Inorder to expand, it is necessaryf or businesso wners to tapfinancial

resources.B usinesso wners can utilize a variety of financing resources,

initially broken into two categories, debt and equity. "Debt" involves
borrowing money to be repaid, plus interest. "Equity" involves raising
money byselling interests in the company. Thef ollowing table discusses
the advantages and disadvantages of debtfinancing as compared to
equityfinancing.
ADVANTAGES OF DEBT COMPARED TO EQUITY
y
B ecause the lender does not have a claim to equity in the business ,
debt does not dilute theo wner's ownership interest in the company.
y
A lender is entitledonly to repaymento f the agreed-upon principalo f
the loan plus interest, and has no direct claimonfuture profits of the
business. If the company is s uccessful, theo wners reap a larger
portiono f the rewards than theyw ould if they hadsoldstock in the
company to investors inorder to f inance the growth.
y
Except in the caseo f variable rate loans, principal and interest
obligations are known amounts which can be forecasted and planned
for.
y
Intereston the debt can be deductedon the company's tax return,
lowering the actual costo f the loan to the company.
y
Raising debt capital is less complicated because the company is not
required to complywithstate andfederalsecurities laws and
regulations.
y
The company is not required to
send periodic mailings to large numbers
ofi n v es tor s , h old periodic meetings of
shareholders, and seek the voteo f
shareholders
before taking
certain
actions.

DISADVANTAGES OF DEBT COMPARED TO EQUITY

y
Unlike equity, debt must atsome point be repaid.
y
Interest is afixed costwhich raises the company's break-even point.
High interest costs during difficultfinancial periods can increase the
risk of insolvency. Companies that are too highly leveraged (that have
large amounts of debt as compared to equity)o ftenfind it difficult to
grow becauseo f the high costo fservicing the debt.
y
Cash flowis r eq u ir e d for b oth principal and interest payments and
must be budgetedf or. Most loans are not repayable in varying
amounts over time basedon the business cycles of the company.
y
Debt instruments often contain restrictions on the company's
activities,
preventing
managementfrom pursuing
alternativefinancingoptions
and
non-core
business
opportunities.
y
The larger a company's debt-
equity ratio, the more risky
the company is considered by
lenders
and
investors.
Accordingly, a business is
limited as to the amounto f
debt it can carry.
y
The company is usually required to pledge assets of the company to
the lender as collateral, ando wners of the company are insome cases
required to personally guarantee repaymento f the loan.
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

A project on:
V/s
Submitted to: Prof. Kamal
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A C K N O W L E D G E
M E N T



On the completion of this Project, I wish to great fully acknowledge,
by taking this opportunity to express my sincere gratitude toProf. Kamal
for giving me kind support and co -operation and her guidance and useful
suggestions that proved very useful in t his Project. Once again thank all
the people who have directly or indirectly help in this Project.
Lastly, I sincerely thank all my friends who have always given their
encouraging support and been a great help all the time at various stage of
development of this Project.
Index
 Debt vs. Equity -- Advantages and Dis advantages
4



 Cost of Capital
6
 S pecif icC os t of Capital
7
 0 $ -25& 21, (5$ 7 ,21 ,1&$ 3 ,7 $ / 6 7 58&7 85(


3 / $ 11,1*
 CAPITALS TRUCTURE THEORIES
14
 B iblio graphy
20
Debt vs. Equity -- Advantages and
Disadvantages



