STUDY NOTES

M.Com. Semester-II

Subject: Financial Management

Chapter: Capital Structure Theories

Prepared by: Dr. Sukumar Pal

Associate Professor in Commerce
Sree Chaitanya Mahavidyalaya
 Capital Structure Theories

Concepts of Capital Structure

Capital structure can be defined as the mix of owned capital (equity, reserves &
surplus) and borrowed capital (debentures, loans from banks, financial institutions)
Maximization of shareholders’ wealth is prime objective of a financial manager. The same
may be achieved if an optimal capital structure is designed for the company. Planning a
capital structure is a highly psychological, complex and qualitative process. It involves
balancing the shareholders’ expectations (risk & returns) and capital requirements of the firm.
Capital Structure.

Planning the Capital Structure Important Considerations

Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and
market price per share.

Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on
interest & no benefit on dividends.

Risk: insolvency risk associated with high debt component.

Control: avoid dilution of management control, hence debt preferred to new equity shares.

Flexible: altering capital structure without much costs & delays, to raise funds whenever
required.

Capacity: ability to generate profits to pay interest and principal.

Value of a Firm
 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. Value of a Firm – directly co-related with the
maximization of shareholders’ wealth.
 An illustration of Income Statement

Particulars Rs.
Sales (A) 10,000
(-) Cost of Goods sold (B) 4,000
Gross Profit (C = A – B) 6,000
(-) Operating Expenses (D) 2,500
Operating Profit (EBIT) (E = C – D) 3,500
(-) Interest (F) 1,000
EBT (G = E – F) 2,500
(-) Tax @ 30% (H) 750
EAT (I = G - H) 1,750
(-) Preference Dividends (J) 750
Profit For Equity Shareholders (K = I – J) 1,000

No. of Equity Share (L) 200

Earnings Per Share (EPS) (K/L) 5

Assumptions
 Firms use only two sources of funds – equity & debt.

 No change in investment decisions of the firm, i.e. no change in total assets.

 100 % dividend payout ratio, i.e. no retained earnings.

 Business risk of firm is not affected by the financing mix.

 No corporate or personal taxation.

 Investors expect future profitability of the firm.

Capital Structure Theories –
A) Net Income Approach (NI)
David Durand proposed this theory in 1959. According to this approach, the firm is
able to increase its total valuation V, an lower its cost of capital, Ko, as it increases the degree
of leverage, D/V. The optimum capital structure is that at which the cost of capital is the
lowest and the value of the firm is the greatest. At that structure the market price per share is
maximised.

The significance of the NI approach is that a firm can lower its overall cost of
capital continuously by increasing the proportion of cheaper debt capital in its capital
structure. It leads to an increase in the total value of the firm. If this process continues, the
firm will be able to achieve the optimum capital structure.

• Net Income approach proposes that there is a definite relationship between capital
structure and value of the firm.
• The capital structure of a firm influences its cost of capital (WACC), and thus directly
affects the value of the firm.
NI approach assumptions –
• NI approach assumes that a continuous increase in debt does not affect the risk
perception of investors.
• Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]
• Corporate income taxes do not exist.
• As per NI approach, higher use of debt capital will result in reduction of WACC. As a
consequence, value of firm will be increased.
• Value of firm = Earnings / WACC
• Earnings (EBIT) being constant and WACC is reduced, the value of a firm will
always increase.
• Thus, as per NI approach, a firm will have maximum value at a point where WACC is
minimum, i.e. when the firm is almost debt-financed.

