ACKNOWLEDGEMENT

 

I would like to express my gratitude to all those who gave me the possibility to complete this project. I want to thank everybody for their stimulating support.

I am deeply indebted to my teacher Ms. Priyanka Chadda from the Keshav Mahavidyalaya (University of Delhi) whose help, stimulating suggestions and encouragement helped me in all the time of research for and writing of this project

CAPITAL STRUCTURE, COST OF CAPITAL AND ITS VALUATION

Definition:

Capital structure is the proportion of debt and preference and equity shares on a firm’s balance sheet. Capital structure refers to the mix or proportion of different sources of finance (debt and equity) to total capitalization. A firm should select such a financing-mix which maximizes its value/the shareholder’s wealth (or minimizes its overall cost of capital). Such a capital structure is referred to as the optimum capital structure.

Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value of the firm.

As a corollary, the capital structure should be examined from the point of view of its impact on value of the firm. It can be legitimately expected that if the capital structure decision affects the total value of the firm, a firm should select such a financing-mix as will maximize the shareholders wealth.

CAPITAL STRUCTURE THEORIES:

Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital and valuation. The four important theories are:

1. Net income (NI) approach

2. Net operating income (NOI) approach3. Modigliani and miller (MM) approach4. Traditional approach

ASSUMPTIONS:

1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares.

2. There are no corporate taxes3. The dividend payout ratio is 100 i.e. 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.5. The total financing remains constant.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.

NET INCOME THEORY:

The capital structure is relevant to the valuation of the firm.A change in financial leverage will lead to a corresponding change in the overall cost of capital and total value of the firm. If therefore the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will

decline, while the value of the firm as well as the market price of ordinary shares will increase. Conversely a decrease in leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as the market price of equity shares.

The NI Approach is based on the following assumptions : 1. There are no taxes.2. The cost of debt is less than cost of equity.3. The cost of debt does not change the risk perception

of investors.

Derivation:

B determines the value of debt.S defines the value of equity.B+S =V (value of the firm).B/V is the proportion of debt.S/V is the proportion of equity.Cost of debt (kd) =I (1-t)/B

=I/B (since there are no taxes)B=I/kd

Cost of equity (ke) =D1/P0 + gThe growth rate is zero.Ke= D1/P0=E1/P0

Since, there are no retained earnings, dividend and earnings are equal.ke =total earnings/S

= (EBIT-Interest)/S = (Net income)/SS= (EBIT-I)/ Ke

V=B+S

V=I/kd+ (EBIT-I)/ke

Cost of capital (Ko) = kd (B/V) +ke (S/V)=kd [(I/kd)/V] + ke [{(EBIT-I)/ke}/V]

=I/V + (EBIT-I)/V = (I+EBIT-I)/V

=EBIT/VV=EBIT/Ko

When market value of firm increases then cost of capital has to decrease.

The NI Approach is illustrated by a numerical example:

Example 1: A company’s expected annual net operating income (EBIT) =Rs.50, 000. The company has Rs.2, 00,000, 10%debentures. The equity capitalization rate (Ke) is 12.5%

Solution:Net operating income (EBIT) =50,000Rs.Less: interest on debentures (I) = (20,000)Earnings available to shareholders (NI) =30,000RsEquity capitalization rate (Ke) =.125Market value of equity(S=NI/Ke) =2, 40,000Market value of debt (B) =2, 00,000

Total value(S+B=V) =4, 40,000Overall cost of capital (EBIT/V) =11.36%

In order to examine the effect of a change in financing-mix on the firm’s overall cost of capital and its total value. Let us suppose that the firm has decided to raise the amount of debentures by Rs. 1, 00,000 and use the proceeds to retire the equity shares. The K d and K e would remain unaffected as per the assumptions of the NI approach. In the new situation the value of the firm will be as follows:

Net operating income (EBIT) =50,000Rs.Less: interest on debentures (I)

= (30,000)Earnings available to shareholders (NI) = 20,000RsEquity capitalization rate (Ke)

=.125Market value of equity(S=NI/Ke)

=1, 60,000Market value of debt (B)

=3, 00,000Total value(S+B=V)

=4, 60,000Overall cost of capital (EBIT/V)

=10.9%

Thus, the use of additional debt has caused the total value of the firm to increase the overall cost of capital to decrease

Now let us suppose that the amount of debt is reduced to Rs. 1, 00,000 and a fresh issue of equity shares is made to retire the debentures. Assuming the other facts, the value of the firm and weighted average cost of capital is shown below:

Net operating income (EBIT) =50,000Rs.

