UNIVERSITY OF CENTRAL PUNJAB

FALL 2020

FALL 2020
Course Title: Financial strategy
Course Code: IVA5833

Assignment No. 1
Name of Course Instructor: Marriam Rao

Submitted by: Ayesha Hamid

Section: B Program: BSAF Date: 05-11-2020

Submission Date: 13-11-2020 Maximum Marks: 25

Program Objective:
Course Objective: CO1 Course Learning Objective: CLO2
PO2

Instructions: Plagiarism would be checked. Please submit soft as well.

Assignment Topic & Details: Capital Structure

 QUESTION NO 1:

Contrast the net operating income (NOI) approach with the Traditional approach theory
of capital structure. Explain with help of graph.

Net Operating Income (NOI) Approach:

Net Operating Income Approach to capital structure believes that the value of a firm is not

affected by the change of debt component in the capital structure. It assumes that the benefit that
a firm derives by infusion of debt is negated by the simultaneous increase in the required rate of
return by the equity shareholders. With an increase in debt, the risk associated with the firm,
mainly bankruptcy risk, also increases and such a risk perception increases the expectations of
the equity shareholders.  Net operating income approach can be represented by the following
formula. WACC = EBIT / (Value of firm)
Assumptions:
- WACC is always constant, and it depends on the business risk.
- Value of the firm is calculated using the overall cost of capital i.e. the WACC only.
- The cost of debt (Kd) is constant.
- Corporate income taxes do not exist.
NOI propositions (i.e. school of thought):
- The use of higher debt component (borrowing) in the capital structure increases the risk
of shareholders.
- Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher
cost of equity (Ke)
- A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of debt
(Kd )
- In other words, the finance mix is irrelevant and does not affect the value of the firm.
Diagrammatic representation of NOI approach to capital structure:
TRADITIONAL APPROACH:

The traditional approach to capital structure advocates that there is a right combination of equity
and debt in the capital structure, at which the market value of a firm is maximum. As per this
approach, debt should exist in the capital structure only up to a specific point, beyond which, any
increase in leverage would result in the reduction in value of the firm.

It means that there exists an optimum value of debt to equity ratio at which the WACC is the
lowest and the market value of the firm is the highest. Once the firm crosses that optimum value
of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above
the threshold, the WACC increases and market value of the firm starts a downward movement.

ASSUMPTIONS UNDER TRADITIONAL APPROACH: 

- The rate of interest on debt remains constant for a certain period and thereafter with an
increase in leverage, it increases. 
- The expected rate by equity shareholders remains constant or increase gradually. After
that, the equity shareholders start perceiving a financial risk and then from the optimal
point and the expected rate increases speedily.
- As a result of the activity of rate of interest and expected rate of return, the WACC first
decreases and then increases. The lowest point on the curve is optimal capital structure. 

DIAGRAMMATIC REPRESENTATION OF TRADITIONAL APPROACH TO

CAPITAL STRUCTURE:
 QUESTION NO 2:
Why might you suspect that the optimal capital structure would differ significantly from
one industry to another? Would the same factors produce differing optimal capital
structures within all industry groupings?

Some of the most important reasons why the debt-to-equity (D/E) ratio varies significantly from
one industry to another, and even between companies within an industry, embody different
capital intensity levels between industries and whether the nature of the business makes carrying
a high level of debt easier to manage.

Yes, the same factors would produce differing optimal capital structures among all industry
groupings because the industries that generally have the highest D/E ratios include Capital-
intensive industries, like oil and gas refinement or telecommunications, need significant financial
resources and huge amounts of money to produce goods or services. Wholesalers and service
industries are among those with the lowest.

For example, the telecommunications industry has to create very substantial investments in
infrastructure, installing thousands of miles of cables to provide customers with service. Beyond
that initial capital expenditure, necessary maintenance, upgrades, and growth of service areas
need further major capital expenditures. Industries like telecommunications or utilities require a
corporate to make a large financial commitment before delivering its initial goods or services and
generating any revenue.

QUESTION NO 3:
What factors determine the interest rate a firm must pay for debt funds? Is it reasonable to
expect this rate to rise with an increasing debt-to-equity ratio? Why?

One of the main factors used to determine the interest rate of a firm for debt funds is Debt Equity
ratio. The Debt Equity ratio relates the amount of a firm’s debt financing to its equity. To
calculate the debt equity ratio, divide a firm's total liabilities by total shareholder equity both
items are found on a company's balance sheet. The company’s capital structure is the driver of
the debt-to-equity ratio. The more debt accompanies uses, the higher the debt-to-equity ratio will
be.
At point A, we see a capital structure that has a low amount of debt and a high amount of equity,
resulting in a high WACC. At point B, we see the opposite: a capital structure with a high
amount of debt and a low amount of equity – which also results in high WACC. In order to
minimize WACC, the capital structure must consist of a balanced combination of debt and
equity.

Yes, it is reasonable to expect this rate to rise with an increasing debt-to-equity ratio. As a
business takes on more and more debt, its probability of defaulting on its debt increases. This is
because more debt equals higher interest payments. If a business experiences a slow sales period
and cannot generate sufficient cash to pay its bondholders, it may go into default. Therefore, debt
investors will demand a higher return from companies with a lot of debt, in order to compensate
them for the additional risk they are taking on. This higher required return manifests itself in the
form of a higher interest rate. Thus, financing purely with debt will lead to a higher cost of debt,
and, in turn, a higher WACC.

QUESTION NO 4:
What is the total-value principle as it applies to capital structure?

