Capital Structure Theories

CAPITAL STRUCTURE, COST OF

CAPITAL AND VALUATION
Capital Structure Theories

Net Income Approach

Net Operating Income (NOI) Approach

Modigliani-Miller (MM) Approach

Traditional Approach

Solved Problems
 Capital Structure

Capital structure is the proportion of debt and

preference and equity shares on a firm’s
balance sheet.
Optimum capital structure is the capital
structure at which the weighted average cost of
capital is minimum and thereby maximum value
of the firm.
Assumptions
1) There are only two sources of funds used by a firm: perpetual riskless
debt and ordinary shares.
2) There are no corporate taxes. This assumption is removed later.
3) The dividend-payout ratio is 100. That is, the total earnings are paid
out as dividend to the shareholders and there are no retained
earnings.
4) The total assets are given and do not change. The investment
decisions are, in other words, assumed to be constant.
5) The total financing remains constant. The firm can change its degree
of leverage (capital structure) either by selling shares and use the
proceeds to retire debentures or by raising more debt and reduce the
equity capital.
6) The operating profits (EBIT) are not expected to grow.
7) All investors are assumed to have the same subjective probability
distribution of the future expected EBIT for a given firm.
8) Business risk is constant over time and is assumed to be independent
of its capital structure and financial risk.
9) Perpetual life of the firm.
Capital structure theories explain the theoretical
relationship between capital structure, overall
cost of capital (k0) and valuation (V ). The four
important theories are:
1) Net income (NI) approach,
2) Net operating income (NOI) approach,
3) Modigliani and Miller (MM) approach and
4) Traditional approach.
 Net Income Approach

According to the NI approach, capital structure is

relevant as it affects the k0 and V of the firm. The core
of this approach is that as the ratio of less expensive
source of funds (i.e., debt) increases in the capital
structure, the k0 decreases and V of the firm increases.
With a judicious mixture of debt and equity, a firm can
evolve an optimum capital structure at which the k0
would be the lowest, the V of the firm the highest and
the market price per share the maximum.
Example 1
A company’s expected annual net operating income (EBIT) is Rs 50,000. The
company has Rs 2,00,000, 10% debentures. The equity capitalisation rate (ke)
of the company is 12.5 per cent.
Solution: With no taxes, the value of the firm, according to the Net Income
Approach is depicted in Table 1.

TABLE 1  Value of the Firm (Net Income Approach)

Net operating income (EBIT) Rs 50,000
  Less: Interest on debentures (I) 20,000
Earnings available to equity holders (NI) 30,000
Equity capitalisation rate (ke) 0.125
Market value of equity (S) = NI/ke 2,40,000
Market value of debt (B) 2,00,000
Total value of the firm (S + B) = V 4,40,000
Overall cost of capital = k0 = EBIT/V (%) 11.36
Alternatively: k0 = ki (B/V) + ke(S/V) where ki and ke are cost of
debt and cost of equity respectively, = 0.10 [(Rs 2,00,000/Rs
4,40,000) + 0.125 (Rs 2,40,000 / Rs 4,40,000)] % 11.36
Increase in Value
In order to examine the effect of a change in financing-mix on the firm’s
overall (weighted average) cost of capital and its total value, let us suppose
that the firm has decided to raise the amount of debenture by Rs 1,00,000 and
use the proceeds to retire the equity shares. The ki and ke would remain
unaffected as per the assumptions of the NI Approach. In the new situation,
the value of the firm is shown in Table 2.

TABLE 2  Value of the Firm (Net Income Approach)

Net operating income (EBIT) Rs 50,000
Less: Interest on debentures (I) 30,000
Earnings available to equity holders (NI) 20,000
Equity capitalisation rate (ke) 0.125
Market value of equity (S) = NI/ke 1,60,000
Market value of debt (B) 3,00,000
Total value of the firm (S + B) = V 4,60,000
K0 = (Rs 50,000 / Rs 4,60,000) or 0.10 (Rs 3,00,000 / Rs 4,60,000) + 10.9 %
0.125 (Rs 160,000 / Rs 4,60,000)
Decrease in Value
If we decrease the amount of debentures in Example 1, the total value of the firm,
according to the NI Approach, will decrease and the overall cost of capital will
increase. Let us suppose that the amount of debt has been reduced by Rs 1,00,000
to Rs 1,00,000 and a fresh issue of equity shares is made to retire the debentures.
Assuming other facts as given in Example 1, the value of the firm and the weighted
average cost of capital are shown in Table 3.

