Chapter 9: Capital Structure and

Valuation of the Firm

Introduction
Capital structure is the proportion of debt, equity and preference share capital on a firm’s balance
sheet.
Type of Fund Amount (₹) Proportion
Equity share capital 4,00,000 0.50
Preference Share Capital 2,00,000 0.25
Debt (Debentures/Bonds/Term Loan etc.) 2,00,000 0.25
Total 8,00,000 1.00
Theoretically, the financial manager should plan an optimum capital structure for his company.
The optimum capital structure is one that maximizes the value of the firm.

Elements of Capital Structure

The following are the important elements of the company’ financial structure that need proper
scrutiny and analysis:
1. Capital Mix: Firms have to decide about the mix of debt and equity capital. Debt capital can
be mobilized from a variety of sources. The firm and analysts use debt ratios, debt-service
coverage ratios, and the funds flow statement to analyze the capital mix.
2. Maturity and Priority: The maturity of securities used in the capital mix may differ. Equity
is the most permanent capital. Within debt, commercial paper has the shortest maturity and
public debt longest. Similarly, the priorities of securities also differ. Capitalized debt like
lease or hire purchase finance is quite safe from the lender’s point of view and the value of
assets backing the debt provides the protection to the lender. Collateralized or secured
debts are relatively safe and have priority over unsecured debt in the event of insolvency.
Do maturities of the firm’s assets and liabilities match? If not, what trade-off is the firm
making?
3. Terms and Conditions: Firms have choices with regard to the basis of interest payments.
They may obtain loans either at fixed or floating rates of interest. In case of equity, the firm
may like to return income either in the form of large dividends or large capital gains. What is
the firm’s preference with regard to the basis of payments of interest and dividend? How do
the firm’s interest and dividend payments match with its earnings and operating cash flows?
The firm’s choice of the basis of payments indicates the management’s assessment about the
future interest rates and the firm’s earnings.
There are other important terms and conditions that the firm should consider. Most loan
agreements include what the firm can do and what it can’t do. They may also state the
scheme of payments, pre-payments, renegotiations etc. What are the lending criteria used
by the suppliers of capital? How do negative and positive conditions affect the operations of
the firm? Do they constraint and compromise the firm’s operating strategy? Do they limit or
enhance the firm’s competitive position? Is the company level to comply with the terms and
conditions in good time or bad time?
4. Currency: Firms in a number of countries have the choice of raising funds from the
overseas markets. The exchange rates fluctuations can create risk for the firm in servicing
its foreign debt and equity. The financial manager will have to ensure a system of risk
hedging.
5. Financial Innovations/Financial Engineering: Firms may raise capital either through the
issue of simple securities or through the issues of innovative securities. Financial
innovations are intended to make the security issue attractive to investor and reduce cost of
capital. The financial manager will have to continuously design innovative securities to be
able to reduce the cost.
6. Financial Market Segments: There are several segments of financial markets from where
the firm can tap capital. For example, a firm can tap the private or the public debt market for
Chapter 9, Capital Structure: 1
 raising long term debt. What segments of financial markets have the firm tapped for raising
funds and why? How did the firm tap and approach these segments?

Capital structure decisions and value of the firm

According to some authors the capital structure decisions affect the value of the firm. But some
others proposed that capital structure decisions do not affect the value of the firm. Here are some
theories given by eminent authors which explains the effect of capital structure decisions on the
value of the firm—
(a) Debt Equity Ratio Analysis
(b) EBIT-EPS Analysis
(c) Financial and NEDC (Non-employment of debt capital)
(d) Net Income Approach
(e) Net Operating Income Approach
(f) Modigliani and Miller Approach
(g) Weighted Average Cost of Capital (WACC) Approach or Traditional Approach
(h) Static Trade-off Theory (Merton and Miller Argument)
(i) Financial Distress and Agency Cost
(j) Durand’s Hypothetical View
(k) Pecking Order Theory
(l) Modified Pecking Order Theory
(m) Solomon Ezra’s View
(n) Capital Asset Pricing Model (CAP-Model)

General Assumptions
1. There are only 2 sources of funds used by a firm—perpetual risk less debt and ordinary
equity shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend payout ratio is 100%. This means there are no retained earnings. So, growth
rate is also zero i.e. 𝑔 = 0.
4. Total assets of the firm are given and do not change. In other words, total investment
decisions remain constant.
5. The total financing of the firm also remains constant. But the firm can change the proportion
of debt and equity.
6. The operating profits (EBIT) of the firm are not expected to grow.
7. All investors are assumed to have the same subjective probability distribution of the firm’s
expected EBIT.
8. Business risk is constant over time.
9. Perpetual life of the firm.

Definitions and symbols

𝑘𝑂 = Overall cost of capital 𝑘𝑒 = Cost of equity capital
𝑘𝑖 =Cost of debt (before tax) 𝑘𝑑 = Cost of debt (after tax)
𝑉 = Market value of the firm 𝑆 = Market value of the equity
𝐵 𝑜𝑟 𝐷 = Market value of debt
𝑁𝐼 = Net income available for equity shareholders
𝐸𝐵𝐼𝑇 = Earnings before interest and tax 𝐼 = Interest
𝑁𝐼 𝑁𝐼
𝑘𝑒 = ⇒𝑆=
𝑆 𝑘𝑒
𝐼 𝐼
𝑘𝑖 = ⇒ 𝐷 =
𝐷 𝑘𝑖
𝐼(1 − 𝑡) 𝐼(1 − 𝑡)
𝑘𝑑 = ⇒𝐷=
𝐷 𝑘𝑑
𝑁𝐼 𝐼 𝐸𝐵𝐼𝑇
𝑉 = 𝑆 + 𝐷 𝑜𝑟 𝑉 = + 𝑜𝑟 𝑉 =
𝑘𝑒 𝑘 𝑖 𝑘𝑂

Chapter 9, Capital Structure: 2

 𝐸𝐵𝐼𝑇 𝐷 𝑆
𝑘𝑂 = 𝑜𝑟 𝑘𝑂 = 𝑘𝑖 [ ] + 𝑘𝑒 [ ]
𝑉 𝑉 𝑉
𝐷
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 )
𝑆
Performa Income Statement
Sales --------
Less: Variable Costs (------)
Contribution --------
Less: Fixed Operating Costs (------)
EBIT (Earnings before interest and tax) or Operating income --------
Less: Interest (𝐼) (------)
EBT (Earning before tax) --------
Less: Taxes at the Prescribed Rate (𝑡) (Ignore if tax rate is not given) (------)
EAT (Earning after tax) --------
Less: Dividend Paid to Preference Shareholders (𝐷𝑝 ) (------)
NI (Net income or earnings available for equity shareholders) --------

1. Net Income Approach

• This approach was given by the Davis Durand to explain the behavior of changing value of
firm and cost of capital due to change in the proportion of debt and equity or to explain the
effect of financial leverage on the value of the firm and cost of capital.
• According to the Davis Durand the use of debt is favorable to the firm and the value of firm
can be increased by employing debt in the capital structure even when there is no increase
in the EBIT of the firm. So, capital structure decision only is sufficient to change the value of
firm.
• Davis Durand also suggests that there is an optimum capital structure at which the value of
the firm (𝑉) is maximum and the cost of capital (𝑘𝑂 ) of the firm is minimum. An optimum
capital structure can be achieved at the level of almost 100% debt in the capital structure.
• Market value of firm=Market value of equity+Market value of debt i.e. 𝑉 = 𝑆 + 𝐷.
𝑁𝐼 𝐼
• 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = and Market v𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 = .
𝑘𝑒 𝑘𝑖

Assumptions
Davis Durand has given some assumptions to explain his theory. These are as follows—
(i) There are no corporate taxes.
(ii) The risk perception of the investors remains constant. This means they do not charge extra
interest rate on additional debt.
(iii) Cost of equity is always greater than the overall cost of capital i.e. 𝑘𝑒 > 𝑘𝑂 .

Graphical Representation
Y Y
ki / ke / kO

ke
₹

kO
ki

O X O X
Degree of Leverage (𝐷/𝑉) Degree of Leverage (𝐷/𝑉)

Chapter 9, Capital Structure: 3

Crux
(i) As we increase the proportion of debt in total funds, the V (value of the firm) increases and
ko (overall cost of capital) decreases.
𝐷
↑⇒ ⋯ ⋯ ⋯ 𝑘𝑂 ↓ ⋯ ⋯ ⋯ 𝑉 ↑ ⋯ ⋯ ⋯ 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 ↑ ⋯ ⋯ ⋯ 𝐸𝑃𝑆 ↑
𝑉
(ii) As we decrease the proportion of debt in total funds, the V (value of the firm) decreases and
ko (overall cost of capital) increases.
𝐷
↓⇒ ⋯ ⋯ ⋯ 𝑘𝑂 ↑ ⋯ ⋯ ⋯ 𝑉 ↓ ⋯ ⋯ ⋯ 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 ↓ ⋯ ⋯ ⋯ 𝐸𝑃𝑆 ↓
𝑉
From the perusal of the above it is clear that the use of debt in the capital structure is beneficial to
the valuation of the firm.

Proof
Let us assume that 𝐸𝐵𝐼𝑇 = ₹ 50,000; 𝑘𝑒 = 0.125; 𝐷 = ₹2,00,000; 𝑘𝑖 = 0.10 and current market
price of a share is ₹100. Show how increase or decrease in debt by ₹1,00,000 affects the value of
firm, overall cost of capital, price of share and earning per share.
DECREASE IN DEBT PRESENT POSITION INCREASE IN DEBT
Particulars DEBT = ₹1,00,000 DEBT = ₹2,00,000 DEBT = ₹3,00,000
EBIT 50,000 50,000 50,000
Less: Int. @ 10% -10,000 -20,000 30,000
Net Income 40,000 30,000 20,000
𝑁𝐼 40,000 30,000 20,000
𝑆= = ₹3,20,000 = ₹2,40,000 = ₹1,60,000
𝑘𝑒 0.125 0.125 0.125
D (given) ₹1,00,000 ₹2,00,000 ₹3,00,000
𝑉 =𝑆+𝐷 ₹4,20,000 ₹4,40,000 ₹4,60,000

1𝐿 3.2 𝐿 2𝐿 2.4 𝐿 3𝐿 1.6 𝐿

𝐷 𝑆
𝑘𝑂 = 𝑘 𝑖 [ ] + 𝑘𝑒 [ ]
0.10 [ ] + 0.125 [ ] 0.10 [ ] + 0.125 [ ] 0.10 [ ] + 0.125 [ ]
𝑉 𝑉 4.2 𝐿 4.2 𝐿 4.4 𝐿 4.4 𝐿 4.6 𝐿 4.6 𝐿
= 0.1190 = 0.1136 = 0.1087

𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = 2,400 𝑠ℎ𝑎𝑟𝑒𝑠 ₹2,40,000 = 2,400 𝑠ℎ𝑎𝑟𝑒𝑠

𝑆 ₹1,00,000 = ₹1,00,000
= + ₹100 −
𝑃0 ₹100 = 2,400 𝑠ℎ𝑎𝑟𝑒𝑠 ₹100
= 3,400 𝑠ℎ𝑎𝑟𝑒𝑠 = 1,400 𝑠ℎ𝑎𝑟𝑒𝑠

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 ₹3,20,000 ₹1,60,000

𝑆 = =
3,400 𝑠ℎ𝑎𝑟𝑒𝑠 ₹100 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝑔𝑖𝑣𝑒𝑛) 1,400 𝑠ℎ𝑎𝑟𝑒𝑠
=
𝑛 = ₹94.12 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ₹114.285 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

₹40,000 ₹30,000 ₹20,000

𝑁𝐼 = = =
𝐸𝑃𝑆 = 3,400 𝑠ℎ𝑎𝑟𝑒𝑠 2,400 𝑠ℎ𝑎𝑟𝑒𝑠 1,400 𝑠ℎ𝑎𝑟𝑒𝑠
𝑛 = ₹11.76 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ₹12.50 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ₹14.26 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 𝑛 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

2. Net Operating Income Approach

• This approach was given by the Davis Durand.
• This approach is opposite to the Net Income Approach.
• This approach states that the value of the firm (𝑉) and the overall cost of capital (𝑘𝑂 ) of the
firm are independent of the capital structure decisions. This means there is no relationship
between capital structure decisions and 𝑉 & 𝑘𝑂 .
• 𝑘𝑂 and 𝑉 remain constant irrespective of the degree of leverage.
• According to this approach, the market value of the firm depends upon the net operating
profit i.e. EBIT and the overall cost of capital i.e. WACC.
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 𝑖.𝑒. 𝐸𝐵𝐼𝑇
• Market value of firm= 𝑘 𝑖.𝑒.𝑊𝐴𝐶𝐶
𝑂

Chapter 9, Capital Structure: 4

 • 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 − 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 (𝑁𝐼) 𝐷
• 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒 ) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑆) 𝑜𝑟 𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) 𝑆

Assumptions
Davis Durand has given some assumptions to explain his theory. These are as follows—
1. kO and V are Constant: According to Davis 𝑘𝑂 and 𝑉 are constant, and are given. Value of
the firm may be computed by the given formula—
𝐸𝐵𝐼𝑇
𝑉=
𝑘𝑂
2. Residual Value of Equity: The value of equity is a residual value. Value of equity can be
computed by deducting the value of debt from the total value of the firm. Symbolically—
𝑆 =𝑉−𝐷
3. Change in the Cost of Equity(𝑘𝑒 ): Under this approach the 𝑘𝑒 is not constant. As we use the
additional debt then there arises a risk for the equity shareholders. In order to compensate
themselves they demand more dividends. As a result, the 𝑘𝑒 increases. Formula to calculate
𝑘𝑒 is—
𝐷
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 )
𝑆
4. Cost of Debt (𝑘𝑖 ): Cost of debt has 2 parts viz. explicit cost of debt and Implicit cost of debt.
a. Explicit Cost of Debt: It is the rate of interest paid by the firm on the debt.
b. Implicit Cost of Debt: Due to additional use of debt there arises a risk for equity
shareholders. Due to this 𝑘𝑒 increases and this increased 𝑘𝑒 is called implicit cost of
debt.
5. No taxes: Under this approach it is assumed that taxes are not there.
6. Optimum Capital Structure: Under this approach Davis Durand rejects his assumption
given under Net Income approach. According to him there is nothing like an optimum
capital structure. Any capital structure may be optimum at any level of debt and equity.

