d as DN approaches one.
Example

To illustrate the NI approach, assume that a firm has an expected annual net operating income
of Rs 1,00,000, an equity rate, k , of 10 per cent and Rs 5,00,000 of 6 per cent debt. The value
the firm, according to the NI approach, will be as shown in Table 18.1.

Table1 VALUE OFTHE FIRM (NI APPROACH)

Net operating income (NOI), X 1,00,000

Total cost of debt, INT = kdD, (Rs 5,00,000 x 0.06) 30,000
Net income (NI) available to shareholders, X - INT 70,000
Market value of equity, S (Rs 70,000/0.10) 7,00,000
Market value of debt, D (Rs 30,000/0.06) 5,00,000
Market value of the firm, V = S + D 12,00,000

The net income approach considered in this section and the net operating income approach in
the next section are based on the works of David Durand, op. cit., pp. 91-116 and Brigham
and Johnson, op. cit.

The costs of equity and debt are respectively 10 per cent and 6 per cent and are assumed to be
instant under the NI approach. The overall cost of capital, ko , is:
NOI 100000
ko = = = 0 . 0833 or 8 . 33 percent
V 1200000
D S 500000 700000
or k o = k d + k e = 0.06( ) + 0.10( )
V V 1200000 1200000
=0.0250 + 0.0583 = 0.0833 or 8.33 percent.

If the firm is assumed to have employed a debt of Rs 7,00,000 instead of Rs 5,00,000, the
value the firm under NI approach would be as shown in Table 18.2.
Table 2 VALUE OFTHE FIRM (NI APPROACH)

Net operating income (NOI), X 10,000

Total cost of debt, INT = K d D (Rs 7,00,000 x 0.06) 42,000

Net income (N!) available to shareholders, X -INT 58,000

Market value of equity, S (Rs 58,000/0.10) 5,80,000
Market value of debt, D (Rs 42,00010.06) 7,00,000
Market value of the firm, V = S + D 1,28,000

Overall, or weighted average, cost of capital is as follows:

NOI 100000
ko = = = 0 . 0781 or 7 . 81 percent
V 1280000

D S 700000 580000
k o = k d + k e = 0 . 06 ( ) + 0 . 10 ( )
V V 1280000 1280000

=0.06(0.547) + 0.10(0.453)

0.0328 + 0.0453 = 0.0781 or 7.81 percent

Thus, by increasing-debt proportion in the capital-structure, the firm is able to increase the
value the firm and lower the average cost capital.

Table 18.3 has been constructed to show the effect of various degrees of financial leverage on
the value of the firm and the cost of capital under the NI approach. It is assumed that the net
operating some is Rs 1,00,000 and the debt-capitalization rate and the equity-capitalization
rate respectively Ko can also be calculated by the following formula:
D
k o = k e − (k e − k d )
V

500000
=0.10 – (0.10 – 0.06) = 0.10 – (0.10 – 0.06) 0.417
200000

= 0.10 – 0.0167 = 0.0833 or 8.33 percent

The costs of equity and debt are respectively 10 per cent and 6 per cent and are assumed to be
constant under the NI approach. The overall cost of capital, ko, is:
 NOI 100000
ko = = = 0.0833 OR 8.33 percent
V 1200000
D S 500000 700000
k o = k d + k e = 0.06( ) + 0.10( )
V V 1200000 1200000

= 0.0250 + 0.0583 = 0.0833 or 8.33 per cent.

If the firm is assumed to have employed a debt of Rs 7,00,000 instead of Rs 5,00,000, the
value of the firm under NI approach would be as shown in Table 18.2.

Table 2 VALUE OFTHE FIRM (NI APPROACH)

Net operating income (NOI), X 1,00,000

Total cost of debt, INT = kdD, (Rs 7,00,000 x 0.06) 42,000
Net income (NI) available to shareholders, X - INT 58,000
Market value of equity, S (Rs 58,000/0.10) 5,80,000
Market value of debt, D (Rs 42,000/0.06) 7,00,000
Market value of the firm, V = S + D 12,80,000

The overall, or weighted average, cost of capital is as follows:

NOI 100000
KO = = = 0.0781 OR 7.81 percent
V 1280000

D S  700000   580000 
KO = Kd + K e = 0.06  + 0.01 
V V  1280000   1280000 

= 0.06(0.547) + 0.10(0.453)

= 0,0328 + 0.0453 = 0.0781 or 7.81 per cent.