TABLE 3  Value of the Firm (Net Income Approach)

Net operating income (EBIT) Rs 50,000
Less: Interest on debentures (I) 10,000
Earnings available to equity holders (NI) 40,000
Equity capitalisation rate (ke) 0.125
Market value of equity (S) = NI/ke 3,20,000
Market value of debt (B) 1,00,000
Total value of the firm (S + B) = V 4,20,000
k0 = (Rs 50,000 / Rs 4,20,000) or 0.10 (Rs 1,00,000 / Rs 4,20,000) + 11.9
0.125 (Rs 3,20,000 / Rs 4,20,000)(%)
Thus, we find that the decrease in leverage has increased the overall cost of
capital and has reduced the value of firm.
Market Price
Thus, according to the NI Approach, the firm can increase/decrease its total value (V)
and lower/increase its overall cost of capital (k0) as it increases/decreases the degree
of leverage. As a result, the market price per share is affected.
To illustrate, assume in Example 1 that the firm with Rs 2,00,000 debt has 2,400
equity shares outstanding. The market price per share works out to Rs 100 (Rs
2,40,000 ÷ 2,400). The firm issues Rs 1,00,000 additional debt and uses the proceeds
of the debt to repurchase/retire Rs 1,00,000 worth of equity shares or 1,000 shares. It,
then, has 1,400 shares outstanding. We have observed in Example 1 that the total
market value of the equity after the change in the capital structure is Rs 1,60,000
(Table 2). Therefore, the market price per share is Rs 114.28 (Rs 1,60,000 ÷ 1,400), as
compared to the original price of Rs 100 per share.
Likewise, when the firm employs less amount of debt, the market value per share
declines. To continue with Example 1, the firm raises Rs 1,00,000 additional equity
capital by issuing 1,000 equity shares of Rs 100 each and uses the proceeds to retire
the debenture amounting to Rs 1,00,000. It would then have 3,400 shares (2,400 old +
1,000 new) outstanding. With this capital structure, we have seen in Example 1 that
the total market value of equity shares is Rs 3,20,000 (Table 3). Therefore, the market
price per share has declined to Rs 94.12 (Rs 3,20,000 ÷ 3,400) from Rs 100 before a
change in the leverage.

We can graph the relationship between the various factors (ke, ki, k0) with the degree
of leverage (Fig. 1).
 The degree of leverage (B/V) is
plotted along the X-axis, while
the percentage rates of ki, ke
Y and k0 are on the Y-axis. This
graph is based on Example 1.
Due to the assumptions that ke
and ki remain unchanged as
ke the degree of leverage
changes, we find that both the
Ke, ki and k0 (%)

15.0 curves are parallel to the X-

k0
axis. But as the degree of
10.0 leverage increases, k0
decreases and approaches the
ki cost of debt when leverage is
5.0 1.0, that is, (k0 = ki). It will
obviously be so owing to the
X fact that there is no equity
0 0.5 1.0 capital in the capital structure.
At this point, the firm’s overall
Degree of Leverage (B/V)
cost of capital would be
Figure 1: Leverage and Cost of Capital (NI Approach)
minimum. The significant
conclusion, therefore, of the NI
Approach is that the firm can
employ almost 100 per cent
debt to maximise its value.
 Net Operating Income (NOI)
Approach
The NOI approach is diametrically opposite to the NI
approach. The essence of this approach is that capital
structure decision of a corporate does not affect its cost of
capital and valuation, and, hence, irrelevant.
The NOI Approach is based on the following propositions.

Overall Cost of Capital/Capitalisation Rate (k0) is Constant

The NOI Approach to valuation argues that the overall
capitalisation rate of the firm remains constant, for all degrees of
leverage. The value of the firm, given the level of EBIT, is
determined by Eq. 13.
V = (EBIT/ko) (13)
Residual Value of Equity
The value of equity is a residual value which is determined by
deducting the total value of debt (B) from the total value of the firm
(V). Symbolcially, Total market value of equity capital (S) =
V – B.

