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Chapter 17
Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.
• Value of a firm depends upon earnings of a firm and its cost of
capital (i.e. WACC).
• Earnings are a function of investment decisions, operating
efficiencies, & WACC is a function of its capital structure.
• Value of firm is derived by capitalizing the earnings by its cost of
capital (WACC).
Value of Firm = Earnings / WACC
• Thus, value of a firm varies due to changes in the earnings of a
company or its cost of capital, or both.
• Capital structure cannot affect the total earnings of a firm
(EBIT), but it can affect the residual shareholders’ earnings.
CAPITAL STRUCTURE THEORIES
Debt
Capital Structure Theories –
Net Income Approach (NI)
Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10% Kd = 6%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000
kd
(Ke) increases.
• No effect on total
Debt
cost of capital
(WACC)
Capital Structure Theories –
Net Operating Income (NOI)
Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
EBIT 200,000 200,000 200,000
• At a point, it settles
ko
• But after this point,
(Ko) increases, due kd
to increase in the
cost of equity. (Ke) Debt
WACC Traditional View
• The traditionalists say that
borrowing at first increases rE
more slowly than MM predicts,
but rE shoots up with higher
levels of debt. Using the right
amount of debt can minimize the
Weighted Average Cost of
Capital. This graph also shows
that the WACC remains constant
as leverage increases and is
consistent with MM Proposition
I.
UNLEVERED UNLEVERED
• VU = NET INCOME/KO • VU = NET INCOME*(1-T)/KO
• Ke=Ko
LEVERED LEVERED
VU=VL VL=VU + [Debt (TAX)]
Ke=Net income/E or S
(this part I discussed in detail in the
following slides)
Introducing Taxes into the MM Theory
Interest paid to 0 80
bondholders
With 50% debt, the net cash flow to the equity is $585 (in thousands). There is a
reduction in taxes by $35 (in thousands). Total cash flow to the holder of equity and
debt is $620 (in thousands). $35 (in thousands) is the tax saving through interest
expense deduction.
*The total cash flow with all equity is $585,000. (Income available to Stock holders)
** The total cash flow with 50% debt is $620,000. (Income available to debt holders
plus income to stock holders)
Case let contd..
• Tax benefit = 100,000 x (.35) = $35,000
• PV of $35,000 in perpetuity = 35,000/.05 =
$700,000
• PV tax shield = $2,000,000 x .35 = $700,000
Tax benefit per year is $35 (in thousands).
Assuming that this benefit will occur through
perpetuity, the present value of the tax shield is
35/0.05 = $700 (in thousands). The same result is
obtained by using the formula (D)(Tc) =
(2,000,000)(0.35) = $700,000.
Case let contd..
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
= 15%
Case
A firm is financed entirely by equity capital with
expected rate of return of 15%. It has EBIT of
INR 450 lakh. The corporate tax stands at
33.33%. As a financing option and considering
the capital structure the firm is expecting to
borrow INR 900 lakh at an attractive rate of 8%
and retire equity by an equivalent amount. Find
out the following:
Case Contd..
• The market value of the firm when it is financed
entirely by equity
• The market value of the firm after it borrows from
the market
• What benefits do the equity shareholders draw
from this borrowing
• What is the cost of equity capital after borrowing
• Find market value of equity using answer to above
question
Assume perpetual income and debt.
Solution
When the firm is financed entirely by equity:
Market value of the firm =
= 1400 lakh
Solution contd..
Changing the Capital Structure
Assume that the unlevered firm had 10 lakh
shares outstanding prior to the issue of debt.
With the issuance of the debt how many shares
will be purchased and what shall be the market
price of the shares?
Solution contd..
• Value of the unlevered firm = Rs. 2000 lakh
• No. Of shares outstanding = 10 lakh
• Market price before the issue of debt = 200
per share
When the issue of debt is announced. The
market value of the firm rises by amount of tax
shield and the entire benefit of the tax shield
The Pecking Order of Financing Choices
• Trade-Off Theory
– Theory that capital structure is based on trade-off
between tax savings and distress costs of debt
• Pecking-Order Theory
– Theory stating firms prefer to issue debt over
equity if internal finances are insufficient
The Pecking Order of Financing Choices
• Retained earnings
• Straight debt
• Convertible debt
• Preference shares
• Equity shares
Reasons for the following pecking order
Un-Levered Firm
• Value of un-levered firm = Rs. 100,000 (all
equity)
• EBIT = Rs. 10,000 and investor holds 10 % share
capital
HOME MADE LEVERAGE
Return from Levered Firm:
Investment 10% 110, 000 50 , 000 10% 60, 000 6 , 000