Capital Structure Theories - (Part 2)

Capital structure
theories (Part 2)
Q.4. Assume a firm has EBIT of Rs.40,000. The firm has 10 per cent
debentures of Rs.1,00,000 and its current equity capitalization rate is
16 per cent. The current value of the firm and its overall cost of capital
is? In case the firm is considering increase in debentures by Rs.50,000
and using proceeds to retire equity, cost of debt would increase to 11
per cent and cost of equity to 17 per cent?
In case the firm is considering increase in debentures by Rs.1,00,000
instead of Rs.50,000 and using proceeds to retire equity, cost of debt
would increase to 12.5 per cent and cost of equity to 20 per cent?
5. Assuming no taxes and given the earnings before interest
and taxes (EBIT), interest (I) at 10% and equity capitalisation rate
(ke) below, calculate the total market value of each firm and
WACC.
Firms EBIT Interest ke (%)
X 200,000 20,000 12
Y 300,000 60,000 16
Z 500,000 200,000 15
W 600,000 200,000 18
6. Company X and Company Y are in the same risk class and are similar in every
respect except that Firm X uses debt while firm Y does not. The levered firm has
Rs.9,00,000 debentures carrying 10 per cent interest. Both firms earn 20 per cent
operating profit on their total assets of Rs.15 lakhs. Assume perfect capital
markets, rational investors so on; a tax rate of 35 per cent and capitalization rate of
15 per cent for an all equity firm.
(i) Compute the value of the firms X and Y using Net Income Approach.
(ii)Compute the value of each firm using the Net Operating Income Approach.
(iii)Using NOI approach, calculate the overall cost of capital (ko) for firms X & Y.
(iv)Which of these two firms has an optimal capital structure according to the NOI
approach? Why?
7. A company wishes to determine the optimal capital structure.
From the following selected information supplied to you,
determine the optimal capital structure of the company.
Situation Debt (Rs.) Equity After-tax cost Ke

(Rs.) of debt (%) (%)
1 400,000 100,000 9 10
2 250,000 250,000 6 11
3 100,000 400,000 5 14
8. A company’s current operating income is Rs.4 lakhs. The company has
Rs.10 lakhs 10% debt outstanding. Its cost of equity is estimated to be 15
per cent.
(i)Determine the current value of the firm using the Traditional Valuation
approach.
(ii)Calculate the overall capitalization rate and both types of leverage
ratios: B/S and B/V.
(iii)The firm is considering increasing its leverage by raising additional
Rs.5,00,000 debt suing proceeds to retire that amount of equity. As a
result of increased financial risk, cost of debt is likely to increase to
12% and cost of equity to 18 %. Would you recommend the plan?
Modigliani – Miller Model (MM)
Modigliani – Miller Model
(MM)
• MM supports the
approach NOI
• The capital structure (debt-equity mix)
has no effect on value of a firm.
• Further, MM model adds
the
behavioural justification
a in favour
of the NOI approach (personal
leverage)
Assumptions – MM Approach
• There are no taxes.
• There are no transaction cost for buying and selling securities, as well as
the bankruptcy cost.
• There is a symmetry of information. This means that an investor will
have access to the same information that a corporation would and
investors will thus behave rationally.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment
to merchant bankers, advertisement expenses, etc.
• There is no corporate dividend tax.
• MM Model proposition
– Value of a firm is independent of the capital structure.
– Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
– Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
• MM Model proposition –
– As per MM, identical firms (except capital structure) will have
the same level of earnings.
– As per MM approach, if market values of identical firms are
different, ‘arbitrage process’ will take place.
– In this process, investors will switch their securities between
identical firms (from levered firms to un-levered firms) and
receive the same returns from both firms.
Formulas in MM
Approach
Db = Mkt value of debt

Value Of The Firm(V) = Eq = Mkt value of
Db + Eq Equity
EBT = EBIT -
Market Value Of Equity (Eq)
Interest
EBT
= Ke Ke = Cost of
equity
Illustration:
• XYZ Ltd intends to set up a project with capital cost of Rs.
50,00,000. Its considering the three alternative proposal of
financing.
– Alternative 1 = 100% Equity
– Alternative 2 = Debt Equity 1:1
– Alternative 3 = Debt Equity 3:1
• The estimated annual net cash inflow is @ 24% on the project. The
rate of interest on debt is 15%.
• Calculate the WACC for three alternatives?
EBIT = 50,00,000*24% = 12,00,000
Particulars Alternative 1 Alternative 2 Alternative 3
Equity 50,00,000 25,00,000 12,50,000
Debt component (Db) 00 25,00,000 37,50,000
Total Capital 50,00,000 50,00,000 50,00,000
Net cash inflow from project @ 24% (EBIT) 12,00.000 12,00,000 12,00,000
12,00,000 – 12,00,000 –
12,00,000 – 0 =
EBT (EBIT- 15% Interest on debt) 3,75,000 = 5,62,500 =
12,00,000
8,25,000 6,37,500
Return on equity
24% 33% 51%
(EBT/ Total Equity*100)
Eq = EBT/Ke 5,000,000 2,500,000 12,50,000
V = Db + Eq 5,000,000 5,000,000 5,000,000
Return on debt ---- 15% 15%
WACC = (Ke x % of equity)+(Kd x % Debt) 24% 24% 24%
V = EBIT / WACC

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Capital structure

Situation Debt (Rs.) Equity After-tax cost Ke

Db = Mkt value of debt

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