Inorder to expand, it is necessaryf or businesso wners to tapfinancial
resources.B usinesso wners can utilize a variety of financing resources,
initially broken into two categories, debt and equity. "Debt" involves
borrowing money to be repaid, plus interest. "Equity" involves raising
money byselling interests in the company. Thef ollowing table discusses
the advantages and disadvantages of debtfinancing as compared to
equityfinancing.
ADVANTAGES OF DEBT COMPARED TO EQUITY
y
B ecaus e the lender do es no t have a claim to equity in the bus iness ,
debt does not dilute theo wner's ownership interest in the company.
y
A lender is entitledonly to repaymento f the agreed-upon principalo f
the loan plus interest, and has no direct claimonfuture profits of the
business. If the company is s uccessful, theo wners reap a larger
portiono f the rewards than theyw ould if they hadsoldstock in the
company to investors inorder to f inance the growth.
y
Except in the caseo f variable rate loans, principal and interest
obligations are known amounts which can be forecasted and planned
for.
y
Intereston the debt can be deductedon the company's tax return,
lowering the actual costo f the loan to the company.
y
Raising debt capital is less complicated because the company is not
required to complywithstate andfederalsecurities laws and
regulations.
y
The company is not required to
send periodic mailings to large numbers
ofi n v es tor s , h old periodic meetings of
shareholders, and seek the voteo f
shareholders
before taking
certain
actions.



DISADVANTAGES OF DEBT COMPARED TO EQUITY
y
Unlike equity, debt must atsome point be repaid.
y
Interest is afixed costwhich raises the company's break-even point.
High interest costs during difficultfinancial periods can increase the
risk of insolvency. Companies that are too highly leveraged (that have
large amounts of debt as compared to equity)o ftenfind it difficult to
grow becauseo f the high costo fservicing the debt.
y
Cash flowis r eq u ir e d for b oth principal and interest payments and
must be budgetedf or. Most loans are not repayable in varying
amounts over time basedon the business cycles of the company.
y
Debt instruments often contain restrictions on the company's
activities,
preventing
managementfrom pursuing
alternativefinancingoptions
and
non-core
business
opportunities.
y
The larger a company's debt-
equity ratio, the more risky
the company is considered by
lenders
and
investors.
Accordingly, a business is
limited as to the amounto f
debt it can carry.
y
The company is usually required to pledge assets of the company to
the lender as collateral, ando wners of the company are insome cases
required to personally guarantee repaymento f the loan.



Cost of Capital
The costo f capital is an important input in
the capital budgeting decision. Conceptually,
it refers to the discount rate thatw ould be
used in determining the present valueo f
estimatedfuture benefits associatedwith
projects. Inoperational terms, it is defined as weighted average costo f
each typeo f capital. It is visualized as being composedo fseveral
elements, the elements being the costo f each componento f the capital.
The term component means differentsources of funds are received by a
firm. The long-termsources of funds are:-
I.
Debt
II.
PreferenceS hares
III.
EquityCapital
IV.
Retained Earning
Eachsource of fundor componento f capital has its cost, called the
specific costo f capital. When these are combined to o verall cost of
capital, it results in theweighted/average/combined costo f capital.
Therefore, the compensationo f the costo f capital, involves twosteps :
1. Calculationo f thespecific costo f cas ho f each typeo f capital- debt,
preferenceshares,ordinaryor equityshares and retained earnings
2. Calculationo f theweighted average costo f capital by combining the
specific cost.
There are two approaches to it by:-
Book Value (BV)
Market value (MV)



Specific Cost of Capital
(We have covered only that portion)
Cost ofD eb t
Perpetual Debt
Ki= I / SV
K d = I / S V (1-t)
Where,
Ki =C osto f debt before tax
Kd =C osto f debt after tax
I = Annual interest payment
S V = Amo unto f debt/ nets ale pro ceeds of debentures (bo nds )
t = Tax rate
The explicit costo f debt is the interest rate as per contract adjustedf or
tax and the costo f raising the debt.
However, debt has an implicit cost also. This arises due to thefact that if
the debt content rises above theoptimal level, investors willstart
considering the company to be too risky and, therefore, their expectations
from equityshares will rise. This rise in the cost ofeq u it ys h a r es is
actually the implicit costo f debt.
Cost ofP r eferenceS hares
Irredeemable
Kp= D p( 1 + D1) / P 0( 1 -f )
Where,
Kp =C osto f preferenceshare capital
Dp = Annual dividend
P0 =S ale price
f = Floatation c ost
Dt = Dividend tax
In the caseo f preferenceshares, the dividend rate can be taken as its
costsince it is this amountwhich the company intends to pay against
preferenceshares. As in the caseo f debt, the issue expenses or the
discount/premiumon issue/redemption has also to be taken into account.

