6 cost of capital and capital structure theories

8/10/2019 6 Cost of Capital and Capital Structure Theories

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FINANCIAL MANAGEMENT

TECHNICAL NOTES

COST OF CAPITAL AND CAPITAL STRUCTURE

COST OF CAPITAL

Concept of Cost of Capital

Investment in capital projects needs funds. These funds are provided by the investors like

equity shareholders, preference shareholders, debenture holders, etc in expectation of a

minimum return from the firm. The minimum return expected by the investors depends

upon the risk perception of the investor as well as on the risk-return characteristics of thefirm. This minimum return expected by the investors, which in turn, is the cost of

procuring funds for the firm, is termed as the cost of capital of the firm. Thus, the cost of

capital of a firm is the minimum rate of return that it must earn on its investments in orderto satisfy the expectation of the various categories of investors who have invested in the

firm.

A firm procures funds from various sources by issuing different securities to finance its

projects. Each of these sources of finance entails cost to the firm. Since the minimum rate

of return expected by various investorsequity investor and debt investorwill be

different depending upon their risk perception of the firm, the cost of each source offinance will be different. Thus the overall cost of capital of a firm will be the weighted

average of the cost of different sources of finance, with the proportion of each source of

finance as the weight. Unless the firm earns this minimum rate of return, the investorswill be tempted to pull out of the company, let alone, to participate in any further capital

issue.

Definition of Cost of capital

Cost of capital may be defined as the minimum rate of return that a company has to offer

to investors to induce them to invest in the firm. It can also be thought of as the rate ofreturn that a firm must earn on its investment projects to maintain the market value of its

stock. If risk is held constant, projects with a rate of return above the cost of capital will

increase the value of the firm, and projects with a rate of return below the cost of capital

will decrease the value of the firm.

Significance (or Importance) of Cost of Capital

Cost of capital is an extremely important financial concept. We know that the basicobjective of financial management is to maximize the wealth of the shareholders or the

value of the firm. The value of a firm is inversely related to the cost of capital of the firm.

So in order to maximize the value of a firm, the overall cost of capital of the firm shouldbe minimized.


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added (EVA) use cost of capital for evaluating the financial performance of a company

and its management.

Assumptions of Cost of Capital

While determining the cost of capital some key assumptions are made:

1. The business risk of a firm is assumed to be unchanged by the acceptance of a

given project.

2. The financial risk of a firm is assumed to be unchanged by the specific method offinancing a given project.

3. Each source of finance has either an explicit cost or an implicit cost.

4. Cost of each source of finance is determined on an after-tax basis

Costs of different Sources of Finance

A firm procures long-term sources of funds to finance its projects and fixed-assetsinvestments. These funds are procured from various sources by issuing different

securities. There are four major sources of finance used by a firm to finance its projects,

namely, Long-term debt, preference shares, equity shares and retained earnings. Long-

term debt can be either debentures (or bonds) and Term loans from financial institutions.Each of these sources of finance entails cost to the firm. Since the minimum rate of return

expected by various investors will be different depending upon their risk perception of

the firm, the cost of each source of finance will be different. Thus the overall cost ofcapital of a firm will be the weighted average of the cost of different sources of finance,

with the proportion of each source of finance as the weight. Unless the firm earns this

minimum rate of return, the investors will be tempted to pull out of the company, let

alone, to participate in any further capital issue.

We have seen that the cost of capital of a firm is the minimum required rates of return of

various investorsshareholders and debt investors- who supply funds to the firm. Howdoes a firm determine the required rates of return of each investor? The required rates of

return are market determined and is reflected in the market price of each security. An

investor, before investing in a security, evaluates the risk-return profile of an investmentand assigns a risk premium to the security. This risk premium and expected return of an

investor is incorporated in the market price of the security. Thus the market price of a

security is a function of the return expected by the investors. The required rate of return

of an investor, which is the cost of that specific source of finance to the firm, is theinternal rate of return which equates the present value of inflows to the firm from the

issue of that security to the present value of outflows to the firm with respect to that

security. It is given by the formula:

CF1 CF2 CFn

P = + + . +

(1 + k ) (1 + k )2 (1 + k )

n


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where,

k = Cost of the source of financeP = Market price of the security

CFn = Cash outflows associated with the security

Cost of Debt

A debt may be in the form of secured/unsecured loans, debentures, bonds, etc. The debt

carries a fixed rate of interest and the payment of interest is mandatory irrespective of theprofit earned or loss incurred by the firm. Since interest payable on debt is tax deductible,

the use of debt provides a tax shield to the company. So the cost of debt is calculated

after-tax.

Cost of Debentures or Bonds

The before-tax cost of debentures or bonds is defined as the discount rate which equatesthe net proceeds from issue of debentures to the present value of the expected cash

outflows in the form of interest and principal repayment. In other words, the before-tax

cost of debentures or bonds is the internal rate of return (or yield-to-maturity) on the cash

flows of the debentures or the bond. i.e.,

n It F

P = +t =1 ( 1+ ki )

t (1+ ki )n

where,

ki = Pre-tax cost of debenture capital

I = Annual interest payment per debenture capital

F = Redemption price per debentureP = Net amount realised per debenture and

n = Maturity period

Net Proceeds from Issue of Debentures

In the above equation P represents the net proceeds from the issue of debentures. The net

proceeds from the issue of bonds are the funds that are actually from the issue ofdebentures. In other words, the net proceeds from the issue of debentures are the fundsreceived from the issue of debentures less the flotation costs. Flotation costs include

underwriting commission and other issue expenses such as brokerage, legal charges and

other administrative expenses related to the issue of the debentures.

After-Tax Cost of Debentures or Bonds


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The Cost of debt-calculated by using the above formula is before-tax cost of debt.

Because the interest on debt is tax deductible, the cost of debt must be stated on an after-

tax basis. The after- tax cost of debt is calculated by using the following formula:

kd = ki(1-t)

ki = Before-tax cost of debtkd = Aft-tax cost of debt and

t = Corporate tax rate

(a) Cost of Irredeemable Debentures (Cost of Perpetual Debt)

Cost of debentures which are not redeemable during the life time of the firm or cost of

perpetual debt is calculated using the formula:

I (1-t)

kd =P

Where,

kd = After-tax cost of debt

I = Annual interest payment per debenture


P = Net proceeds from issue of debentures

(b)Cost of Redeemable Debentures (Cost of Redeemable Debt)

The cost of redeemable debentures or debt is the discount rate which equates the net

proceeds from issue of debentures to the present value of the expected cash outflows in

the form of interest and principal repayment. i.e.,

n I FP = +

t =1( 1+ ki )

t (1+ ki )

n

where,

ki = Before-tax cost of debenture capital

I = Annual interest payment per debenture capitalt = Corporate tax rate

F = Redemption price per debenture

P = Net amount realised per debenture andn = Maturity period


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Thus, the cost of redeemable debenture is the internal rate of return of the cash flows

associated with the debenture or yield-to-maturity of the debenture.