The total value principle allows for company borrowing and excludes personal borrowings via
arbitrage. The total value principle must hold or else arbitrage will take place and then its
presence will cause the value to stay constant no matter the capital structure.

Modigliani and Miller (M&M) in their original position advocate that the relationship between
financial leverage and the cost of capital is explained by the net operating income approach.
They create a formidable attack on the traditional position by providing behavioral justification
for having the firm’s overall capitalization rate, ko, remain constant throughout the whole range
of financial leverage possibilities. M&M argue that the total risk for all security holders of a firm
is not altered by changes in the firm’s capital structure. Therefore the total value of the firm must
be the identical, regardless of the firm’s financing mix. Simply put, the M&M position is based
on the idea that no matter how you divide up the capital structure of a firm among debt, equity,
and other claims, there is a conservation of investment value. That is, because the total
investment value of a corporation depends on its underlying profitability and risk, firm value is
unchanging with respect to changes in the firm’s capital structure. Thus, in the absence of taxes
and other market imperfections, the value of the total pie does not change as it is divided into
debt, equity, and other securities. This idea is illustrated with the 2 pie graphs. Different mixes of
debt and equity do not alter the overall size of the pie; in other words, the total value of the firm
stays the same.

QUESTION NO 5:
If there were no imperfections in financial markets, what capital structure should the firm
seek? Why are market imperfections important considerations in finance? Which
imperfections are most important?

If there were no imperfections in the financial markets, the firm should opt for an entirely
leveraged structure and if possible, a homemade leverage otherwise known as internal Debt as
proposed by the MM theory.

Market imperfections are important considerations in finance because in an imperfect market,

individual buyers and sellers can influence prices and production, there is no full disclosure of
information about products and prices, and there are high barriers to entry or exit in the market.
The market imperfections theory asserts that the competition is not perfect. There will always be
corporations with advantages and superior qualities. Some corporations will offer better
products, have advantages in technology or information, or there is a barrier of entry for smaller
corporations. An example of this is the domination of the 6 major media corporations controlling
90% of what we see or hear in the news. These companies are GE, Viacom, News-Corp, Disney,
CBS, and Time Warner. In a perfect market these 6 corporations wouldn’t have this much
influence and power.

Market Imperfection theory states that there is no economy in the world which has a perfect
market. Economists earlier have used the perfect market competition theory to explain different
economic concepts. A perfect market has features which cannot exist in the real world such as:
  Each product is homogeneous.
 The taste and trend of the people is same or constant.
 Buyers and sellers are unlimited.

Basically, market imperfections theory states that the perfect market cannot exist and also
demand and supply can never be equal.
Market structures that are categorized as imperfect include monopolies, oligopolies,
monopolistic competition, monopsonies, and oligopsonies. Some examples of imperfect
markets:
 Monopolies and oligopolies: An organization could have established a monopoly, so
it would charge prices that would normally be considered so high. The same situation
arises in an oligopoly, where there are very few competitors that there is no point in
competing on price.
 State intervention: Governments may intervene in a market, usually to set prices
less than the actual market level (such as by subsidizing the price of oil). When this
happens, a large quantity is purchased. The reverse situation can also occur; where a
government imposes high regulatory barriers that very few companies are allowed to
compete.
 Monopolistic Competition: In monopolistic competition, there are many sellers who
offer same products that can't be substituted. Businesses compete with one another and
are price makers, but their particular decisions do not affect the other.
 Monopsony and Oligopsony: These systems have many sellers, but few buyers. In both
of these cases, the buyer is the one who manipulates market prices by playing firms
against one another.

QUESTION NO 6:

What are bankruptcy costs? What are agency costs? How do they affect the valuation of
the firm when it comes to financial leverage?

Bankruptcy Costs:

Within the theory of corporate finance, bankruptcy costs of debt are the increased costs of
financing with debt instead of equity that result from a higher probability of bankruptcy. The fact
that bankruptcy is generally a costly process in itself and not only has a transfer of ownership
implied that these costs negatively affect the total value of the firm.

Agency costs:

Agency costs are the costs of disagreement between shareholders and business managers.

Shareholders and managers often find themselves in disagreement about the best moves a
company can make, and this is known as the "agency problem." Costs stemming from agency
problems are agency costs.
There are two types of agency costs, but they each stem from that very same inherent tension
between shareholders and managers. The first type of agency cost is when managers use
resources to further their own goals—at the expense of shareholders' goals (like when a manager
books a luxurious hotel room during a business trip). The second type of agency cost is when
shareholders spend resources to monitor managers and ensure that the first type of agency cost
doesn't occur (like when shareholders must review all travel expenditures to ensure that
managers didn't book overly expensive hotels).

How these costs affect the valuation of the firm:

Modigliani and Miller assumed perfect capital markets; thus, a company would always be able to
rise funding and avoid bankruptcy. In the real world, a major disadvantage of a corporation
taking on high levels of debt is that there is a big risk of the company defaulting on its increased
interest payments and therefore being declared bankrupt. If shareholders and debt-holders
become concerned about the likelihood of bankruptcy risk, they ought to be compensated for this
additional risk. Therefore, the cost of equity and the cost of debt will increase, so the WACC will
increase and the share price reduces. It is interesting to note that shareholders suffer a higher
degree of bankruptcy risk as they come last in the creditors’ hierarchy on liquidation.

If this with-tax model is modified to take into consideration the existence of bankruptcy risks at
high levels of gearing, then an optimal capital structure emerges which is considerably below the
99.99% level of debt previously recommended.