Graphical Representation
Y Y

ke
Value of the Firm (₹)
ki / ke / kO

kO
V

ki

O X O X
Degree of Leverage (𝐷/𝑉) Degree of Leverage (𝐷/𝑉)

Crux
(i) As we increase the proportion of debt in total funds, the 𝑉 (𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚) and
𝑘𝑂 (𝑜𝑣𝑒𝑟𝑎𝑙𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) remain constant but 𝑘𝑒 increases.
𝐷
↑ ⋯ ⋯ ⋯ 𝑘𝑂 , 𝑉 𝑎𝑛𝑑 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝑎𝑟𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑏𝑢𝑡 𝐸𝑃𝑆 𝑎𝑛𝑑 𝑘𝑒 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒.
𝑉
(ii) As we decrease the proportion of debt in total funds, the 𝑉 (𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚) and
𝑘𝑂 (𝑜𝑣𝑒𝑟𝑎𝑙𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙) remain constant but 𝑘𝑒 decreases.
𝐷
↓ ⋯ ⋯ ⋯ 𝑘𝑂 , 𝑉 𝑎𝑛𝑑 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝑎𝑟𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑏𝑢𝑡 𝐸𝑃𝑆 𝑎𝑛𝑑 𝑘𝑒 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒.
𝑉

Chapter 9, Capital Structure: 5

 Why the Value of the Firm Remains Constant
When there is debt in the capital structure then due to the effect of leverage the value of the firm
increases. But at the same time the increased risk to the equity shareholders due to use of debt
affects the value of equity adversely. As a result, there is decrease in the value of the firm. Hence
the value of the firm remains constant.
Finally, the
increase and
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜 𝑁𝐼 𝐴𝑝𝑝. : 𝑈𝑠𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑙𝑒𝑎𝑑𝑠 𝑡𝑜 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚
decrease in the
𝑎𝑛𝑑
values
𝐴𝑐𝑐𝑜𝑟𝑑𝑖𝑛𝑔 𝑡𝑜 𝑁𝑂𝐼 𝐴𝑝𝑝. : 𝑈𝑠𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑙𝑒𝑎𝑑𝑠 𝑡𝑜 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚
counterbalance
each other.

Proof
Let us assume that 𝐸𝐵𝐼𝑇 = ₹50,000; 𝑘𝑂 = 0.125; 𝐷 = ₹2,00,000; 𝑘𝑖 = 0.10 and current market
price of share is ₹100. Show how increase or decrease in debt by ₹1,00,000 does not affect the value
of firm, overall cost of capital and share price but affects the cost of equity and earning per share.
DECREASE IN DEBT PRESENT POSITION INCREASE IN DEBT
Particulars DEBT = ₹1,00,000 DEBT = ₹2,00,000 DEBT = ₹3,00,000
EBIT 50,000 50,000 50,000
Less: Int. @ 10% -10,000 -20,000 -30,000
Net Income 40,000 30,000 20,000
𝐸𝐵𝐼𝑇 50,000 50,000 50,000
𝑉= = ₹4,00,000 = ₹4,00,000 = ₹4,00,000
𝑘𝑂 0.125 0.125 0.125
𝐿𝑒𝑠𝑠: 𝐷 -₹1,00,000 -₹2,00,000 -₹3,00,000
𝑆 =𝑉−𝐷 ₹3,00,000 ₹2,00,000 ₹1,00,000

1𝐿 2𝐿 3𝐿
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 )
𝐷 0.125 + (0.125 − 0.10) 0.125 + (0.125 − 0.10) 0.125 + (0.125 − 0.10)
𝑆 3𝐿 2𝐿 1𝐿
= 0.1333 = 0.15 = 0.20

1𝐿 3𝐿 2𝐿 2𝐿 3𝐿 1𝐿
𝐷 𝑆
𝑘𝑂 = 𝑘 𝑖 [ ] + 𝑘𝑒 [ ]
0.10 [ ] + 0.1333 [ ] 0.10 [ ] + 0.15 [ ] 0.10 [ ] + 0.20 [ ]
𝑉 𝑉 4𝐿 4𝐿 4𝐿 4𝐿 4𝐿 4𝐿
= 0.1250 = 0.1250 = 0.1250

𝑁𝑜. 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = 2,000 𝑠ℎ𝑎𝑟𝑒𝑠 ₹2,00,000 = 2,000 𝑠ℎ𝑎𝑟𝑒𝑠

𝑆 ₹1,00,000 = ₹1,00,000
= + ₹100 −
𝑃0 ₹100 = 2,000 𝑠ℎ𝑎𝑟𝑒𝑠 ₹100
= 3,000 𝑠ℎ𝑎𝑟𝑒𝑠 = 1,000 𝑠ℎ𝑎𝑟𝑒𝑠

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 ₹3,00,000 ₹1,00,000

𝑆 = =
3,000 𝑠ℎ𝑎𝑟𝑒𝑠 ₹100 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (𝑔𝑖𝑣𝑒𝑛) 1,000 𝑠ℎ𝑎𝑟𝑒𝑠
=
𝑛 = ₹100 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ₹100 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

₹40,000 ₹30,000 ₹20,000

𝑁𝐼 = = =
𝐸𝑃𝑆 = 3,000 𝑠ℎ𝑎𝑟𝑒𝑠 2,000 𝑠ℎ𝑎𝑟𝑒𝑠 1,000 𝑠ℎ𝑎𝑟𝑒𝑠
𝑛 = ₹13.33 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ₹15 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = ₹20 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑠ℎ𝑎𝑟𝑒 𝑛 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

Chapter 9, Capital Structure: 6

3. Franco Modigliani and Merton H. Miller Approach/Model
(MM-Approach)
Introduction
Modigliani and Miller do not agree with the traditional view. They argue that, in a perfect capital
market without taxes and transaction costs, a firm’s market value and the cost of capital remain
invariant/constant to the capital structure changes. The value of a firm depends upon the earnings
and risk of its assets (business risk) rather than the way in which the assets have been financed.
There are 3 propositions given by MM—

Proposition-I
For firms in the same risk class, the total market value is independent of the debt-equity mix and is
given by capitalizing the expected net operating income by the capitalization rate (i.e. the opportunity
cost of capital) appropriate to that risk class.
𝑉𝐿 = 𝑉𝑈
𝑁𝑂𝐼 𝑜𝑟 𝐸𝐵𝐼𝑇
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 = ′
𝐹𝑖𝑟𝑚 𝑠 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑁𝑂𝐼 𝑜𝑟 𝐸𝐵𝐼𝑇
𝑉 = 𝑉𝐿 = 𝑉𝑈 =
𝑘𝑂
𝑉 = 𝑆 + 𝐵 𝑎𝑛𝑑 𝑁𝑂𝐼 = 𝐸𝐵𝐼𝑇 = 𝑋̅
Both 𝑉and 𝑘𝑂 are assumed to be constant with regard to the level of financial leverage.
For a Levered Firm For an Unlevered Firm
𝐸𝐵𝐼𝑇 = 𝐼𝑛𝑐𝑜𝑚𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝐵𝐼𝑇 = 𝐼𝑛𝑐𝑜𝑚𝑒 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠
+ 𝐼𝑛𝑐𝑜𝑚𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 ℎ𝑜𝑙𝑑𝑒𝑟𝑠

𝑆𝑜, 𝐸𝐵𝐼𝑇 = 𝑁𝐼 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑆𝑜, 𝐸𝐵𝐼𝑇 = 𝑁𝐼

𝑉 =𝑆+𝐵 𝑉=𝑆

𝑁𝑂𝐼 𝑜𝑟 𝐸𝐵𝐼𝑇 𝑁𝑂𝐼 𝑜𝑟 𝐸𝐵𝐼𝑇 𝑁𝑂𝐼 𝑜𝑟 𝐸𝐵𝐼𝑇

𝑘𝑂 = 𝑘𝑂 = 𝑜𝑟
𝑉 𝑉 𝑆
Since the values of L and U firms and the expected NOI do not change with financial leverage, the
WACC (𝑘𝑂 ) would also not change with financial leverage. Hence MM’s proposition-I implies that
the WACC for two identical firms, one levered and another unlevered will be equal to the
opportunity cost of capital.
𝑆𝑜, 𝑘𝑂 𝑜𝑓 𝐿 = 𝑘𝑂 𝑜𝑓 𝑈
𝑘𝑂𝐿 = 𝑘𝑂𝑈

The cost of capital under MM

proposition-I
𝑘𝑂 (%)

𝑘𝑂

𝐷
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 [ ]
𝑉

Arbitrage Process
Why should MM’s proposition-I should work? As stated earlier the simple logic of proposition-I is,
that two firms with identical assets, irrespective of how these assets have been financed, cannot
command different market values. Suppose this were not true and two identical firms, except for their
capital structures, have different market values. In such a situation, the Arbitrage (switching) will take place
Chapter 9, Capital Structure: 7
to enable investors to engage in the personal or homemade leverage as against the corporate leverage, to
restore the equilibrium in the market.

Assumptions
There are certain key assumptions given by the MM in order to explain the arbitrage process. These
are—
1. There is a perfect capital market. Perfect capital market is a market which possesses the
following characteristics—
a. Securities are infinitely divisible;
b. Investors are free to sell and buy securities;
c. Investors can borrow without restrictions on the same terms and conditions as the firm
can;
d. Information is perfect i.e. investors have complete knowledge of the market;
e. Investors are rational;
f. There are no transaction costs.
2. There is “homogenous risk class”. This means that the expected earnings of all the firms
have identical risk characteristics.
3. The dividend payout ratio is 100%.
4. There are no corporate taxes. This assumption is removed later.
5. All investors have the same expectations of firm’s net operating income (EBIT).

Explanation to the Arbitrage Process

1. MM proves Net Operating Income approach through the Arbitrage Process.
2. Arbitrage process means an act of buying an asset/security in one market (at lower price)
and selling it in another market (at higher price). As a result, equilibrium is established in
the market price of the security in different markets. The arbitrage process is essentially a
balancing operation. It implies that a security cannot be sold at different prices.
Actually, arbitrage process is an act of selling the shares of higher price and
purchasing the shares of a lower price.
3. Firms are divided in to 2 parts according to their leverage position—
a. Levered Firm (firm which uses debt in its capital structure)
b. Un-levered Firm (firm which does not use debt in its capital structure)
4. Firms are divided in to 2 parts according to their valuation—
a. Firm with higher valuation
b. Firm with lower valuation
5. The investors of the firm with higher value will sell their equity shares and buy the equity
shares of the firm the valuation of which is lower.
6. In this process they will earn the same income with the lower investment and will earn the
higher income with the same investment.
7. Homemade/Personal Leverage: If the investors need more funds to invest then they will
borrow from the market on the same terms and conditions as the firm can (see the
assumptions). This is called the personal or homemade leverage. He will borrow the funds
proportionate to his shareholding of the debt of the levered firm. Actually
homemade/personal leverage is a substitute for the corporate leverage. E.g. Suppose an
investor “A” has 10% shares in equity in the levered firm. Then he will borrow 10% of the
debt of the levered firm from the market. (Doing so will ensure that the financial risk
assumed by Investor “A” as a shareholder in the unlevered firm remains the same as it
would have been in the levered firm.)
8. How arbitrage process makes the value of the firms equal? The action taken by investor
“A” would be followed by other equity shareholders also and as a result there would be a
selling pressure on equity shares of the higher value firm and a buying pressure on equity
shares of the lower value firm. The selling pressure on equity shares of higher value firm
would result in a fall in market price of its equity shares whereas a buying pressure on
equity shares of lower value firm would increase the market price of its equity shares. Then
arbitrage process would come to an end when the value of both the firms would become
equal.

Chapter 9, Capital Structure: 8

Switching Over from One Firm to Another in the Arbitrage Process

(A) When the value of the levered firm is higher

(i) An investor will sell his investment in the levered firm.
(ii) He will borrow an amount equal to his shareholding percentage from the market.
(iii) He will purchase equity of the un-levered firm equal to percentage holding of equity in the
levered firm.
(iv) In this switching over process, he will earn the same income with the lower investment and
will earn the higher income with the same investment.
When investors sell their equity in levered firm and buy the equity in un-levered firm with
personal leverage, the market value of levered firm tends to decline and the market value of the un-
levered firm tends to rise. This process continues until the market value of both the firms become
equal because only then the possibility of earning a higher income, for a given level of investment
and leverage, by arbitraging is eliminated. As a result, the cost of capital for both the firms becomes
the same.

(B) When the value of the un-levered firm is higher

1. An investor will sell his investment in the un-levered firm.
2. He will buy securities of the levered firm equal to his % holding in the un-levered firm.
3. In the switching over process, he will earn the same income from the levered firm with the
reduced investment or higher income on same investment.