CATIPAL STRUCTURE THEORIES

The capitalstructure is s aid to beoptimum capitalstructurewhen thefirm

has s electedsuch a combinationo f equity and debtso that thewealtho f
firm is maximum. At this capitalstructure the cost of capital is minimum
and market price pershare is maximum.
It is however, difficult to f indoutoptimum debt and equity mixwhere the
capitalstructurew ould beoptimum because it is difficult to measure afall
in the market valueo f an equityshareon accounto f increase in risk due
to high debt content in the capitalstructure.
In theoryone canspeak of anoptimum capitalstructure but in practice
appropriate capitalstructure is more realistic term than thef ormer.

1. Profitability:
The most profitable capitalstructure is one that tends to minimize costo f
financing and maximize earning per equityshare.
2. Flexibility:
The capitalstructureshould besuch that company can raisefunds
whenever needed.
3. Conservation:
The debt content in the capitalstructureshould not exceed the li mitwhich
the company can bear.
4. S olvency:
The capitalstructureshould besuch thatfirm does not run the risk of
becoming insolvent.
5. Control:
The capitalstructureshould beso devised that it involves minimum risk
ofloss ofcontrol of the company.

There are three major considerations:

y
Risk
y
Cost ofc a p i ta l
y
Control
These help thefinance manager in determining the proportion inwhich he
can raisefunds from various s ources.
Although, threefactors, i.e., risk, cost and control determine the capital
structureo f a particular business undertaking at a given pointo f time.
Thefinance manager attempts to design the capitalstructure insuch a
manner that his risk and costs are the least and the controlo f the existing
manager is diluted to the least extent. However, there are also subsidiary
factors like marketability of the issue, maneuverability and flexibility of
the capitalstructure and timingf or raising thefunds.S tructuring capital is
ashrewdfinancial management decision and is s omethingwhich makes
or mars the fortunes of the company. These factors are discussed here
under.


Risk is of two kinds, i.e.,financial risk andB usiness risk. Herewe are
concerned primarilywith thefinancial risk. Financial risk also is of two
types:
1 . Risk of cash insolvency:
If afirm raises more debt, its risk of cash insolvency increases. This is
due to two reasons. Firstly, higher proportiono f debt in the capital
structure increases the commitments of the company with regard to fixed
charges. This means that a companystands committed to pay a higher
amounto f interest irrespectiveo f thefactwhether it has cashor not.
S econdly, there is a possibility that thesupplier of funds maywithdraw
thefunds at any given pointo f time. Thus the long -term creditors may
have to be paid back in installments, even if sufficient cash to doso does
not exist. This risk is not there in the caseo f equityshares.
2. Risk of variation in the expected earnings available to equity
share-holders:
In case afirm has higher debt content in ca pitalstructure, the risk of
variations in expected earnings available to equityshareholders will be
higher. This is becauseo f tradingon equity. We haveknow thatfinancial
leveragew orks bothways, i.e., it enhances theshareholders¶ return by a
high magnitudeor brings it downsharply depending uponwhether the
returnon investment is higheror lower than the rateo f interest. Thus
therewill be lower probability that equityshareholders will enjoy astable
dividend if the debt content is high in the capitalstructure. Inother
words, the relative dispersion of expected earnings available toeq u it y
shareholders will be greater if the capital structureo f afirm hash ig h er
debt content.
Thefinancial risk involved in various s ources of finance can be u nderstood
by taking the exampleo f debentures. A company has to pay interest
charges on debentures evenwhen it does not make any profit. Also the
principalsum has to be repaid under thestipulated agreement. The
debenture holders also have a charge against the assets of the company.
Thus, they can enforce asaleo f the assets in case the companyfails to
meet its contractualobligations. Debentures also increase the risk of
variation in the expected earnings available to equityshareholders
through leverage effect, i.e., if the returnon investment remains higher