The NI approach can be explained with the help of the following illustration,

Illustration
Assume that a firm’s EBIT is Rs. 20,000. The cost of equity, Ke, is 15% and the cost of debt,
Kd, is 10%. Its total capital amounts to Rs. 2,00,000. Assuming that the firm can have the
following alternative degree of leverage:
Leverage (Debt to Total Capital): 0%, 20%, 50%, 80%, & 100%.
Compute the cost of capital and value of the firm for each alternative leverage using the NI
approach.
 Leverage 0 0.2 0.5 0.8 1.0
Particulars Rs. Rs. Rs. Rs. Rs.
Equity Capital 2,00,000 1,60,000 1,00,000 40,000 NIL
Debt Capital NIL 40,000 1,00,000 1,60,000 2,00,000
Total (Rs.) 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
EBIT (Rs.) 20,000 20,000 20,000 20,000 20,000
Interest on Debt Capital
@ 10% (I) (Rs.) NIL 4,000 10,000 16,000 20,000
Earnings to Equity (E)
(EBIT-I ) 20,000 16,000 10,000 4,000 -
20,000 20,000 20,000 20,000 20,000
Market Value of Debt
(I/Kd) : (D) (Rs.) NIL 40,000 1,00,000 1,60,000 2,00,000
Market Value of equity
(E/Ke) (S) (Rs.) 1,33,333 1,06,667 66,667 26,667 -
Total Value of the firm
(D+ S=V) (Rs.) 1,33,333 1,46,667 1,66,667 1,86,667 2,00,000

Kd 10% 10% 10% 10% 10%

Ke 15% 15% 15% 15% 15%
Ko (EBIT/V) 15% 13.63% 12% 10.71% 10%

The NI approach may be illustrated graphically in Fig. 1.

Fig.-1
Effect of Capital Structure on Cost of Capital
(NI Approach)

16% 15% 15% 15% 15% 15%

15%
14%
13.63%
12% 12%
Cost of Capital (%)

10.71%
10% 10%
10% 10% 10% 10% 10%
8% Kd
Ke
6%
Ko
4%

2%

0%
0 0.2 0.5 0.8 1
Degree of Leverage
 The degree of leverage, debt to total capital, is plotted along the X-axis while the cost
of capital (Kd, Ke and Ko) is on the Y-axis. The graph shows that as the proportion of
cheaper debt capital in the capital structure is increased, the weighted average cost of capital,
Ko, decreases and gradually approaches the cost of debt, Kd. The optimal capital structure is
corresponding to the minimum cost of capital, Ko, when financial leverage is one, i.e. with
maximum use of debt capital. At this level, the value of the firm is also maximum.

Capital Structure Theories –

(B) Net Operating Income Approach
Net Operating Income Approach was advocated by David Durand in 1959. In addition
to the list of common assumptions described earlier this theory is based on different set of
further assumptions, viz.-
1. Overall cost of capital, K0 is independent of capital structure and does not vary with
leverage. It implies that K0 remains constant irrespective of the degree of financial leverage.
In other words, K0 remains the same for all debt-equity ratios. The advantages of using
cheaper debt capital are offset exactly by the increase in the cost of equity, Ke.

2. The market capitalises the value of the firm as a whole (the split between debt and equity is
not important). The value of the firm, V, is measured by dividing the firm’s net operating
𝐸𝐵𝐼𝑇
income (EBIT) by the overall cost of capital (Ko), Thus, V=
𝐾𝑜

As both EBIT and Ko are constant and independent of financial leverage, V does not change
as leverage is changed.

3. The value of the equity, S, is found as a residual by subtracting the value of the debt, D,
from the (constant ) value of the firm (V) viz.-

S= V-D

The cost of debt, Kd, is a constant. The cost of equity is :

𝐸𝐵𝐼𝑇−𝐼
Ke=
𝑆

4. The use of cheaper debt capital increases the risk to shareholders. This raises the cost of
equity or equity capitalisation rate.

NOI propositions (i.e. school of thought) –

 The use of higher debt component (borrowing) in the capital structure increases the
risk of shareholders.

 Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e.
higher cost of equity (Ke).
  A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of
debt (Kd ).

 This approach implies that there is no one optimum capital structure as the cost of
capital remains the same for all debt-equity ratios.

 In other words, this means that as the cost of capital is the same at all capital
structures, every capital structure are optimal. Thus, capital structure would be a
matter of indifference to the investor.

