1. CAPITAL STRUCTURE & COST OF EQUITY MODIGLIANI AND MILLER MODEL CAPITAL STRUCTURE & COST OF EQUITY MODIGLIANI AND MILLER MODEL www.vuaskari.com www.vuaskari.com

2. CAPITAL STRUCTURE & COST OF EQUITY MODIGLIANI AND MILLER MODEL Value of firm: Whatever the capital structure the operating income and value of its assets will remain same or unchanged. Value of firm: Whatever the capital structure the operating income and value of its assets will remain same or unchanged. Proposition 1 of MM Model, says value of a firm is independent of its capital structure. Proposition 1 of MM Model, says value of a firm is independent of its capital structure.

3. CAPITAL STRUCTURE OPTION1 OPTION 2 OPTION1 OPTION 2 Equity 40%60% Loan – debt60%40% Total capital100%100% A firm may employ any of the above options of capital structure, the value of firm is not affected as long as the capital is fixed (does not exceed 100%). This is because the operating income will remain constant and nothing positive (additional income) will increase the equity and share price.

4. CAPITAL STRUCTURE WACC does not depend on debt equity ratio. Because it is the function of relative costs of debt & equity, and any change in debt and equity mix will change the cost of each component accordingly, making no movement in overall WACC. WACC does not depend on debt equity ratio. Because it is the function of relative costs of debt & equity, and any change in debt and equity mix will change the cost of each component accordingly, making no movement in overall WACC. For example – take one Pizza, slice it in four quarters and then half each quarter to make 8 pieces of Pizza. Even you have 8 pieces but you don't have more Pizza. For example – take one Pizza, slice it in four quarters and then half each quarter to make 8 pieces of Pizza. Even you have 8 pieces but you don't have more Pizza. How is it possible? Let’s see. How is it possible? Let’s see.

5. WACC remain constant at every combination of Debt Equity CURRENT STATUS CAPITAL STRUCTURE COMBINATIONS ASSETS 6,000,000.00 6,000,000.00 DEBT - 2,000,000.00 2,000,000.00 3,000,000.00 3,000,000.00 4,000,000.00 4,000,000.00 5,000,000.00 5,000,000.00 EQUITY 6,000,000.00 6,000,000.00 4,000,000.00 4,000,000.00 3,000,000.00 3,000,000.00 2,000,000.00 2,000,000.00 1,000,000.00 1,000,000.00 DEBT/EQUITY RATIO - 0.50 0.50 1.00 1.00 2.00 2.00 5.00 5.00 SHARE PRICE 20.00 20.00 SHARES OUTSTANDING 300,000.00 300,000.00 200,000.00 200,000.00 150,000.00 150,000.00 100,000.00 100,000.00 50,000.00 50,000.00 INTEREST RATE 10.00 10.00 EBIT800,000.00800,000.00800,000.00800,000.00800,000.00 ROE 13.33 13.33 15.00 15.00 16.67 16.67 20.00 20.00 30.00 30.00 EPS 2.67 2.67 4.00 4.00 5.33 5.33 8.00 8.00 16.00 16.00 WACC 13.33 13.33

6. PROPOSITION II OF MM MODEL It tells us three things: It tells us three things: Required Return of a Assets Required Return of a Assets Cost of Debt and Cost of Debt and Debt /Equity Ratio Debt /Equity Ratio Expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity mix (market values to be used). Expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity mix (market values to be used). this means that for an un-levered firm, Return on equity (RE) is equal to return on asset. this means that for an un-levered firm, Return on equity (RE) is equal to return on asset. In other words, a firm’s cost of equity is positive linear function of the firm’s capital structure. In other words, a firm’s cost of equity is positive linear function of the firm’s capital structure.