Less: interest on debentures (I) = (10,000)

Earnings available to shareholders (NI) =40,000Rs

Equity capitalization rate (Ke) =.125

Market value of equity(S=NI/Ke) =3, 20,000

Market value of debt (B) =1, 00,000

Total value(S+B=V) =4, 20,000

Overall cost of capital (EBIT/V) =11.9%

We find that the decrease in leverage has increased the overall cost of capital and has reduced the value of the firm.

Thus, according to the NI approach, the firm can increase/decrease its total value (V) and lower/increase its overall cost of capital (Ko) as it increases/decreases the degree of leverage.

Graphical representation:

We can graph the relationship between the various factors (Kd, Ke, and Ko) with the degree of leverage.

The degree of leverage is plotted along the x-axis, while the percentage rates of Kd, Ke and Ko are on the y axis. Due to the assumption that Ke and Kd 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, Ko decreases and approaches the cost of debt when leverage is 1, i.e. (Ko=Kd). It also means that there is no equity in the capital structure. This also means that firm’s overall cost of capital is minimum. The significant conclusion therefore, of the NI approach is

that the firm can employ 100% debt to maximize its value.

NET OPERATING INCOME APPROACH:

The approach is diametrically opposite to the NI approach.The essence of this approach is that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.

The NOI approach is based on the following propositions:1.Overall cost of capital/capitalization rate (Ko)

is constantThe NOI approach to valuation argues that the overall capitalization rate of the firm remains constant, for all degrees of leverage. the value of the firm is given by the formula.

V=EBIT/Ko

In other words, the market evaluates the firm as a whole. The split of the capitalization between debt and equity is, therefore not significant.

2.Residual value of equity

The value of equity is the residual value which is determined by deducting the total value of debt (B) from the total value of the firm (V). Symbolically, total market value of equity capital (S) =V-B

3.Changes in cost of equity capitalThe equity capitalization rate 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 capitalization rate would match the increase in the debt-equity ratio. The Ke would be =Ko+ (Ko-Kd) [B/S]

4.Cost of debtThe cost of debt has two parts

a)Explicit cost which is represented by the rate of interest. Irrespective of the degree of leverage, the firm is assumed to able to borrow at a given rate of interest. This implies that the increasing proportion of debt in the financial structure does not affect the financial risk of the lenders and they do not penalize the firm by charging higher interest.

b)Implicit or hidden costImplicit cost is the increase in cost of equity due to increase in debt.

As a result, the real cost of debt and the real cost of equity are the same and equal Ko.

5.Optimum capital structure

The total value of the firm is unaffected by its capital structure. No matter what the degree of leverage is, the total value of the firm will remain constant. The market price of shares will also not change with the change in debt-equity ratio. Any capital structure is optimum, according to the NOI approach.

The effect of NOI approach on the value of the firm and market price share is numerically illustrated below: Numerical example:

Assuming operating income= Rs. 50000, 10% outstanding debt= Rs2, 00, 000 and overall cost of capital is 12.5%

Solution:EBIT = Rs.50, 000Ko (capitalization rate) = 0.125Total market value (V=EBIT/Ko) = Rs.4, 00,000 Total value of debt (B)

= Rs.2, 00,000 Mkt. value of equity(S=V-B) = Rs.2, 00,000

Equity capitalization rate [Ke= {(EBIT -I)/ (V-B)}] = 0.15 = (50,000-20,000)/ (2, 00,000)

In order to examine the effect of leverage, let us assume that the firm increases the amount of debt from 2, 00,000 to 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 capitalization rate becomes 20%