Example (Switching from Levered to Un-levered Firm)

Assume that there are 2 firms, L and U in the market. Both firms are identical in all respects except
that firm L has 10% ₹5,00,000 debentures. The EBIT of both the firms is ₹1,00,000. The 𝑘𝑒 for the
firm L is 16% and 12.5% for the firm U.
Particulars Firm “L” Firm “U”
EBIT ₹1,00,000 ₹1,00,000
Less: Interest (₹5,00,000 × 10%) ₹ 50,000 NIL
NI (Net Income) ₹50,000 ₹1,00,000

𝑘𝑒 16% 12.5%
𝑁𝐼
𝑆 (𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦) = ₹3,12,500 ₹8,00,000
𝑘𝑒
Add: D or B (Debt) ₹5,00,000 NIL
𝑉 =𝑆+𝐷 ₹8,12,500 ₹8,00,000
𝐸𝐵𝐼𝑇
𝑘𝑂 = 12.3% 12.5%
𝑉
Suppose Mr. Nivesh an investor holds 30% of the equity shares in firm “L”. He will sell his equity
shares in the firm “L” and will borrow additional funds on his personal account. Borrowing will be—
𝐷𝑒𝑏𝑡 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑖𝑛𝑔. He will earn same income with less
investment and will earn more income with the same investment.
Effect of arbitrage will be as follows—

(A) Mr. Nivesh’s position in firm “L” with 30% equity holding
(i) Investment outlay:
(₹3,12,500(𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝐿 𝑓𝑖𝑟𝑚) × 30%) ₹93,750
(ii) Dividend income:
(₹93,750(𝐼𝑛𝑣. ) × 16%(𝑘𝑒 )) 𝑜𝑟 (₹50,000(𝑁𝐼) × 30%(𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔)) ₹15,000

(B) Mr. Nivesh’s position in firm “U” with 30% equity holding
(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹93,750 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹1,50,000) ₹2,43,750
(ii) Investment outlay:
Chapter 9, Capital Structure: 9
 (𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹90,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹1,50,000) ₹2,40,000
Note:
1. 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐹𝑢𝑙𝑙 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑢𝑠𝑒𝑑.
(iii) Net income from the levered firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹2,40,000 × 12.5% (𝑘𝑒 )) 𝑜𝑟 (₹1,00,000 × 30% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹30,000.00
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹1,50,000 × 10%) = ₹15,000.00 ₹15,000
So, he is earning the same income with the reduced investment.

(C) Mr. Nivesh’s position in firm “U” if he invests the total funds available
(i) Investment outlay:
𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹93,750 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹1,50,000 ₹2,43,750
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹2,43,750 × 12.5% (𝑘𝑒 )) = ₹30,468.75
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹1,50,000 × 10%) = ₹15,000.00 ₹15,468.75
So, he is earning the more income with the same investment.

Example (Switching from Un-levered to Levered Firm)

Assume there are 2 firms, L and U in the market. Both firms all identical in all respects except that
firm L has 10% ₹5,00,000 debentures. The EBIT of both the firms is ₹1,00,000. The 𝑘𝑒 for the firm L
is 20% and 12.5% for the firm U.
Particulars Firm “L” Firm “U”
EBIT ₹1,00,000 ₹1,00,000
Less: Interest ₹50,000 NIL
NI (Net Income) ₹50,000 ₹1,00,000

𝑘𝑒 20% 12.5%
𝑁𝐼
𝑆 (𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦) = ₹2,50,000 ₹8,00,000
𝑘𝑒
Add: D or B (Debt) ₹5,00,000 NIL
𝑉 =𝑆+𝐵 ₹7,50,000 ₹8,00,000
𝐸𝐵𝐼𝑇
𝑘𝑂 = 13.33% 12.5%
𝑉
Suppose Mr. Nivesh an investor holds 30% of the equity shares in firm “U”. He will sell his equity
shares in the firm “U”. He will invest in equity shares and debt of the “L” firm. He will earn same
income with less investment and will earn more income with the same investment.
Effect of arbitrage will be as follows—

(A) Mr. Nivesh’s position in firm “U” with 30% equity holding
(i) Investment outlay:
(₹8,00,000 × 30%) ₹2,40,000
(ii) Dividend income:
(₹2,40,000(𝐼𝑛𝑣. ) × 12.5%(𝑘𝑒 ) 𝑜𝑟 (₹1,00,000(𝑁𝐼) × 30%(% 𝐻𝑜𝑙𝑑𝑖𝑛𝑔)) ₹30,000

(B) Mr. Nivesh’s position in firm “L” with 30% equity holding
(i) Total funds available: ₹2,40,000
(ii) Investment outlay:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 “𝐿” 𝐹𝑖𝑟𝑚 = ₹75,000
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 𝑜𝑓 “𝐿” 𝐹𝑖𝑟𝑚 = ₹1,50,000 ₹2,25,000
Note:
1. 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
= 𝐸𝑞. 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞. 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑑𝑒𝑏𝑡 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞. 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
(iii) Net Income from levered Firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹75,000 × 20%(𝑘𝑒 )) 𝑜𝑟 (₹50,000(𝑁𝐼) × 30% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹15,000
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑑𝑒𝑏𝑡 (₹1,50,000 × 10%) = ₹15,000 ₹30,000
So, he is earning the same income with the reduced investment.
Chapter 9, Capital Structure: 10
(C) Mr. Nivesh’s position in firm “L” if he invests the total funds available
(i) Investment outlay:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 “𝐿” 𝐹𝑖𝑟𝑚 = ₹80,000
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 𝑜𝑓 “𝐿” 𝐹𝑖𝑟𝑚 = ₹1,60,000 ₹2,40,000
Note: Divide the total funds in the ratio of Equity and Debt of Levered firm
₹2,50,000
1. 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 = ₹2,40,000 × = ₹80,000
₹7,50,000
₹5,00,000
2. 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑑𝑒𝑏𝑡 = ₹2,40,000 × = ₹1,60,000
₹7,50,000
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹80,000 × 20%(𝑘𝑒 )) = ₹16,000
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝑑𝑒𝑏𝑡 (₹1,60,000 × 10%(𝑘𝑖 )) = ₹16,000 ₹32,000
So, he is earning the more income with the same investment.

Proposition-II
As explained earlier that the value of the firm depends on the net operating income and the 𝑘𝑂 ,
which is same for levered and unlevered firms. In the absence of corporate taxes, the firm’s capital
structure (financial leverage) does not affect its net operating income. Hence, for the value of the
firm to remain constant with financial leverage, the opportunity cost of capital (𝑘𝑂 ) must also stay
constant with financial leverage. The 𝑘𝑂 depends upon operating risk. Since financial leverage does
not affect the firm’s operating risk there is no reason for the opportunity cost of capital, 𝑘𝑜 to
change with financial leverage.
As we know that financial leverage does not affect a firm’s net operating income but it does affect
the shareholders’ return (EPS and ROE (Return on equity)). EPS and ROE increase with the leverage
when the interest rate is less than the firm’s return on assets. Financial leverage also increases
shareholders’ financial risk by amplifying the variability of EPS and ROE.
Thus financial leverage causes two opposing effects—
(i) It increases the shareholders’ return; but
(ii) It also increases their financial risk.
So, shareholders will increase the required rate of return (i.e. the cost of equity) on their investment
to compensate for the increased financial risk. The higher the financial risk, the higher the
shareholders’ required rate of return or the cost of equity. So, this is the MM’s proposition-II.
Overall cost of capitals can be calculated using following formulae—

𝐹𝑜𝑟 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚: 𝑘𝑂𝑈 = 𝑘𝑒

𝐵 𝑆
𝐹𝑜𝑟 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚: 𝑘𝑂𝐿 = 𝑘𝑖 × + 𝑘𝑒 ×
𝑉 𝑉
MM’s proposition-II provides justification for the levered firm’s 𝑘𝑂 remaining constant with
financial leverage. It states that— “the cost of equity, 𝑘𝑒, will increase enough to offset the advantage
of cheaper cost of debt so that the 𝑘𝑂 , does not change”.
For a levered firm 𝑘𝑒 shall be calculated as follows—
A levered firm has financial risk while an unlevered firm is not exposed to financial risk. Hence, a
levered firm will have higher required return on equity as compensation for financial risk. So, the
𝑘𝑒𝐿 > 𝑘𝑂𝐿 . It should be equal to 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑘𝑂 + 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚.
𝐵 𝑆
𝑘𝑂 = 𝑘𝑖 × + 𝑘𝑒 × ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ [𝑉 = 𝐵 + 𝑆]
𝑉 𝑉
𝐵 𝑆
𝑘𝑂 − 𝑘𝑖 × = 𝑘𝑒 ×
𝑉 𝑉
𝐵 𝐵
𝑘𝑂 − 𝑘𝑖 × 𝑉 𝑘𝑂 − 𝑘𝑖 [ 𝐵 + 𝑆 ] 𝐵 𝑆
𝑘𝑒 = ⇒ 𝑘𝑒 = ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ ⋯ [ + = 1]
𝑆 𝐵 𝑉 𝑉
1 − [𝐵 + 𝑆 ]
𝑉

Chapter 9, Capital Structure: 11

 𝑘𝑂 (𝐵 + 𝑆) − 𝑘𝑖 × 𝐵 𝑘𝑂 𝐵 + 𝑘𝑂 𝑆 − 𝑘𝑖 𝐵
𝐵 + 𝑆 𝐵+𝑆 𝑘𝑂 𝐵 + 𝑘𝑂 𝑆 − 𝑘𝑖 𝐵 𝐵 + 𝑆
𝑘𝑒 = ⇒ 𝑘𝑒 = ⇒ 𝑘𝑒 = ×
(𝐵 + 𝑆 − 𝐵) 𝑆⁄ 𝐵 + 𝑆 𝑆
⁄(𝐵 + 𝑆) 𝐵+𝑆
𝑘𝑂 𝐵 + 𝑘𝑂 𝑆 − 𝑘𝑖 𝐵 𝑘𝑂 𝐵 − 𝑘𝑖 𝐵 + 𝑘𝑂 𝑆
⇒ 𝑘𝑒 = ⇒ 𝑘𝑒 = ⇒ 𝑘𝑒
𝑆 𝑆
𝐵(𝑘𝑂 − 𝑘𝑖 ) + 𝑘𝑂 𝑆 𝑘𝑂 𝑆 + (𝑘𝑂 − 𝑘𝑖 )𝐵 𝑘𝑂 𝑆 (𝑘𝑂 − 𝑘𝑖 )𝐵
= ⇒ 𝑘𝑒 = ⇒ 𝑘𝑒 = +
𝑆 𝑆 𝑆 𝑆
𝐵
⇒ 𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) ∎
𝑆
For an unlevered firm 𝑘𝑒 shall be calculated as follows—
𝐵 𝐵
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) ⇒ 𝑘𝑒 = 𝑘𝑂 + 0 ⇒ 𝑘𝑒 = 𝑘𝑂 (𝑠𝑖𝑛𝑐𝑒 𝑡ℎ𝑒𝑟𝑒 𝑖𝑠 𝑛𝑜 𝑑𝑒𝑏𝑡 𝑠𝑜, (𝑘𝑂 − 𝑘𝑖 )
𝑆 𝑆
= 0)∎

Example:
Suppose Alpha Limited is an all-equity firm having 10,000 equity shares the market value of which
is ₹1,20,000. EBIT is ₹18,000.
₹18,000
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝑃𝑆 = = ₹1.8 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
10,000 𝑠ℎ𝑎𝑟𝑒𝑠
Since it is an all-equity firm so it’s 𝑘𝑂 = 𝑘𝑒
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑁𝑂𝐼 ₹18,000
𝑆𝑜, 𝑘𝑂 = 𝑘𝑒 = ⇒ 𝑘𝑂 = = 𝑘𝑂 = 0.15
𝑉 =𝑆+𝐵 ₹1,20000
Let us assume that Alpha Limited is considering borrowing ₹60,000 at 6% per annum and buying
back 5,000 equity shares at the market value of ₹60,000. Now—
Equity (₹1,20,000–₹60,000) ₹60,000
6% Debt ₹60,000
Total ₹1,20,000
The change in the company’s capital structure does not affect its assets and net operating income.
However, EPS will change.
₹18,000 − ₹3,600 (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡)
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝑃𝑆 = = ₹2.88 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
5,000 𝑠ℎ𝑎𝑟𝑒𝑠
2.88 − 1.8
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝑃𝑆 = = 60% 𝑑𝑢𝑒 𝑡𝑜 𝑡ℎ𝑒 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒
1.8
The cost of equity will increase to compensate for the financial risk—
𝐵 60,000
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) ⇒ 𝑘𝑒 = 0.15 + (0.15 − 0.06) × ⇒ 𝑘𝑒 = 0.24
𝑆 60,000
𝐵 𝑆 60,000 60,000
𝑘𝑂 = 𝑘𝑖 × + 𝑘𝑒 × ⇒ 𝑘𝑂 = 0.06 × + 0.24 × ⇒ 𝑘𝑂 = 0.15
𝑉 𝑉 1,20,000 1,20,000
Since, the firm’s operating risk does not change its opportunity cost of capital i.e. 𝑘𝑂 still remains at
15%. Y
The crucial part of the proposition-II is that the
levered firm’s opportunity cost of capital will not ke
rise even if very excessive use of financial leverage
ki / ke / kO

is made. The excessive use of debt increases the

risk of default. Hence, in practice, the cost of debt, kO
𝑘𝑖 , will increase with high level of financial
leverage.
“MM argues that when 𝑘𝑖 increases, 𝑘𝑒 will increase ki
at a decreasing rate and may even turn down
eventually.” The reason for this behavior of 𝑘𝑒 , is
that debt-holders, in the extreme leveraged
O X
situations, own the firm’s assets and bear some of Degree of Leverage
the firm’s business risk. Since the operating risk of
shareholders is transferred to debt-holders, ke declines.

