COST OF EQUITY Ke
COST OF DEBT Kd
WACC
Leveraged firm and Unleveraged firm
BASICS and TERMINOLOGY
FOR FINANCIAL LEVERAGE- EPS, ROE
FOR CAPITAL STRUCTURE THEORIES- IMPACT
ON THE VALUE OF A FIRM
Kd .05
Kd .05
o No financial risk
o Kd < Ke
o
ke, ko ke
The optimum capital
structure would be
100 per cent debt kd
ko
kd
financing under NI
approach.
Criticism D ebt
This approach has no
basis in reality.
. 5
TRADITIONAL APPROACH
Financial Plan
DEBT INCR
Kd .07
Kd .07
8
NET OPERATING INCOME APPROACH
Financial Plan
Unlevered Levered
Kd
Value of the debt
Value of the firm 10000 10000
WACC/ OPPURTUNITY COST OF CAPITAL .010 .010
Net Operating Income (NOI)
Approach
Assumptions
o Perfect capital
market
C ost
o No taxes
ke
o NOI and Opportunity
cost is constant
for all levels.
o ko
o No optimum capital kd
structure exists.
o
o D ebt
10
MM Approach Without Tax:
Proposition I
Assumptions
o Perfect capital market
o Investors can borrow at
the same rate C ost
corporate can.
o Same expectations
about operating
profits. ko
Kd .05
Levered Unlevered
Kd - .05
Value of the debt 3000
Value of the firm 10000 10000
WACC/ OPPURTUNITY COST OF CAPITAL .010 .010
M&M’s Proposition II
Assumptions : same
C ost
But Rise is Ke= Fall in ke
WACC due to lower
rate debt.
ko
kd
D ebt
M M 's P r o p o s i t i o n I I
14
M&M – WITH TAXES
Unlevered levered
1. Earnings before interest and taxes, EBIT 1000 1000
2. Less: Interest, INT 0 150
3. Profit before taxes, PBT = EBIT – INT 1000 850
Taxes @ 50 % 500 425
Profit after tax 500 425
Amount to EQ and Debt holders 500 425+150=575
Value of the equity and Firm (u) 10000
Value of firm (L)= V (u) + P V of tax shield (TD) - 11500
S o , 1 0 0 % d e b t Fa vo u ra b le . b u t fo r ta p p in g o p p o rtu n itie s
a n d re m a in in g fle xib le it sh o u ld n o t b e 1 0 0 % a s su g g e ste d
b y M &M
M & M (WITH TAXES)
Maximum value of firm
Market Value of The Firm
PV of interest
tax shields
Value of
unlevered
firm