than the interest rate,shareholders will get a high return; but if reverse is
the case,shareholders may get no return at all.
As compared to debentures, preferenceshares entailslightly lower risk
for the company,since the payment ofd i v id en ds onsuchshares is
contingent upon the earningo f profits by the company. Even in the case
of cumulative preferenceshares, dividends have to be paid only in the
year inwhich a company makes profits. Again, the repaymento f
preferenceshares has to be redeemable and that too after astipulated
period. However, preferenceshares also increase the variations in the
expected earnings available to equityshareholders. From the pointo f
view of the company, equityshares are the least risky. This is because a
company does not repay equityshare capital excepton its liquidation.
Also, it may not declare a dividendf or years together.
Inshort,financial risk encompasses the volatilityo f earnings available to
equityshareholders as well as the probabilityo f cash insolvency.

Cost i s an important consideration in capitalstructure decisions. It is

obvious that a business should be at least capable of earning enough
revenue to meet its costo f capital andfinance its growth. Hence, along
with a risk as a factor, the finance manager has toconsider the cost
aspect carefullywhile determining the capitalstructure.

Alongwith cost and risk f actors, the control aspect is also an important
consideration in planning the capitalstructure. When a company issues
further equityshares, it automatically dilutes the controlling interest of
the presento wners.S imilarly, preferenceshareholders can have voting
rights and thereby affect the compositiono f theB oardo f Directors.
Financial institutions normallystipulate that theyshall haveoneor more
directors on theB oard. Hence,when the management agrees to raise
loans fromfinancial institutions, by implication it agrees to forget a parto f
its controlover the company. It is obvious, therefore, that decisions
concerning capitalstructure are taken afterkeeping the controlfactor in
mind.

 

Theobjectiveo f afirmshould be directed towards the maximizationo f
the valueo f thefirm, the capitalstructure,or leverage decisionshould be
examinedfrom the pointo f view of its impacton the valueo f thefirm. If
the valueo f thefirm can be affected by capitalstructureorfinancing
decision, afirmw ould like to have a ca pitalstructurewhich maximizes
the market valueo f thefirm.
There are broadlyf our approaches in this regard. These are:
1. N et Income Approach (N .I. approach)
2. N et Operating Income Approach (N .O.I. approach)
3. Traditional Theory
4. Modigliani and Miller Approach
These approaches analys is relationship between the leverage, costo f
capital and the valueo f thefirm in differentways. However, thef ollowing
assumptions are made to understand these relationships .
1. There areonly twosources of funds viz., d ebt and equity.
2. The total assets of firm are given. The degreeo f leverage can be
changed byselling debt to purchaseshares orsellingshares to
retire debt.
3. There are no retained earnings. It implies that entire profits are
distributed amongshareholders.
4. Theoperating profit of firm is given and expected to grow.
5. The business risk is assumed to be constant and is not affected by
thefinancing mix decision.
6. There are no corporateor personal taxes.
7. The investors have thesamesubjective probability distributiono f
expected earnings.
Net Income Approach (NI-approach)

 

This approach has beensuggested by Durand. According to this approach
afirm can increase its valueor lower theoverall costo f capital by
increasing the proportiono f debt in the capitalstructure. Inotherw ords,
if the degree of financial leverage increases theweighted average costo f
capitalwill declinewith every increase in the debt content in totalfunds
employed,while the value of firmwill increase. Reversewill happen in a
conversesituation.
Net income approach is based on the following three assumptions:
I.
There are no corporate taxes
II.
The costo f debt is less than costo f equityor equity capitalization rate.
III.
The useo f debt content does not change at risk perce ptiono f investors
as a result both thekd (debt capitalization rate) andkc (equity-
capitalization rate) remains constant.
The valueo f thefirmon the basis ofN et Income Approach can be
ascertained as follows:
V =S + D
Where,
V = Valueo f thefirm
S = Mark et valueo f equity
D = Market valueo f debt
Market valueo f equity (S ) =N I/Kc
Where,
N I = Earnings availablef or equitys hareho lders.
Kc = EquityCapitalization rate
Under,N I approach, the valueo f thefirmwill be maximum at a point
where weighted average cost of capital is minimum. Thus, the theory
suggests totalor maximum possible debtfinancingf or minimizing the cost
ofc a p ita l. T h eN . I. A p p roach can be illustrated with help oft h e
following
example.
Theoverall costo f capital under this approach is:
Overall costo f capital = (N PB IT)/ (Valueo f thefirm)
Net operating Income (NOI) Approach