Since the interest payments are tax-deductible, the cost of debentures must be stated on

an after-tax basis. The after-tax cost of debenture, kd, can be found by multiplying before-tax cost of debenture, ki, by 1 minus tax rate. However, it should be noted that this tax-shield is available only when the firm is profitable. A firm incurring losses is not required

to pay any taxes and hence its actual cost of debt is the before-tax cost and not the after-

tax cost. The relationship between before-tax cost of debenture and after-tax cost ofdebenture is given below:

kd = ki(1- t )

where,

kd = After-tax cost of debtki = Before-tax cost of debtt = Corporate tax rate

An approximate formula for the calculation of the cost of redeemable debenture is:

FP

I + (1t )

n

kd =F + P

2

Where,

kd = After-tax cost of debenture capital

I = Annual interest payment per debenture capital

t = Corporate tax rateF = Redemption price per debenture

P = Net amount realized per debenture and

n = Maturity period

(c) Cost of Term Loan


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The cost of term loan is equal to the interest rate multiplied by (1tax rate). The interest

rate to be used here is the interest rate applicable to the new term loan. The interest rate is

multiplied by (1tax rate) as interest on term loans is a tax deductible expense. Theformula for calculation of cost of term loan will be:

kt = I (1t )

where,

kt = Post-tax cost of term loanI = Interest Rate


Cost of Preference Share Capital

Preference shares carry a fixed rate of dividend. Preference shareholders also have a

preferential right for dividend and repayment of capital over equity shareholders. Thecost of preference share capital is the discount rate which equates the net proceeds fromissue of preference shares to the present value of the expected cash outflows in the form

of dividend and principal repayment on redemption. i.e.,

n D F

P = +t =1

( 1+ kp )t (1+ kp )

n

where,

kp = Cost of preference capitalD = Preference dividend per share

F = Redemption value

P = Net amount realised per share andn = Maturity period

The net amount realized on issue of preference shares is the amount of money received

on issue minus any flotation costs. Since preference dividend is not deductible for taxpurpose, no further adjustment is required for tax shield.

(a) Cost of Irredeemable Preference shares

Cost of preference shares which are not redeemable during the life time of the firm is

calculated using the formula:

Dkp =

P


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kp = Cost of preference capital

D = Preference dividend per share

F = Redemption priceP = Net amount realised per share and

n = Maturity period

As already stated, the net amount realized on issue of preference shares is the amount ofmoney received on issue minus any flotation costs. Further, since preference dividend is

not deductible for tax purpose, no further adjustment is required for tax shield.

Cost of Equity Share Capital

Theoretically, the cost of equity share capital is the minimum return expected by the

equity investors on the equity shares of a company. The minimum return expected by the

equity investors depends upon the risk perception of the investor as well as on the risk-return complexion of the firm.

Determination of the cost of equity share capital is a complex process compared todetermination of cost of debt. This is because the interest on debt is specified by a legal

agreement while the dividend on equity shares is not stipulated by any such legal

agreement. Measurement of the cost of equity share capital requires an understanding of

the factors basically concerning the behaviour of investors and their expectations.Because of this, there are various approaches for determining the cost of equity. The

different approaches for determining the cost of equity are discussed below.

Dividend Growth Model Approach (or Gordons Dividend Growth Model

Approach)

An investor, who invests in the equity shares of a company, does so in the expectation ofcertain return. In other words, when an investor buys equity shares of a certain risk, he

expects a certain return. This expected rate of return of an equity investor is the cost of

equity share capital.

According to the Dividend Growth Model, the value of equity shares of a company is the

present value of all future cash flows an investor can expect from holding the stock. Withequity shares, these expected cash flows are the cash dividends and selling price.

However, equity shares can have an infinite life due to the perpetual nature of a company.

So the value of equity share can be expressed as the present value of all future dividends

expected from the share for infinite period. Mathematically this can be expressed as,

D1 D2 D

P0 = + + . +(1 + ke) (1 + ke)

2 (1 + ke)

i.e.,


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Dt

P0 = Eq. (1)t=1

(1 + ke)t

where,

ke = rate of return required by the equity shareholdersDt = expected dividend per share at the end of year t, and

P0 = price or value per share

In practice, the model suggested by equation (1) cannot be used in its present form

because it is not possible to forecast the future dividend stream completely and accurately

over the life of the company.

In the case of most equity shares, the dividend per share grows because of the growth in

earnings of a company. The growth in dividend can be categorized as nil or constant

growth or super normal growth. If we assume that the dividends are expected to grow at aconstant rate of g per cent per year, then:

DN = D0(1 + g )N

Where,

DN = dividend at the end of year ND0 = dividend for year 0

g = constant growth rate in dividend

The equation (1) can now be rewritten as,

D1 D1(1+ g ) D1(1+ g )2 D1(1+ g )

P0 = + + ... +(1 + ke) (1 + ke)

2 (1 + ke)

3 (1 + ke)

The above equation can be simplified to:

D0(1+g) D1

P0 = =keg keg

Solving the above equation for kewe get

D1ke = + g


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Realised Yield Approach

According to this approach, the past returns on a security are taken as a proxy for the

return required in the future by the investors. The assumptions behind this approach are

that (a) the actual returns have been in line with the expected returns, and (b) theinvestors will continue to have the same expectations from the security.

The realised return over a n year period is calculated as (W1x W2x .Wn)1/n

1

Where Wtis referred to as the wealth ratio. The wealth ratio Wtis calculated as,

Dt+ Pt

Wt = and t = 1,2,.n.Pt-1

Dt = Dividend per share for year t payable at the end of yearPt = Price per share at the end of year t.

Earnings Price Ratio Approach (or Earnings-Capitalization Approach)

According to this approach, the cost of equity can be calculated as the ratio of expected

earnings (E1) to current market price (P) of a share. Thus cost of equity

ke = E1/P

Where,

E1 = expected EPS for the next year

P = current market price per share

E1can be arrived at by multiplying the current EPS by (1 + growth rate).

This method provides meaningful results in the following two cases:

The dividend payout ratio of the firm is 100% and

If the dividend payout ratio of the firm is less than 100 per cent, then the

retained earnings are expected to earn a rate of return equal to the cost of equity.