Under the NOI approach, the cost of equity, Ke, increases but the cost of debt, Kd, the
weighted average cost of capital, Ko, and the total value of the firm, V all remain constant as
leverage is changed. Thus the advantage of having cheaper debt capital is lost to the company
as there will be an offsetting increasing in its cost of equity. Thus, there is no one single
optimal capital structure to the company as its cost of capital remains the same of all debt-
equity ratios.
The NOI approach can be explained with the help of the following illustration:
Assuming:
Average cost of capital, Ko = 12%
Cost of debt capital, Kd = 10%
Net Operating Income (EBIT) = Rs. 15,000
Total capital structure value = Rs. 1,00,000
Calculate the cost of equity, Ke, and value of the firm, V, for each of the following
alternative leverage under NOI approach.
Leverage: 0%, 20%, 50%, 80% & 100%.
(Debt to Total Capital)
Solution
Leverage 0 0.2 0.5 0.8 1.0
Particulars

Debt (Rs.) NIL 20,000 50,000 80,000 1,00,000

Equity (Rs.) 1,00,000 80,000 50,000 20,000 NIL
Total (Rs.) 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Interest on Debt Capital
@ 10% (I) (Rs.) NIL 2,000 5,000 8,000 10,000
EBIT (Rs.) 15,000 15,000 15,000 15,000 15,000
EBIT-I = EBT (Rs.) 15,000 13,000 10,000 7,000 5,000
(Earnings to Equity)
Value of the firm (V)
(Rs.) EBIT/Ko 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
Value of Debt (D) (Rs.) - 20,000 50,000 80,000 1,00,000
Value of equity (S) (Rs.)
(V-D=S) 1,25,000 1,05,000 75,000 45,000 25,000
Ke [Earning available to
equity share holder /S] 12% 12.4% 13.3% 15.6% 20%
Ko [EBIT/V] 12% 12% 12% 12% 12%
Kd 10% 10% 10% 10% 10%
 The above table reveals that the cost of debt, Kd and the average cost of capital, Ko, are
respectively 10% and 12% and assumed to be constant. The value of the firm, V of Rs.
1,25,000 remains constant at all levels. Whereas, cost of equity, Ke, increases with increase
in debt to capital employed ratio. In other words, an increase in the use of cheaper debt
capital is offset by the increase in the cost of equity, Ke.

The NOI approach may be illustrated graphically in Fig. 2.

Fig.-2
Effect of Capital Structure on Cost of Capital
(NOI Approach)

25%

20% 20%
15.60%
COST OF CAPITAL (%)

15% 13.30%
12% 12.40%
Ke
12% 12% 12% 12% 12% Ko
10%
10% 10% 10% 10% 10%
Kd

5%

0%
0 0.2 0.5 0.8 1
LEVERAGE

Using the data of above illustration, debt to capital employed ratio is plotted on the
horizontal axis and Kd, Ke and Ko, are plotted on the vertical axis. The graph shows that Ko
is equal to Ke when the debt to capital employed ratio is equal to zero. Then with the every
increase of its degree of leverage, the firm becomes increasingly more risky. So, cost of
equity, Ke, or the equity capitalisation rate, increases. But use of greater proportion of
cheaper debt capital offset the increase in the cost of equity. However, overall cost of capital,
Ko, remains the same as before. Hence, any capital structure is treated as optimal for the
company.