Chapter 9, Capital Structure: 12

Proposition-III
The cut off rate for investment purposes will be the WACC and it will be completely independent of the
type of source to finance the investments. WACC provides a guideline for optimum investment policy.
Therefore, for maximizing the shareholders’ wealth, the firm should use its WACC as cut off rate.

When there are taxes also

Proposition-I
If we introduce the corporate taxes then definitely, the levered firm will have higher earnings to be
distributed among equity shareholders as compared to unlevered firm. This is due to the tax
deductibility of the interest payments. The effective cost of debt will be less than the explicit rate of
interest because of tax benefits. The value of the levered firm (𝑉𝐿 ) would be higher than the
value of unlevered firm (𝑉𝑈 ) by an amount equal to the present value of the tax savings due
to tax deductibility of interest payment. The present value of the tax saving is equal to the
levered firm’s debts multiplied by tax rate. This is also known as tax shield of debt. Hence—
𝐸𝐵𝐼𝑇(1 − 𝑡)
𝑉𝑈 =
𝑘𝑂 𝑜𝑟 𝑘𝑒
𝑉𝐿 = 𝑉𝑈 + (𝐷 × 𝑡)
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 (𝑆)
= 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 (𝑉𝐿 ) – 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡𝑠 (𝐷)
Where,
𝑉𝑈 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚
𝑉𝐿 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚
𝐷 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡
𝑡 = 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒

Proposition-II
With increase in debt proportion in the capital structure, the cost of equity of levered firm will rise
due to the increase in financial risk perceived by the equity shareholders. However, it will rise at a
lesser rate than it would have risen in the absence of taxes. It will rise by the differential of overall
cost of all equity firm (𝑘𝑂 ) and the cost of debts (𝑘𝑑 ) and proportion of increase would be (1 − 𝑡)
times the market value of debt-to-equity ratio. However, its overall cost of capital will be lower.
𝑁𝐼 (𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑡)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 (𝑘𝑒𝐿 ) = ⇒ 𝑘𝑒𝐿 = 𝑜𝑟 𝑘𝑒𝐿
𝑆 𝑆
B B
= 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 (1 − t)) × ⇒ 𝑘𝑒𝐿 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑑 ) ×
S S
𝑂𝑣𝑒𝑟𝑎𝑙𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 (𝑘𝑂𝐿 ) = 𝑘𝑖 (1 − 𝑡 ) × 𝑊𝑑 + 𝑘𝑒 × 𝑊𝑒 ⇒ 𝑘𝑂𝐿
= 𝑘𝑑 × 𝑊𝑑 + 𝑘𝑒 × 𝑊𝑒
Where,
𝐵
𝑊𝑑 =
𝑉
𝑆
𝑊𝑒 =
𝑉
𝑁𝐼
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒𝑈 )𝑜𝑟 𝑂𝑣𝑒𝑟𝑎𝑙𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑘𝑂𝑈 )𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 =
𝑆
EBIT(1 − t)
⇒ 𝑘𝑒𝑈 or 𝑘𝑂𝑈 = … … … (𝐼𝑛 𝑐𝑎𝑠𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 𝑘𝑒𝑈 = 𝑘𝑂𝑈 )
S

Example
Two firms L and U are identical in all respects except the degree of leverage. Firm L has 6%
debentures of ₹12 lakh, while firm U is an all-equity firm. EBIT for both firms is ₹2,00,000 each. The
equity capitalization rate is 10% and the tax rate is 50%. Compute the market value of two firms as
per MM approach.

Chapter 9, Capital Structure: 13

Solution
Particulars Firm L Firm U
EBIT 2,00,000 2,00,000
Less: Interest -72,000 NIL
Earnings before taxes 1,28,000 2,00,000
Less: Taxes @ 50% -64,000 -1,00,000
Earnings available for equity shareholders (NI) 64,000 1,00,000
𝐸𝐵𝐼𝑇(1 − 𝑡) 2,00,000(1 − 0.50)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑈 (𝑉𝑈 ) = = = ₹10,00,000
𝑘𝑂 0.10
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐿 (𝑉𝐿 ) = 𝑉𝑈 + 𝐷𝑡 = 10,00,000 + (12,00,000 × 0.50) = ₹16,00,000

Limitations of the Modigliani and Miller Approach (When taxes are not
there)
1. Risk Perception: According to MM an investor can use the personal leverage. They also
suggested that home-made leverage and corporate leverage are perfect substitutes. In real
life there is difference in the risk to the firm and investor. The risk exposure to the investor
is greater with personal leverage than with corporate leverage. The reason is simple—the
liability of an investor is limited in corporate enterprises is limited. The liability of an
individual borrower is, on the other hand, unlimited as even his personal property is liable
to be used for payment to the creditors.
2. Convenience: Personal leverage is inconvenient for the investor. This is so because with
corporate leverage the formalities and procedures involved in borrowing are to be observed
by the firms. While these will be the responsibility of the investor borrower in case of
personal leverage.
3. Cost: According to MM a company can issue shares to finance the investment projects
instead of using the profits. But MM ignored the cost associated with the issue of new
shares.
4. Institutional Restrictions: MM also opine that it is not necessary to pay the dividends if
there are attractive investment opportunities. But sometimes a company already had issued
its shares to some institutional investors such as LIC, UTI, GIC, Reliance Capital, etc. There is
an obligation of the company to pay dividends to these investors due to the terms of the
issue agreement. So, it is not possible for the company to skip the dividends.
5. Double Leverage: A related dimension is that in certain situations, the arbitrage process
(substituting corporate leverage by personal leverage) may not actually work. For instance,
when an investor has already borrowed funds while investing in shares of an unlevered
firm. If the value of the firm is more than that of the levered firm, the arbitrage process
would require selling the securities of the overvalued (unlevered) firm and purchasing the
securities of the levered firm. Thus, an investor would have double leverage both in personal
as well as in the firm’s portfolio. The MM assumption would not hold true in such a
situation.
6. Transaction Costs: MM suggests that a shareholder can easily to switch from one company
to another i.e. from levered firm to unlevered firm and unlevered firm to levered firm. But
for switching they have to sell their shares and there involved transaction costs in such
selling. The MM ignored this aspect.
7. Perfect Capital Market: Last but not least the MM is criticized due the assumption of
perfect capital market. In real world there is no perfect capital market. All the assumptions
of perfect capital market are unreal. For example—there are no transaction costs according
to MM but in real life there are transaction costs.

Limitations of the Modigliani and Miller Approach (When taxes are

there)
1. As debt increases, the savings of corporate taxes also increases and at the same time the
amount of personal taxes to be paid also increases. Thus, the liability of personal taxes
offsets the advantage of corporate taxes.

Chapter 9, Capital Structure: 14

 2. Greater amount of debt also increases financial risk of the firm. Thus, the cost of financial
distress also increases which again offsets the advantage of corporate tax savings.

4. Traditional Approach
Introduction
The NI and the NOI approach hold extreme views on the relationship between the leverage, cost of
capital and the value of firm. In real life, both these approaches seem to be unrealistic. The
traditional approach is a compromising view between the NI and NOI approach. This approach lies
somewhere in between the NI and the NOI approach.

Explanation
As per the traditional approach, a firm should make a judicious use of both the debt and the equity
to achieve a capital structure which may be called the optimal capital structure. An optimal capital
structure that proportion of debt and equity at which the cost of capital of the firm is minimum and
the value of the firm is maximum. According to the traditional approach use of debt is beneficial up
to a certain limit but after this limit, the increase in financial leverage will increase the WACC of the
firm and as a result the value of firm will decline.
Under the traditional approach 𝑘𝑑 < 𝑘𝑒 . In case of 100% equity firm, 𝑘𝑂 = 𝑘𝑒 , but with the
introduction of cheaper debt, the financial leverage increases and 𝑘𝑒 remains constant as the equity
investors expect a minimum leverage in every firm. The 𝑘𝑒 does not increase even with the increase
in leverage. The reason is that up to a particular degree of leverage, the interest charge may not be
large enough to pose a real threat to the dividend payable to the shareholders. So, this constant 𝑘𝑒
and 𝑘𝑑 makes the 𝑘𝑂 to fall initially. Thus, it shows that the use of debt is beneficial to the firm. But
this is not a continuous situation as the benefits of cheaper debt tend to decline with the increasing
leverage. The increase in leverage beyond a certain limit increases the risk of equity investors and
as a result 𝑘𝑒 starts increasing. However, the benefits of debt may be so large that even after
offsetting the effects of increase in 𝑘𝑒 , the 𝑘𝑂 may still go down or may become constant for some
degree of leverage.
However, if the firm increases the leverage further, then the risk of debt investor may also increase
and consequently the 𝑘𝑑 also starts increasing. The money lenders will penalize the firm for
increased leverage by charging higher interest charges. Now, the already increased 𝑘𝑒 and the now
increasing 𝑘𝑑 makes the 𝑘𝑂 to increase. Therefore, the use of leverage beyond a certain point will
result in an increase in the 𝑘𝑂 and a decrease in the value of the firm.

Crux
1. Moderate degree of debt can lower the firm’s overall cost of capital and thereby, increase
the value of firm.
2. The initial increase in the cost of equity is offset by the lower cost of debt.
3. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a
point is reached at which the advantage of lower cost of debt is more than offset by more
expensive equity.

Example
ABC Limited having EBIT of ₹1,50,000 is contemplating to redeem a part of capital by introducing
the debt financing. Presently, it is 100% equity firm with equity capitalization rate of 16%. The firm
is to redeem the capital by introducing debt financing up to ₹3,00,000 i.e. 30% of total funds or up
to ₹5,00,000 i.e. 50% of total funds. It is expected that for debt financing up to 30%, the rate of
interest will be 10% and the cost of equity will increase to 17%. However, if the firm opts for 50%
debt financing, then interest will be payable at the rate of 12% and the cost of equity will be 20%.
Find out the value of firm and WACC under different levels of debt financing.
Particulars 0% debt 30% debt 50% debt
Total debt -- 3,00,000 5,00,000
Cost of debt (𝑘𝑖 ) -- 0.10 0.12
Cost of equity (𝑘𝑒 ) 0.16 0.17 0.20
Chapter 9, Capital Structure: 15
 EBIT 1,50,000 1,50,000 1,50,000
Less: Interest -- -30,000 -60,000
EBT 1,50,000 1,20,000 90,000
Less: Taxes (-NA-) -- -- --
Net Income 1,50,000 1,20,000 90,000
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 9,37,500 7,05,882 4,50,000
𝑘𝑒
Add: Market value of debt (given) -- 3,00,000 5,00,000
Total value of firm 9,37,500 10,05,882 9,50,000
𝐸𝐵𝐼𝑇
𝑘𝑂 = 0.1600 0.1490 0.1580
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚
Thus, we can see from the above table that value of firm increases and WACC goes down with
increase in debt but up to a certain limit only i.e. up to 30% debt. But if we employ more than 30%
debt, then value of the firm goes down and WACC increases. Therefore, firm should make judicious
use of both debt and equity to maximize firm’s value and minimize WACC.

Graphical Representation
ke ke
kO kO
kd kd
kO (%)

kO (%)

Degree of Degree of
Leverage Leverage
O
Optimal Capital Range of Optimal
Structure Capital Structure

(PART-A) (PART-B)

5. The Trade-off Theory: Cost of Financial Distress and

Agency Costs
Introduction
Theory suggests that a firm can employ 100% debt because of debt advantage. But in practice firms
do not borrow 100% debt. What are the offsetting disadvantages of the debt?
• According to Miller, personal tax on interest income reduces the attractiveness of the debt.
• The other offsetting disadvantages of debt are grouped under financial distress.

Financial Distress
Financial distress arises when a firm is not able to pay the interest and principal to its debt-holders.
The firm’s continuous failure to make payments to debt-holders can ultimately lead to the
insolvency of the firm. Financial distress increases with the higher debt. So, with higher debt and
higher business risk the probability of financial distress becomes much greater. The degree of
business risk depends upon the following factors—
1. Degree of Operating Leverage
2. General Economic Conditions
3. Demand and Intensity of Competition
4. Extent of Diversification
5. Maturity of Industry
6. Extent of Capital

Chapter 9, Capital Structure: 16

Costs of Financial Distress
There are certain costs associated with the financial distress. These may be classified in to
categories viz. direct costs and indirect costs.

Direct Costs of Financial Distress with Insolvency

1. Insolvency: Financial distress may ultimately force a company to insolvency.
2. Cost of insolvency: The major cost associated with the financial distress is the cost of
insolvency.
3. Complex Procedure of Insolvency: Also, the procedure of being insolvency is also very
complex.
4. Conflict between Creditors and Shareholders: Further due to insolvency, there arises a
conflict between the creditors and shareholders. This conflict can delay the liquidation
process.
5. Deterioration in the Value of the Assets: The problem become more difficult when due to
long time period involved in the insolvency process, the value of the assets of the company
deteriorates considerably.
6. High Legal/Administration Costs: Insolvency also causes high legal and administrative
costs.
7. Effect on the Value of Equity: Decrease in the market value of equity and increase in the
lender’s required rate of return.