Thus, by increasing debt proportion in the capital structure, the firm is able to increase
the value of the firm and lower the average cost capital.

Table 3 has been constructed to show the effect of various degrees of financial leverage on
the value of the firm and the cost of capital under the NI approach. It is assumed that the net
operating income is Rs 1,00,000 and the debt-capitalization rate and the equity-capitalization
rate respectively
1. KO can also be calculated by the following formula:
D
2. K O = K e − (K e − K d )
V
500000
0.10 – (0.10 – 0.06) = 0.10 − (0.10 − 0.06)0.417
1200000

= 0.10 - 0.0167 = 0.0833 or 8.33 per cent.

Table 3 EFFECT OF LEVERAGE ON VALUE AND COST OF CAPITAL UNDER NI

APPROACH

(Rs '000)
Leverage = DIV 0.0 18.18% 33.34% 46.15% 66.67% 94.74% 100%

NOI = X 100 100 100 100 100 100 100

Interest, INT - 10 20 30 50 90 100
NI= X − INT 100 90 80 70 50 10 0
Kd 0.05 .0.05 0.05 0.05 0.05 0.05 0.05
Ke 0.10 0.10 0.10 0.10 0.10 0.10 0.10
S = ( X − INT ) / K e 1,000 900 800 700 500 100 0

D = INT/kd - 200 400 600 1,000 1,800 2,000

V=S+D
1,000 1,100 1,200 1,300 1,500 1,900 2,000
ko =NOI / W 0.10 0.0909 0.0833 0.0769 0.0667 0.0526 0.0500

The optimum capital structure would occur at the point where the value of the firm is
maximum and overall cost of capital is minimum. Under the NI approach, the firm will have
the maximum value and the lowest cost of capital when it is all most debt-financed.

II. CAPITAL STRUCTURE DOES NOT MATTER: THE NET

OPERATING INCOME APPROACH

According to the net operating income (NOI) approach the market value of the firm is not
affected by the capital structure changes. The market value of the firm is found out by
capitalizing the net operating income at the overall, or the weighted average cost of capital, ko
which is a constant. The market value of the firm V, is determined by Equation (8):

NOI X
V = (D + S) = =
KO KO

Where ko is the overall capitalisation rate and depends on the business risk of the firm. It is
independent of financial mix. If NOI and ko are independent of financial mix, V will be a
constant and independent of capital structure changes. The critical assumptions of the NOI
approach are:

The market capitalizes the value of the firm as a whole. Thus, the split between debt
and equity is not important.
The market uses an overall capital is at ion rate, ka to capitalize the net operating
income. kO depends on the business risk. If the business risk is assumed to remain
unchanged, kO is a constant.
The Use of less costly debt funds increases the risk of shareholders. This causes the
equity capitalization rate to increase. Thus, the advantage of debt is offset exactly by
the increase in the equity-capitalization rate, ke.
The debt-capitalization rate" kef is a constant.
The corporate income taxes do not exist.

As stated above, under NOI approach, the total value of the firm is found out by dividing the
net operating income by the overall cost of capital, ko The market value of equity, S, can be
determined by subtracting the value of debt, D, from the total market value of the firm V (i.e.,
S = V - D). The cost of equity, ke will be measured as follows:

NOI − INT NI X − K d D
Ke = = =
V −D S S

where INT is the interest charges. Alternatively, the cost of equity can be defined as follows:
D
K e = K O + (K O − K d )
S
 Equation (7) indicates that, if ko and kd are constant, ke would increase linearly, with
debt equity ratio, D/S.

Example

To illustrate the NOI approach; assume that a firm has an annual operating income of Rs
1,00,000 an average cost of capital Ko of 10 percent and an initial debt of Rs 5,00,000 at 6
percent rate of interest. Under NOI approach, the total value of the firm will be as shown in
table 18.4

Table 18.4 VALUE OF THE FIRM (NOI APPROACH) (RS)

Net operating income (NOI), X 1,00,000

Market value of the firm, V = S + D = Rs. 100000/0.10 10,00,000
Market value of debt, D 5,00,000
Market value of the equity, S=V-D 5,00,000

The cost of equity will be:

NOI − INT NI
Ke = =
V −D S

100000 − 30000 70000

= = 0 . 14 OR 14%
1000000 − 500000 500000

Alternatively
D
K e = K o + (K o K d )
S
500000
= 0.10 + (0.10 – 0.06) = 0.10 + 0.04 = 0.14 OR 14%
500000
To verify that the weighted average cost of capital is a constant, let us calculate it:

D S  500000   500000 
Ko = Kd + K e = 0.06  + 0.14 
V V  1000000   1000000 

= 0.06(0.50) + 0.14(0.50) = 0.03 + 0.07 = 0.10 or 10%

If debt is increased from Rs 5,00,000 to Rs 7,00,000, the value of the firm would still remain
at Rs 10,00,000. The value of equity will drop to Rs 3,00,000. The equity-capitalization rate
will be:

100000 − 42000 58000

Ke = = = 0.193or19.3%
300000 300000

700000
K e = 0.10 + (0.10 − 0.06)
300000

= 0.10+(0.04) (2.33) = 0.10 + 0.093 = 0.193 OR 19.3%

 700000   300000 
And K O = 0.06  + 0.193 
 1000000   1000000 

= 0.06(0.70) + 0.193(0.30) = 0.042 + 0.058 = 0.10 or 10%

Thus, we find that the weighted cost of capital is constant and the cost of equity increases as
debt is substituted for equity capital.

To demonstrate the effect of the various degrees of financial leverage on the value of the firm
and the cost of capital under NOI approach, table 8.5 has been constructed. The calculations
in Table 18.5 are based on the following data NOI= Rs 1,00,000; ko = 0.10.and kd = 0.05 The
firm is supposed to pay no income tax.
Table 18.5 EFFECT OF LEVERAGE ON VALUE AND COST OF CAPITAL (NOI
APPROACH

D/V 0.0% 20% 40% 50% 70% 90%

D/S -- 25% 66.67% 100% 200.33% 900%
NOI, X 100 100 100 100 100 100
Interest, INT -- 10 20 25 35 45

NI = X -INT 100 90 80 75 65 55

Kd 0.05 0.05 0.05 0.05 0.05 0.05

Ko 0.10 0.10 0.10 0.10 0.10 0.10

V= X / Ko 1000 1000 1000 1000 1000 1000

D=INT/ Kd -- 200 400 500 700 900

S=V-D 1000 800 600 500 300 100

Ke = NI/S 0.10 0.1125 0.1333 0.15 0.2167 0.55

This approach implies that there is not any unique optimum capital structure. In other words
as the cost of capital is the same at all capital structures every capital structure is optimum.
IMPORTANT
Slide 1

Chapter
Capital
Capital Structure
Structure

17-1

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Slide 2

Capital Structure
Capital Structure -- The mix (or proportion) of
a firm’s permanent long-
long-term financing
represented by debt, preferred stock, and
common stock equity.
Concerned with the effect of capital market
decisions on security prices.
Assume: (1) investment and asset
management decisions are held constant and
(2) consider only debt-versus-equity financing.
17-2

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Slide 3

A Conceptual Look --
Relevant Rates of Return
ki = the yield on the company’s debt
I Annual interest on debt
ki =
B
=
Market value of debt

Assumptions:
• Interest paid each and every year
• Bond life is infinite
• Results in the valuation of a perpetual bond
• No taxes (Note: allows us to focus on just
capital structure issues.)
17-3

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Slide 4

A Conceptual Look --
Relevant Rates of Return
ke = the expected return on the company’s equity
Earnings available to
E
E common shareholders
ke = S =
S Market value of common
stock outstanding
Assumptions:
• Earnings are not expected to grow
• 100% dividend payout
• Results in the valuation of a perpetuity
• Appropriate in this case for illustrating the
theory of the firm
17-4

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Slide 5

A Conceptual Look --
Relevant Rates of Return
ko = an overall capitalization rate for the firm
O
O Net operating income
ko = VV =
Total market value of the firm

Assumptions:
• V = B + S = total market value of the firm
• O = I + E = net operating income = interest
paid plus earnings available to common
shareholders
17-5

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Slide 6

Capitalization Rate
Capitalization Rate, ko -- The discount rate
used to determine the present value of a
stream of expected cash flows.

B S
ko = ki + ke
B+S B+S

What happens to ki, ke, and ko

when leverage, B/S, increases?
17-6

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Slide 7

Net Operating
Income Approach
Net Operating Income Approach -- A theory of
capital structure in which the weighted average
cost of capital and the total value of the firm
remain constant as financial leverage is changed.
Assume:
Net operating income equals $1,350
Market value of debt is $1,800 at 10% interest
Overall capitalization rate is 15%
17-7

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Slide 8

Required Rate of
Return on Equity
Calculating the required rate of return on equity

Total firm value = O / ko = $1,350 / .15

= $9,000
Market value =V-B = $9,000 - $1,800
of equity = $7,200 Interest payments
= $1,800 x 10%
Required return =E/S
on equity*
equity = ($1,350
$1,350 - $180)
$180 / $7,200
= 16.25%
17-8 * B / S = $1,800 / $7,200 = .25

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Slide 9

Required Rate of
Return on Equity
What is the rate of return on equity if B=$3,000?

