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THEORY
USE OF FINANCIAL LEVERAGE –
INCREASES SHAREHOLDERS EXPECTED RETURNS
ALSO IT INCREASES RISK FOR SHAREHOLDERS
The cost of equity and debt are respectively 10% and 6% and are
Assumed to be constant under the Net Income
Approach
Ko= NOI/V = 200,000/24,00,000 = 0.0833
Or
Ko = Kd (D/V) + Ke (S/V)
= 0.06 (10,00,000/24,00,000) + 0.10 (14,00,000/24,00,000)
= 0.025 + 0.0583 = 0.0833 or 8.33%
Ke = Ko + (Ko-Kd)D/S
= 0.10 + (0.10 – 0.06) 14,00,000/6,00,000
= 0.10 + 0.04 (2.33) = 0.1933 or 19.33%
B’cause
The increase in the cost of equity due to the added financial risk
offsets the advantage of low cost debt.
At a specific point, the value of the firm will be maximum or the
cost of capital will be minimum
THIRD STAGE
Beyond the acceptable limit of leverage, the value of the firm
decreases with leverage or the cost of the capital increases with
leverage
V
A
L
E
U
O
F
S
T
O
C
K
Threshold Debt Level Optimal capital structure Marginal tax
Where bankruptcy shelter benefits = marginal Bankruptcy
costs become related costs
material
LEVERAGE X
Some considerations in the
Capital Structure Decision:
1. Managerial conservatism
2. Lender and Rating Agency Attitudes
3. Reserve Borrowing capacity and Financing Flexibility
4. Control
5. Business Risk
6. Asset Structure
7. Growth Rate
8. Profitability
9. Taxes
10. Market conditions
MM HYPOTHESIS
1. Securities are traded in the perfect capital market situation.
2. Investors are free to buy and sell securities
3. They can borrow without restriction at the same terms as the
firms do;
4. Investors behave rationally
5. There is no transaction cost
6. Firms can be grouped into homogeneous risk classes
7. The expected NOI is a random variable, with a constant mean
probability distribution and a finite variance
8. Firms distribute all net earnings to the shareholders, which
means the dividend payout ratio is 100%
9. No corporate income taxes (later they relaxed)
Assignment Problem
Capital Structure Debt (Rs.) Kd% Ke%
I 3,00,000 10.0 12.0
II 4,00,000 10.0 12.5
III 5,00,000 11.0 13.5
IV 6,00,000 12.0 15.0
V 7,00,000 14.0 18.0
SOLUTION
Particulars Plan I II III IV V
EBIT 300000 300000 300000 300000 300000
Further . . . . . . . .
COMPANIES CURRENT
CAPITAL STRUCTURE
LIABILITIES AMOUNT ASSETS AMOUNT