1. Net Operating Income Approach MM Proposition I &II

2. Traditional Approach
The traditional approach argues that moderate degree of debt can lower the firm’s overall cost of capital and thereby, increase the firm value.
But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

3. The traditional approach is known as intermediate approach in between the Net income approach and NOI approach.
The cost of overall capital will come down due to the application cheaper source of financing viz Debt financing to some extent, after certain usage, the application of debt will enhance the financial risk of the firm, which will require the share holders to expect additional return nothing but is risk premium.

4. The risk premium which is expected by the investors will enhance the overall cost of capital.
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 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

5. In considering the most desirable capital structure for a company, the following estimates of the cost of debt and equity capital (after tax) has been made at various levels of debt-equity mix. You are required to determine the optimal debt-equity mix for the company by calculating composite cost of capital.

6. Debt as % of total capital employed
Cost of debt
Cost of equity 5 12 10 20
12.5 30
5.5 13 40 6 14 50
6.5 16 60 7

7. Statement showing the co’s composite cost of capital (after tax)
Debt % of total capital employed
Kd%
Ke% Ko
Ko% 5 12
(5*0) + (12*1.00) 10
(5*.10) + (12*.90)
11.3 20
12.5
(5*.20) + (12.5*.80) 11 30
5.5 13
(5.5*.30) + (13*.70)
10.75 40 6 14
(6*.40) + (14*.60)
10.80 50
6.5 16
(6.5*.50) + (16*.50)
11.25 60 7
(7*.60) + (20*.40)
12.20
Optimal debt-equity mix is 30% debt and 70% equity, where the Ko is the least

8. Problem
Compute the equilibrium values and capitalization rates of equity of the company A and B on the basis of following data. Assume that:
There is no income tax
The equilibrium value of average cost of capital (P) is 8.5%
Particulars
Company A
Company B
Total Market value
250
300
Less: Debt
150
Value of equity
Expected Net operating income 25
Less: Interest 9
Net Income 16 Ke
10.0%
10.7%
Financial Leverage
0.5
Average cost of capital
8.33%

9. (Equilibrium value orVe)=EBIT/Equilibrium cost of capital = Rs. 25/
(Equilibrium value orVe)=EBIT/Equilibrium cost of capital = Rs.25/.085 =Rs
Equity Equalization rates for Companies A & B
Particulars A B
Expected Net operating Income 25
Less: Interest - 9
NI available for Equity 16
Equilibrium cost of capital
8.5%
Total value of company
294.12
Less: Market value of debt
150
Market value of equity
144.12
Cost of equity(Ke) = NI/Mkt value of equity
11.1%

10. MM Theory : No Taxation The debt is less expensive than equity.
An increase in debt will increase the Ke.
With increase in the levels of debt, there will be higher level of interest payments affecting the cash flow of the company.
With increase in the levels of debt, there will be higher level of interest payments affecting the cash flow of the company

11. MM Approach Without Tax: Proposition I
MM’s Proposition I states that the firm’s value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

12. This approach is discussed under the perfect market conditions
Securities are divisible infinitely.
Investors are allowed to buy and sell securities
Investors are rational to access the information
No transaction costs involved in the process of the buying and selling of securities

13. MM hypothesis with corporate Taxation
The tax burden on the company will less to the extent of relief available on interest payable on the debt, which makes the Kd cheaper which reduces Ko.

14. MM’s Proposition II
Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest.

15. MM Proposition III
Ko is the cut-off points for all investment decisions.
The Ko is completely unaffected by the debt-equity mix.
This implies a complete separation of investment and financing decisions of the firm.