Changes in Cost of Equity Capital

The equity-capitalisation rate/cost of equity capital (ke) increases
with the degree of leverage. The increase in the proportion of debt
in the capital structure relative to equity shares would lead to an
increase in the financial risk to the ordinary shareholders. To
compensate for the increased risk, the shareholders would expect
a higher rate of return on their investments. The increase in the
equity-capitalisation rate (or the lowering of the price-earnings
ratio, that is, P/E ratio) would match the increase in the debt-equity
ratio. The ke would be

K0 + (k0 – ki) [B/S]

Cost of Debt
The main argument of NOI is that an increase in the
proportion of debt in the capital structure would lead to
an increase in the financial risk of the equityholders. To
compensate for the increased risk, they would require a
higher rate of return (ke) on their investment. As a result,
the advantage of the lower cost of debt would exactly be
neturalised by the increase in the cost of equity.
The cost of debt has two components: (i) explicit,
represented by rate of interest, and (ii) implicit,
represented by the increase in the cost of equity capital.
Therefore, the real cost of debt and equity would be the
same and there is nothing like an optimum capital
structure.
Example 2
Assume the figures given in Example 1: operating income Rs 50,000; cost of debt,
10 per cent; and outstanding debt, Rs 2,00,000. If the overall capitalisation rate
(overall cost of capital) is 12.5 per cent, what would be the total value of the firm
and the equity-capitalisation rate?
Solution:  The computation is depicted in Table 4.

TABLE 4  Total Value of the Firm (Net Operating Income Approach)

Net operating income (EBIT) Rs 50,000
Overall capitalisation rate (k0) 0.125
Total market value of the firm (V) = EBIT/k0 4,00,000
Total value of debt (B) 2,00,000
Total market value of equity (S) = (V – B) 2,00,000
Equity-capitalisation rate, ke = [(EBIT – I) / (V – B)] = (Earnings available
to equityholders / Total market value of equity shares) = [(Rs 50,000 –
0.15
Rs 20,000) / Rs 2,00,000]
Alternatively, ke = k0 + (k0 – ki)B/S: 0.125 + (0.125 – 0.10) (Rs 2,00,000 /
0.15
Rs 2,00,000)
The weighted average cost of capital to verify the validity of the NOI Approach:
k0 = ki(B/V) + ke(S/V) = 0.10 (Rs 2,00,000 / Rs 4,00,000) + 0.15 (Rs 0.125
2,00,000 / Rs 4,00,000)
Thus, we find that the overall cost of capital is 12.5 per cent as per the
requirement of the NOI Approach.
In order to examine the effect of leverage, let us assume that the firm
increases the amount of debt from Rs 2,00,000 to Rs 3,00,000 and uses the
proceeds of the debt to repurchase equity shares. The value of the firm would
remain unchanged at Rs 4,00,000, but the equity-capitalisation rate would go
up to 20 per cent as shown in Table 5.

TABLE 5  Value of the Firm (NOI Approach)

Net operating income (EBIT) Rs 50,000
Overall capitalisation rate (k0) 0.125
Total market value of the firm (V) = EBIT/k0 4,00,000
Total value of debt (B) 3,00,000
Total market value of equity (S) = (V – B) 1,00,000
ke = [(Rs 50,000 – Rs 30,000) / Rs 1,00,000] 0.20
Alternatively: ke = 0.125 + (0.125 – 0.10) (Rs 3,00,000 / Rs 1,00,000) 0.20
k0 = 0.10 (Rs 3,00,000 / Rs 4,00,000) + 0.20 (Rs 1,00,000 / Rs 0.125
4,00,000)
Let us further suppose that the firm retires debt by Rs 1,00,000 by issuing
fresh equity shares of the same amount. The value of the firm would remain
unchanged at Rs 4,00,000 and the equity-capitalisation rate would come down
to 13.33 per cent as manifested in the calculations in Table 6.

