Prof.

Meghana Patil

Concept of value of the firm

y The value of the firm depends on the earning of the

firm & earning depends upon the investment decision y The earning of the firm is capitalized at the rate equal to cost of capital in order to find out the value of the firm.

y EBIT has three claimants y The debt holders-interest y Govt. tax y The shareholders-dividend y The investment decision decides the size of the EBIT

pool while capital structure mix will decides the way it is to be sliced

y The total value of the firm is the sum of its value to the

debt holder & to its shareholder & is determined by the amount of EBIT going to them respectively y The investment decision can increase the value of the firm by increasing the size of EBIT whereas the capital structure mix can affect the value of the firm only by reducing the share of EBIT going to the Govt.

Meaning of Capital Structure

y Capital Structure: Include only long-term debt and total stockholder investment

Capital Structure = Long-term Debt + Preferred Stock + Net worth (or) Capital Structure = Total Assets Current Liabilities

Optimum Capital structure

Optimum Capital Structure: The level of debt equity proportion where market value of share is maximum, and cost of capital is minimum Features: Profitability Solvency Flexibility Conservatism Control

Determinants of Capital structure

y y y y y y y y y y y y y y

Tax benefit of debt Flexibility Control Industry leverage ratios Seasonal variations Degree of competition Industry life cycle Agency cost Company characteristics Timing of public issue Requirements of investors Period of finance Purpose of finance Legal requirements

Approaches in Determining Optimum Capital Structure

1. EBI T EPS Approach: This approach is helpful to analyse the impact of debt on earnings per share. 2. Valuation Approach: It determines the impact of use of debt on the shareholders value and 3. Cash Flow Approach: It analyses the firms debt service capacity.

Indifferent point
y Point of Indifference: The level of EBIT at which EPS is same for two alternative capital structures
(X I1) (1 t) PD (1 + Dt) = ES1 ES2 (X I2) (1 t) PD (1 + Dt)

Where: X = EBIT I1,I2 = Interest under alternatives 1 and 2 t = Tax rate PD = Preference dividend Dt = Preference dividend tax ES1, ES2 = No. of equity share outstanding under alternative 1 and 2

Capital Structure Theories

y The total capital structure theories can be categorised into relevant and irrelevant theories. The following are the main theories/Approaches of capital structure: 1. Net income (theory) Approach (Relevant) 2. Net operating income Approach (Irrelevant) 3. Modigliani and Miller Approach (Irrelevant) 4. Traditional Approach (Neutral)

Assumption of Capital Sturcture Theories

1. 2. 3. 4. 5. 6. 7. 8. 9.

Firm uses only two sources of funds: perceptual riskless debt and equity; There are no corporate or income: or personal tax; The dividend payout ratio is 100% [There are no retained earnings]; The firms total assets are given and do not change [Investment decision is assumed to be constant]. The firms total financing remains constant. [Total capital is same, but proportion of debt and equity may be changed]; The firms operating profits (EBIT) are not expected to grow; The business risk is remained constant and is independent of capital structure and financial risk; All investors have the same subject probability distribution of the expected EBIT for a given firm; and The firm has perpetual life;

Definitions used in Capital Structure

E = Total market value of equity D = Total market value of debt V = Total market value of the firm I = Annual interest payment NI = Net income or equity earnings NOI = Net operating income Kd = pre-tax cost of debt I Cost of debt (Kd) = D 100 Cost of equity (Ke) = NI or Ko+ [KoKd] D or D1/Po
E

Cost of Capital (Ko) = WdKd + WeKe or [EBIT/ V] 100 Value of the Firm (V) = EBIT zKo

y Ko= {D/(D+E)} Kd +{ E/(D+E)} Ke

= Kd (D/V) + Ke (E/V) y Ke = Ko Kd (D/V) y (E/V)

y

Net Income Approach

y NI Approach: A change in the proportion in capital structure will lead to a corresponding change in Ko and V. y Assumptions:

(i) There are no taxes; (ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the risk perception of investors. (iv) Cost of debt and cost of equity remains constant;