Indirect Costs of Financial Distress with/without Insolvency

Indirect costs related to the financial distress are in the form of effect on the following:
1. Employees: Employees will get demoralized, as they worried about their future. Their
efficiency, productivity and quality of product decline. The efficient managers and other
employees start leaving the company.
2. Customers: Customers of the financially distressed firm may fear its liquidation. They ask
about the after sales services and maintenance repeatedly. Consequently, the demand for
the firm’s products or services starts falling rapidly.
3. Suppliers: They curtail and discontinue granting credit to the firm. They become less
tolerant when a firm faces financial problems. They force the firm to settle their claim as
soon as possible.
4. Investors: They become more concerned about the firm than before. Either investors
refused to provide capital to the firm or they make funds available at high costs and rigid
terms and conditions. So non-availability of the funds adversely affects the operating
efficiency of the firm.
5. Shareholders: Shareholders of financially distressed firm starts behaving differently. When
a firm is under financial distress, but not insolvent, shareholders may ready to invest in
risky projects. If a risky project succeeds, their gain can be high. If the project fails, creditors
will suffer the loss.
6. Managers: When the firm is under financial distress, they may get the resources of the firm
in their own pockets. They also start to make decisions in the short-term interests of the
shareholders. They may cut the costs that affect the quality of the product. They look at the
profitable projects only to avoid any risk. The above sub optimal (less profitable) decisions
will further complex the problems of a distressed firm, and ultimately cause its liquidation.

Financial Distress Reduces the Value of the Firm

The value of an un-levered and levered firm is given below—
𝐸𝐵𝐼𝑇(1 − 𝑡)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 (𝑉𝑈 ) =
𝑘𝑒
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 (𝑉𝐿 ) = 𝑉𝑈 + 𝑃𝑉𝐼𝑁𝑇𝑆 − 𝑃𝑉𝐹𝐷
Where,
(𝑃𝑉𝐼𝑁𝑇𝑆 ) = Present value of tax shield
(𝑃𝑉𝐹𝐷 ) = Present value of financial distress

Chapter 9, Capital Structure: 17

 Y

PVFD

VL

Market Value
PVINTS

VU
VU

O X
Leverage Optimum Ratio
Value of levered firm under corporate taxes and financial distress

The above graph suggests how the capital structure of the firm is determined as a result of the tax
benefits and the costs of financial distress. The PVINTS increases with borrowing but so does the
PVFD. However, the costs of financial distress are quite insignificant with moderate level of debt.
With more and more debt, the costs of financial distress increases and therefore, the tax benefit
shrinks. The optimum point is reached when the marginal present value of the tax benefit and the
financial costs are equal. The value of the firm is maximum at this point.

Agency Costs
In practice, there may be a conflict of interest among shareholders, debt holders and management.
These conflicts give a rise to agency problem, which involve agency costs. Agency costs have their
influence on a firm’s capital structure.

Shareholders

Conflicts among
Shareholders,
Debt-Holders &
Management

Debt-Holders Management

1. Shareholders-Debt-Holders Conflict: Rights of debt-holders are much strong than that of

shareholders. In case of financial distress, shareholders can simply opt out from owning the
firm. In a highly levered firm, the debt-holders risk is very high since shareholders liability is
limited. Further debt-holders are not compensated for the added risk of default, which
results in the transfer of wealth from debt-holders to shareholders. The conflict between
shareholders and debt-holders arise because of the possibility of shareholders transferring
the wealth of shareholders in their favor. The debt-holders may lend money to the firm to
invest in less-risk projects while the firm may invest in high-risk projects. Firm may also
raise substantial risky new debt and thus, increase the debt-holders’ risk.
2. Shareholders-Managers Conflict: Shareholders are the legal owners of a company, and
management is required to act in their best interests as their agents. The conflict between
shareholders and management arises due to following two reasons:
(i) Managers may transfer shareholders wealth to their advantage by increasing their
compensation and perquisites.
Chapter 9, Capital Structure: 18
 (ii) Managers may not act in the best interest of shareholders to protect their jobs. They
may not undertake risk.
3. Monitoring and Agency Cost: The agency problem is handled through monitoring and
restrictive actions. External investors know that management is not working in their favor,
so they have a tendency of discounting the prices of the firm’s securities. These investors
require monitoring and restrictive actions in order to protect their interests. Debt-holders
put restrictions on the firm’s borrowing capacity.
Similarly, shareholders create many monitoring mechanisms to ensure that managers raise
and invest funds in the interests of shareholders. The costs of monitoring and restrictive
actions are called agency costs. The implication of agency cost for capital structure is that
management should use debt to the extent that it maximizes that shareholder’s wealth. Agency
cost reduces the tax advantage of debt.

Resolving Agency Problem

Now agency problem can be resolved in two ways—
1. By incurring agency costs—To make sure that management takes care of the interest of
the shareholders, shareholders have to incur the agency cost. Jenson and Meckling
developed the theory of the agency cost. This theory suggests that management will take
care of the interest of shareholders and will try to maximize the wealth of the shareholders,
if sufficient incentives are given to the management. These costs can be categorized in to the
following—
a. Monitoring cost—Monitoring means a constant check on the activities of the
management so that their performance can be appraised from time to time and their
activities can be controlled. Cost incurred to monitor their activities is called monitoring
cost. Monitoring costs put the required pressure on the management to act in the
interest of the shareholders. Examples of these costs are—management performance
analysis cost, periodic audit cost, credit rating fees, etc.
b. Compensation cost—If sufficient compensation is provided to the management then it
can be assumed that the management will act in the interest of the shareholders and to
maximize the wealth. Under this, comparatively higher salary packages along with stock
option are offered to the managers. Stock option gives the managers ownership of the
company up to some extent. Now both have the common goals. Also, if the management
will work efficiently, then increase in the share price will increase their wealth also.
2. Pressures from outside groups/market forces—Outside groups/market forces also exert
pressure on the management to perform well. These pressures help in resolving the agency
problem up to some extent. Some of these pressures are—
a. Institutional pressure—Some large institutional investors like mutual funds, financial
institutions, banks, insurance companies, etc. hold a large shareholding in the company
and can throw out the non-performing managers by exercising their voting rights.
b. Threat of hostile takeover—When a company does not perform well then, the market
value of the company goes down. In such a case other company can acquire this
undervalued company. Due to pressure of hostile takeover and fear of loss of the job,
management always tries to perform in the best interest of the shareholders.
c. Competitive labor market—If the management is non-performing and the labor
market is competitive enough then there will be fear of replacement and this fear will
force the managers to perform well in the interest of the shareholders.
d. Pressure from media, financial analysts, etc.—Media and financial analysts comment
on the performance of the companies. Pressure of poor comments will deteriorate the
image of the management. It will also affect the career of the management. So, pressure
from media, financial analysts, etc. forces the management to perform well in the
interest of the shareholders.

Chapter 9, Capital Structure: 19

Illustration
1. If 𝑘𝑒 is given and 𝑘𝑂 is to be calculated then it is NI approach.
2. If tax rate is given in NI approach then use 𝑘𝑑 instead of 𝑘𝑖 .
3. If 𝑘𝑂 is given and 𝑘𝑒 is to be calculated then it is NOI approach.
4. Single firm: If along with NOI tax rate is given then it is MM approach and value of the firm
shall be calculated as per the NOI approach and do not ignore the tax rate. Use 𝑘𝑑 instead of
𝑘𝑖 in all other formulae.
5. Two firms: Whenever in the question it is given that calculate the value as per MM
approach and tax rate is given then calculate the value of the firms as per the Proposition-II.
In such a case first of all calculate the value of unlevered firm and then on the basis of
the value of the unlevered firm calculate the value of the levered. Formula for the
valuation of the levered firm would be—(𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 + 𝐷𝑡). In order to
calculate the value of equity of levered firm, subtract the value of debt from the total value of
the levered firm. Use 𝑘𝑑 instead of 𝑘𝑖 in all other formulae.
6. If in the question it is given that investor moves from levered firm to unlevered firm and tax
rate is also given, then, value of the firms shall be calculated as per NI approach i.e. 𝑉 = 𝑆 +
𝐷 and calculate the amount of borrowing using formula—𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 =
𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚(1 − 𝑡) × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚.

Example 1 (Illustration 3)
Two firms X and Y are identical in all respects including risk factors for debt and equity. X has
issued 10% debentures of ₹18 lakh while Y has issued only equity. Both the firms earn 20% before
the interest and taxes on their total assets of ₹30 lakh.
Assuming a tax rate of 50 percent and capitalization rate of 15 percent for an all-equity firm,
compute the value of company X and Y using net income approach.
(CA (F), 1994, B. Com Honors, Delhi University, 2003)

Solution
Valuation as per NI approach
Particulars X Y
EBIT (₹30,00,000 × 0.20) 6,00,000 6,00,000
Less: Interest (𝐼) -1,80,000 --
EBT (Earning before tax) 4,20,000 6,00,000
Less: Taxes @ 50% -2,10,000 -3,00,000
NI (Net income) 2,10,000 3,00,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 0.15 0.15
𝑁𝐼 2,10,000 3,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = = 14,00,000 = 20,00,000
𝑘𝑒 0.15 0.15
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 18,00,000 --
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 (𝑉) = 𝑆 + 𝐷 32,00,000 20,00,000

Example 2 (Illustration 4)
ABC Limited has all equity capital structure with a cost of capital of 15%. The company decides to
raise ₹2,00,000, 12% debt and use the proceeds to retire equity. The expected EBIT is ₹90,000
which is expected to remain unchanged. Assuming net income approach assumptions are
applicable; calculate value of equity and debt, and the value of firm before and after change in
capital structure. Also calculate weighted average cost of capital after change.
(B. Com Honors, Delhi University, 2005)

Solution
Valuation as per net income (NI) approach and calculation of WACC
After change (debt and
Particulars Existing (equity only) equity)

Chapter 9, Capital Structure: 20

 EBIT 90,000 90,000
Less: Interest (𝐼) -- -24,000
NI (Net income) 90,000 66,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 0.15 0.15
𝑁𝐼 90,000 66,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = = 6,00,000 = 4,40,000
𝑘𝑒 0.15 0.15
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 0 2,00,000
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 (𝑉) = 𝑆 + 𝐷 6,00,000 6,40,000
𝐸𝐵𝐼𝑇 𝐷 𝑆
𝑘𝑂 = 𝑜𝑟 𝑘𝑂 = 𝑘𝑖 [ ] + 𝑘𝑒 [ ] 0.15 0.1406
𝑉 𝑉 𝑉

Example 3 (Illustration 6)
A company has annual operating income of ₹5,00,000. It has ₹30 lakh 8% debentures. The overall
capitalization rate is 10%. You are required to calculate the value of the firm and the equity
capitalization rate according to net operating income (NOI) approach. What will be the effect on the
value of the firm and the equity capitalization rate if the debenture debt is increased to ₹40 lakh?
(Calcutta University, 2003)

Solution
Valuation as per net operating income (NOI) approach when debt is ₹30,00,000
EBIT 5,00,000
Less: Interest (₹30,00,000 × 8%) -2,40,000
NI 2,60,000
Overall capitalization rate (𝑘𝑂 ) 0.10
𝐸𝐵𝐼𝑇 5,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 (𝑉) = = 50,00,000
𝑘𝑂 0.10
Less: 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) -30,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = 𝑉 − 𝐷 20,00,000
30𝐿
0.10 + (0.10 − 0.08)
20𝐿
𝐷 𝑁𝐼 = 0.13
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖. 𝑒. 𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) 𝑜𝑟 𝑘𝑒 = or
𝑆 𝑆
2,60,000
= 0.13
20,00,000

Valuation as per net operating income (NOI) approach when debt is ₹40,00,000
EBIT 5,00,000
Less: Interest (₹40,00,000 × 8%) -3,20,000
Net income 1,80,000
Overall capitalization rate (𝑘𝑂 ) 0.10
𝐸𝐵𝐼𝑇 5,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 (𝑉) = = 50,00,000
𝑘𝑂 0.10
Less: 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) -40,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = 𝑉 − 𝐷 10,00,000
𝑁𝐼 1,80,000
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖. 𝑒. 𝑘𝑒 = = 0.18
𝑆 10,00,000

Example 4 (Illustration 7)
The management of Vishwas Limited subscribing to the net operating income approach, believes
that it’s cost of debt and overall cost of capital will remain at 8% and 12% respectively. If the equity
shareholders of the firm demand a return of 20%, what should be the proportion of debt and equity
in the firm’s capital structure? Assume that there are no taxes.
(Calcutta University, 2003)

Chapter 9, Capital Structure: 21

Solution
Under net operating income, the formula for the calculation of cost of equity is—
𝐷 𝐷
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) (𝑖𝑛 𝑡ℎ𝑖𝑠 𝑓𝑜𝑟𝑚𝑢𝑙𝑎 𝑖𝑠 𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜)
𝑆 𝑆
𝐷 𝐷 𝐷 0.08 𝐷 𝐷
0.20 = 0.12 + (0.12 − 0.08) ⇒ 0.20 − 0.12 = 0.04 ⇒ 0.08 = 0.04 = = ⇒
𝑆 𝐸 𝐸 0.04 𝐸 𝐸
2
=
1
So, the desired debt equity ratio is 2:1.
We can verify the answer as follows—
𝐷 𝑆 2 1
𝑘𝑂 = 𝑘𝑖 [ ] + 𝑘𝑒 [ ] ⇒ 𝑘𝑂 = 0.08 × + 0.20 × ⇒ 𝑘𝑂 = 0.12 (𝐻𝑒𝑛𝑐𝑒, 𝑣𝑒𝑟𝑖𝑓𝑖𝑒𝑑. )
𝑉 𝑉 3 3

Example 5 (Illustration 8)
A company has an EBIT of ₹3,00,000 and overall cost of capital 12.5%. The company has debt of
₹5,00,000 borrowed at the rate of 8%. Find the value of the company using NOI approach and show
using NOI approach, how change in debt by ₹3,00,000 have impact on the cost of equity capital of
the company?
(B. Com Honors, Delhi University, 2013)

Solution
In this question it is given— “how change in debt by ₹3,00,000 have impact on the cost of equity
capital of the company”. Now this change can be in either side i.e. debt may increase or decrease. So,
we will consider both the situations.
Increase in debt by Decrease in debt by
Present position ₹3,00,000 ₹3,00,000
Particulars Total debt = ₹5,00,000 Total debt ₹8,00,000 Total debt ₹2,00,000
EBIT 3,00,000 3,00,000 3,00,000
Less: Int. @ 8% -40,000 -64,000 -16,000
Net Income 2,60,000 2,36,000 2,84,000
𝐸𝐵𝐼𝑇 3,00,000 3,00,000 3,00,000
𝑉= = ₹24,00,000 = ₹24,00,000 = ₹24,00,000
𝑘𝑂 0.125 0.125 0.125
𝐿𝑒𝑠𝑠: 𝐷 -₹5,00,000 -₹8,00,000 -₹2,00,000
𝑆=𝑉−𝐷 ₹19,00,000 ₹16,00,000 ₹22,00,000
0.125 0.125 0.125
𝑘𝑒 5𝐿 8𝐿 2𝐿
𝐷 + (0.125 − 0.08) + (0.125 − 0.08) + (0.125 − 0.08)
= 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) 19 𝐿 16 𝐿 22 𝐿
𝑆
= 0.1368 = 0.1475 = 0.1291
𝑘𝑒 can also
be calculated as 2,60,000 2,36,000 2,84,000
follows = 0.1368 = 0.1475 = 0.1291
19,00,000 16,00,000 22,00,000
𝑁𝐼
⇒ 𝑘𝑒 =
𝑆
How change in debt by ₹3,00,000 have impact on the cost of equity capital: The change in the
proportion of debt does not affect the value of firm, but the change in the debt affects the cost of
equity. An increase in debt increases the cost of equity and decrease in the proportion of debt
decrease the cost of equity.