TABLE 6  Total Value of the Firm (NOI Approach)

Net operating income (EBIT) Rs 50,000
Overall capitalisation rate (k0) 0.125
Total market value of the firm (V) = EBIT/k0 4,00,000
Total value of debt (B) 1,00,000
Total market value of equity (S) = (V – B) 3,00,000
ke =[(Rs 50,000 - Rs 10,000) / Rs 3,00,000] 0.133
Alternatively: ke = 0.125 + (0.125 – 0.10) (Rs 1,00,000 / Rs 3,00,000) 0.133
K0 = 0.10 (Rs 1,00,000 / Rs 4,00,000) + 0.133 (Rs 3,00,000 / Rs 0.125
4,00,000)
Market Price of Shares
In example 2, let us suppose the firm with Rs 2 lakh debt has 2,000
equity shares (of Rs 100 each) outstanding. The firm has issued
additional debt of Rs 1,00,000 to repurchase its shares amounting
to Rs 1,00,000; it has to repurchase 1,000 shares of Rs 100 each
from the market. It, then, has 1,000 equity shares outstanding,
having total market value of Rs 1,00,000. The market price per
share, therefore, is Rs 100 (Rs 1,00,000 ÷ 1,000) as before.
In the second situation the firm issues, 1,000 equity shares of Rs
100 each to retire debt aggregating Rs 1,00,000. It will have 3,000
equity shares outstanding, having total market value of Rs
3,00,000, thus, giving a market price of Rs 100 per share.
Thus, we note that there is no change in the market price per share
due to change in leverage.
We have portrayed the relationship between the leverage and the
various costs, viz. ki, ke and k0 in Fig. 2.
The graph is based on Example 2. Due to the assumption that k0 and ki remain
unchanged as the degree of leverage changes, we find that both the curves are
parallel to the x-axis. But as the degree of leverage increases, the ke increases
continuously.

Y
25.0

20.0
ke
Ke, ki and k0 (%)

15.0

k0
10.0
ki
5.0

X
0 0.5 1.0
Degree of Leverage (B/V)

Figure 2: Leverage and Cost of Capital (NOI Approach)

Modigliani-Miller (MM) Approach

Modigliani and Miller (MM) concur with NOI and

provide a behavioural justification for the
irrelevance of capital structure. They maintain
that the cost of capital and the value of the firm
do not change with a change in leverage.
The MM Approach maintains that the weighted average
(overall) cost of capital does not change, as shown in Fig. 3,
with a change in the proportion of debt to equity in the capital
structure (or degree of leverage). They offer operational
justification for this and are not content with merely stating
the proposition.

(in Rs)
v
k0 (%)

V0 x
k0 Degree of Leverage (B/V)

Figure 3: Leverage and Cost of Capital (MM Approach)