The method can be used only in the case of stable and matured firms. In the case of

growth firms the method gives unreliable estimates.

Bond Yield Plus Risk Premium Approach


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The logic behind this approach is that the return required by the investors is directly

based on the risk profile of a company. This risk profile is adequately reflected in the

return earned by the bondholders. Since the risk borne by the equity investors is higherthan that by the bondholders, the return earned by them should also be higher. Hence this

required rate of return on equity capital can be calculated as:

Required rate of return on equity = Yield on long-term bonds of the company + RiskPremium.

The risk premium is arrived at after considering the various operating and financial risksfaced by the firm.

Cost of Retained Earnings

When a firm earns profit, it can either retain the profit for reinvestment or pay it as

dividend to its shareholders. If a firm pays its earnings as dividend, the same will be

available to the shareholders for investment elsewhere and earn further income. On theother hand, if the firm retained part of its earnings for future investment, instead of

paying it as dividend, the shareholders will have to forgo an opportunity to earn further

return by investing the same. Since this opportunity cost of shareholders is their expected

return on equity, the cost of retained earnings is the same as the cost of equity. As aresult, the cost of retained earnings simply represents shareholders expected return from

the firms equity shares. Viewing retained earnings as the cost of equity shares we can set

the firms cost of retained earnings Krto be equal to cost of equity capital.

i.e. Kr = Ke

It is important to note that retained earnings are internally generated capital. Since theyare not raised through new issue of shares, they do not incur flotation costs. Thus, no

adjustment is required for flotation costs in the case of the retained earnings. Because of

this the cost of retained earnings is always less than the cost of new issue of commonstock.

Flotation Costs

Flotation costs are costs incurred for issuing a security. These costs include underwriting

commission, brokerage and other issuing expenses like legal charges and fees paid to

investment bankers. Flotation costs are incurred for all public issues of debentures,preference shares and equity shares. While determining cost of capital, adjustment should

be made for flotation costs.

Costs of New Issue of Equity Shares or Cost of External Equity

Costs of new issue of equity shares, otherwise known as Cost of external equity, comes

into picture when there are certain floatation costs involved in the process of raisingequity from the market. It is the rate of return that the company must earn on the net


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funds raised, in order to satisfy the equityholders demand for return. Under the dividend

growth model, the following formula can be used for calculating the cost of external

equity:

D1Ke = + g

P0(1f )

Where,

Ke = cost of external equity

D1 = dividend expected at the end of year 1

P0 = current market price per share andg = constant growth in dividend.

f = flotation costs as percentage of the current market price.

For all other approaches, the following formula can be used:

Ke = ke/ (1f )

Where,

Ke = cost of external equity

ke = rate of return required by the equity investor

f = flotation costs as percentage of the current market price.

If flotation cost is given in amount instead of as a percentage, the adjustment for flotationcost involves finding out the net proceeds from issue. The net proceeds from issue will be

the market price of the security minus the flotation cost.

Weighted Average Cost of Capital (WACC)

A firm uses various sources of finance to finance its projects. Each source of finance will

be having a specific cost. So in order to determine the overall cost of capital of the firm,

the weighted average cost of individual sources of finance should be determined with theweights being the proportion of each type of capital used.

The weighted average cost of capital (WACC) is defined as the weighted average of the

after-tax cost of various sources of finance, weights being the book value or market

values of each source of finance. If WACC represents the weighted average cost ofcapital or overall cost of capital then,

WACC = wdkd+ wpkp+ wtkt+ weke+ wrkr


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where,

WACC = weighted average cost of capitalkd = after-tax cost of debt

kp = cost of preferred stock

kt = after-tax cost of term loanke = cost of equitykr = cost of retained earnings.

wd = Proportion of total capital supplied by debt

wp = Proportion of total capital supplied by preferred stockwt = Proportion of total capital supplied by term loan

we = Proportion of total capital supplied by external equity

wd = Proportion of total capital supplied by retained earnings

If debt and equity are the only sources of finance used by the firm, the WACC can be

calculated as follows:

WACC = Cost of equity x Proportion of equity in the financing mix + Cost of debt x

Proportion of debt in the financing mix

i.e. WACC = wdkd+ wekeor

E D

WACC = ke x + kd xD + E D + E

Where,

D = proportion of debt in the financing mixE = proportion of equity in the financing mix

The weights used in determining the weighted average cost of capital of a firm arehistorical weights. Historical weights are based on a firms existing capital structure. The

use of these weights is based on the assumption that the firms existing capital structure is

optimal and therefore should be maintained in the future. Two types of historical weightscan be usedbook value weights and market value weights.

Book Value Weights

The use of book value weights in calculating the firms weighted cost of capital assumes

that new financings will be raised using the same method the firm used for its present

capital structure. The weights are determined by dividing the book value of each capital

component by the sum of the book values of all the long-term capital sources.

Market Value Weights


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Market value weights are determined by dividing the market value of each source by the

sum of the market values of all sources. The use of market value weights for computing a

firms weighted average cost of capital is more scientific than the use of book valueweights because the market values of the securities closely approximate the amount to be

received from their sale.

Steps in Calculation of WACC

The following steps are involved in calculation of WACC:

1. Determine the proportion of each source of finance in the capital structure to the

total capital.

2. Determine the after tax cost of each component of the capital structure.

3. Multiply the cost of each source of finance in the capital structure with itsrespective weights.

4. Determine the total of the products of the weights and cost of each source of

finance. The resulting figure is the WACC.

Interpretation of Weighted Average Cost of Capital

The interpretation of the weighted average cost of capital is straightforward. It is theoverall return the firm must earn on its existing assets to maintain the value of its shares.

It can also be interpreted as the required return on any investment by the firm that has

essentially the same risks as existing operations.

The weighted average cost of capital of a firm is the minimum return expected by the

investors from the firm and reflects the overall risk of the firm. Any project, which has

the same risk as the average risk of the firm will be evaluated by using WACC as thediscount rate. But what if a company is considering a project that is much riskier than the

average risk of the firm? Or what if a firm has divisions in several business lines that

differ in risk? It does not make sense for a company to use the same WACC to discountcash flows of projects and divisions with different risks. In such cases, multiple costs of

capital reflecting the risk of each project or division should be used to discount the cash

flows.

Importance of Weighted Average Cost of Capital

The weighted average cost of capital (overall cost of capital) is of utmost importance incapital structure planning and in capital budgeting decisions.