Capital Structure Theories-

Traditional Approach
According to the NI approach, the use of the debt capital in the capital structure always
affects the overall cost of capital as well as the total value of the firm whereas the NOI
approach advocates that the capital structure decision is totally irrelevant to the overall cost of
capital and the total value of the firm.
 However, the Traditional Approach is midway between the NI and NOI approaches. It, in
fact, adopts some features of both the NI and NOI approaches. It compromise between the
two approaches, therefore it is known as Intermediate Approach.
This approach subscribes to the view of the NI approach that cost of capital and total
value of the firm are not independent of the capital structure. But it disagrees with the view of
the NI approach that a firm can continuously enjoy a higher market value by increasing its
debt-equity ratio.
On the other hand, the traditional approach shares a feature with the NOI approach that
beyond a certain value of debt-equity (or a certain degree of financial leverage), the overall
cost of capital increases which results in a decrease in the total value of the firm. However, at
the same time, the traditional approach disagrees with the proposition of the NOI approach
that the overall cost of capital is constant for all degrees of leverage (all values of debt-equity
ratio).
There are considerable differences in the opinion among the followers of the traditional
approach. But all of them are in substantial agreement that the judicious use of debt capital
will reduce the overall cost of capital and increase the value of the firm. The optimal capital
structure is that combination of debt and equity at which the overall cost of capital is
minimum and the market value of the firm is maximum.
There are two variant of the traditional approach.

Traditional Approach: First Variant

 According to this variant of the traditional approach, the use of debt capital will increase
the value of the firm and reduce the cost of capital up to a certain point.
 Beyond that the increase of equity more than offsets the use of cheaper debt capital in the
capital structure and average cost of capital begins to rise.
 There is further rise in the average cost of capital when cost of debt also begins to rise.
 The optimal capital structure is the point at which overall cost of capital is the minimum or
value of the firm, maximum.
Example

Total Investment Rs. 1,00,000

EBIT Rs. 15,000
Cost of equity:
Up to Rs. 50,000 15%
Beyond that level but up to Rs. 80,000 18%
Between Rs. 80,001 and Rs. 1,00,000 20%
Cost of Debt:
Up to Rs. 50,000 10%
Above that level but up to Rs. 80,000 13%
Above Rs. 80,000 but up to Rs. 1,00,000 15%
Assuming the following leverage, calculate cost of capital and value of the firm for each
level of alternative plans and recommended the optimum capital structure.
 Leverage 0 0.2 0.5 0.8 1.0
Particulars
Kd 10% 10% 10% 13% 15%
Ke 15% 15% 15% 18% 20%
Ko [ Kd (D/V) + Ke (S/V) 15% 14% 12.5% 14% 15%
Interest on Debt Capital(I)
[ Kd x D] (Rs.) NIL 2,000 5,000 10,400 15,000
EBIT (Rs.) 15,000 15,000 15,000 15,000 15,000
EBIT-I = EBT (Rs.)
(Earnings to Equity) 15,000 13,000 10,000 4,600 NIL
Value of Debt (D) [I/Kd] (Rs.) NIL 20,000 50,000 80,000 1,00,000
Value of equity (S) [EBT/Ke] (Rs.)
Total value of the firm 1,00,000 86,667 66,667 25,556 -
(D+S=V)
1,00,000 1,06,667 1,16,667 1,05,556 1,00,000

The above table shows that cost of capital is lowest (12.5%) and value of the firm is
the highest (Rs. 1,16,667) when debt-equity combination is 1:1, i.e. Rs. 50,000 debt and Rs.
50,000 equity in the above case. Therefore, optimum capital structure, in this case, would be
Rs. 50,000 equity capital and Rs. 50,000 debt capital to maximise the value of the firm or to
minimise the overall cost of capital.
Fig.-3
Effect of Capital Structure on Cost of Capital
(Traditional Approach- First Variant)

25%

Ke 20%
20% 18.00%

15% 15.00%
15.00% Ko 15%
Cost of Capital (%)

15% 15% 14%

14% 15%
X 13% Kd
13% Ke

10% Ko
10% 10% 10%
Kd

5%

0%
0 0.2 0.5 0.8 1
LEVERAGE
 The first variant of the traditional can also be shown graphically (Fig.-3) using the
data from the above illustration. Here, the average cost curve is U shaped. There is a point at
which the cost of capital would be minimum. This is denoted by letter X in the graph. Aq
perpendicular drawn to the X-axis indicates the optimum capital structure.
Thus, the traditional position implies that the cost of capital is not independent of the
capital structure. For degrees of leverage before that point, the marginal real cost of debt is
less than that of equity; beyond that point, the marginal cost of debt exceeds that of equity. At
the optimum structure, the marginal real cost of debt is the same as the marginal real cost of
equity is equilibrium.