Total firm value = O / ko = $1,350 / .15

= $9,000
Market value =V-B = $9,000 - $3,000
of equity = $6,000 Interest payments
= $3,000 x 10%
Required return =E/S
on equity*
equity = ($1,350
$1,350 - $300)
$300 / $6,000
= 17.50%
17-9 * B / S = $3,000 / $6,000 = .50

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Slide 10

Required Rate of
Return on Equity
Examine a variety of different debt-
debt-to-
to-equity
ratios and the resulting required rate of
return on equity.
B/S ki ke ko
0.00 --- 15.00% 15%
0.25 10% 16.25% 15%
0.50 10% 17.50% 15%
1.00 10% 20.00% 15%
2.00 10% 25.00% 15%
17-10 Calculated in slides 9 and 10

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Slide 11

Required Rate of
Return on Equity
Capital costs and the NOI approach in a
graphical representation.
.25
ke = 16.25% and
.20 17.5% respectively
Capital Costs (%)

ke (Required return on equity)

.15
ko (Capitalization rate)
.10
ki (Yield on debt)
.05

0
0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
17-11 Financial Leverage (B / S)

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Slide 12

Summary of NOI Approach

Critical assumption is ko remains constant.
An increase in cheaper debt funds is
exactly offset by an increase in the
required rate of return on equity.
As long as ki is constant, ke is a linear
function of the debt-to-equity ratio.
Thus, there is no one optimal capital
structure.
structure
17-12

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Slide 13

Traditional Approach

Traditional Approach -- A theory of capital

structure in which there exists an optimal capital
structure and where management can increase
the total value of the firm through the judicious
use of financial leverage.

Optimal Capital Structure -- The capital structure

that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.

17-13

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Slide 14

Optimal Capital Structure:

Traditional Approach
Traditional Approach

ke
.25
ko
.20
Capital Costs (%)

.15
ki
.10
Optimal Capital Structure
.05

0
Financial Leverage (B / S)
17-14

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Slide 15

Summary of the
Traditional Approach
The cost of capital is dependent on the capital
structure of the firm.
Initially, low-cost debt is not rising and replaces
more expensive equity financing and ko declines.
Then, increasing financial leverage and the
associated increase in ke and ki more than offsets
the benefits of lower cost debt financing.
Thus, there is one optimal capital structure
where ko is at its lowest point.
This is also the point where the firm’s total
value will be the largest (discounting at ko).
17-15

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Slide 16

Total Value Principle:

Modigliani and Miller (M&M)
Advocate that the relationship between
financial leverage and the cost of capital is
explained by the NOI approach.
Provide behavioral justification for a constant
ko over the entire range of financial leverage
possibilities.
Total risk for all security holders of the firm is
not altered by the capital structure.
Therefore, the total value of the firm is not
altered by the firm’s financing mix.
17-16

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Slide 17

Total Value Principle:

Modigliani and Miller
Market value Market value
of debt ($35M) of debt ($65M)

Market value Market value

of equity ($65M) of equity ($35M)

Total firm market Total firm market

value ($100M) value ($100M)

Total market value is not altered by the capital

structure (the total size of the pies are the same).
M&M assume an absence of taxes and market
imperfections.
Investors can substitute personal for corporate
financial leverage.
17-17

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Slide 18

Arbitrage and Total

Market Value of the Firm
Two firms that are alike in every respect
EXCEPT capital structure MUST have
the same market value.
Otherwise, arbitrage is possible.