(a) Role of WACC in Capital structure planning

In capital structure planning a company strives to achieve the optimal capital structure in

order to maximize the value of the firm. The optimal capital structure occurs at a point

where the overall cost of capital is minimum.


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(b) Role of WACC in Capital Budgeting Decisions

Since overall cost of capital is the minimum rate of return required by the investors, thisrate is used as the discount rate or the cut-off rate for evaluating the capital budgeting

proposals.

CAPITAL STRUCTURE

The Capital structure of a company refers to the mix of the long-term finances used bythe firm. It is the financing plan of the company.

Importance of Capital Structure Decision

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

initially when it starts its operation and also subsequently whenever it has to raiseadditional funds for various new projects. Whenever a company needs to raise long-term

finance, it involves a capital structure decision because it has to decide the amount of

such finance to be raised as well as the sources from which it is to be raised.

Capital Structure decision Process

The capital structure decision process can be diagrammatically represented as:

Capital Budgeting Decision

Need for long-term sources of finance

Capital Structure Decision


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Debt-Equity Mix Selection of Source of Finance

Effect on Earnings Effect on risks to be Risk Cost Control Flexibility

per Share borne by investors

Effect on Cost of Capital

Optimal Capital Structure

Value of the Company

Factors affecting the Capital Structure (Factors determining Capital Structure)

There are many factors that affect the capital structure of a firm. Some of the important

factors that should be considered while designing the capital structure of a firm arediscussed below:

1. Risk

The capital structure of a firm should be designed in such a way that it keeps the total risk

of the firm to the minimum level.

The total risk of a firm consists of business risk, operating risk and financial risk.

Business risk may be defined as the variation in operating income of a firm due to

variation in the sales. Business risk is caused by such factors like economic cycle,business cycle, competitive settings, etc. Operating risk is caused due to the existence of

fixed cost in the total cost structure of a firm. Operating risk is measured by the operating

leverage. Financial risk may be defined as the variation in the earnings available to equity

shareholders due to the existence of debt capital in the overall capital structure of a firm.Financial risk is measured by the financial leverage.

While designing the capital structure, a firm should keep the total risk to the minimum.

Firms with high business or operating risk should opt a less levered capital structure, withreduced debt, in order to balance the business risk and financial risk. The impact of the

capital structure on the long-term solvency and financial risk should be assessed. Since,

increase in debt financing affects the solvency as well as the financial risk of the firm, theexcessive use of debt financing should be avoided.


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2. Control

The equity shareholders, being the owners of the company, are concerned about the

dilution of their control over the company. Financing by new issue of equity shares will

dilute the control of existing shareholders. If there is a dilution of control, themanagement may prefer to issue debt rather than equity shares to raise funds. So thecapital structure should involve minimum dilution of control of the company.

3. Flexibility

The flexibility of a capital structure refers to ability of the firm to raise additional capital

funds whenever needed to finance profitable and viable investment opportunities. The

capital structure should be one, which enables the firm to meet the requirements of thechanging situations. More precisely, flexibility means that a capital structure should

always have an untapped borrowing powers which can be used in conditions which may

arise any time future due to uncertainty of capital market, government policies, etc. Sothe capital structure of a company should be flexible to be able to meet the changing

conditions with a minimum cost and delay. The company should be able to raise funds

whenever the need arises and also retire debts whenever it becomes too costly to continue

with that particular source.

4. Profitability

A capital structure should be the most profitable from the point of view of equity

shareholders. Within the given constraints, that capital structure should be selected which

will increase the returns available to the equity shareholders.

Optimal Capital Structure

An optimal capital structure is that capital structure which will minimize the overall costof capital of the company. In other words, it is that capital structure which will maximize

the value of the firm. An optimal capital structure should have the following features:

(a)Minimum Risk:An optimal capital structure should keep the total risk of the firm to

the minimum level. It should not be a threat to the solvency of the company and

should ensure a proper balance between business risk and financial risk.

(b)Maximum Profitability:An optimal capital structure should be the most profitablecapital structure from the point of view of the equity shareholders. It should be that

capital structure which will maximize the value of the equity shareholders.

(c)Minimum Dilution of Control:An optimal capital structure should involve

minimum dilution of control of the company.(d)Maximum Flexibility:The optimal capital structure should be flexible to be able to

meet the changing conditions. It should have untapped borrowing powers which

would enable the firm to raise additional capital funds whenever needed to financeprofitable investment opportunities.


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Approaches for determining Optimal Capital Structure

The three most common approaches for determining the optimal capital structure are:

EBIT-EPS Approach Cash Flow Approach

Valuation Approach

EBIT-EPS Approach:In EBIT-EPS approach the impact of the various alternative

capital structures on the EPS of the company is analyzed. The capital structure, which

results in the highest EPS, will be selected as the optimal capital structure.

Cash Flow Approach:In this approach, the impact of alternative capital structures on

the ability of the firm to service its debt is analyzed. Ratios such as Debt Service

Coverage Ratio can be used for this purpose. The capital structure, which ensures the

payment of all debt obligations under any circumstances, is selected as the optimal capital

structure.

Valuation Approach:under this approach alternative capital structures are analyzed as

to their impact on the overall cost of capital and value of the firm. The capital structure,

which will minimize the overall cost of capital of the firm or maximize the value of thefirm, will be selected as the optimal capital structure.

Capital Structure Theories

Capital structure theories examine the relationship between capital structure and the value

of the firm. The capital structure theories are based on the following general assumptions:

1. A firm employs only two types of capitals: debt and equity.2. The total assets of the firm are given and there would be no change in the investment

decisions of the firm.

3. The net operating income of the firm is given and is not expected to grow.4. The firm has a policy of distributing 100 per cent of its earnings as dividend, i.e., it

follows 100 per cent dividend payout policy.

5. The business risk complexion of the firm is given and is constant and is not affectedby the financing mix.

6. The investors have the same subjective probability distributions of expected future

operating earnings of the firm.7. There are no corporate or personal income taxes.8. A firm can change its capital structure instantaneously without incurring any

transaction costs.

In our analysis of capital structure theories, the following legends will be used.

E = Total market value of equity shares


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D = Total market value of the debt

V = Total market value of the firm, i.e., V = D+E

I = Annual interest chargesEBIT = Earnings before interest and tax

NP = Net profit or profit after tax

D0 = Dividend paid by the company at time 0 (i.e., now)D1 = Expected dividend at the end of year 1 (from now)P0 = Current market price of the share

P1 = Expected market price of the share after 1 year

kd = After tax of cost of debtke = Cost of equity

k0 = Overall cost of capital, i.e., WACC.