Traditional Approach: Second Variant

According to this variant of the traditional approach, the impact of the use of debt
capital in the capital structure of the firm on its overall cost of capital and its total value can
be divided into three distinct phases. These phases are discussed below:

Phase I
In this phase, the following are discernable:
(i) Cost of debt (Kd) remains constant or increases to a very small extent;
(ii) Cost of equity (Ke) remains constant or rises as debt is added but does not rise fast
enough to offset the benefit of cheaper debt capital.
As a result, in this phase with an increase in the proportion of debt capital in the capital
structure, the overall cost of capital declines and the total value of the firm goes up.
Phase II
Once the firm has reached a certain degree of leverage, the addition of debt will have
an insignificant impact on the cost of capital or the value of the firm. As a consequence, Ko
or V, remains relatively constant within a range. In this phase both the cost of equity and cost
of debt increases in such a way that their combined effect on the overall cost of capital
remains unchanged.
Phase III
After a critical point any further increase in the debt to a firm’s capital structure
causes an increase in the cost of capital, Ko, and decrease in the value of the firm, V. This is
because both cost of debt, Kd, and cost of equity, Ko, will rise at an abnormal rate due to
high degree of financial risk.
These three phases are represented in Fig.-4.
Debt-equity ratio is plotted on the horizontal axis and Kd, Ke, Ko are plotted on the
vertical axis. It shows that the overall cost of capital Ko curve is saucer-shaped. It implies
that debt-equity ratios corresponding to the bottom of the curve constitute the optimal range.
It shows that there is a range of debt-equity ratios in which the overall cost of capital is
minimized and the value of the firm is maximized.
 Fig.- 4
Effect of Capital Structure on Cost of Capital
(Traditional Approach- Second Variant)

C Ke
O
Ko
S
T
O Kd
F PHASE-I PHASE-III
PHASE-I
C
A
P
I
T
A
L
%
LEVERAGE (DEBT-EQUITY RATIO)

Debt-equity ratio is plotted on the horizontal axis and Kd, Ke, Ko are plotted on the
vertical axis (Fig.-4). It shows that the overall cost of capital Ko curve is saucer-shaped. It
implies that debt-equity ratios corresponding to the bottom of the curve constitute the optimal
range. It shows that there is a range of debt-equity ratios in which the overall cost of capital is
minimized and the value of the firm is maximized.

Capital Structure Theories -Modigliani-Miller Hypothesis

Franco Modigliani and Merton H. Miller developed a theoretical argument entitled
“The Cost of Capital, Corporation Finance and The Theory of Investment” which was
published in American Economic Review, June, 1958.
The theory supports the NOI approach. They argue that there is no influence of the
capital structure of a firm on its cost of capital and market value. In other words, the overall
cost of capital and the value of the firm are independent of the capital structure.

Assumptions

1. Capital markets are perfect.

It implies that-
(a) There is no transaction cost.
(b) There is no bankruptcy cost.
(c) Investors are free to buy, sell & switch between securities
(d) Securities are infinitely divisible.
 (e) Individual investors can borrow without restrictions on the same terms and conditions
as firms can.
(f) Investors are rational and behave accordingly.
2. Investors have identical expectations about future operating earnings. That is, investors
have homogenous expectations.
3. Firms operate in similar business conditions and have similar business risk. All firms can
be classified into homogeneous risk classes.
4. The dividend payout ratio is 100%. It implies that all earnings are distributed among
shareholders as dividend.
5. There is no corporate tax. However, this assumption is removed later on.
Based on the above assumptions, M-M developed two propositions which are discussed as
follows:

Proposition I

• This identical to the NOI hypothesis.