 

According to this approach, the market valueo f thefirm is not affected by
the capitalstructure changes. The market valueo f thefirm is ascertained
by capitalizing the netoperating income at theoverall costo f capital
which is constant. The market value oft h e firm is determined as follows:
Market valueo f thefirm (V) = (Earnings before interest and tax)/
(Overall costo f capital)
The valueo f equity can be determined by thef ollowing equation
Valueo f equity (S ) = V (market value of firm) ± D (Market valueo f debt)
And the costo f equity = (Earnings after interest and before tax)/
(market value of firm (V) - Market valueo f debt (D))
TheNet Operating Income Approach is basedon thefollowing
assumptions:
a. Theoverall costo f capital remains constantfor all degreeo f debt
equity mix.
b. The market capitalizes the value of firm as awhole. Thus thesplit
between debt and equity is not important.
c. The useo f less costly debtfunds increases the risk of shareholders.
This causes the equity capitalization rate to increase. Thus, the
advantageo f debt is s eto ff exactly by increase in equity capitalization
rate.
d. There are no corporate taxes
e. The costo f debt is constant.
UnderN OI approachsinceoverall costo f capital is constant, therefore
there is no o ptimal capitalstructure rather every capitalstructure is as
good as anyother andso every capitalstructure is optimalone.
T raditional Approach

 

The traditional approach is also called an intermediate approach as it
takes a midway betweenN I approach (that the valueo f thefirm can be
increased by increasingfinancial leverage) andN OI approach (that the
value of firm is constant irrespectiveo f the degree of financial leverage).
According to this approach thefirmshouldstrive to reach theoptimal
capitalstructure. At theoptimal capitalstructure theoverall costo f
capitalwill be minimum and the valueo f thefirm is maximum. Itfurther
states that the valueo f thefirm increases with financial leverage uptoa
certain point. B eyond this point the increase infinancial leveragewill
increase its overall costo f capital and hence the value of firmwill decline.
This is because the benefits of useo f debt may beso large that even after
off-setting the effect of increase in cost of equity, the overall cost of
capital maystill go down. However, if f inancial leverage increases beyond
an acceptable limit the risk of debt investor may also increase,
consequently costo f debt also starts increasing. The increasing costo f
equityo wing to increasedfinancial risk and increasing costo f debt makes
theoverall costo f capital to increase.
Thus as per the traditional approach the costo f capital is afunctiono f
financial leverage and the value of firm can be affected by the judicious
mixo f debt and equity in capitalstructure. The increase of financial
leverage upto a pointfavourably affects the value of firm. At this point
the capitalstructure is optimal & theoverall costo f capitalwill be the
least.
M odigliani and M iller Approach
According to this approach the total costo f capitalo f particularfirm is
independento f its methods and level of financing. Modigliani and Miller
argued that theweighted average costo f capitalo f afirm is completely
independento f its capitalstructure. Inotherw ords, a change in the debt
equity mix does not affect the costo f capital. They gave asimple
argument insupporto f their approach. They argued that according to the
traditional approach, costo f capital is theweighted averageo f costo f
debt and costo f equity, etc. The costo f equity, they argued, is
determinedfrom the levelo fshareholder¶s expectations.N ow, if
shareholders expect 16%from a particular company, they do take into
account the debt equity ratio and they expect 16^ merely because they
find that 16% covers the particular risk which this company entails.
S uppos e,f urther that the debt co ntent in the capitals tructureo f this
company increases; this means that in the eyes of s hareholders, the risk
of the company increases,since debt is a more risky m ode of finance.
Hence,shareholders will nowstart expecting a higher rateo f returnfrom
theshares of the company. Hence, each change in the debt equity mix is