Based on the above assumptions and some more stated as and when required, the cost ofdebt, equity and the firm are derived as follows.

Assuming that the debt capital is perpetual,

I

kd =

D

Based on the assumption of 100% dividend payout and constant earnings, cost of equity

NP

ke =

E

Given the net operating income to be constant, the cost of capital of the firm,

EBITko =

V

Where V = D + E

Since overall cost of capital kois the weighted average cost of capita, WACC, it may be

expressed as,

Kdx D kex E

ko = +(D + E) (D + E)

NET INCOME APPROACH


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O Leverage (degree)

From the graph it is clear that keand kdare constant for all levels of leverages. As the

leverage of a firm increases, the overall cost of capital of the firm, kodecreases since kdis

less than ke. This decrease in overall cost of capital of the firm will lead to an increase invalue of the firm. From the graph it is can be seen that kowill approach kdas the debt

proportion is increased. For an all equity firm kowill be equal to keand for an all debt

firm it will be equal to kd.

The NI approach suggests that a firm is able to increase its value, V, and lower its cost of

capital, ko, as it increases the degree of leverage. With a judicious use of the debt and

equity, a firm can achieve an optimal capital structure. This optimal capital structure isone at which the overall cost of capital, koof the firm is minimum and the value of the

firm, V, is maximum.

NET OPERATING INCOME APPROACH

The Net Operating Income (NOI) approach suggests that the firms overall cost of

capital, ko, and its value, V, are both independent of the leverage of the firm. Accordingto the Net Operating Income approach, the market value of the firm is not affected by the

change in capital structure of the firm and the capital structure is irrelevant in determining

the value of the firm. The key assumption of this approach is that the overall cost of

capital kois constant regardless of the degree of leverage. The NOI approach makes the

following specific assumptions:

1. The market capitalizes the value of the firm as a whole. Thus the proportion in whichdebt and equity have been used in the capital structure is not relevant in determining

the value of the firm.

2. The market uses an overall capitalisation rate, koto capitalize the net operatingincome. kodepends on the business risk of the firm. It is assumed that the business

risk of the firm remains unchanged and the overall cost of capital, koof the firm is

constant.

3. The cost of debt, kdis also constant.4. The use of more and more debt in the capital structure increases the risk of the

shareholders and thus results in the increase in the cost of equity capital i.e., ke. The

increase in keis such as to completely offset the benefits of employing cheaper debt.

5. There is no corporate tax.

The NOI is approach is based on the premise that the market values the firm as a whole

for a given risk complexion. Thus, for a given value of EBIT, the value of the firmremains same irrespective of the capital structure of the firm and instead depends on the


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overall cost of capital. Under NOI approach, the total value of the firm is found out by

dividing the net operating income (EBIT) by the overall cost of capital, ko. The market

value of equity, E, can be determined by subtracting the value of debt, D, from the totalmarket value of the firm V. i.e.,

EBIT

V = ko

and E = VD

The cost of equity capital, ke, is

EBIT - Ike =

VD

Where,

V = total market value of the firm, i.e., V = D + E

E = total market value of the equityD = total market value of the debt.

I = total interest payments

ke= cost of equityko = overall cost of capital, i.e. WACC

Thus, the NOI approach states that the financing mix is irrelevant for determining the

value of the firm. The value of the firm remains the same for all debt-equity mix.

The relationship between leverage and the cost of capital is presented graphically below:

Cost of keCapital (%)

ko


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kd

O Leverage (degree)

From the graph, it can be seen that the cost of debt kdand the overall cost of capital, ko,are constant for all levels of leverage. As the proportion of debt or financial leverage

increases, the risk of the shareholders also increases and thus the cost of equity capital, ke

also increases. However, the overall cost of capital, koremains constant because increase

in keis just sufficient to offset the benefits of cheaper debt financing.

Since NOI approach assumes that kois constant at all levels of leverage, this approach

suggests that there is no optimal capital structure. In other words, as the cost of capital isthe same for all capital structures, every capital structure is optimum.

TRADITIONAL APPROACH

The NI approach and the NOI approach hold extreme views on the relationship between

the leverage, cost of capital and the value of the firm. the traditional approach takes a

midway between these two approaches.

According to traditional approach, there exists an optimal capital structure for every firm.

At this capital structure, the overall cost of capital of the firm is minimized and the value

of the firm is maximized. The traditional viewpoint states that the value of the firmincreases with increase in financial leverage but up to a certain limit only. Beyond this

limit, the increase in financial leverage will increase its overall cost of capital also and

hence the value of the firm will decline.

Under the traditional approach, the cost of debt (kd) is assumed to be less than the cost of

equity. (ke). In the case of a 100 per cent equity firm, the overall cost of capital of thefirm (ko) is equal to the cost of equity (ke). But when cheaper debt is introduced in the

capital structure and the financial leverage increases, the cost of equity (ke) remains

constant as the equity investors expect a minimum leverage in every firm. The ke does not

increase even with increase in leverage. This constant keand kdmakes the koto fallinitially. But this position does not continue when leverage is further increased. The

increase in leverage beyond a limit increases the risk of the equity investors also and as a

result the kealso starts increasing. However, the benefit of use of debt may be so large

that even after offsetting the effects of increase in ke, the komay still go down or maybecome constant for some degree of leverages. However, if the firm increases the

leverage further, then the risk of the debt investor may also increase and consequently the

kdalso starts increasing. The already increasing keand the now increasing kdmakes the


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koto increase. Therefore the use of the leverage, beyond a point will result into an

increase in the overall cost of capital of the firm and a decrease in the value of the firm.

Thus, there is a level of financial leverage in any firm, up to which it favourably affectsthe value of the firm but thereafter if the leverage is increased further, then the effect may

be adverse and the value of the firm may decrease. In other words, a firm can be

benefited from a moderate level of leverage when the advantage of using debt (havinglower cost) outweighs the disadvantage of increasing ke(as a result of higher financialrisk).

The relationship between leverage and the cost of capital is presented graphically below:


ko

kd

O Leverage (degree)Optimal Capital

Structure

MODIGLIANI AND MILLER APPROACH

Modigliani and Miller (MM) approach states that the value of a firm and its cost of

capital are independent of its capital structure. In other words, according to Modigliani

and Miller, capital structure is irrelevant in determining the value of a firm. Modiglianiand Miller argue against the traditional approach and state that the relationship between

leverage and value of a firm is explained by the Net Operating Income (NOI) approach.