Net operating income (EBIT) = Rs.50, 000

Ko (capitalization rate) = 0.125Total market value (V=EBIT/Ko) = Rs.4, 00,000Total value of debt (B) = Rs.3, 00,000Mkt. value of equity(S=V-B) = Rs.1, 00,000Equity capitalization rate (Ke) = 0.20

= (EBIT - I)/ (V - B) = (50,000-30,000)/ (1, 00,000)

Let us further suppose that the debt get reduced to Rs.1, 00,000 by issuing fresh equity capital of the same amount. The value of the firm would remain unchanged at Rs. 4, 00,000 and the equity capitalization rate becomes 13.3%.

EBIT = Rs.50, 000 Ko (capitalization rate) = 0.125 Total market value (v=EBIT/Ko) = Rs.4, 00,000 Total value of debt (B)

= Rs.100, 000Mkt. value of equity(S=V-B) = Rs.3, 00,000 Equity capitalization rate (Ke) = 0.133

= (EBIT - I)/ (V - B)

= (50,000-10,000)/ (2, 00,000)

The significant feature is that the equity capitalization rate increases with the increase in the degree of leverage. It has gone up from 15% to 20% with the increase in leverage from 0.5 to 0.75. the equity capitalization rate decreases with the decrease in the degree of leverage. It has come down from 15% to 13.33% with the decrease in leverage from 0.5 to 0.25.Thus, we note that there is no change in the market price due to change in leverage.

Graphical representation:

We have portrayed the relationship between the leverage and the various costs. Due to the assumption that Ko and Kd remain unchanged as the degree of leverage changes, we find both the curves are parallel to x axis. But as the degree of leverage increases the Ke increases continuously.

MODIGLIANI-MILLER (MM) APPROACH:

The MM proposition supports the NOI approach relating to the independence of the cost of capital of the degree of leverage at any level of debt-equity ratio.

It provides behavioral justification for constant overall cost of capital and therefore total value of the firm, weighted average cost of capital doesn’t change with a change in the proportion of debt to equity in the capital structure.In other words, MM approach maintains that the weighted average (overall) does not change with a change in the proportion of debt to the equity in capital structure (or degree of leverage). They offer operational justification for this and are not content with merely stating the proposition.

BASIC PROPOSITIONS:

1. Ko (overall cost of capital) and V are independent of its capital structure. The Ko and V are constant for all degrees of leverage. The total value is given by capitalizing the expected stream of operating

earnings at a discount rate appropriate for its risk class.

2. Ke is equal to the capitalization rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity capitalization rate (Ke) and K times the ratio of debt to equity. 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:

1.Perfect capital markets: the implication of a perfect capital market is that

a)Securities are infinitely divisibleb)Investors are free to buy/sell securities.c) Investors can borrow without restrictions on the

same terms and conditions as firms can.d)There are no transaction costse) Information is perfect i.e. each investor has the

same information which is readily available to him without cost.

f) Investors are rational and behave accordingly. 2. Expectations regarding EBIT are same for all

investors.3. Dividend payout ratio is 100%.4. There are no taxes.

5. Business risk is equal among all firms with similar operating environment. That means all firms can be divided into ‘equivalent risk classes or ‘homogeneous risk classes. The term equivalent risk class means that the expected earnings have identical risk characteristics. Firms within an industry are assumed to have the same risk categories. The categorization of firms into equivalent risk class is on the basis of the industry group to which the firm belongs.

The Operational justification is the arbitrage process. The term ‘Arbitrage’ implies buying a security in a market where price is low and selling where it is high. It is a balancing operation. The essence of the arbitrage process is the purchase of securities/assets whose prices are lower and sale of securities whose prices are higher in related markets which are temporarily out of equilibrium. The investors of the firm whose value is higher will sell their shares and instead buy shares of the firm whose value is lower. Investors would be able to earn the same return at lower outlay with the same perceived risk. This will continue till the market prices of two identical firms become identical. Thus the switching operation derives the total value of two homogeneous firms in all respects, except the debt equity ratio, together. The arbitrage process, as already indicated, ensures to the investor the same return at lower outlay as he was getting by investing in the firm whose total value was higher and yet, his risk is not increased. This is so because the investors would borrow in the proportion of the degree of leverage present in the firm. The use of debt by the investor for arbitrage is called as homemade or personal leverage. Homemade

leverage can replicate the firm’s capital structure, thereby causing investors to be indifferent to it. The essence is that the investors are able to substitute personal leverage or homemade leverage for corporate leverage, i.e. the use of debt by the firm itself.