Basic Propositions
1) The overall cost of capital (k0) and the value of the firm
(V) are independent of its capital structure. The k0 and V
are constant for all degrees of leverage. The total value is
given by capitalising the expected stream of operating
earnings at a discount rate appropriate for its risk class.
2) The second proposition of the MM Approach is that the ke
is equal to the capitalisation rate of a pure equity stream
plus a premium for financial risk equal to the difference
between the pure equity-capitalisation rate (ke) and ki
times the ratio of debt to equity. In other words, ke
increases in a manner to offset exactly the use of a less
expensive source of funds represented by debt.
3) The cut-off rate for investment purposes is completely
independent of the way in which an investment is
financed.
Assumptions
a) Perfect capital markets: The implication of a perfect capital
market is that (i) securities are infinitely divisible; (ii) investors
are free to buy/sell securities; (iii) investors can borrow without
restrictions on the same terms and conditions as firms can; (iv)
there are no transaction costs; (v) information is perfect, that is,
each investor has the same information which is readily available
to him without cost; and (vi) investors are rational and behave
accordingly.
b) Given the assumption of perfect information and rationality, all
investors have the same expectation of firm’s net operating
income (EBIT) with which to evaluate the value of a firm.
c) Business risk is equal among all firms within similar operating
environment. That means, all firms can be divided into ‘equivalent
risk class’ or ‘homogeneous risk class’. The term
equivalent/homogeneous risk class means that the expected
earnings have identical risk characteristics. The dividend payout
ratio is 100 per cent.
d) There are no taxes. This assumption is removed later.
Example 3
Assume there are two firms, L and U, which are identical in all
respects except that firm L has 10 per cent, Rs 5,00,000 debentures.
The earnings before interest and taxes (EBIT) of both the firms are
equal, that is, Rs 1,00,000. The equity-capitalisation rate (ke) of firm
L is higher (16 per cent) than that of firm U (12.5 per cent).
Solution:
The total market values of firms L and U are computed in Table 7.
TABLE 7  Total Value of Firms L and U
Particulars Firms
L U
EBIT Rs 1,00,000 Rs 1,00,000
Less: Interest 50,000 —
Earnings available to equity-holders 50,000 1,00,000
Equity-capitalisation rate (ke) 0.16 0.125
Total market value of equity (S) 3,12,500 8,00,000
Total market value of debt (B) 5,00,000 —
Total market value (V) 8,12,500 8,00,000
Implied overall capitalisation rate/cost of capital (k0) 0.123 0.125
= EBIT/V
Debt-equity ratio = B/S 1.6 —
Thus, the total market value of the firm which employs debt in the capital structure (L) is
more than that of the unlevered firm (U). According to the MM hypothesis, this situation
cannot continue as the arbitrage process, based on the substitutability of personal
leverage for corporate leverage, will operate and the values of the two firms will be
brought to an identical level.
Arbitrage Process The modus operandi of the arbitrage process is as follows:
Suppose an investor, Mr X, holds 10 per cent of the outstanding shares of the
levered firm (L). His holdings amount to Rs 31,250 (i.e. 0.10 × Rs 3,12,500) and his
share in the earnings that belong to the equity shareholders would be Rs 5,000
(0.10 × Rs 50,000).
He will sell his holdings in firm L and invest in the unlevered firm (U). Since firm U
has no debt in its capital structure, the financial risk to Mr X would be less than in
firm L. To reach the level of financial risk of firm L, he will borrow additional funds
equal to his proportionate share in the levered firm’s debt on his personal
account. That is, he will substitute personal leverage (or home-made leverage) for
corporate leverage.
In other words, instead of the firm using debt, Mr X will borrow money. The effect,
in essence, of this is that he is able to introduce leverage in the capital structure
of the the unlevered firm by borrowing on his personal account. Mr X in our
example will borrow Rs 50,000 at 10 per cent rate of interest. His proportionate
holding (10 per cent) in the unlevered firm will amount to Rs 80,000 on which he
will receive a dividend income of Rs 10,000. Out of the income of Rs 10,000 from
the unlevered firm (U), Mr X will pay Rs 5,000 as interest on his personal
borrowings. He will be left with Rs 5,000 that is, the same amount as he was
getting from the levered firm (L). But his investment outlay in firm U is less (Rs
30,000) as compared with that in firm L (Rs 31,250). At the same time, his risk is
identical in both the situations. The effect of the arbitrage process is summarised
in Table 8.
TABLE 8  Effect of Arbitrage
(A) Mr X’s position in firm L (levered) with 10 per cent equity-holding
(i) Investment outlay Rs 31,250
(ii) Dividend Income 5,000
(B) Mr X’s position in firm U (unlevered) with 10 per cent equity holding
(i) Total funds available (own funds, Rs 31,250 + borrowed funds, Rs 81,250
50,000)
(ii) Investment outlay (own funds, Rs 30,000 + borrowed funds, Rs 50,000) 80,000
(iii) Dividend Income:
Total Income (0.10 × Rs 1,00,000) Rs
10,000
Less: Interest payable on borrowed funds 5,000 5,000
(C) Mr X’s position in firm U if he invests the total funds available
(i) Investment costs 81,250.00
(ii) Total income 10,156.25
(iii) Dividend income (net) (Rs 10,156.25 – Rs 5,000) 5,156.25
It is, thus, clear that Mr X will be better off by selling his securities in the levered firm and
buying the shares of the unlevered firm.
Arbitrage Process:
Reverse Direction  According to the MM hypothesis, since debt
financing has no advantage, it has no disadvantage either. In other
words, just as the total value of a levered firm cannot be more than
that of an unlevered firm, the value of an unlevered firm cannot be
greater than the value of a levered firm. This is because the arbitrage
process will set in and depress the value of the unlevered firm and
increase the market price and, thereby, the total value of the levered
firm. The arbitrage would, thus, operate in the opposite direction.