They have , in fact, restated the NOI approach by offering a behavioural justification for

having the cost of capital ko, remain constant throughout all degree of leverage. The MMmodel is based on the following assumptions:

Assumptions of the MM Model


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1. The capital markets are perfect and complete information is readily available to all

the investors free of cost.

2. The capital markets are frictionless and there are no transaction costs or flotationcosts.

3. All securities are infinitely divisible and no investor is large enough to affect the

market price of the securities.4. Investors are assumed to be rational and choose a combination of risk and return thatis most advantageous to them.

5. The firm has a given investment policy and is not subjected to change.

6. All investors have same probability distribution about the expected future earnings ofthe firm.

7. Firms can be grouped into equivalent return classes on the basis of their business

risks. All firms falling into one class have the same degree of business risk.

8. The personal leverage and the corporate leverage are perfect substitute.9. There is no corporate or personal income tax.

Based on the above assumptions MM derived the following three propositions.

Proposition I

MM proposition I states that the value of a firm is independent of its capital structure.

M & M proposition I states that the value of a firm is independent of its capital structure.

In other words it states that capital structure is irrelevant for the value of the firm. Thevalue of a firm depends upon its investment decision and not on how a firm chooses to

finance its investments. The right hand side of the balance sheet (asset side) creates value

and the left hand side of the balance sheet only determines how this value is sliced among

the investors.

One way to illustrate the MM proposition I is using a Pie model. Imagine two firms

identical in all respects, except in their capital structure. Their assets and operations areexactly the same. The only difference is in their capital structure; that is they use different

proportions of debt and equity to finance their operations.

The values of the two firms then can be represented in the form of Pies as shownbelow:

Value of firm Value of firm

Equity

40% Debt

60%

Debt

Equity 40%

60%


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The above figure shows two possible ways of cutting up the pie between equity slice, E,and the debt slice, D: 40% - 60% and 60% - 40%. However, the size of the pie in the

above figure is the same for both firms because the value of the assets is the same. This is

precisely what MM proposition I states: The size of the pie does not depend on how it issliced. In a perfect market, no matter how one slices the corporate pie between debt and

equity, there is a conservation of value, so that the sum of the parts is always the same. In

other words nothing is lost or gained in the slicing.

Thus, according to MM theorem, two firms, identical in all respects, except in their

capital structure, cannot command two different values. If that is not so, an arbitrageoperation will set in, driving the values of the two firms to equality. To prove their

argument, MM suggested an arbitrage process.

An arbitrage process involves undertaking two related actions simultaneously in order toderive a benefit. The benefit from the arbitrage may be either increased income fron same

level of investment or same income from a lesser investment.

The arbitrage process suggested by MM can be explained with the help of the following

example:

Consider two firms A and B identical in every respect except that firm A is not leveredand firm B is a levered firm with a 10% debt of Rs. 3,00,000 in its capital structure.

Assume further that both firms have the same net operating income (EBIT) of Rs.

1,00,000 and their cost of equity are 20%. According to traditional approach the value ofthe two firms would be different as shown below:

Firm A Firm B

EBIT Rs. 1,00,000 Rs.1,00,000

(-) Interest - 30,000

Net Profit 1,00,000 70,000

Equity capitalization rate, ke 0.20 0.20

Value of equity 5,00,000 3,50,000Value of debt - 3,00,000

Total value of firm, V 5,00,000 6,50,000

WACC, ko 20% 15.38%

Though, the unlevered firm A and the levered firm B are in the same risk class and have

the same net operating income, the market value of the levered firm B is higher than that

of the unlevered firm A. MM argue that this situation cannot continue for long and soon


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an arbitrage process will drive the values of the two firms equal. According to them, if

two firms are alike in all respects, except that they differ only in their capital structure, as

we have now, then investors will develop a tendency to sell the shares of the overvaluedfirm (creating a selling pressure) and to buy the shares of the undervalued firm (creating a

buying pressure). This, buying and selling pressures will continue till the two firms have

the same value.

The arbitrage process, which would make the values of the two firms, can be explained

by the following steps:

1) Suppose an investor is holding 10% of the equity share capital of the levered firm B.

Then the value of his ownership right will be Rs. 35,000, i.e., 10% of Rs. Rs.

3,50,000. Further, out of the total net profit of Rs. 70,000 of the firm, he will be

entitled to 10%, i.e., Rs. 7,000 per annum.2) In order to make a profit, suppose he now decides to convert his holdings from firm B

to firm A.

3)

He disposes of his 10% holding in firm B for Rs. 35,000 and acquires 10% holding inthe unlevered firm A.

4) In order to buy 10% holding in firm A he requires a total sum of Rs. 50,000 (10% of

Rs. 5,00,000) where as his proceeds from sale of holdings in firm B are only Rs.

35,000.5) The investor, thus, borrows Rs. 30,000 at 10%. This personal debt of the investor is

equal to 10% of the debt of the company B, his previous proportional ownership of

the company. This process would shift his corporate leverage in firm B to anequivalent personal leverage. The investor now has a total sum of Rs. Rs. 65,000 (i.e.,

the proceeds of Rs.35,000 from the sale of his 10% holdings in company B and the

proceeds of his personal borrowings of Rs.30,000).

6) Out of the total funds of Rs.65,000, he now invests Rs.50,000 in shares of company Ain order to buy 10% of the holdings of the company. Still he has funds of Rs.15,000

available with him. The net returns available to the investor from the firm A are:

Profit available from firm A (being 10% of net profit) Rs. 10,000(-) Interest payable @10% on Rs.30,000 borrowing 3.000

Net return 7,000

7) So, the investor is able to get the same return of Rs.7,000 from firm A also, which he

was receiving as an investor of firm B. He is also having funds of Rs.15,000 left overfor investment elsewhere. Thus, his total return may now be more than Rs.7,000

(inclusive of some return on the investment of Rs.15,000).

8) More over his risk is the same as before. Though his new outlet, i.e., firm A is an

unlevered firm (hence no risk), the position of the investor is levered because he hascreated a homemade leverage by borrowing Rs.30,000 from the market. In fact, he

has replaced the corporate leverage of firm B by his personal leverage.


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The above example shows that, the investor, who originally owns a part of the levered

firm and enter into the arbitrage process as above, will be better off selling the holding in

levered firm and buying the holding in unlevered firm using his home made leverage.

MM argue that this opportunity to earn extra income through arbitrage process will

attract many investors. The gradual increase in sales of the shares of the levered firm willpush its prices down and the tendency to purchase the shares of unlevered firm A willdrive its prices up. These selling and buying pressures will continue until the market

values of the two firms are equal. At this stage, the values of the levered and the

unlevered firms and their costs of capital will be the same. Thus the value of a firm andits overall cost of capital, ko, are independent of its capital structure.

