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BECAUSE OF FINANCIAL LEVERAGE THE SHAREHOLDERS WILL ALSO HAVE TO BEAR FINANCIAL RISK ALONG WITH BUSINESS RISK
Assume that a firm has an expected annual net operating income of Rs.200,000, an equity rate, ke, of 10% and Rs. 10,00,000 of 6% debt.
The value of the firm according to NET INCOME approach: Net Operating Income NOI 2,00,000 Total cost of debt Interest= KdD, (10,00,000 x .06) 60,000 Net Income Available to shareholders, NOI I 1,40,000
Therefore:
Market Value of Equity (Rs. 140,000/.10) Market value of debt D (Rs. 60,000/.06) Total
The cost of equity and debt are respectively 10% and 6% and are Assumed to be constant under the Net Income Approach
Market Value of Equity (Rs. 116,000/.10) Market value of debt D (Rs. 60,000/.06) Total
Ko= NOI/V = 200,000/25,60,000 = 0.078125 Or Ko = Kd (D/V) + Ke (S/V) = 0.06 (14,00,000/25,60,000) + 0.10 (11,60,000/25,60,000) = 0.03281+ 0.04531 = 0.07812 or 7.81%
1.
ASSUMPTIONS OF NOI APPROACH a whole. Thus, the split The market capitalises the value of the firm as
between debt and equity is not important.
2. The market uses an overall capitalisation rate, Ko to capitalise the net operating income. Ko depends on the business risk. If the business risk is assumed to remain unchanged, Ko is a constant. 3. The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate to increase. Thus the advantage of debt is offset exactly by the increase in the equity capitalisation rate, Ke. 4. The debt capitalisation rate, Kd is a constant. 5. The corporate income taxes do not exist.
10,00,000
Ko= NOI/V = 200,000/0.10 = 20,00,000 Here, Ke is not a constant as that in NI approach It is computed by using the formula Ke = Ko + (Ko-Kd)D/S = 0.10 + (0.10 0.06) 10,00,000/10,00,000 = 0.10 + 0.04 (1) = 0.14
To verify that the weighted average cost of capital is a constant: Ko = Kd (D/V) + Ke (S/V) = 0.06 (10,00,000/20,00,000) + 0.14 (10,00,000/20,00,000) = 0.06 (0.50) + 0.14 (0.5) = 0.03 + 0.07 = 0.10
TRADITIONAL VIEW
FIRST STAGE In the first stage, the cost of equity rises less than proportionate to cost of debt ie It does not increase fast enough to offset the advantage of low cost debt During this stage the cost of debt, Kd, remains constant or rises negligibly on the assumption that the market views use of debt as a reasonable policy
SECOND STAGE
Once the firm has reached a certain degree of leverage,
A further increase in leverage will have a negligible effect on the value, or the cost of the capital of the firm. Bcause 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
Bcause the investors perceive a high degree of financial risk and increase equity capitalisation rate by more than to offset the advantage of low cost debt.
GRAPHIC PRESENTATION
Y
V A L E U
O F
S T O C K
Optimal capital structure Marginal tax shelter benefits = marginal Bankruptcy related costs
LEVERAGE
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
Debt (Rs.) 3,00,000 4,00,000 5,00,000 6,00,000 7,00,000
Kd% Ke% 10.0 12.0 10.0 12.5 11.0 13.5 12.0 15.0 14.0 18.0
SOLUTION
Particulars
EBIT Less Interest Net Profit
Plan I
300000 30,000 270,000
II
300000 40,000 260,000
III
300000 55,000 245,000
IV
300000 72,000 228,000
V
300000 98,000 202,000
Ke
MV of Eq. MV of Debt Total Mkt. Value Ko
0.12
22,50,000 300,000 25,50,000 11.76
0.125
20,80,000 400,000 24,80,000 12.10
0.135
18,14,815 500,000 23,14,815 12.95
0.15
15,20,000 600,000 21,20,000 14.15
0.18
11,22,222 7,00,000 18,22,222 16.46
PROJECTED SALES
SALES (25% CHANCE) 400,000 SALES (50% CHANCE) 600,000 SALES (25% CHANCE) 800,000 FIXED OPERATING 200,000
COSTS
50% OF SALES
Further . . . . . . . . . . . . . .
AMOUNT ASSETS
500,000 FIXED AND CURRENT 000,000 MISC. EXPENSES
AMOUNT
500,000 000,000
TOTAL
500,000 TOTAL
500,000
WHAT TO DO?
AS A FINANCE MANAGER USING THE DATA DECIDE UP ON A CHOICE OF THE CAPITAL STRUCTURE THAT YOU WOULD ADVISE THE FIRM. THE REASONS FOR THE SPECIFIC PROPORTION OF USAGE OF DEBT i.e. LEVERAGE WHAT CAN BE THE BEST OPTION FOR THE FIRM; WHY YOUR OPTION IS THE BEST BET REASONS TO SUBSTANTIATE THE SAME.