EXAMPLE:

Assume there are two firms, L and U, which are identical in all respects except that the firm L has 10 % 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 capitalization rate (Ke) of firm L is higher (16%) than that of firm U (12.5%).

Particulars L U

EBIT Rs.1,00,000 Rs.1,00,000

-interest Rs.50,000 -

Earnings available to equity holders

Rs.50,000 Rs.1,00,000

Ke .16 .125

S Rs.3,12,500 Rs.8,00,000

B Rs.5,00,000 -

V Rs.8,12,500 Rs.8,00,000

EBIT/V=Ko .123 .125

B/S=debt-equity ratio

1.6 -

The modus operandi of the arbitrage process is as follows-Suppose an investor, Mr. X, hold 10% of the outstanding shares of the levered firm (L). His holdings amount to Rs. 31,250 (i.e. 0.1 * Rs. 3, 12,500) and his share in the earnings that belong to the equity shareholders would be Rs. 5,000 (0.1 * Rs. 50,000)He will sell his holdings in firm L and invest in the unlevered (U) firm. 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 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% rate of interest. His proportionate holding (10%) in the unlevered firm will amount to Rs. 80,000 on which he will receive a dividend income of Rs. 10,000. Out of this income, he will pay Rs. 5,000 as interest on his personal borrowings. He will be left with Rs. 5,000 that is the same amount he was getting from the levered firm (L). But his investment outlay in firm U is less as compared with that in firm L. at the same time, his risk is identical in both the situations.

The effect of arbitrage process is summarized below: (A)Mr. X’s position in firm L with 10% equity holding

a) Investment outlay Rs. 31,250

b)Dividend income 5,000

(B)Mr. X’s position in firm U with 10% equity holdinga)Total funds available(Own funds, Rs. 31,250 + borrowed funds, Rs.50, 000)

81,250b)Investment outlay (Own funds, Rs. 30000+borrowed funds, Rs. 50000)

80,000c) Dividend income:Total income (0.1*100000) 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

a) Investment costsRs.81,250

b)Total income 10,156

c) Dividend income (net)(Rs. 10,156- Rs. 5,000) Rs. 5,156

It is thus, clear that X will be better off by selling his securities in the levered firm and buying the shares of the unlevered firm. With identical risk characteristics of the two firms, he gets the same income with lower investment outlay in 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. This is so 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 reverse direction. Here the investors will dispose of their holdings in the unlevered and obtain the same return by acquiring proportionate share in the equity capital and the debt of the levered firm at a lower outlay without any increase in the risk.

Example: assume that the equity capitalization rate is 20% in the case of the unlevered firm (L), instead of the assumed 16%.

PARTICULARS L U

EBIT Rs.1,00,000 Rs.1,00,000

-Interest Rs.50,000 -

Income to equity share holders

Rs.50,000 Rs.1,00,000

Ke .2 .125

S Rs.2,50,000 Rs.8,00,000

B Rs.5,00,000 -

V Rs.7,50,000 Rs.8,00,000

Ko .133 .125

B/S 2 0

The modus operandi of the arbitrage process is as follows-Suppose an investor, Mr. Y, hold 10% of the outstanding shares of the unlevered firm (U). He earns Rs. 10,000 (0.1*1, 00,000).He will sell his holdings in firm U and invest in the levered (L) firm. He can purchase 10% of firm L’s debt at a cost of Rs. 50,000 which will provide Rs. 5,000 interest and 10% of L’s equity at a cost of Rs. 25,000 with an expected income of Rs. 5,000 (0.1*50,000). The purchase of a 10% 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. It is summarized below:

Effect of reverse arbitrage:

(A)Mr. Y’s current position in firm U with 10% equity holding

Investment outlay Rs. 80,000Dividend income 5,000

(B) Mr. Y sells his holdings in firm U and purchases 10% of the levered firm’s equity and debentures

Investment Income

Debt Rs. 50,000 Rs. 5,000Equity 25,000 5,000Total 75,000 10,000Y would prefer this situation to previous one as he is able to earn the same amount of income with a smaller outlay.