N I Approach (Contd..)
E = NI Ke

Degree Of Leverage

D E

y The figure shows that Ki or Kd is constant for all levels

of leverage i. for all levels of debt financing y As the debt proportion or the financial leverages increases , the WACC , Ko decreases as the Kd is less than K e y Ko will never equal to Kd as there is no 100% debt finance

y However if the firm is 100% equity firm then Ko is

equal to Ke y The rate of decline in Ko will depend upon the relative position of Kd & Ke y Under NI approach the firm will maximise the value of the firm at a point where Ko is minimised y With judicious se of debt & equity a can achieve an optimal capital structure .

y Kd is lesser than Ke so as the debt proportion

increases the Ko will decrease which will increase the value of the firm.

y The expected EBIT of a firm is Rs. 2,00,000 .It has

equity share capital; with Ke @10%& 6% debt of Rs. 5,00,000 find out the value of the firm & overall cost of capital , WACC

y NOW if the firm has issued 6% debt of Rs. 7,00,000

instead of Rs. 5,00,000 .Find the value of the firm y Value of the firm= value of the equity + value of the debt y Overall cost of capital =EBIT/V y WACC= {D/(D+E)}Kd+ {E/(D+E)}Ke

Net Operating Income Approach (NOI)

NOI Approach: Says that there is no relation between capital structure and Ko and V. y Assumptions: (i) Overall Cast of Capital (Ko) remains unchanged for all degrees of leverage. (See Fig. 11.2) (ii) The market capitalises the total value of the firm as a whole and no importance is given for split of value of firm between debt and equity; (iii) The market value of equity is residue [i.e., Total value of the firm minus market value of debt) (iv) The use of debt funds increases the received risk of equity investors, there by ke increases (v) The debt advantage is set off exactly by increase in cost of equity. (vi) Cost of debt (Ki) remains constant (vii)There are no corporate taxes.
y

NOI (Contd.)
V = EBIT z Ko E = V-D

Degree Of Leverage

D E

y In the diagram the cost of debt Kd overall cost of

capital Ko are constant for all levels of leverages . y As the debt proportion or financial leverage increases , the risk of the shareholder also increases & thus the cost of equity Ke also increases
y

y However increase in Ke is such that overall cost of

capital remains same . y It may be notified that for an all equity firm Ke is just equal to Ko y As the debt proportion increases , the Ke also increases . y However , the overall cost of capital remains same because increase in Ke is just sufficient to off set the benefits of cheaper debt finance

y The NOI approach considers Ko to be constant &

therefore ,there is no optimal capital structure y So the capital structure does not matter

y A firm has EBIT oaf Rs.2,00,000& belongs to risk class

of 10% what is the value of cost of equity capital if it employees 6% debt to the extent of 30%,40%& 50% of the total capital of Rs. 10,00,000 y from the following data determine the value of firm P & Q belonging to the homogeneous risk class under y NI approach y NOI approach

y from the following data determine the value of firm P

& Q belonging to the homogeneous risk class under y NI approach y NOI approach

Modigliani-Miller Approach
y MM Approach: Total value of firm is independent of its capital structure y Assumptions: a. Information is available at free of cost b. The same information is available for all investors c. Securities are infinitely divisible d. Investors are free to buy or sell securities e. There is no transaction cost f. There are no bankruptcy costs g. Investors can borrow without restrictions as the same terms on which a firm can borrow h. Dividend payout ratio is 100 percent i. EBIT is not affected by the use of debt

MM Approach (Contd.)
Proposition: I. Ko and V are independent of capital structure II.Ke = to capitalisation rate of the pure equity plus a premium for financial risk. Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt) III.The cut of rate for investment purposes is completely independent of the way in which an investment is financed.