Proposition II

MM proposition II states that a firms cost of equity capital is a positive linear function of

the firms capital structure.

MM proposition II states that the cost of equity of a firm is a positive linear function ofits capital structure. This proposition can be algebraically expressed as:

ke = ko+ ( kokd) x (D/E)where,

ke = Cost of equity of a levered firm

ko = Overall cost of capital of a firm or Cost of equity of an unlevered firm

kd = cost of debtD = Value of the debt

E = Value of the equity

So MM proposition II states that the cost of equity capital of a levered firm is equal to theoverall cost of capital of the firm (or cost of equity capital of an unlevered firm) plus a

risk premium related to the financial risk equal to the debt-equity ratio times the

difference between the overall cost of capital and the cost of debt.

The term ( kokd) x (D/E) in the preceding equation represents the financial risk

premium, that is, the premium related to the use of debt. In other words, Proposition II of

the MM model states that the cost of equity of a firm is a linear function of its capitalstructure. MM proposition II can be graphically represented as follows:



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ko

kd

O Leverage (D/E Ratio)

From the above graph, it is clear that as the financial leverage, measured by the debt-

equity ratio, increases, the cost of equity kealso increases due to increase in risk of the

equity holders. The overall cost of capital koremains constant for all levels of leverage.This implies that a tradeoff takes place between debt and equity: The advantages of using

cheaper debt are neutralized by the increasing costs of equity.

Note that, in the above graph, the overall cost of capital does not depend on the leverage

(debt-equity ratio); it is the same no matter what the debt-equity ratio is. This is another

way of stating MM proposition I: The firms overall cost of capital is unaffected by its

capital structure.

Proposition III

MM proposition III states that the cut-off rate for investments of a firm is equal to the

overall cost of capital (WACC) of the firm, which is independent of the capital structure.

In other words, according to MM proposition III, the cut-off rate for investments isindependent of the firms financing choice and depends only on the risk of the projects in

which investment is made. The proposition emphasizes the point that the weighted

average cost of capital of a firm is not affected by the firmsfinancing decisions, as both

investment and financing decisions are independent.

MM Propositions with Corporate Taxes

The irrelevance of capital structure rests on an absence of market imperfections To the

extent that there are capital market imperfections, however, changes in the capitalstructure of a company may affect the total value of the firm. That is to say, the firmsvaluation and cost of capital may change with changes in its capital structure. One of the


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most important imperfections is the presence of taxes. In this regard, we will examine

now the impact of corporate taxes on the value of the firm.

MM Proposition I with Corporate Taxes

Debt financing is advantageous to a firm when corporate tax is present. The reason is thatinterest on debt is a tax-deductible expense whereas dividends are not deductible for tax.

Consequently, the total amount of payments available to both debt holders and

stockholders is greater if debt is employed.

To illustrate this point, suppose the earnings before interest and taxes are Rs. 2,00,000 for

companies X and Y, and they are alike in every respect except in leverage. Company Y

has Rs. 5,00,000 in debt at 12 percent interest, whereas company X has no debt. If thecorporate tax rate is 40 percent for each company, we have:

Company X Company Y

Rs. Rs.

Earnings before interest and taxes 2,00,000 2,00,000Interest income to debt holders 0 60,000

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

Earnings before taxes 2,00,000 1,40,000

Taxes 80,000 56,000----------- -------------

Income available to shareholders 1,20,000 84,000

======= =======Income to debt holders plus income

To shareholders 1,20,000 1,44,000======= =======

Thus, total income to both debt holders and shareholders is larger for the levered

company Y than it is for the unlevered company X. Total income to all investors

increases by the interest payment times the tax rate. In our example this amounts to Rs.60,000 x 0.40 = Rs. 24,000. This figure represents the tax shield or tax savings on interest

payments, due to the existence of debt in the capital structure of the levered firm Y. If the

debt employed by the company is permanent (or perpetual), present value of the taxshield using perpetuity formula is,

D x kex t

Present value of the tax shield = ---------------

ke

Present value of tax shield = D x t = Debt x t


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Where,

D = Value of debt

t = Corporate tax rateke = Cost of debt

Note that the discount rate used is cost of debt, because the tax shield is generated bypaying interest on debt and so it has the same risk as the debt. So the appropriate discount

rate is ke. Thus the value of a levered firm is:

Value of a levered firm = Value of an unlevered firm + Value of tax shield.

Thus, debt financing will increase the value of the firm by an amount equal to the present

value of the tax shield on the interest payments. In general, when corporate taxes are

considered the value of the firm that is levered would be equal to the value of theunlevered firm increased by the tax shield associated with the debt. That is,

VL = VU+ Debt x (t)

Where,

VL = value of the levered firm

VU = value of the unlevered firm

Debt = total debt raised by the levered firmt = corporate tax rate.

Criticisms of MM modelOne of the important assumptions of MM theory is that capital markets are perfect. So the

irrelevance of capital structure in valuation of a firm, as postulated by MM hypothesis,

rests on the absence of the capital market imperfections. However, in the face ofimperfections in the capital markets, the capital structure of a firm may affect the

valuation of the firm; i.e., the firms value and cost of capital may change with changes in

its capital structure. The following imperfections of the capital markets will affect the

value of the firm:

(a)Bankruptcy Costs

Existence of bankruptcy costs is another important imperfection affecting the capital

structure. Capital markets when perfect, has no costs associated with the bankruptcy.Assets of a bankrupt firm can be sold at their economic values and legal and


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administrative expenses are not present. However, in the real world, there are costs

associated with bankruptcy. Under distress conditions, assets are sold at a significant

discount below their economic values. Moreover, costs like legal and administrative costsassociated with bankruptcy proceedings are high.

The probability of bankruptcy for a levered firm is higher than that for an unlevered firm.

The probability of bankruptcy increases as the debt-equity ratio increases. This meansthat the expected cost of bankruptcy increases when the debt-equity ratio increases.Investors expect a higher rate of return from a firm which is faced with the prospect of

bankruptcy, as bankruptcy costs represent a loss that cannot be diversified away.

The following figure is a graphical representation of the relationship between the required

rate of return on equity, ke, and the leverage ratio, D/E.

Required rate

of return ke

on equity

Premium for

Financial risk

Premium for

Business risk

Risk free rate

O Leverage D/E

Agency Costs

Another set of market imperfections that make the debt-equity mix relevant to the firms

value is agency costs. Agency costs are costs due to conflict of interest. Agency costs

arise when the interests of stockholders conflict with those of the bondholders or themanagers.