(C)He invests the entire sum of Rs. 80,000 in firm L.Investment Income

Debt Rs. 53,333 Rs. 5,333Equity 26,667 5,333Total 80,000

10,666He augments the income by Rs. 666

Thus, MM approach shows that the value of a levered firm can neither be greater nor smaller than that of an unlevered firm; the two must be equal. There is neither an advantage nor disadvantage in using debt in the capital structure. The principle involved is simply that investors are able to reconstitute their former position by offsetting changes in corporate leverage with personal leverage. As a result the investment opportunities available to them are not altered by changes in the capital structure of the firm.

Graphical representation:

The MM approach maintains that the weighted average cost of capital does not change, with a change in the proportion of debt to equity in the capital structure.

LIMITATIONS of MM APPROACH:

1.RISK PERCEPTION:

In the first place, the risk perceptions of personal and corporate leverage are different. If home-made leverage and corporate leverage 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. The risk exposure to the investor is greater with personal leverage than corporate leverage. The liability of an investor is limited in corporate enterprises in the sense that is liable to the extent of his proportionate shareholdings in case the company is forced to go in to liquidation. The risk, to which he is exposed, therefore, is limited to his relative holding. The liability of an individual borrower is, on the other hand, unlimited as even his personal property is liable to used for the payment to the creditors. The risk to the investor with personal borrowings is higher.

2.CONVINIENCE:

The investors would find it investor-borrower in case of personal leverage. That corporate leverage is more convenient to the investor means that the investors would prefer the personal leverage inconvenient. This is so because with corporate leverage the formalities and procedures involved in borrowing are to be observed by the firms while these will be the responsibility of them rather than to do the job themselves. The perfect substitutability of the two leverages is thus open to question.

3.COST:

Another constraint on the perfect substitutability of personal and corporate leverage and hence, the

effectiveness of the arbitrage cost is the relatively high cost of borrowing with the personal leverage. Lending costs are not uniform for all categories of borrowers. Large borrowers with high credit standing can borrow at a lower rate of interest compared to borrowers who are small and do not enjoy high credit standing. Therefore, it is reasonable to assume that a firm can obtain a loan at a cost lower than what the individual investor would have to pay. As a result of higher interest charges, the advantage of personal leverage would largely disappear and the MM assumption of personal and corporate leverage being perfect substitutes would be of doubtful validity.

4.INSTITUTIONAL RESTRICTIONS:

Institutional restrictions stand in the way of smooth operations 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. Thus, switching the option from the unlevered to the levered firm may not apply to investors and, to that extent, personal leverage is an imperfect substitute for corporate leverage.

5.DOUBLE LEVERAGES:

Double leverage includes leverage both in personal portfolio as well as in the firm’s portfolio. For instance, when an investor has already borrowed funds while investing in the shares of the unlevered firm. If the value of the firm is more than that of the levered firm, the arbitrage process would require selling the securities of

the overvalued firm and purchasing securities of the levered firm.

6.TRANSACTION COSTS:

Transaction costs would affect the arbitrage process. The effect of transaction/floatation 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 levered/unlevered firm, than his present investment, to earn the same return.

7.TAXES:

Finally, if corporate taxes are taken into account, MM approach would fail to explain the relationship between financing decision and value of the firm.