7. PROPOSITION II OF MM MODEL WACC = D/V(R D ) + E/V(R E ) Renaming the equation: r ASSETS = r DEBT x D/V + r EQUITY x E/V Re-arranging the equation for r EQUITY: r EQUITY = r ASSETS + D/E ( r ASSETS - r DEBT ) r EQUITY = r ASSETS + D/E ( r ASSETS - r DEBT )

8. In other words, a firm’s cost of equity capital is a positive linear function of the firm’s capital structure. In other words, a firm’s cost of equity capital is a positive linear function of the firm’s capital structure. M & M; PROPOSITION 2 ROE WACC INT RATE X Y

9. BUSINESS & FINANCIAL RISK PROPOSITION II shows that cost of equity of a firm is a function of two components: PROPOSITION II shows that cost of equity of a firm is a function of two components: 1) r ASSETS is overall return on assets and depends on firm’s operations. In other words, it is the systematic risk of firm’s assets. This is also called as business risk faced by firm’s equity. 1) r ASSETS is overall return on assets and depends on firm’s operations. In other words, it is the systematic risk of firm’s assets. This is also called as business risk faced by firm’s equity. 2) Second component (Ra – Rd) x D/E emerges from the capital structure at a given time. For an un-levered firm, this part is zero, therefore, Ra = Re =WACC. The reason being, debt increases the risk by shareholder. This extra risk arising from using debt is called financial risk. 2) Second component (Ra – Rd) x D/E emerges from the capital structure at a given time. For an un-levered firm, this part is zero, therefore, Ra = Re =WACC. The reason being, debt increases the risk by shareholder. This extra risk arising from using debt is called financial risk.

10. POINTS TO REMEMBER Systematic risk is the sum of business risk and financial risk. Systematic risk is the sum of business risk and financial risk. Business risk arises from assets and operations of the firm and has nothing to do with capital structure of the firm. Business risk arises from assets and operations of the firm and has nothing to do with capital structure of the firm. Financial risk is determined by the financial policy. As debt weight is increased financial risk increases. Financial risk is determined by the financial policy. As debt weight is increased financial risk increases.

11. M & M MODEL WITH TAXES Taxes are reality of business environment. Taxes are reality of business environment. How taxes effect the firm and M&M Model? How taxes effect the firm and M&M Model? Does taxes have any effect on value of firm? Does taxes have any effect on value of firm? Let’s take an Example:

12. EXAMPLE: M&M WITH TAXES Assume two firms which are identical on the assets side of balance sheet. Firm ‘A’ is all equity financed and firm ‘B’ is all debt financed. Assume two firms which are identical on the assets side of balance sheet. Firm ‘A’ is all equity financed and firm ‘B’ is all debt financed. EBIT is estimated at Rs.100,000/- per year forever and tax rate is 40%. Firm ‘B’ pays 10% loan on the debt. For the sake of simplicity there is no depreciation. Cost of capital for firm ‘A’ is 12%. EBIT is estimated at Rs.100,000/- per year forever and tax rate is 40%. Firm ‘B’ pays 10% loan on the debt. For the sake of simplicity there is no depreciation. Cost of capital for firm ‘A’ is 12%.

13. Taxes and M&M PARTICULARS FIRM "A" UN-GEARED(NO-DEBT) FIRM "B" GEARED (ALL DEBT) EBIT 100,000.00 100,000.00 INTEREST EXPENSE - 10,000.00 10,000.00 TAXABLE PROFIT 100,000.00 100,000.00 90,000.00 90,000.00 TAX ON PROFIT 40% 40,000.00 40,000.00 36,000.00 36,000.00 NET PROFIT 60,000.00 60,000.00 54,000.00 54,000.00 IMPACT OF TAXES ON THE CASH FLOW IN TERMS OF CASH FLOW TO SHARE/BOND HOLDERS FIRM "A" UN-GEARED(NO-DEBT) FIRM "B" GEARED (ALL DEBT) EBIT 100,000.00 100,000.00 LESS: TAXES 40,000.00 40,000.00 36,000.00 36,000.00 TOTAL 60,000.00 60,000.00 64,000.00 64,000.00

14. WE OBSERVE: WE OBSERVE: Even assets of both companies are identical. Even assets of both companies are identical. After tax cash flow of both firms is not same. Hence the value of both firms is not equal. After tax cash flow of both firms is not same. Hence the value of both firms is not equal. The difference in cash flow or value is Rs. 4,000. The difference in cash flow or value is Rs. 4,000. We can reach at Rs. 4,000 in an other way: We can reach at Rs. 4,000 in an other way: Total Interest x Tax Rate Total Interest x Tax Rate = 10,000 x 0.40 = 4,000 = 10,000 x 0.40 = 4,000 Since interest is tax deductible, it generates saving called “Interest Tax Shield”. Since interest is tax deductible, it generates saving called “Interest Tax Shield”.

