BASICS and TERMINOLOGY

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


 VALUE = VALUE AS EQ + VALUE AS DEBT



 VALUE = NET EARNINGS

 Ke/WACC
 NET INCOME APPROACH
Financial Plan
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
Ke .10 .10
Value of the equity 10000 ?

Kd .05

Value of the debt 3000

Value of the firm 10000 ?
WACC .10 ?
 NET INCOME APPROACH
Financial Plan
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
Ke .10 .10
Value of the equity 10000 8500

Kd .05

Value of the debt 3000

Value of the firm 10000 11500
WACC .10 .087
 Net Income (NI) Approach

 Assumptions:
o No taxes C ost

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

1. Earnings before interest and taxes, EBIT 1000

2. Less: interest, INT 450

3. Profit before taxes, PBT = EBIT – INT 550
Ke .15
Value of the equity ?

Kd .07

Value of the debt ?

Value of the firm ?
WACC .095
 TRADITIONAL APPROACH
Financial Plan
DEBT INCR

1. Earnings before interest and taxes, EBIT 1000

2. Less: interest, INT 450

3. Profit before taxes, PBT = EBIT – INT 550
Ke .15
Value of the equity 3667

Kd .07

Value of the debt 6248

Value of the firm 9910
WACC .095
Traditional Approach
 Assumptions:
o Same as Net Income C ost
Approach except that there
is a financial risk. ke


 Initial rise in Ke is less than ko

gain by issuing debt with
lower Kdbut at higher
stages Ke rises more.
 kd
 So there is an Optimum
capital structure where Ko
is the lowest.
D ebt

8
 NET OPERATING INCOME APPROACH
Financial Plan

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
Ke
Value of the equity 10000

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

o Same Business Risk

o No taxes.

D ebt
 No optimum capital
M M 's P r o p o s i ti o n I
structure explained
through operation al
arbitrage process
11
using home made
 M&M- operational Arbitrage
Financial Plan
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
Ke .10 .10
Value of the equity 10000 8500

Kd .05

Value of the debt 3000

Value of the firm 10000 11500
WACC .10 .087
 M&M – PROPOSITION II
Financial Plan

Levered Unlevered

1. Earnings before interest and taxes, EBIT 1000 1000

2. Less: Interest, INT 0 150

3. Profit before taxes, PBT = EBIT – INT 1000 850
Ke .10 ?
Value of the equity 10000

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

Optimum capital struture

100% Debt
 Then why is there not an
inclination of firm towards
DEBT?