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Financial Management ­ MGT201
VU
Lesson 34
APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE
THEORIES
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topics:
·  Applicability of the Miller Modigliani Capital Structure theory, Modified Miller Modigliani
Capital Structure Theory and other theories to the Real World to see the Impact of Debt on Firm
Value & WACC Graphs
Effect of Leverage on Cost of Debt & Cost of Equity:
We need to know both of these effects to see the impact of leverage on WACC.
·  Effect of Financial Leverage (or Debt) on Cost of Debt (rD):
­  At low leverage, increase in leverage leads to slight increase in overall risk and return
of firm.
­  At higher leverage, there is risk of financial distress & bankruptcy. Therefore, banks
raise interest rate charges as now company has become more risky. Cost of debt raises
faster and required rate of return (ROR) of firm's debt holders (rD) raises faster. So, as a
result of leverage financial risk of firm rises and its cost of debt also go up.
·  Effect of Financial Leverage (or Debt) on Cost of Equity (rE):
­  Firm's total risk rises slowly at low leverage and
­  Firm's total risk rises faster when leverage becomes excessive and risk of financial
distress arises. Also, firm's stock beta rises and firm's stock required ROR (rE) rises,
and cost of equity goes up. From the Capital asset pricing model, we know whenever
the risk of the firm raises, its required rate of return also rises and as a result cost of
stock will also go up.
Effect of Leverage on WACC:
·  WACC = rDxD + rExE (assuming no Preferred Equity) where
xD = Fraction of Debt
xE = Fraction of Equity
·  Effect of Debt on WACC Changes with the theory choice:
­  Effect under Pure MM View (Ideal Efficient Markets): Its assumptions are No
Taxes and No Bankruptcy Costs so Debt increases Risk BUT is also cheaper than
Equity. Change in Debt has no effect on WACC and Value of the firm. WACC curve is
flat.
­  Effect under Traditionalist View (Tradeoff Theorists, Real Markets): Combined
Effect of Taxes and Financial Distress / Bankruptcy Costs are a Flat U-Shaped WACC
Curve with a Minimum Point which represents the Optimal Capital Structure (i.e. Best
Debt Ratio for the Firm).
Now we discuss these effects in detail. First we shall discuss Effect of Debt on WACC under
MM ideal market theory in detail and then later we will discuss it under traditional view.
Effect of Debt on WACC under MM ideal market theory:
Visualize the following graph keeping in view ideal Miller Modigliani Capital Structure theory
conditions and assumptions of no taxes and bankruptcy costs and equal information available to all:
146
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Financial Management ­ MGT201
VU
Pure MM Theory - Ideal Markets
WRisk.CC Graph
A
Financial
Cost of
rE = Cost of Equity
Higher Required
Capital
Return on Equity.
=WACC+D/E (WACC-rD)
Higher rE
(%)
WACC =
rE
rDxD + rExE
rD = Cost
rD
of Debt
Debt / Equity =
100%
D/E = xD / ( 1- xD )
Equity
Firm
On the Y-axis we have cost of capital and on the X-axis Debt to equity ratio is proportional to
financial leverage. WACC is constant shown by WACC line starting from point rE on Y-axis and going
straight flat along X-axis. We know WACC = rDxD + rExE. When Debt to equity ratio is zero at the
origin, the firm is un levered or 100% equity firm. As there is no debt the cost of equity of the firm is
equal to its WACC at this point. The straight line WACC curve shows there is no change in WACC
even after debt under pure MM ideal markets. As the leverage increases, cost of debt and cost of equity
rises but WACC remains unaffected.
MM View - Ideal Markets Numerical Example:
Now we do a numerical example to calculate these impacts just discussed above:
·  A 100% Equity Firm (or Un-levered) has Total Assets of Rs.1000. It has a weighted average
cost of capital for un levered firm (WACCU) of 21% and Cost of debt for un levered firm
( rD,U ) of 10%. It then adds Rs.400 of Debt. Financial Risk increases Cost of debt (rD,L ) of
Levered Firm to 13%. What is the Levered Firm's cost of equity rE,L and WACCL ?
·
Assuming Pure MM View - Ideal Markets: Total Market Value of Assets of Firm (V) is
UNCHANGED. Value of un levered firm = Value of levered firm. Also, WACC remains
UNCHANGED by Capital Structure and Debt.
·
WACCU = WACCL = 21%
·
Now we come to the cost of equity of levered firm
rE,L =WACC + Debt/Equity (WACCL - rD,L)
= 21% + 400/600 (21% - 13%)
= 26.3%
rE,L= (WACC - rD,L xD)/ xE
= (21% - 13% (400/1000)) / (600/1000)
= 26.3%
·
Cost of Equity for Levered Firm
= rE,L = Risk Free Interest Rate + Business Risk Premium + Financial Risk Premium.
rE,L increases because required ROR for stock increased because of financial risk.
147
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Financial Management ­ MGT201
VU
This is the case of pure MM theory where there are no taxes and bankruptcy costs. But in case of trade
off theory in reality initially value of the firm rises as there is interest tax saving but with excessive
leverage, value of the firm starts declining as interest cost goes very high due to bankruptcy risk. This
can be shown in the following graph:
Tradeoff Theory Graph ­
Linked to Traditionalist Theory of
Leverage & Optimal Capital Structure
Slightly Leveraged Firm: Interest Tax
Shield Benefit. Total Return to Investors
Excessively Leveraged Firm:
Rises so Stock Value Rises. Total Return
Threat of Bankruptcy has Real
= Net Income (paid to Shareholders) +
Value of
Costs. Less Investor
Interest (paid to Debt Holders)
Firm or
Confidence and Lower Share
Price.