Firstly, conflict between shareholders and managers arise because managers are not

entitled to 100% of the residual claims. Consequently the managers do not capture theentire gain from the profit enhancement activities, but they do bear the entire costs of

these activities. The managers may, therefore, put in less efforts in value enhancement

activities and may also try to maximise their private gains through lavish perquisites,


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plush offices, empire building through sub-optimal investments. These inefficiencies

decrease with the increase in the managers stakes in the firm.

Secondly, conflicts also arise between the interests of debt holders and equity holders. If

an investment financed with debt yields high return (higher than the cost of debt), equity

holders are entitled to the gains. On the other hand, if the investment fails, the debtholders suffer the losses due to limited liability of the equity holders. As a result, equityholders may benefit from investing in very risky projects even if they are value

decreasing. Such investments result in a decline in the value of debt. The loss in the value

of the equity from poor investments can be more than offset by the gains in equity valueat the expense of the lenders. The lenders to the firm protect themselves against

expropriation by imposing certain conditions on the firm. These conditions are called

protective covenants and remain in force till the debt is repaid. These conditions may

relate to restrictions on further borrowings by the firm, cap on payment on dividends,managerial remuneration, sale of assets, limitations on new investments, etc. these

conditions may lead to sub-optimal operations resulting in inefficiencies. Further, the

lenders put in place strong monitoring and corrective mechanisms to enforce the debtcovenants. The monitoring and enforcement costs are passed on to the firm in the form of

higher cost of debt (kd). These costs, together with the cost of inefficiencies (due to the

covenants) are called agency costs.

Monitoring costs are a function the level of debt in the capital structure. When the

amount of debt is considerably less, then the creditors may limit their monitoring activity.

But if the level of debt is high, then they may insist on continuous monitoring whichentails substantial costs. The agency cost may be virtually non-existent at low levels of

leverage. However, after the threshold point, the lenders start perceiving the firm to be

increasingly risky. This may result in a disproportionate increase in the agency costs due

to the need for extensive monitoring.

The agency costs are reduction in the value of the firm due to these conflicts. These

conflicts were assumed not to exist in Modiglianis and Millers perfect marketenvironment.

Critical Evaluation of MM Model

MM hypothesis states that the value of a firm is independent of its capital structure.

This conclusion of MM model is based on a set of assumptions, including existence of a

perfect and frictionless market. However many of these assumptions may not be valid inreal world. The following are the major objections or limitations of the model:

1. Non-Substitution of personal and corporate leverage: MM model assumes

that personal and corporate leverage are perfect substitutes. This may not be so

because of the following reasons:


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a. An individual normally cannot borrow at the same rate at which a

corporate can borrow, because the credit rating of a corporate firm would

be better than that of the individual.b. When an individual investor borrows money in his personal capacity, his

liability is unlimited. However, as a shareholder of a levered firm, his

liability is limited only to the capital subscribed irrespective of the level ofborrowings of the firm.

2. Transaction costs:MM model assumes that the market is frictionless with the

absence of transaction costs like brokerage. However, brokerage and othertransaction costs do exist, and they impede the arbitrage process assumed by MM.

3. Availability of complete information:MM model assumes a perfect capital

market with complete information available to all investors. In real world this

assumption is not valid.4. Corporate taxes:The MM model assumes that there is no corporate tax. This

assumption is also unrealistic in real world.

5.

Costs of Financial distress and Agency costs: MM model also assumes thatthere is no costs associated with financial distress and ignores agency costs. This

is also not correct.

CAPITALISATION

Meaning of Capitalisation

Capitalisation means the sum of the shares and debentures outstanding for a company.

Capitalisation also includes capital reserve and revenue reserve provided that the

company plans to retain them permanently. In the broadest sense, capitalisation means

the sum of all long-term sources of funds of a company, i.e., the sum of the shareholdersfunds and long-term debt funds.

The total value of capitalisation of a company can be determined either by taking the total

cost of fixed assets and working capital or by capitalizing the operating earnings of a

company at the overall cost of capital of the company.

Over-Capitalisation

Over-capitalisation is a situation where:

(a)

the aggregate of the par values of shares and debentures of a company exceedsthe true economic values of its fixed assets or

(b)the capitalized value of the operating earnings of the company, capitalized at thenormal rate of return for similar companies in the same industry, is less than the

aggregate value of the shares and debentures of the company.

Causes of Over-Capitalisation


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Some of the factors, which lead to over-capitalisation, are discussed below:

1. Diversity between book value and real worth of assets:Some times, the value ofthe assets of a company has no relevance to its earning capacity. This might happen

when the assets of a company are revalued at higher prices on merger. This results in

the book value of the company being more than its real worth.2. Existence of Non-Productive Assets:Existence of non-productive assets willdepress the operating earnings of the company, thereby leading to over-capitalisation.

Examples will be existence of fictitious intangible assets like patents, goodwill, etc.

3. Low Operating Efficiency and Under-Utilisation of Capacity:Lower operatingefficiency and under utilization of capacity will lead to lower productivity and higher

operating cost. This will depress the operating earnings of a firm, thus leading to

over-capitalisation.

4. High Financial Leverage and Gearing:High financial leverage indicates, excessivereliance on debt. When the return on investment is less than the cost of debt, this

might lead to reduction of earnings leading to over-capitalisation.

5.

Effect of Inflationary Conditions:Inflationary conditions results in higher operatingcosts, thereby depressing the operating profits. Inflationary conditions also result in

higher capital cost for procuring new assets. The depressed operating earnings and

higher capital cost for additional investments under inflationary conditions lead to

over-capitalisation.6. Technological Obsolescence:Technological obsolescence of assets lead to depressed

operating earnings, due to lower operating revenue and productivity and higher

maintenance cost. These reduced operating earnings will result in over-capitalisation.

Under-Capitalisation

Under-capitalisation is a situation where:

(a) the true economic values of the fixed assets of a company exceed the aggregate

of the par values of shares and debentures of the company or(b)the capitalized value of the operating earnings of the company, capitalized at the

normal rate of return for similar companies in the same industry, is more than

the aggregate value of the shares and debentures of the company.

When a company is earning an extraordinarily large return on its outstanding stock, it is

said to be undercapitalized. When the real worth of the assets of a company exceeds their

book value and the rate earnings of the company is higher than the normal rate ofearnings of similar companies in the same industry, it is a situation of under-

capitalisation.

Causes of Under-Capitalisation

Some of the factors leading to under-capitalisation are as follows:


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