Example 6 (Illustration 9)
Two companies are identical in all respects except that X Limited has debt of ₹5,00,000 borrowed
at the rate of 12% whereas Y Limited has no debt in its capital structure. The total assets of both the
companies amount to ₹15,00,000 on which the companies have earnings of 20%. You are required
to do the following—
(i) Calculate value of companies and 𝑘𝑂 using NI approach taking 𝑘𝑒 as 18%.
(ii) Calculate value of companies and 𝑘𝑒 using NOI approach taking 𝑘𝑂 as 18%.
(iii) Compare the results and comment on the differences of the two approaches.
Chapter 9, Capital Structure: 22
 (B. Com. Honors, Delhi University, 2006)

Solution

(i) Calculate value of companies and 𝒌𝑶 using NI approach taking 𝒌𝒆 as

18%
Particulars X Limited Y Limited
EBIT (₹15,00,000 × 0.20) 3,00,000 3,00,000
Less: Interest (₹5,00,000 × 0.12) -60,000 --
NI (Net income) 2,40,000 3,00,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒 ) 0.18 .18
𝑁𝐼 2,40,000 3,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = = 13,33,333 = 16,66,667
𝑘𝑒 0.18 0.18
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 5,00,000 --
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 (𝑉) = 𝑆 + 𝐷 18,33,333 16,66,667
𝐸𝐵𝐼𝑇 𝐷 𝑆
𝑘𝑂 = 𝑜𝑟 𝑘𝑂 = 𝑘𝑖 [ ] + 𝑘𝑒 [ ] 0.1636 0.18
𝑉 𝑉 𝑉

(ii) Calculate value of companies and 𝒌𝒆 using NOI approach taking 𝒌𝑶 as

18%
Particulars X Limited Y Limited
EBIT (₹15,00,000 × 0.20) 3,00,000 3,00,000
Less: Interest (₹5,00,000 × 0.12) -60,000 --
NI (Net income) 2,40,000 3,00,000
Overall capitalization rate (𝑘𝑂 ) 0.18 0.18
𝐸𝐵𝐼𝑇 3,00,000 3,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 (𝑉) = = 16,66,667 = 16,66,667
𝑘𝑂 0.18 0.18
Less: 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 5,00,000 --
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = 𝑉 − 𝐷 11,66,667 16,66,667
⇒ 0.18 ⇒ 0.18
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖. 𝑒. 5𝐿 0𝐿
𝐷 + (0.18 − 0.12) + (0.18 − 0.12)
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) 11.67𝐿 16.67𝐿
𝑆 = 0.2057 = 0.18
𝑘𝑒 can also be calculated as follows 2,40,000 3,00,000
NI = 0.2057 = 0.1799 ≅ 0.18
= 11,66,667 16,66,667
S

(iii) Compare the results and comment on the differences of the two
approaches
As per NI approach the value of the firms is not same whereas as per NOI approach the value of the
firm remains same for both of the firms.
The cost of equity is not same for the X Limited under NI as well as NOI approach. In case of Y
Limited the cost of equity is same under NI and NOI approach.

Example 7 (Same as example 6)

Company X and Company Y are in the same risk class and identical in all respects except that Y uses
debt of ₹2,00,000 carrying an interest of 12%, whereas X is an all-equity firm. Both companies earn
a return of 20% on their assets of ₹4,50,000.
(i) Calculate the value of both the companies and their overall cost of capital under the net
income approach taking cost of equity as 15%.
(ii) Calculate value of both the companies and equity capitalization rate using NOI approach
taking overall cost of capital as 15%.
(iii) Compare the results and comment on the differences.
(B. Com. Honors, Delhi University, 2019)
Chapter 9, Capital Structure: 23
Solution

(i) Calculate value of companies and 𝒌𝑶 using NI approach taking 𝒌𝒆 as

15%
Particulars X Limited Y Limited
EBIT (₹4,50,000 × 0.20) 90,000 90,000
Less: Interest (₹2,00,000 × 0.12) -- -24,000
NI (Net income) 90,000 _66,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒 ) .15 0.15
𝑁𝐼 90,000 66,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = = 6,00,000 = 4,40,000
𝑘𝑒 0.15 0.15
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) -- 2,00,000
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 (𝑉)
6,00,000 6,40,000
= 𝑆+𝐷
𝐸𝐵𝐼𝑇 𝐷 𝑆
𝑘𝑂 = 𝑜𝑟 𝑘𝑂 = 𝑘𝑖 [ ] + 𝑘𝑒 [ ] 0.15 0.1406
𝑉 𝑉 𝑉

(ii) Calculate value of companies and 𝒌𝒆 using NOI approach taking 𝒌𝑶 as

15%
Particulars X Limited Y Limited
EBIT (₹4,50,000 × 0.20) 90,000 90,000
Less: Interest (₹2,00,000 × 0.12) -- -24,000
NI (Net income) 90,000 _66,000
Overall capitalization rate (𝑘𝑂 ) 0.15 0.15
𝐸𝐵𝐼𝑇 90,000 90,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 (𝑉) = = 6,00,000 = 6,00,000
𝑘𝑂 0.15 0.15
Less: 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) -- 2,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = 𝑉 − 𝐷 6,00,000 4,00,000
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖. 𝑒. 0𝐿 2𝐿
𝐷 ⇒ 0.15 + (0.15 − 0.12) ⇒ 0.15 + (0.15 − 0.12)
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) 6𝐿 4𝐿
𝑆 = 0.15 = 0.165
𝑘𝑒 can also be calculated as follows 90,000 66,000
NI = 0.15 = 0.165
= 6,00,000 4,00,000
S

(iii) Compare the results and comment on the differences of the two
approaches
As per NI approach the value of the firms is not same whereas as per NOI approach the value of the
firm remains same for both of the firms.
The cost of equity is not same for the Y Limited under NI as well as NOI approach. In case of X
Limited the cost of equity is same under NI and NOI approach.

Example 8 (Illustration 10)

Two firms X and Y are identical in all respects except the degree of leverage. Firm X has 8%
debentures of ₹20,00,000. Operating profit of both the firms is ₹6,00,000 and tax rate is 45%. Equity
capitalization rate of firm Y is 10%. Calculate value of each firm according to MM approach and cost
of equity of X. Also compute the overall cost of capital.
(B. Com. Honors, Delhi University, 2015, 2013 (Similar question))

Solution
In this question tax rate is given so Proposition-I (with taxes) of the MM approach is applicable.

Chapter 9, Capital Structure: 24

(i) Calculation of total value of firm Y and X
Firm X is a levered firm and firm Y is an unlevered firm.
𝐸𝐵𝐼𝑇(1 − 𝑡) 6,00,000(1 − 0.45)
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑌(𝑉𝑌 ) = ⇒ ⇒ ₹33,00,000
𝑘𝑒 0.10

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋(𝑉𝑋 ) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 𝑖. 𝑒. 𝑉𝑌 + (𝐷 × 𝑡)

⇒ 33,00,000 + (20,00,000 × 0.45) ⇒ ₹42,00,000

(ii) Calculation of value of equity of firm Y and X

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑌 = Y is an unlevered firm so the value of ₹33,00,000 is the value of
equity.

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋 = 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

⇒ 42,00,000 − 20,00,000 ⇒ ₹22,00,000

(iii) Calculation of 𝒌𝒆 of firm Y and X

𝑘𝑒(𝑌) = 0.10 (no need to calculate as it’s already given that 𝑘𝑒 is 10% for an all-equity firm)

(𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑡) (6,00,000 − 1,60,000)(1 − 0.45)

𝑘𝑒(𝑋) = ⇒ ⇒ 0.11
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 22,00,000

(iv) Calculation of 𝒌𝑶 of firm Y and X

𝑘𝑂(𝑌) = 𝑘𝑒 = 0.10 (For an all-equity firm 𝑘𝑂 = 𝑘𝑒 ).

𝐷 𝑆 20,00,000 22,00,000
𝑘𝑂(𝑋) = 𝑘𝑑 (𝑆𝑒𝑒 𝑛𝑜𝑡𝑒) × + 𝑘𝑒 (𝑃𝑜𝑖𝑛𝑡 𝑖𝑖𝑖) × ⇒ 0.044 × + 0.11 ×
𝑉 𝑉 42,00,000 42,00,000
⇒ 0.0786
Note: 𝑘𝑑 = 𝑘𝑖 (1 − 𝑡) ⇒ 0.08(1 − 0.45) ⇒ 0.044

Example 9 (Illustration 22)

Companies U and L are identical in every respect except that U is unlevered while L has ₹20 lakh of
8% debt. EBIT of both firms is ₹6 lakh and tax rate is 35%. Equity capitalization rate for U is 10%.
Calculate the value of each firm according to MM approach and cost of equity for L Limited.
(B. Com. Honors, Delhi University, 2006)

Solution
In this question tax rate is given so Proposition-I (with taxes) of the MM approach is applicable.

(i) Calculation of value of firm U and L

a. Total value of firm U and L
Firm L is a levered firm and firm U is an unlevered firm.
𝐸𝐵𝐼𝑇(1 − 𝑡) 6,00,000(1 − 0.35)
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑈(𝑉𝑈 ) = ⇒ ⇒ ₹39,00,000
𝑘𝑒 0.10

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐿(𝑉𝑋 ) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 𝑖. 𝑒. 𝑉𝑌 + (𝐷 × 𝑡)

⇒ 39,00,000 + (20,00,000 × 0.35) ⇒ ₹46,00,000

b. Value of equity of firm U and L

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑈 = Y is an unlevered firm so the value of ₹39,00,000 is the value of
equity.

Chapter 9, Capital Structure: 25

 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐿 = 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡
⇒ 46,00,000 − 20,00,000 ⇒ ₹26,00,000

(iii) Calculation of 𝒌𝒆 of firm Y and X (not required)

𝑘𝑒(𝑌) = 0.10 (no need to calculate as it’s already given that 𝑘𝑒 is 10% for an all-equity firm)

(𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑡) (6,00,000 − 1,60,000)(1 − 0.45)

𝑘𝑒(𝑈) = ⇒ ⇒ 0.11
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 22,00,000

(iv) Calculation of 𝒌𝑶 of firm L

𝑘𝑂(𝑈) = 𝑘𝑒 = 0.10 (For an all-equity firm 𝑘𝑂 = 𝑘𝑒 ). (not required)

𝐷 𝑆 20𝐿 26𝐿
𝑘𝑂(𝐿) = 𝑘𝑑 (𝑆𝑒𝑒 𝑛𝑜𝑡𝑒) × + 𝑘𝑒 (𝑃𝑜𝑖𝑛𝑡 𝑖𝑖𝑖) × ⇒ 0.065 × + 0.11 × ⇒ 0.0848
𝑉 𝑉 46𝐿 46𝐿
Note: 𝑘𝑑 = 𝑘𝑖 (1 − 𝑡) ⇒ 0.10(1 − 0.35) ⇒ 0.065

Example 10 (Illustration 11)

‘L’ Limited and ‘U’ Limited are identical in all respects except that ‘L’ Limited has issued 10%
debentures of ₹9,00,000 while ‘U’ Limited has only equity in their capital structure. Both the firms
have operating profit of ₹3,00,000. Assume capitalization rate of 15% for an all-equity firm.
(i) Compute the value of the two firms using net income (NI) approach.
(ii) Compute the value of the two firms using net operating income (NOI) approach.
(B. Com Honors, Delhi University, 2015)

Solution

(i) Value of the firms as per NI approach

Particulars L Limited U Limited
EBIT 3,00,000 3,00,000
Less: Interest (₹9,00,000 × 0.10) -90,000 --
NI (Net income) 2,10,000 3,00,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒 ) 0.15 0.15
𝑁𝐼 2,10,000 3,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = = 14,00,000 = 20,00,000
𝑘𝑒 0.15 0.15
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 9,00,000 --
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 (𝑉) = 𝑆 + 𝐷 23,00,000 20,00,000
𝐸𝐵𝐼𝑇 𝐷 𝑆
𝑘𝑂 = 𝑜𝑟 𝑘𝑂 = 𝑘𝑖 [ ] + 𝑘𝑒 [ ] 0.1304 0.15
𝑉 𝑉 𝑉