TRADITIONAL APPROACH:

The traditional approach is midway between the two extreme (NI and NOI) approaches. While the NI approach takes the position that the use of debt in the capital structure will always affect the overall cost of capital and the total valuation, the NOI approach argues that the capital structure is totally irrelevant. Traditional approach partakes some features from both these approaches. It is also known as the intermediate approach. It resembles the NI approach in arguing that cost of capital and total value of the firm are independent of the capital structure. But it does not subscribe to the view that value of a firm

will necessarily increase for all degrees of leverage. In one respect it shares a feature with the NOI approach that beyond a certain degree of leverage, the overall cost increases leading to decrease in the total value of the firm. But it differs from the NOI approach in that it does not argue that the weighted average cost of capital is constant for all degrees of leverages.

The crux of this approach is that through a judicious combination of debt and equity, a firm can increase its value and reduce its cost of capital (Ko) up to a point. However, beyond that point, the use of additional debt will increase the financial risk of the investors as well as of the lenders and as a result will cause a rise in the Ko. At such a point, the capital structure is optimum. In other words, at the optimum capital structure the marginal real cost of debt wiz; be equal to the real cost of equity.

At the optimum capital structure, the marginal real cost of debt, defined to include both implicit and explicit, will be equal to the real cost of equity. For a debt equity ratio before that level, the marginal real cost of debt would be less than that of equity capital, while beyond that level of leverage, the marginal real cost of debt would exceed that of equity.

Example:

Assuming a firm has EBIT=Rs. 40,000, 10% debentures of Rs. 1, 00,000 and current Ke=16%. The current value of the firm and its overall cost of capital is as follows:

EBIT =Rs.40, 000

Less: Interest on debentures (I) (10,000)

Earnings available to share holders (NI) 30, 000Ke

0.16Mkt. value of equity(S) Rs.1, 87,500Mkt. value of debt (B)

1, 00,000Total value(S+B=V)

2, 87,500Overall cost of capital (EBIT/V)

0.139Debt/equity ratio (B/S) 0.53

Assuming the firm issues additional Rs. 50,000 debentures which increases the Ke to 17%.

EBIT =Rs.40, 000

-Interest on debentures (I) = (16,500)Earnings available to share holders (NI)

=Rs.23, 500Ke

=0.17Mkt. value of equity(S) =1, 38,325Mkt. value of debt (B)

=1, 50,000

Total value(S+B=V) =2, 88,235Overall cost of capital (EBIT/V)

=0.138Debt/equity ratio (B/S) =1.08

Assuming the firm issues more additional Rs. 50,000 debentures which increases the Ke to 20%.

EBIT =Rs.40, 000

-Interest on debentures (I) = (25,000)Earnings available to share holders (NI)

=Rs.15, 000Ke

=0.2Mkt. value of equity(S) = 75,000Mkt. value of debt (B) =2, 00,000Total value(S+B=V) =2, 75,000Overall cost of capital (EBIT/V) =0.145Debt/equity ratio (B/S) =2.67

During the first phase, increasing leverage increases the total valuation of the firm and lowers the overall cost of capital. As the proportion of debt in the capital structure increases, the cost of equity begins to rise as a reflection of the increased financial risk. But it does not rise fast enough to offset the advantage of using the cheaper source of debt capital. Likewise, for most of the range of

this phase, the cost of debt (Kd) either remains constant or rises to a very small extent because the proportion of debt by the lender is considered to be within safe limits. Therefore, they are prepared to lend to the firm at almost the same rate of interest.

After a certain degree of leverage is reached, further moderate increases in leverage have little or no effect on total market value. During the middle range, the changes brought in equity capitalization rate and debt capitalization rate balance each other. As a result, the values of V and Ko remain almost constant.

Beyond a certain critical point, further increases in debt proportions are not considered desirable. They increase financial risks so much that both Ko and Kd start rising rapidly causing Ko to rise and V to fall.

Graphical representation:

The Ko curve is a shallow saucer with a horizontal section over the middle ranges of leverage. The firm should not go to the left or to the right of the saucer part of the curve. The traditional view on leverage is commonly referred to as one of the U shaped cost of capital curve. In such a situation, the degree of leverage is optimum at a point at which the rising marginal cost of borrowing is equal to the average overall cost of capital.

Thus, according to the traditional approach the cost of capital of a firm is dependent on the capital structure of the firm and there is an optimum capital structure in which the firm’s Ko is minimum and its V is maximum.