y The MM model argues that if two firms are alike in all

respect except that they differ in respect of their financial pattern and their market value , then the investors will develop the tendency to sell their shares of the overvalued firm( creating a selling pressure ) and to buy the shares of the undervalued firm(creating demand pressure )

y This buying & selling process will continue till both

the firms will have same market value. y suppose two co. LEV. & ULEV. these two co.s are alike & identical in all respect except the LEV. Firm has a 10% debt of Rs. 30,00,000 in its capital structure . On the other hand the ULEV. Is an unlevered form & has raised the funds only thru equity y Both have EBIT of Rs. 10,00,000 & the equity capitalisation rate Ke 20%

y Under this situation the total value of the firm &

WACC will be?

y The LEV co. has overall cost of capital less & higher

market value i.e. (15.38%<20%) y MM argues that this position will not persist for longer period because of buying & selling y They have suggested arbitrage procedure

MM Approach [Proposition:I]
y Arbitrage Process: Refers to an act of buying an asset or security in one

market at lower price and selling it is an other market at higher price. y Steps in working out Arbitrage Process Students need to keep in mind the following three steps in working of arbitrage process. Step 1: Investors Current Position: In this step there is a need to find out the current investment and income (return). Step 2: Calculation of Savings in Investment by moving from levered firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of investment. Here the income will be same which was earning in previous firm. Step 3: Calculation of Increased Income, by investing total funds available.

y With the same example suppose an investor is holding

10% equity of LEV. The value of the ownership will be y 10% of 35,00,000 i.e 3,50,000 y Further out of the total net profit he will earn y 10% of 7,00,000 = 70,000 (20%return on equity)

y In order to make an opportunity now he decide to

convert his holding fro LEVto ULEV. y But to avail the same position in ULEV he should have 5,00,000 y He has Rs.3,50,000so he takes a loan @10% of an amount equals to 3,00,000(i.e .10%of the debt of the LEV ) y Now he is having total funds the proceeds of 3,50,000+ 3,00,000)

y Out of the total 6,50,000 he invests Rs. 5,00,000 in the

ULEV y Assuming that the ULEV continues to earn 10,00,000 the net returns available to investors is y Profit available from ULEV 1,00,000 - Interest payable @10% ( 30,000) NET RETURN 70,000

y now the investor has 70,000 + 1,50,000 as a return y The risk is also same as he has shifted himself from

corporate leverage to personal leverage .

y The following is the data regarding two companies

X&Y belonging to the same risk

Company X Number of equity shares Market price per share (Rs.) 6% debenture (Rs.) Profit before interest 90,000 1.20 60,000 18,000 Company Y 1,50,000 1.00 18,000

y All profits after interest are distributed as dividends , y Explain how under the M&M approach an investor

holding 10% of shares in company X will be better off in switching his holding 10% of shares in company Y

y The two companies U & L belong to an equivalent

risk class . These two firms are in identical in every respect except that U company is unlevered while company L has 10% debentures of Rs. 30 lakhs the other relevant information regarding their valuation & capitalisation rates are as follows

Particulars NET OPERATING INCOME Interest on debt Earnings to equity holders Equity capitalisation rate Market value of equity Market value of debt Total value of the firm Overall capitalisation rate Debt equity ratio

Firm U 750000 7,50,000 .15 50,00,000 50,00,000 .15 0

Firm L 7,50,000 3,00,000 4,50,000 .20 22,50,000 30,00,000 52,50,000 .143 1.33

y An investor owns 10% equity shares of company L

show the arbitrage process & the amount by which he could reduce his out lay through the use of leverage .

Limitations of MM Approach
y Investors cannot borrow on the same terms and conditions of a firm y Personal leverage is not substitute for corporate leverage y Existence of transaction cost y Institutional restriction on personal leverage y Asymmetric information y Existence of corporate tax

MM Approach: with Corporate Taxes

y MM Approach with tax says affects value of the firm VL = VU + Dt Where VL = Value of levered firm VU = Value of unlevered firm, D = Amount of Debt t = Tax rate y In other words value of levered firm (VL) is equal to the market to the market value of unlevered firm VU plus the discounted present value of the tax saving resulting from tax - deductibility a interest payments.(7) Symbolically y VL = VU + pv of tax shield