(ii) Value of the firms as per NOI approach

Particulars X Limited Y Limited
EBIT 3,00,000 3,00,000
Less: Interest (₹9,00,000 × 0.10) -90,000 --
NI (Net income) 2,10,000 3,00,000
Overall capitalization rate (𝑘𝑂 ) 0.15 0.15
𝐸𝐵𝐼𝑇 3,00,000 3,00,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 (𝑉) = = 20,00,000 = 20,00,000
𝑘𝑂 0.15 0.18
Less: 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 9,00,000 --
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = 𝑉 − 𝐷 11,00,000 20,00,000
𝐸𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖. 𝑒. 9𝐿 0𝐿
𝐷 ⇒ 0.15 + (0.15 − 0.10) ⇒ 0.15 + (0.15 − 0.10)
𝑘𝑒 = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑖 ) 11𝐿 20𝐿
𝑆 = 0.19091 = 0.15
2,10,000 3,00,000
𝑘𝑒 can also be calculated as follows = 0.19091 = 0.15
11,00,000 20,00,000
Chapter 9, Capital Structure: 26
Example 11 (Illustration 12)
Two companies are identical except that A Limited has a debt of ₹10,00,000 at 10% whereas B
Limited does not have debt in its capital structure. The total assets of both the companies A and B
are same i.e. ₹20,00,000 on which each company earns 20% return. Find the value of each company
and overall cost of capital using net operating income approach. Equity capitalization rate for B
Limited is 15%. The tax rate is 50%.
(B. Com. Honors, Delhi University, 2011)

Solution
In this question tax rate is given so Proposition-I (with taxes) of the MM approach is applicable.
Further, operating profits (EBIT) is ₹4,00,000 i.e. ₹20,00,000 × 0.20.

(i) Calculation of total value of firm B Limited and A Limited

Firm A is a levered firm and firm B is an unlevered firm.
𝐸𝐵𝐼𝑇(1 − 𝑡) 4,00,000(1 − 0.50)
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐵(𝑉𝐵 ) = ⇒ ⇒ ₹13,33,333
𝑘𝑒 0.15

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐴(𝑉𝐴 ) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 𝑖. 𝑒. 𝑉𝐵 + (𝐷 × 𝑡)

⇒ 13,33,333 + (10,00,000 × 0.50) ⇒ ₹18,33,333

(ii) Calculation of value of equity of firm B Limited and A Limited

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐵 = B is an unlevered firm so the value of ₹13,33,333 is the value of
equity.

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐴 = 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐴 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

⇒ 18,33,333 − 10,00,000 ⇒ ₹8,33,333

(iii) Calculation of 𝒌𝒆 of firm B Limited and A Limited

𝑘𝑒(𝐵) = 0.15 (no need to calculate as it’s already given that 𝑘𝑒 is 15% for an all-equity firm)

(𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑡) (4,00,000 − 1,00,000)(1 − 0.50)

𝑘𝑒(𝐴) = ⇒ ⇒ 0.18
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 8,33,333

(iv) Calculation of 𝒌𝑶 of firm B Limited and A Limited

𝑘𝑂(𝐵) = 𝑘𝑒 = 0.15 (For an all-equity firm 𝑘𝑂 = 𝑘𝑒 ).

𝐷 𝑆 10,00,000 8,33,333
𝑘𝑂(𝐴) = 𝑘𝑑 (𝑆𝑒𝑒 𝑛𝑜𝑡𝑒) × + 𝑘𝑒 (𝑃𝑜𝑖𝑛𝑡 − 𝑖𝑖𝑖) × ⇒ 0.050 × + 0.18 ×
𝑉 𝑉 18,33,333 18,33,333
⇒ 0.1091
Note: 𝑘𝑑 = 𝑘𝑖 (1 − 𝑡) ⇒ 0.10(1 − 0.50) ⇒ 0.05

Example 12 (Illustration 13)

Companies X and Y are in the same risk class, and are identical in every respect except that
Company X uses debt, while company Y does not. The levered firm has ₹9,00,000 debentures,
carrying 10% rate of interest. Both the firms earn 20% operating profit on their total assets of ₹15
lakhs. Assume perfect capital markets, rational investors and so on; a tax rate of 35% and
capitalization rate of 15% for an all-equity company. Compute—
(i) Value of firms X and Y using Net Income (NI) approach.
(ii) Value of each firm using Net Operating Income (NOI) approach.
(iii) Overall cost of capital (𝑘𝑂 ) for firms X and Y.
(iv) Which of these two firms has an optimum capital structure using NOI approach and why?
(CS Final, 2002, B. Com. Honors, Delhi University, 2012)

Chapter 9, Capital Structure: 27

Solution

(i) Value of firms X and Y using Net Income (NI) approach

Particulars X Y
EBIT (₹15,00,000 × 0.20) 3,00,000 3,00,000
Less: Interest (𝐼) -90,000 --
EBT (Earning before tax) 2,10,000 3,00,000
Less: Taxes @ 35% -73,500 -1,05,000
NI (Net income 1,36,500 1,95,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 0.15 .0.15
𝑁𝐼 1,36,500 1,95,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦(𝑆) = = 9,10,000 = 13,00,000
𝑘𝑒 0.15 0.15
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 (𝐷)(𝑔𝑖𝑣𝑒𝑛) 9,00,000 --
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 (𝑉) = 𝑆 + 𝐷 18,10,000 13,00,000

(ii) Value of each firm using Net Operating Income (NOI) approach
Tax rate is given so Proposition-I (with taxes) of the MM approach is applicable. Further, operating
profits (EBIT) are ₹3,00,000 i.e. ₹15,00,000 × 0.20.

a. Total value
Firm X is a levered firm and firm Y is an unlevered firm.
𝐸𝐵𝐼𝑇(1 − 𝑡) 3,00,000(1 − 0.35)
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑌(𝑉𝑌 ) = ⇒ ⇒ ₹13,00,000
𝑘𝑒 0.15

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋(𝑉𝑋 ) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 𝑖. 𝑒. 𝑉𝑌 + (𝐷 × 𝑡)

⇒ 13,00,000 + (9,00,000 × 0.35) ⇒ ₹16,15,000

b. Value of equity
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑌 = B is an unlevered firm so the value of ₹13,00,000 is the value of
equity.

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋 = 𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋 − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡

⇒ 16,15,000 − 9,00,000 ⇒ ₹7,15,000

(iii) Overall cost of capital (𝒌𝑶 ) for firms X and Y

a. Overall cost of capital under NI approach
𝑘𝑂(𝑌) = 𝑘𝑒(𝑌) =0.15 (For an all-equity firm 𝑘𝑂 = 𝑘𝑒 )

𝐷 𝑆 9,00,000 9,10,000
𝑘𝑂(𝑋) = 𝑘𝑑 [ ] + 𝑘𝑒 [ ] ⇒ 0.065 × + 0.15 × ⇒ 0.1077
𝑉 𝑉 18,10,000 18,10,000
Note: 𝑘𝑑 = 𝑘𝑖 (1 − 𝑡) ⇒ 0.10(1 − 0.35) ⇒ 0.065

b. Overall cost of capital under NOI approach

𝑘𝑂(𝑌) = 𝑘𝑒 = 0.15 (For an all-equity firm 𝑘𝑂 = 𝑘𝑒 ).

𝐷 𝑆 9,00,000 7,15,000
𝑘𝑂(𝑋) = 𝑘𝑑 (𝑆𝑒𝑒 𝑛𝑜𝑡𝑒) × + 𝑘𝑒 (𝑃𝑜𝑖𝑛𝑡 𝑖𝑖𝑖) × ⇒ 0.065 × + 0.1909 ×
𝑉 𝑉 16,15,000 16,15,000
⇒ 0.1207
Note: 𝑘𝑑 = 𝑘𝑖 (1 − 𝑡) ⇒ 0.10(1 − 0.35) ⇒ 0.065

𝑘𝑒(𝑌) = 0.15 (no need to calculate as it’s already given that 𝑘𝑒 is 15% for an all-equity firm)

Chapter 9, Capital Structure: 28

 (𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑡) (3,00,000 − 90,000)(1 − 0.35)
𝑘𝑒(𝑋) = ⇒ ⇒ 0.1909
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 7,15,000

(iv) Which of these two firms has an optimum capital structure using NOI
approach and why?
Under NOI approach no capital structure is optimum provided taxes are not there. In this question
the presence of taxes violates the two of the assumptions of the NOI approach. First-there are no
taxes and second-there is no optimum capital structure. As it has violated the second assumption so
there is an optimum capital structure. The value of the firm X (𝑉𝑋 = ₹16,15,000) is higher and
overall cost of capital (𝑘𝑂 = 0.1207) lower, so it has an optimum capital structure.

Example 13 (Illustration 15)

Following is the data relating to two companies A and B—
Particulars Company A Company B
Number of equity shares 80,000 1,20,000
Market price per share (₹) 1.10 1.00
8% debentures (₹) 50,000 --
Profit before interest (₹) 15,000 15,000
Entire profit after interest was distributed as dividend. Explain using the MM approach, how an
investor holding 12.5% of shares in company A will be better off in switching his holding to
Company B.
(B. Com. Honors, Delhi University, 2017)

Solution
Particulars Company “A” Company “B”
EBIT 15,000 15,000
Less: Interest -4,000 --
NI (Net Income) 11,000 15,000
𝑁𝐼 11,000 15,000
𝑘𝑒 = = 0.125 = 0.125
𝑆(𝑆𝑒𝑒 𝑏𝑒𝑙𝑜𝑤) 88,000 1,20,000
80,000 𝑠ℎ𝑎𝑟𝑒𝑠 1,20,000 𝑠ℎ𝑎𝑟𝑒𝑠
𝑆 (𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞. ) = 𝑁𝑜. 𝑜𝑓 𝑒𝑞. 𝑠ℎ.× 𝑆ℎ. 𝑝𝑟𝑖𝑐𝑒 × ₹1.10 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 × ₹1.00 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
= ₹88,000 = ₹1,20,000
Add: B (Debt) ₹50,000 NIL
𝑉 =𝑆+𝐵 ₹1,38,000 ₹1,20,000
𝐸𝐵𝐼𝑇
𝑘𝑂 = 12.3% 12.5%
𝑉
Effect of arbitrage will be as follows—

(A) Investor’s position in company “A” with 12.5% equity holding

(i) Investment outlay:
(88,000 × 12.5%) ₹11,000
(ii) Dividend income:
(11,000(𝐼𝑛𝑣. 𝑜𝑢𝑡𝑙𝑎𝑦) × 12.5% (𝑘𝑒 ))𝑜𝑟 (11,000 (𝑁𝐼) × 12.5% (𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑖𝑛𝑔)) ₹1,375

(B) Investor’s position in company “B” with 12.5% equity holding

(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹11,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹6,250) ₹17,250
(ii) Investment outlay (𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝐵 × 12.5%):
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹8,750 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹6,250) ₹15,000
Note:
1. 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐹𝑢𝑙𝑙 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑢𝑠𝑒𝑑.
(iii) Net income from the unlevered firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹15,000 × 12.5% (𝑘𝑒 )) 𝑜𝑟 (₹15,000 × 12.5% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹1,875.00 ₹1,375
Chapter 9, Capital Structure: 29
 𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹6,250 × 8%) = ₹500.00
So, he is earning the same income with the reduced investment.

(C) Investor’s position in company “B” if he invests the total funds

available
(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹11,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹6,250) ₹17,250
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹17,250 × 12.5% (𝑘𝑒 )) = ₹2,156.25
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹6,250 × 8%) = ₹500.00 ₹1,656.25
So, he is earning the more income with the same investment.
In the point (b) and (c) above it can be seen that investor is earning same income on reduced
investment and higher income on same investment. So, it can be said that he is better off in
switching his holding from company A to company B.

Example 14 (Illustration 17)

The two companies X and Y belong to the same risk class. They have everything in common except
that firm Y has 12.5% debentures of ₹12,00,000. The following information about the two firms is
available to you—
Particulars Firm X Firm Y
Net operating income (EBIT) ₹3,00,000 ₹3,00,000
12.5% debentures -- ₹12,00,000
Equity capitalization rate (𝑘𝑒 ) 0.15 0.16
Calculate the value of two firms and explain how under Modigliani-Miller approach an investor who
owns 10% equity shares of the overvalued firm will be better off switching his holdings to the other
firm. Also explain when arbitrage process will come to an end.
(B. Com. Honors, Delhi University, 2017)

Solution
Particulars Firm “X” Firm “Y”
EBIT 3,00,000 3,00,000
Less: Interest -- -1,50,000
NI (Net Income) 3,00,000 1,50,000
𝑘𝑒 (𝑔𝑖𝑣𝑒𝑛) 0.15 0.16
𝑁𝐼 3,00,000 1,50,000
𝑆 (𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦) = = ₹20,00,000 = ₹9,37,500
𝑘𝑒 0.15 0.16
Add: D (Debt) NIL ₹12,00,000
𝑉 =𝑆+𝐷 ₹20,00,000 ₹21,37,500
𝐸𝐵𝐼𝑇
𝑘𝑂 = 15% 14.04
𝑉
Effect of arbitrage will be as follows:

(A) Investor’s position in firm “Y” with 10% equity holding

(i) Investment outlay:
₹93,750
(9,37,500 × 10%)
(ii) Dividend income:
(93,750 × 16% (𝑘𝑒 ))𝑜𝑟 (1,50,000 × 10% (𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑖𝑛𝑔)) ₹15,000

(B) Investor’s position in firm “X” with 10% equity holding

(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹93,750 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹1,20,000) ₹2,13,750
(ii) Investment outlay (𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋 × 10%):
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹80,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹1,20,000) ₹2,00,000
Note:

Chapter 9, Capital Structure: 30

 1. 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐹𝑢𝑙𝑙 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑢𝑠𝑒𝑑.
(iii) Net income from the unlevered firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹2,00,000 × 15% (𝑘𝑒 )) 𝑜𝑟 (₹3,00,000 × 10% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹30,000.00
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹1,20,000 × 12.5%) = ₹15,000.00 ₹15,000
So, he is earning the same income with the reduced investment.