• Total market value of the firm (V) and its cost of capital (Ko) are independent of its capital
structure.

• Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the
appropriate rate (i.e. WACC).

• Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT/Expected
WACC . This can be stated symbolically as follows:

𝐸𝐵𝐼𝑇
V = D+S =
𝐾𝑜
𝐸𝐵𝐼𝑇
Ko = ,
𝑉
𝐷 𝑆
Ko = Kd ( ) + Ke (𝑉)
𝑉

• EBIT is not influenced by the sources from which the funds have been raised and thus, it
is independent of capital structure.

• The overall cost of capital (Ko) is also assumed to be constant with regard to the level of
debt-equity ratio.

• As both EBIT and Ko are independent of capital structure, V is also constant and is not
influenced by the capital structure.

• Thus, Proposition I is identical with the NOI approach.

 Fig.- 5 Modigliani-Miller Hypothesis- Proposition I

Over
all
cost
of Ko
capital
(Ko)

Debt-equity ratio

The cost of capital curve, as hypothesised by M-M, is shown in Fig.-5. Like NOI approach,
the Cost of Capital, Ko, is a constant irrespective of change in the capital structure.

• M-M developed an argument in favour of an arbitrage process in order to prove their first
proposition.
• The M-M hypothesis states that two firms with identical assets, irrespective of how these
assets have been financed cannot have different market values.
• But if any difference in their market values arises, a process of arbitrage (or switching
process) will take place to enable investors to switch their securities between identical
firms (from levered firms to un-levered firms) and receive the same returns from both
firms.
Arbitrage or Switching Process

Unlevered Firm A Ltd. Levered Firm B Ltd.

(Financed by equity only) (Financed by a mix of
equity and debt)
Net Operating Income (EBIT) Rs. 2,00,000 Rs. 2,00,000
Interest on debt capital (I) - Rs. 72,000
Net income available to equity Rs. 2,00,000 Rs. 1,28,000
shareholders (E= EBIT-I)
Cost of equity (Ke) 0.20 0.25
Cost of debt (Kd) - 0.144

Market value of equity (S=E/Ke) 10,00,000 5,12,000

Market value of debt (D=I/Kd) - 5,00,000

Total value of the firm (V=D+S) 10,00,000 10,12,000

Overall cost of capital 0.20 0.1976

(Ko= EBIT/V Or Or
20% 19.76%
(approx.)
 The above particulars show that the value of B Ltd. (levered firm) is higher than that
of A ltd. (unlevered firm) even though both the firms are identical in every respect except
their capital structure. However, according to the M-M, this situation cannot continue
because of the existence of arbitrage mechanism. M-M argue that by investing in unlevered
firm, investors in levered can obtain the same rate of return without any increase in financial
risk. Moreover, they can do so with a lesser investment outlay. This arbitrage process persists
until the price of levered firm declines and that of unlevered firm goes up enough to make the
total value of both the firms identical.
Suppose, Mr. R is a rational investor who own 1% of the equity shares of B Ltd. (levered
firm), worth Rs. 5,120 (market value). If he intends to increase his total returns without
increasing financial risk, he has to:

(i) Sell his equity shares in B Ltd. For Rs. 5,120.

(ii) Borrow Rs. 5,000, an amount equal to 1% of B Ltd.’s debt at 14.4% interest.
(iii) Buy 1% of the equity shares of Deep Ltd. (Unlevered firm) for Rs. 10,000.
If the above steps are taken, Mr. R will get Rs. 10,120 (Rs. 5120 as sale proceeds of his
equity plus Rs. 5,000 as borrowings) and spend Rs. 10,000 in order to acquire the equity
shares of A Ltd. So, a surplus amount of Rs. 120 will be available in the hands of Mr. R.