 

automaticallyo f fset by a change in the expectations of theshareholders
from the equityshare capital. This is because a change in the debt equity
ratio changes the risk elemento f the company,which in turn changes the
expectations of theshareholders from the particularshares of the
company. Modigliani and Miller, therefore, argued thatfinancial leverage
has nothing to do w ith theoverall costo f capital and theoverall costo f
capitalo f a company is equal to the capitalization rateo f pure equity
streamo f itsc lasso fr isk. Hence,financial leverage hasno im p a c to n
share market prices or on the costo f capital.
Modigliani and Miller make the following propositions:
1. The total market valueo f afirm and its costo f capital are independent
of its capitalstructure. The total market value oft h e firm is given by
capitalizing the expectedstream of operating earnings at a discount rate
considered appropriatef or its risk class.
2. The costo f equity (Ke) is equal to capitalization rateo f pure equity
stream plus a premiumf orfinancial risk. Thefinancial risk increaseswith
more debt content in the capitalstructure. As a result,Ke increases in a
manner to offset exactly the useo f less expensivesource of funds.
ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH
1. The capital markets are assumed to be perfect. This means that
investors arefree to buy andsellsecurities. They arewell informed about
the risk-returnon all typeo fsecurities. These are no transaction costs.
The investors behave rationally. They can borrow without restrictions on
thesame terms as thefirms do.
2. Thefirms can be classified into µhomogeneous risk class¶. They belong
to this class if their expected earnings are having identical risk
characteristics.
3. All investors have thesame expectations from afirm¶s netoperating
income (EB IT)which are necessary to evaluate the valueo f afirm.
4. The dividend payment ratio is 100%. Inotherw ords, there are no
retained earnings.
5. There are no corporate taxes. However this assumption has been
removed later.

 

Modigliani and Miller agree thatwhile companies in different industries
face different risks which will result in their earnings being capitalized at
different rates, it is not possiblefor these companies to affect their
market values, and therefore theiroverall capitalization rate by useo f
leverage. That is,f or a company in a particular risk class, the total market
value must besame irrespectiveo f proportiono f debt in company¶s
capitalstructure. Thesupportf or this hypothesis lies in the presenceo f
arbitrage in the capital market. They contend that arbitragewillsubstitute
personal leveragef or corporate leverage. This is illustrated below:
S uppos e there are two co mpanies A & B in thes ame risk class.C ompany
A is financed by equity and companyB has a capitalstructurewhich
includes debt. If market priceo fshareo f companyB is higher than
company A, market participants would take advantageo f difference by
selling equity shares ofcompanyB , borrowing money to equate their
personal leverage to the degreeo f corporate leverage in companyB , and
use thesefunds to invest in company A. Thesale of CompanyB sharewill
bring down its price until the market valueo f companyB debt and equity
equals the market valueo f the companyfinancedonly by equity capital.
Criticism of Modigliani and Miller Approach
These propositions have been criticized by numerous author ities. Mostly
criticism is about perfect market assumption and the arbitrage
assumption. MM hypothesis argue that through personnel arbitrage
investors would quickly eliminate any inequalities between the valueo f
leverages firms and valueo f unleveragedf irms in thesame risk class. The
basic-argument here is that individual¶s arbitragers, through the useo f
personal leverage can alter corporate leverage. This argument is not valid
in the practicalw orld,f or it is extremely doubtful that personnel investo rs
wouldsubstitute personal leverage for c orporate leverage,since they do,
not have thesame risk characteristics. The MM approach assumes
availability of free and upto date information. This also is not normally
valid.

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