Arbitrage -- Finding two assets that are

essentially the same and buying the
cheaper and selling the more expensive.
17-18

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Slide 19

Arbitrage Example
Consider two firms that are identical
in every respect EXCEPT:
EXCEPT
Company NL -- no financial leverage
Company L -- $30,000 of 12% debt
Market value of debt for Company L equals its
par value
Required return on equity
-- Company NL is 15%
-- Company L is 16%
NOI for each firm is $10,000
17-19

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Slide 20

Arbitrage Example:
Company NL
Valuation of Company NL
Earnings available to =E =O–I
common shareholders = $10,000 - $0
= $10,000
Market value = E / ke
of equity = $10,000 / .15
= $66,667
Total market value = $66,667 + $0
= $66,667
Overall capitalization rate = 15%
Debt-to-equity ratio =0
17-20

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Slide 21

Arbitrage Example:
Company L
Valuation of Company L
Earnings available to =E =O–I
common shareholders = $10,000 - $3,600
= $6,400
Market value = E / ke
of equity = $6,400 / .16
= $40,000
Total market value = $40,000 + $30,000
= $70,000
Overall capitalization rate = 14.3%
Debt-to-equity ratio = .75
17-21

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Slide 22

Completing an
Arbitrage Transaction
Assume you own 1% of the stock of
Company L (equity value = $400).
You should:
1. Sell the stock in Company L for $400.
2. Borrow $300 at 12% interest (equals 1% of debt
for Company L).
3. Buy 1% of the stock in Company NL for
$666.67. This leaves you with $33.33 for other
investments ($400 + $300 - $666.67).
17-22

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Slide 23

Completing an
Arbitrage Transaction
Original return on investment in Company L
$400 x 16% = $64

Return on investment after the transaction

$666.67 x 16% = $100 return on Company NL
$300 x 12% = $36 interest paid
$64 net return ($100
$100 - $36)
$36 AND $33.33 left over.
over
This reduces the required net investment to
$366.67 to earn $64.
17-23

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Slide 24

Summary of the
Arbitrage Transaction
The investor uses “personal” rather than
corporate financial leverage.
The equity share price in Company NL rises
based on increased share demand.
The equity share price in Company L falls
based on selling pressures.
Arbitrage continues until total firm values are
identical for companies NL and L.
Therefore, all capital structures are equally as
acceptable.
17-24

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Slide 25

Example of the Effects

of Corporate Taxes
The judicious use of financial leverage
(i.e., debt) provides a favorable impact
on a company’s total valuation.
Consider two identical firms EXCEPT:
EXCEPT

Company ND -- no debt, 16% required return

Company D -- $5,000 of 12% debt
Corporate tax rate is 40% for each company
NOI for each firm is $10,000
17-25

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Slide 26

Corporate Tax Example:

Company ND
Valuation of Company ND (Note: has no debt)
Earnings available to =E =O-I
common shareholders = $2,000 - $0
= $2,000
Tax Rate (T
T) = 40%
Income available to = EACS (1 - T)
common shareholders = $2,000 (1 - .4)
.4
= $1,200
Total income available to = EAT + I
all security holders = $1,200 + 0
= $1,200
17-26

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Slide 27

Corporate Tax Example:

Company D
Valuation of Company D (Note: has some debt)
Earnings available to =E =O-I
common shareholders = $2,000 - $600
= $1,400
Tax Rate (T
T) = 40%
Income available to = EACS (1 - T)
common shareholders = $1,400 (1 - .4)
.4
= $840
Total income available to = EAT + I
all security holders = $840 + $600
= $1,440*
$1,440
17-27 * $240 annual tax-shield benefit of debt (i.e., $1,440 - $1,200)

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Slide 28

Tax-Shield Benefits
Tax Shield -- A tax-
tax-deductible expense. The
expense protects (shields) an equivalent dollar
amount of revenue from being taxed by reducing
taxable income.

Present value of
tax-
tax-shield benefits (rr) (B
B) (ttc)
= = (B
B) (ttc)
of debt*
debt r

= ($5,000
$5,000) (.4
.4) = $2,000**
$2,000
* Permanent debt, so treated as a perpetuity
** Alternatively, $240 annual tax shield / .12 = $2,000, where
17-28 $240=$600 Interest expense x .40 tax rate.

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Slide 29

Value of the Levered Firm

Value of Value of Present value of
levered = firm if + tax-
tax-shield benefits
firm unlevered of debt

Value of unlevered firm = $1,200 / .16

(Company ND) = $7,500*
$7,500

Value of levered firm = $7,500 + $2,000

(Company D) = $9,500

* Assuming zero growth and 100% dividend payout

17-29

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Slide 30

Summary of
Corporate Tax Effects
The greater the amount of debt, the greater the
tax-shield benefits and the greater the value of the
firm.
The greater the financial leverage, the lower the
cost of capital of the firm.
The adjusted M&M proposition suggests an
optimal strategy is to take on the maximum
amount of financial leverage.
leverage
This implies a capital structure of almost 100%
debt! Yet, this is not consistent with actual
behavior.
17-30

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