Income Position of Mr. R

Old Income: Income from investment in equity Rs. 1,280

shares of B ltd. = Rs. (5,120 x 25/100)
New Income Income from investment in equity shares of A Ltd.
= Rs. (10,000 x 20/100) = Rs. 2,000
Less: 14.4% interest on loan of
Rs. 5,000 = Rs. (5,000 x 14.4/100) = Rs. 720 Rs. 1,280

If Mr. R utilises the surplus amount of Rs. 120 by making a suitable investment, his new
income will be higher than his old income. But his risk exposure will remain unchanged as he
substitutes homemade or personal leverage from corporate leverage.
Similar actions of a number of investors undertaking similar arbitrage transactions will
tend to increase the price of equity shares of A Ltd. And decrease its cost of equity. It will
also tend to decrease the price of equity shares of A ltd. and increase its cost of equity. This
arbitrage will continue until the value of B Ltd. (levered firm) equals that of B Ltd.
(unlevered firm). Thus, in equilibrium the value of B Ltd. will be equal to that of A Ltd. It
also implies that at this equilibrium the overall cost of capital for both the firms will be the
same.
Proposition II

M-M argue that the cost of equity, Ke, is equal to a constant average or overall cost of
capital, Ko, plus a risk premium that depends on the degree of leverage. This proposition can
be symbolically expressed as follows:
Ke = Ko + Risk premium
The premium for financial risk equals to the difference between the pure equity capitalisation
𝐷
rate, Ko, and cost of debt, Kd, times the ratio , i.e.
𝑆
D
Ke = Ko + (Ko-Kd)
S
This equation can be derived in the following way:
The overall cost Ko, in case of a levered firm, is the weighted average of the cost of equity
Ke and cost of debt Kd, i.e.
S D
Ko = Ke × + Kd ×
D+S D+S

S D
or, Ke × = Ko - Kd ×
D+S D+S

D+S D
or, Ke = Ko - Kd ×
S D+S

D+S D+S D
or, Ke = × Ko - × Kd ×
S S D+ S

D D
or, Ke = × Ko + Ko – Kd ×
S S

D
or, Ke = Ko + (Ko – Kd)
S

D
This equation implies that there is a linear relationship between Ke and . i.e. Y = a + bx.
S
Ke increases in a manner to offset exactly the use of a less expensive source of funds
represented by debt capital. As a result, the market value of the firm remains unchanged.

Interpretation of the M-M Hypothesis

When proposition I and II of M-M hypothesis are combined, it implies that although debt
is considered as cheaper source of capital as compared to equity, inclusion of additional debt
in the capital structure of the firm will not increase its value because the benefits of cheaper
debt capital are exactly off-set by the increase in the cost of equity. So, the capital structure of
the firm has no bearing on its value.

Criticisms of the MM hypothesis

The M-M hypothesis is based on certain assumptions. Most of the assumptions underlying
the M-M hypothesis are unrealistic in the real world situation. The major areas of criticism
are as follows:
1. It is assumed that there is no transaction cost. This is also an unrealistic assumption
because in reality such costs do exist and interfere with the working of arbitrage process.
2. In M-M hypothesis it is assumed that firms and individuals can borrow and lend at the
same rate of interest. This does not hold good in reality. Generally, holding of more
 assets and higher credit reputation the firms in a better position to borrow than
individuals. Therefore, the cost of borrowing could be higher for the individuals than that
for the firm.
3. The M-M hypothesis assumes that personal or homemade leverage is a perfect substitute
for corporate leverage. But firms have limited liability as against the unlimited liability
of individuals. It places firms and individuals on a different footing in the capital
markets. So, personal leverage and corporate leverage are not perfect substitutes.
4. The M-M theory assumes that informational asymmetry does not exist. But in reality this
assumption does not hold good. In fact, informational asymmetry exists because
managers are better informed than investors.
5. It is assumed that the dividend payout ratio is 100%. But, generally, a firm does not
distribute 100% of its earnings as dividend among shareholders.
6. The M-M theory assumes non-existence of corporate taxes. But in real world situation,
corporate income taxes exist and interest paid to debt holders is treated as deductible
expenses. So, the existence of corporate taxes makes debt financing advantageous.
7. The assumption of all firms have similar business risk does not hold good in reality.
Business risk depends on firm, industry, and economic specific factors. So, specially due
to firm and industry specific factors all firms do not have similar degree of business risk.
8. The underlying assumptions of M-M are not valid and that, in the real world situation,
value of the firm and the cost of capital are functions of financial leverage. They cannot
remain invariant to change in the capital structure or degree of leverage as advocated by
M-M.