Example 4
Assume that in Example 3, the equity-capitalisation rate (ke) is 20 per
cent in the case of the levered firm (L), instead of the assumed 16
per cent. The total values of the two firms are given in Table 9.
TABLE 9  Total Value of Firms L and U
Particulars L   U
EBIT Rs 1,00,000 Rs 1,00,000
Less: Interest 50,000 —
Income to equity holders 50,000 1,00,000
Equity-capitalisation rate (ke) 0.20 0.125
Market value of equity 2,50,000 8,00,000
Market value of debt 5,00,000 —
Total value (V) 7,50,000 8,00,000
(k0) 0.133 0.125
B/S 2 0

Since both firms are similar, except for financing-mix, a situation in which their total
values are different, cannot continue, as arbitrage will drive the two values together.
Suppose, Mr Y has 10 per cent shareholdings of firm U. He earns Rs 10,000 (0.10 × Rs
1,00,000). He will sell his securities in firm U and invest in the undervalued levered firm,
L. He can purchase 10 per cent of firm L’s debt at a cost of Rs 50,000 which will provide
Rs 5,000 interest and 10 per cent of L’s equity at a cost of Rs 25,000 with an expected
dividend of Rs 5,000 (0.10 × Rs 50,000). The purchase of a 10 per cent claim against the
levered firm’s income costs Mr Y only Rs 75,000, yielding the same expected income of
Rs 10,000 from the equity shares of the unlevered firm. He would prefer the levered
firm’s securities as the outlay is lower. Table 10 portrays the reverse arbitrage process.
TABLE 10  Effect of Reverse Arbitrage Process
(A) Mr Y’s current position in firm U
Investment outlay Rs 80,000
Dividend income 10,000
(B) Mr Y sells his holdings in firm U and purchases 10 per cent of the levered firm’s
equity and debentures
Investment Income
Debt Rs 50,000 Rs 5,000
Equity 25,000 5,000
Total 75,000 10,000
Y would prefer alternative B to A, as he is able to earn the same income with a smaller
outlay.
(C) He invests the entire sum of Rs 80,000 in firm L
Investment Income
Debt Rs 53,333.00 Rs 5,333.30
Equity 26,667.00 5,333.40
Total 80,000,00 10,666.70
He augments his income by Rs 666.70.
The above illustrations establish that the arbitrage process will make the values of
both the firms identical. Thus, Modigliani and Miller show that the value of a levered
firm can neither be greater nor smaller than that of an unlevered firm; the two must be
equal
Limitations
The most crucial element in the MM Approach is the arbitrage process which
forms the behavioural foundation of, and provides operational justification to,
the MM hypothesis. The arbitrage process, in turn, is based on the crucial
assumption of perfect substitutability of personal/home-made leverage with
corporate leverage. The arbitrage process is, however, not realistic and the
exercise based upon it is purely theoretical and has no practical relevance.
Risk Perception  
In the first place, the risk perceptions of personal and corporate leverage are
different. If home-made and corporate leverages are perfect substitutes, as the
MM Approach assumes, the risk to which an investor is exposed, must be
identical irrespective of whether the firm has borrowed (corporate leverage) or
the investor himself borrows proportionate to his share in the firm’s debt. If
not, they cannot be perfect substitutes and consequently the arbitrage
process will not be effective
Convenience
Apart from higher risk exposure, the investors would find the personal
leverage inconvenient.
Cost
Another constraint on the perfect substitutability of personal and corporate
leverage and, hence, the effectiveness of the arbitrage process is the
relatively high cost of borrowing with personal leverage.
Institutional Restrictions  
Yet another problem with the MM hypothesis is that institutional
restrictions stand in the way of a smooth operation of the arbitrage process.
Several institutional investors such as insurance companies, mutual funds,
commercial banks and so on are not allowed to engage in personal leverage.
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 unlevered 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 portfolio
as well as in the firm’s portfolio. The MM assumption would not hold true in
such a situation.
Transaction Costs
Transaction costs would affect the arbitrage process. The effect of
transaction/flotation cost is that the investor would receive net
proceeds from the sale of securities which will be lower than his
investment holding in the levered/unlevered firm, to the extent of the
brokerage fee and other costs. He would, therefore, have to invest a
larger amount in the shares of the unlevered/ levered firm, than his
present investment, to earn the same return.
Taxes
Finally, if corporate taxes are taken into account, the MM Approach
will fail to explain the relationship between financing decision and
value of the firm. Modigliani and Miller themselves, as shown below,
are aware of it and have, in fact, recognised it.
Corporate Taxes
The MM contend that with corporate taxes, debt has a definite
advantage as interest paid on debt is tax-deductible and leverage
will lower the overall cost of capital. The value of the levered firm
(V1) would exceed the value of the unlevered firm (Vu) by an
amount equal to levered firm's debt multiplied by tax rate.
Vl = Vu + Bt (14)
where Vl = value of levered firm
Vu = value of unlevered firm
B = amount of debt
t = tax rate
Example 5
The earnings before interest and taxes are Rs 10 lakh for companies
L and U. They are alike in all respects except that Firm L uses 15 per
cent debt of Rs 20 lakh; Firm U does not use debt. Given the tax rate
of 35 per cent, the stakeholders of the two firms will receive different
amounts as shown in Table 11.