(C) Investor’s position in firm “X” if he invests the total funds available
(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹93,750 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹1,20,000) ₹2,13,750
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹2,13,750 × 15%(𝑘𝑒 )) = ₹32,062.50
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹1,20,000 × 12.5%) = ₹15,000.00 ₹17,062.50
So, he is earning the more income with the same investment.
In the point (b) and (c) above it can be seen that investor is earning same income on reduced
investment and higher income on same investment. So, it can be said that he is better off in
switching his holding from firm Y to firm X.
Arbitrage process will come to an end when market price of the shares of both the firms becomes
equal.

Example 15 (Illustration 16)

“The value of a firm is independent of the proportion of debt to total capitalization. The arbitrage
process will establish a market equilibrium in which the total value of the firm will depend only on
investor’s estimate of the firm’s business risk, and its expected future income.”
Explain the above-mentioned statement with the help of the following data regarding two
companies A and B, with the same expected annual income and same risk class.
Variables Company A Company B
Expected annual income (𝑌) ₹30,000 ₹30,000
Market value of debt (𝐷) -- ₹1,20,000
Rate of interest on debt (𝐼) -- 0.125
Required rate of return on equity (𝑘𝑒 ) 0.15 0.16
Market value of equity (𝐸) ₹2,00,000 ₹93,750
Market value of company (𝑉), (𝑉 = 𝐷 + 𝐸) ₹2,00,000 ₹2,13,750
Show your workings in relation to an investor who holds 10% of the outstanding shares of the
levered company.
(BBS Honors, Delhi University, 2011)

Solution
Particulars Firm “A” Firm “B”
EBIT 30,000 30,000
Less: Interest -- -15,000
NI (Net Income) 30,000 15,000
𝑘𝑒 (𝐺𝑖𝑣𝑒𝑛) 0.15 0.16

𝑆 (𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦)(𝐺𝑖𝑣𝑒𝑛) ₹2,00,000 ₹93,750

Add: B (Debt) NIL ₹1,20,000
𝑉 =𝑆+𝐵 ₹2,00,000 ₹2,13,750
𝐸𝐵𝐼𝑇
𝑘𝑂 = 15% 14.03%
𝑉
In this question two companies A and B are there which are identical in all respects except that the
company B has debt it its capital structure. If an investor holds 10% of the outstanding shares of the
levered company B, then he will earn same income on reduced investment and higher income on
same investment due to the effect of arbitrage process. The effect of arbitrage will be as follows—

Chapter 9, Capital Structure: 31

(A) Investor’s position in firm “B” with 10% equity holding
(i) Investment outlay:
(93,750 × 10%) ₹9,375
(ii) Dividend income:
(93,750 × 16%)𝑜𝑟 (15,000 × 10%) ₹15,00

(B) Investor’s position in firm “A” with 10% equity holding

(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹9,375 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹12,000) ₹21,375
(ii) Investment outlay:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹8,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹12,000) ₹20,000
Note:
1. 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐹𝑢𝑙𝑙 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑢𝑠𝑒𝑑.
(iii) Net income from the unlevered firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹20,000 × 15% (𝑘𝑒 )) 𝑜𝑟 (₹30,000 × 10% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹3,000.00
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹12,000 × 12.5%) = ₹1,500.00 ₹1,500
So, he is earning the same income with the reduced investment.

(C) Investor’s position in firm “A” if he invests the total funds available
(i) Investment outlay:
Own funds=₹9,375+Borrowed funds=₹12,000 ₹21,375
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹21,375 × 15% (𝑘𝑒 )) = ₹3,206.25
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹12,000 × 12.5%) = ₹1,500.00 ₹1,706.25
So, he is earning the more income with the same investment.
The above analysis shows that an investor can earn more income if he invests funds in Company A
(undervalued firm). Other investors will follow the same process and buying demand will increase
the share price of Company A. On the other hand, due to selling pressure, share price of the
Company B (overvalued firm) will decline. This process will continue as long as it is possible to
reduce the investment amount and get the same return. Beyond this point, it will not be possible for
the investors to get the extra benefits from any of the firm. This is known as equilibrium point.
This is the level where total value of the two firms as well as their overall cost of capital would also
be same. This process is known as arbitrage process. So, according to Merton and Miller
hypothesis, due to arbitrage process, the total value of a levered firm cannot be more than that of an
unlevered firm and the reverse is also true. Hence, ultimately the total value of the firm will
depend only on investor’s estimate of the firm’s business risk, and its expected future income.

Example 16 (Illustration 20)

The two companies U an L, belong to an equivalent risk class. These two firms are identical in every
respect except that U company is unlevered while the company L has 10% debentures of
₹30,00,000. The other relevant information regarding their valuation and capitalization rates are as
follows—
Particulars Firm “U” Firm “L”
₹ ₹
Net operating income (EBIT)
Less: Interest on debt (𝐼) 7,50,000 7,50,000
Earnings to equity shareholders -- -3,00,000
(𝑁𝐼) 7,50,000 4,50,000
Equity capitalization rate (𝑘𝑒 ) 0.15 0.20
𝑁𝐼 7,50,000 4,50,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝐸) = = ₹50,00,000 = ₹22,50,000
𝑘𝑒 0.15 0.20
Market value of debt (D) NIL ₹30,00,000
Total value of firm (𝑉) = (𝐸 + 𝐷) ₹ 50,00,000 ₹52,50,000
Overall capitalization rate (𝑘𝑂 ) 0.15 0.143

Chapter 9, Capital Structure: 32

 Debt-equity ratio (𝐷/𝐸) 0 1.33
(i) An investor owns 10% equity shares of company L. Show the arbitrage process and the
amount by which he could reduce his outlay through the use of leverage.
(ii) According to Modigliani-Miller, when will this arbitrage process come to an end?
(B. Com. Honors, Delhi University, 2012, Similar question in 2007, 2011)

Solution

(i) Arbitrage process and effect of arbitrage:

(A) Investor’s position in firm “L” with 10% equity holding
(i) Investment outlay:
₹2,25,000
(22,50,000 × 10%)
(ii) Dividend income:
(2,25,000 × 20% (𝑘𝑒 ))𝑜𝑟 (4,50,000 × 10% (𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑖𝑛𝑔)) ₹45,000

(B) Investor’s position in firm “U” with 10% equity holding

(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹2,25,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹3,00,000) ₹5,25,000
(ii) Investment outlay (𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑈 × 10%):
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹2,00,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹3,00,000) ₹5,00,000
Note:
1. 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 × 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐹𝑢𝑙𝑙 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑢𝑠𝑒𝑑.
(iii) Net income from the unlevered firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹5,00,000 × 15% (𝑘𝑒 )) 𝑜𝑟 (₹7,50,000 × 10% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹75,000
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹3,00,000 × 10%) = ₹30,000 ₹45,000
So, he is earning the same income with the reduced investment.

(C) Investor’s position in firm “U” if he invests the total funds available
(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹2,25,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹3,00,000) ₹5,25,000
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹5,25,000 × 15%(𝑘𝑒 )) = ₹78,750
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹3,00,000 × 10%) = ₹30,000 ₹48,750
So, he is earning the more income with the same investment.
In the point (b) and (c) above it can be seen that investor is earning same income on reduced
investment and higher income on same investment. So, it can be said that he is better off in
switching his holding from firm L to firm U.

(ii) According to Modigliani-Miller, when will this arbitrage process

come to an end?
Arbitrage process will come to an end when market price of the shares of both the firms become
equal.

Example 17 (Illustration 21)

Firm X and Y are similar except that firm X is unlevered, while Y has ₹3,00,000 of 6% debentures
outstanding. Assuming tax rate at 50%, net operating income (EBIT) at ₹50,000 and the cost of
equity at 10%, (i) Calculate the value of both the firms, if the MM assumptions are met. (ii) If the
value of the firm Y is ₹4,20,000, then do this represent equilibrium value? If not, how will
equilibrium be reached?

Chapter 9, Capital Structure: 33

Solution

(i) Value of both the firms, if the MM assumptions are met

Firm Y is a levered firm and firm X is an unlevered firm.
𝐸𝐵𝐼𝑇(1 − 𝑡) 50,000(1 − 0.50)
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑋(𝑉𝑋 ) = ⇒ ⇒ ₹2,50,000
𝑘𝑒 0.10

𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 𝑌(𝑉𝑌 ) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚 𝑖. 𝑒. 𝑉𝑋 + (𝐷 × 𝑡)

⇒ 2,50,000 + (3,00,000 × 0.50) ⇒ ₹4,00,000
Firm X is undervalued and firm Y is overvalued.

(ii) If the value of the firm Y is ₹4,20,000, then do this represent

equilibrium value? If not, how will equilibrium be reached?
Value of the firm Y is ₹4,00,000 whereas it is given at ₹4,20,000, so it is overvalued by ₹20,000. It
does not represent the equilibrium. To restore the equilibrium, the arbitrage process will take place
as follows—
Value of equity of firm Y Income statement
Particulars Y X
₹ ₹
EBIT 50,000 50,000
₹ Less: Interest (₹3,00,000 × 6%) -18,000 --
Value of firm Y (given) 4,20,000 EBT 32,000 50,000
Less: Value of debt -3,00,000 Less: Tax @ 50% -16,000 -25,000
Value of equity 1,20,000 Net income 16,000 25,000
(𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑡) 𝐷 𝑆
𝑘𝑂(𝑌) = 𝑘𝑂(𝑌) = 𝑘𝑑 × + 𝑘𝑒 ×
𝑉 𝑉 𝑉
(50,000 − 18,000)(1 − 0.50) 3,00,000 1,20,000
⇒ ⇒ 0.03 × ̅̅̅̅ ×
+ 13. 33
4,20,000 4,20,000 4,20,000
⇒ 0.05952 ⇒ 0.05952
𝐷
𝑘𝑒(𝑌) = 𝑘𝑂 + (𝑘𝑂 − 𝑘𝑑 )
𝑆 𝑁𝐼 16,000
3,00,000 𝑘 𝑒(𝑌) = ⇒ ̅̅̅̅
⇒ 13. 33
⇒ 0.05952 + (0.05952 − 0.03) 𝑆 1,20,000
1,20,000
̅̅̅̅
⇒ 0.1333
𝑘𝑑(𝑌) = 𝑘𝑖 (1 − 𝑡) ⇒ 0.06(1 − 0.50) ⇒ 0.03 𝑘𝑒(𝑋) = 𝑘𝑒(𝑋) = 0.10 (𝐺𝑖𝑣𝑒𝑛)
Now, let us assume that there is an investor who holds 10% equity share capital of the firm Y
(Overvalued firm).

(A) Investor’s position in firm “Y” with 10% equity holding

(i) Investment outlay:
₹12,000
(1,20,000 × 10%)
(ii) Dividend income:
(12,000 × 13.33% (𝑘𝑒 ))𝑜𝑟 (16,000 × 10% (𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑖𝑛𝑔)) ₹1,600

(B) Investor’s position in firm “X” with 10% equity holding

(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹12,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹15,000) ₹27,000
(ii) Investment outlay (𝑬𝒒𝒖𝒊𝒕𝒚 𝒐𝒇 𝒇𝒊𝒓𝒎 𝑼 × 𝟏𝟎%):
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹10,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹15,000) ₹25,000
Note:
1. 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 = 𝐷𝑒𝑏𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚(1 − 𝑡)
× 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑖𝑛 𝑒𝑞. 𝑜𝑓 𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚
2. 𝐹𝑢𝑙𝑙 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 𝑠ℎ𝑜𝑢𝑙𝑑 𝑏𝑒 𝑢𝑠𝑒𝑑.
(iii) Net income from the unlevered firm:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹25,000 × 10% (𝑘𝑒 )) 𝑜𝑟 (₹25,000 × 10% ℎ𝑜𝑙𝑑𝑖𝑛𝑔) = ₹2,500 ₹1,600
Chapter 9, Capital Structure: 34
 𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹15,000 × 6%) = ₹900
So, he is earning the same income with the reduced investment.

(C) Investor’s position in firm “U” if he invests the total funds available
(i) Total funds available:
(𝑂𝑤𝑛 𝑓𝑢𝑛𝑑𝑠 = ₹12,000 + 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 = ₹15,000) ₹27,000
(ii) Income:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 (₹27,000 × 10%(𝑘𝑒 )) = ₹2,700
𝐿𝑒𝑠𝑠: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 𝑓𝑢𝑛𝑑𝑠 (₹15,000 × 6%) = ₹900 ₹1,800
So, he is earning the more income with the same investment.
In the point (b) and (c) above it can be seen that investor is earning same income on reduced
investment and higher income on same investment through the arbitrage process. This process will
continue until the share prices of both the firms become equal. As soon as the prices will become
equal the equilibrium will be restored. So, arbitrage process comes to an end when market price of
the shares of both the firms becomes equal.

Chapter 9, Capital Structure: 35