M-M Hypothesis with corporate taxes

Modigliani and Miller reviewed their earlier study in 1963 and agreed that if corporate
taxes exist then the value of the firm will increase and the cost of capital will decrease. As
interest on debt is a tax-deductible expense, it definitely saves taxes. This makes debt
financing advantageous. So the levered firm would have a higher market value than the
unlevered firm of the same size and belonging to the same business risk class, by an amount
equal to the levered firm’s debt capital multiplied by the tax rate. This may be stated as:

VL = Vu + tD
Where, VL = Value of the levered firm,
Vu = Value of the unlevered firm,
t = Corporate income tax rate and
D = Amount of debt in Levered firm.
The above equation can be derived in the following way:
It is assumed that both the levered firm (L) and unlevered firm (U) are identical in all respect
except their capital structure. EBIT are identical in each firm. On the basis of these
assumptions, the operating cash flows (CF) for the levered (L) and unlevered firms (U) can
be expressed as follows:
 CFu = EBIT (1- t)
CFL = (EBIT - I) (1-t) + I
or, CFL = (EBIT - Kd.D) (1-t) + Kd.D
= EBIT – Kd.D – EBIT (t) + tKdD + Kd.D
= EBIT – EBIT (t) + tKdD
= EBIT (1- t) + tKdD
Where, EBIT = Earnings before interest and taxes
I = Interest on debt capital = Kd.D
D = Amount of debt in L
t = Corporate tax rate.
(EBIT-I) represents the income available to the shareholders and the term ‘I’ or ‘Kd.D’ is that
available to the providers of debt capital. CFL is thus the total income available to all investors
(equity plus debt).
Unlevered firm U does not use debt capital. Net earnings after tax of this firm will therefore,
be capitalised by the cost of equity, Ke. Thus,
𝐸𝐵𝐼𝑇 (1−𝑡)
Vu =
𝐾𝑒
The value of the levered firm is determined by capitalising both the components of its after
tax earnings. Thus-
𝐸𝐵𝐼𝑇 (1−𝑡) 𝑡𝐾𝑑.𝐷
VL = +
𝐾𝑒 𝐾𝑑
𝐸𝐵𝐼𝑇 (1−𝑡)
= + tD
𝐾𝑒
𝐸𝐵𝐼𝑇 (1−𝑡)
VL = Vu + tD [ as Vu =
𝐾𝑒
]

So, it is observed that the total value of a levered firm will be higher than that of an
unlevered firm of the same size and belonging to the same risk class, by the amount of tD.
From this equation it can be concluded that a firm can maximise its value by maximising the
proportion of debt capital in its capital structure. Thus, the optimal capital structure is reached
when the firm uses almost 100 per cent debt in its capital structure. However, in real world
situation neither the firms employ large amounts of debt, nor are the lenders ready to lend
beyond certain limits, which they fix. The extensive use of debt capital would expose a firm
to bankruptcy because it may be difficult for the firm to meet the payments of interest and
principal on time. Too much debt may increase the cost of capital owing to increased
financial risk and reduce the value of the firm. M-M suggest that firms should adopt a ‘target
debt ratio’, keeping in view the limits acceptable to lenders.
 Fig.- 6
Effect of Capital Structure on Cost of Capital
(M-M Hypothesis with taxes)

C
O Ke
S
T
O
F
C Ko
A
P
I
T
Kd (1-t)
A
L
%
o
LEVERAGE (DEBT-EQUITY RATIO)