TABLE 11  Effect of Leverage on Shareholders

Particulars Company L Company U
EBIT Rs 10,00,000 Rs 10,00,000
Less: Interest 3,00,000 —
Earnings before taxes 7,00,000 10,00,000
Less: Taxes 2,45,000 3,50,000
Income available for equity-holders 4,55,000 6,50,000
Income available for debt-holders and 7,55,000 6,50,000
equity-holders
The total income to both debt holders and equity holders of levered
Company L is higher. The reason is that while debt-holders receive interest
without tax-deduction at the corporate level, equity-holders of Company L
have their incomes after tax-deduction. As a result, total income to both
types of investors increases by the interest payment times the rate, that is,
Rs 3,00,000 × 0.35 = Rs 1,05,000.
Assuming further that the debt employed by Company L is permanent, the
advantage to the firm is equivalent to the present value of the tax shield, that
is, Rs 7 lakh (Rs 1,05,000/0.15). Alternatively, it can be determined with
reference to equation 15.
(Brt/r) = Bt (15)
where t = Corporate tax
r = Rate of interest on debt
Bt = Amount of debt = 0.35 × Rs 20 lakh = Rs 7 lakh
It may be noted that value of levered firm (as shown by equation 14) reckons
this tax shield due to debt.
The implication of MM analysis in this case is that the value of the firm is
maximised when its capital structure contains only debt.
Bankruptcy Costs
MM assume that there are no bankruptcy costs. However, in practice,
excessive use of debt would involve such costs. These costs expose
businesses to high probabilities of default. A firm would find it
difficult to meet the obligations relating to payments of interest and
repayment of principal. This, in turn, may lead to liquidation of the
firm. Bankruptcy costs can be classified into two categories: (1)
direct bankruptcy costs and (2) indirect bankruptcy costs.
Direct Bankruptcy Costs  These are the legal and administrative
costs associated with the bankruptcy proceedings of the firm. They
also include the costs of selling assets at a price lower than their
worth/book value. In fact, it is very hard to find buyers for the
expensive assets like plant and equipment as they are configured to
a company’s specific needs and it is not easy to dismantle and move
them.11 The firm may incur heavy dismantling and removal costs.
Direct bankruptcy costs can be staggering and may be a disincentive
to debt financing. Such costs are referred to as bankruptcy tax.12
There is a tax shield on debt/borrowings, but it has potential
dangers/threats in that the more a company borrows, the more likely
it is that it will become bankrupt and pay the bankruptcy tax.
Therefore, a company faces a trade-off between advantages and
disadvantages of debt financing.
Indirect Bankruptcy Costs  These are the costs of avoiding a
bankruptcy filing by a financially distressed firm.13 What happens in
such firms is that valuable employees leave, suppliers do not grant
credit, customers seek more reliable suppliers and lenders demand
higher interest rates and impose more restrictive/protective
covenants in loan agreements. In brief, normal business operations
are disrupted and sales are adversely affected. Customers avoid
buying from such firms as they fear that the company might not
honour the warranty and it might be difficult to purchase/replaced
parts. All these costs are the costs of the threat of bankruptcy and
not bankruptcy per se. Therefore, prohibitive bankruptcy costs
discourage corporates to use excessive levels of debts. Debt should,
therefore, be used in safe limits. Figure 19.4 is modified to
incorporate the impact of bankruptcy cots on ke.
Figure 19.4 portrays the cost components of ke (Risk-free rate of