15. Since debt is for ever, the value of firm ‘B’ levered firm, will always be greater than firm ‘A’ by the present value of interest tax shield. Since debt is for ever, the value of firm ‘B’ levered firm, will always be greater than firm ‘A’ by the present value of interest tax shield. Present value of interest tax shield can be calculated as: Present value of interest tax shield can be calculated as: PV = Rs. 4000 / 0.1 = Rs. 40,000 PV = Rs. 4000 / 0.1 = Rs. 40,000 M&M Model proposition 1 says: M&M Model proposition 1 says: V L = V U + T X x D V L = V U + T X x D

16. Value of un-geared firm ‘A’ can be worked out as under: Value of un-geared firm ‘A’ can be worked out as under: V u = EBIT x (1-t) / R u V u = EBIT x (1-t) / R u EBIT and taxable income of this firm is same. EBIT and taxable income of this firm is same. V u = 100,000 x (1 - 0.4)/ 0.12 = 500,000 V u = 100,000 x (1 - 0.4)/ 0.12 = 500,000

17. We now find out the value of geared firm: We now find out the value of geared firm:  V L = V E + T x x D = 500,000 + (100000 x 0.40) = 540,000 It means that for every Re. 1, the value of firm will increase by (Re.1 x tx) or 0.40. It means that for every Re. 1, the value of firm will increase by (Re.1 x tx) or 0.40. Taxes do effect capital structure, therefore, we incorporate tax effect in proposition 1 of the Model: Taxes do effect capital structure, therefore, we incorporate tax effect in proposition 1 of the Model: V of Levered Firm = V of Un-levered Firm + Tax on Debt

18. We also need to incorporate tax in Proposition II of M&M Model: We also need to incorporate tax in Proposition II of M&M Model: WACC = E/V(R E ) + D/V (R D ) x (1 – t) WACC = E/V(R E ) + D/V (R D ) x (1 – t) Where t is the tax rate. To find out Cost of Equity: R E = R U + (R U – R D ) X D/E X (1 – t) Continuing our example to Proposition II

19. Value of geared or levered firm was Rs. 540,000 because the debt is Rs.100,000 then the equity must be 440,000. Value of geared or levered firm was Rs. 540,000 because the debt is Rs.100,000 then the equity must be 440,000. Return on equity of levered or geared firm is then: Return on equity of levered or geared firm is then: R E = R U + (R U – R D ) X D/E X (1 – t) R E = R U + (R U – R D ) X D/E X (1 – t) =.12 + (.12 -.10) x (100000/440000) x 0.4 = 12.27% WACC is: = (4400/5400) x 12.27 + (1000/5400) x 0.1 x (1 – 0.40) = (4400/5400) x 12.27 + (1000/5400) x 0.1 x (1 – 0.40) = 11.11% = 11.11%

20. AIDING UNDERSTANDING OF M&M MODEL Example M & M Model Example M & M Model EBIT = 80,000 EBIT = 80,000 Tax = 40% Tax = 40% Debt = 50,000 Debt = 50,000 Rate of Return (un-levered) firm = 20% Rate of Return (un-levered) firm = 20% Interest rate = 10% Interest rate = 10% Required: a) What is value of firm’s equity? Required: a) What is value of firm’s equity? b) What is the cost of equity capital? b) What is the cost of equity capital? c) What is WACC? c) What is WACC?

21. M&M MODEL a) VALUE OF UN-LEVERED FIRM Vu WITH NO DEBT =EBIT x ( 1 - t) / Ru Vu = 240,000.00 240,000.00 From MM proposition I, Value of firm with Debt = VL VL = Vu + D x t 260,000.00 260,000.00 Because this is the value of Levered firm then, the equity value is: E = VL - D 210,000.00 210,000.00 b) Based on MM proposition 2, with tax cost of equity is: RE = Ru + (Ru - Rd) x (D/E) x (1 - t) 0.21 0.21 21.43 21.43 8437.5 c) WACC WACC = E/V(RE) + D/V(RD) x (1 – t) 0.18 0.18 18.46 18.46

22. M&M MODEL This shows that the WACC of a levered firm is lesser than that of un-levered. This shows that the WACC of a levered firm is lesser than that of un-levered. The WACC of un-levered firm was 20% and of levered firm is 18.46%. The WACC of un-levered firm was 20% and of levered firm is 18.46%. This means that debt financing carries financial advantage. This means that debt financing carries financial advantage.