return Rf, Business risk premium, Bp, Financial risk premium, Fp)
and the impact of bankruptcy costs on it. Business risk premium is a
constant amount as it is not affected by debt financing. Therefore,
the line representing it is parallel to the ‘X’ axis. Financial risk
premium increases with the increased debt-equity ratio. Bankruptcy
costs result when debt is used beyond some point and such costs
increase with higher debt-equity ratio entailing increasing probability
of bankruptcy. As leverage increases, so does the penalty. For
extreme leverage, the penalty becomes very substantial indeed.
Thus, the value of a levered firm would be lower due to bankruptcy
costs. As a result, the value of a levered firm would be less than the
value shown as per equation 19.14 by the amount of bankruptcy
costs (BC). Symbolically,
Vl = Vu + Bt – BC (16)
Figure 19.5 shows the impact of MM approach on weighted average
cost of capital, WACC (Ko) in three specific cases. The Case I shows
ko remains constant at varying debt-equity ratios (in a world of no
taxes). The advantage of debt as a cheaper source of finance is
exactly offset by the increased equity capitalisation rate. In a
situation of taxes (Case II), there is always an advantage in using
debt according to MM. Therefore, Ko consistently decreases with the
increased leverage. Case III recognises the presence of bankruptcy
costs due to excessive use of debt. As a result, beyond point, ‘D’,
bankruptcy costs are higher than the advantage of using debt. Prior
to point ‘D’, there is a net advantage of leverage. Therefore,
WACC*/Ko* is minimum at OD point of leverage.
Figure 4 Costs of Equity, ke and Bankruptcy costs
Figure 5 Degree of Leverage (B/S) and WACC
SOLVED PROBLEM 1
Company X and Company 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 Rs 9,00,000 debentures, carrying 10 per cent rate of
interest. Both the firms earn 20 per cent operating profit on their total assets of
Rs 15 lakhs. Assume perfect capital markets, rational investors and so on; a tax
rate of 35 per cent and capitalisation rate of 15 per cent for an all-equity
company.
(a) Compute the value of firms X and Y using the Net Income (NI)
Approach.
(b) Compute the value of each firm using the Net Operating Income (NOI)
Approach.
(c) Using the NOI Approach, calculate the overall cost of capital (k0) for
firms X and Y.
(d) Which of these two firms has an optimal capital structure according to
the NOI Approach? Why?
Solution
(a) Valuation under NI approach
Particulars Firm X Firm Y
EBIT Rs 3,00,000 Rs 3,00,000
Less: Interest 90,000 —
Taxable income 2,10,000 3,00,000
Less: Taxes 73,500 1,05,000
Earnings for equity holders 1,36,500 1,95,000
Equity capitalisation rate (ke) 0.15 0.15
Market value of equity (S) 9,10,000 13,00,000
Market value of debt (B) 9,00,000 —
Total value of firm (V) 18,10,000 13,00,000

(b) Valuation under NOI Approach

Rs 3,00,000  1-0.35 
V   Rs 13,00,000
Y 0.15
V  Rs 13,00,000  Rs 9,00,000 (0.35)  Rs 16,15,000
X
 Rs 9,00,000   Rs 7,15,000 
(c) K ox  
 k .065 
d   
 k e 0.191    12.1 per cent
 Rs 16,15,000   Rs 16,15,000 
Similarly, K o  15 per cent
y
Working Notes
EBIT Rs 3,00,000
Less: Interest 90,000
Taxable income 2,10,000
Less: Taxes 73,500
NI 1,36,500
V as determined in (ii) 16,15,000
B 9,00,000
S (V – B) 7,15,000
Ke = (Rs 1,36,500/Rs 7,150,000) = 19.1 per cent or ke = k0 + (k0 – kd) B/S
= 12.1% + (12.1% - 6.5%) 9,00,000 / 7,15,000 = 19.1%
kd = 0.10 (1–0.35) = 6.5 per cent
(d) Neither firm has an optimum capital structure according to the NOI
Approach. Under the MM assumptions, the optimum capital structure requires
100 per cent debt.