Price of
Stock
Firm Remains 100%
Equity (Un-Levered)
Financial Leverage =
OPTIMAL Capital
Debt / Assets =
Structure - MAXIMUM
D/(D+E)
VALUE & MINIMUM
WACC
Here maximum value point of the firm is also the minimum point of WACC. It is the best
capital structure for the firm to operate.
Pure MM Ideal Markets ­ Example:
We know the basic objective of the firm is to maximize shareholder's worth.
·  Example: Assuming Pure MM Theory with Ideal Efficient Markets where Total MARKET
VALUE of Assets of Firm (V =Debt + Equity) is UNCHANGED by the Capital Structure (and
Leverage). Given the following Data on Leverage and Cost of Capital:
Debt (D)
Interest (rD)  Equity
Cost of Equity
(E = V-D)
(rE = (WACC- rD xD)/ xE)
Rs.0 (=V)
0
Rs.1000
21% (=WACC) Un-Levered
Rs.200
10% (rRF)
Rs.800
(21% - 10% (0.2))/0.8 = 23.75%
Rs.300
11%
Rs.700
(21% - 11% (0.3))/0.7 = 25.3%
Rs.400
13%
Rs.600
(21% - 13% (0.4))/0.6 = 26.3%
Rs.500
15%
Rs.200
(21% - 15% (0.8))/0.2 = 45%
As the level of debt increases from Rs.0 to Rs.500 the cost of equity rises from 21% to 45%.
Consider the graph we discussed above again:
148
img
Financial Management ­ MGT201
VU
Pure MM Theory - Ideal Markets
WRisk.CC Graph
A
Financial
Cost of
rE = Cost of Equity
Higher Required
Capital
Return on Equity.
=WACC+D/E (WACC-rD)
Higher rE
(%)
WACC =
rE
rDxD + rExE
rD = Cost
rD
of Debt
Debt / Equity =
100%
D/E = xD / ( 1- xD )
Equity
Firm
On the Y-axis we have cost of capital and X-axis Debt to equity ratio= Financial leverage. When
Debt to equity ratio is zero at the origin, the firm is un levered or 100% equity firm. As there is no debt
the cost of equity of the firm is equal to its WACC. The straight line WACC curve shows there is no
change in WACC after debt under pure MM ideal markets. As firm takes more debt, the line slope at top
in the graph increases at an accelerating rate, this is due to very high debt that has raised bankruptcy risk
of the firm.
·  Problem of the theory: In Real Markets, Total Market Value of Firm (V) DOES CHANGE as
Leverage Increases. We have made above calculations very simply under ideal conditions.
So we have a traditional view to take real effects into account. The following is the same graph with
traditional views. Here cost of equity for a levered firm rises very fast. Also cost of debt rises. Another
point to note is that WACC line has become curve with a minimum point at its lowest. Initially it comes
down s it moves away from Y-axis and then after reaching its minimum it starts going up. The
minimum point is the best optimal point for firm to operate for it capital structure.
149
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Financial Management ­ MGT201
VU
Traditionalist Theory - Real Markets
Bankruptcy Risk & ACC Graph
W
Costs. Higher
Cost of
Required Return on
Capital
rE,L = Cost of Equity =
Equity. Steeper Rise.
(%)
WACCU + xD(WACCU -rD) (1-TC)
WACCL = rD(1-Tc)xD + rExE
rE
rD = Cost of Debt
rD
Interest Tax Shield
Advantage
100%
Debt / Equity =
Optimal
Equity
Capital
D/E = xD / ( 1- xD )
Firm
Structure
Note: xD = D / (D+E)
Traditionalist View ­ Example:
·  We are using same example with some additional information to incorporate the effects of real
world: A 100% Equity Firm (or Un-levered) had total assets of Rs.1000. It had a WACCU
(Weighted average cost of capital of un levered firm) of 21%. It then added Rs.400 at a cost of
debt rD,L (for Levered Firm) of 13%. What is the Levered Firm's rE,L and WACCL (Weighted
average cost of capital of levered firm)? Given Data for rE,
Corporate tax rate of 30% on Earnings before Tax, and EBIT = Rs.300.
·  Traditionalist View is based on Practical Reality. Leverage provides interest tax savings (or
shield) but also increases financial risk. Excessive leverage leads to bankruptcy risk. Increases
in risk will change value of firm and WACC.
·  Now rE is based on Observed Data and Equity Value (E) is based on Simple Income Statement
Formulas.
·  Traditionalists Formulas for Equity:
E = Net Income (NI)/ Cost of Equity for levered firm (rE,L)
Note that
NI = EBIT - Interest - Tax = EBT ­ Tax
NI = (EBIT - xD rD) (1 - Tc)
rE,L = WACCU + xD (WACCU - rD ) (1 - Tc).
·  Traditionalists Formula for WACC:
WACCL = xD rD (1 - Tc) + xE rE.
(1-Tc) is the Tax Discount Factor.
Note:
Value of firm = Debt + Equity
xD = Debt /Value = Debt/ (Debt + Equity)
xD + xE = 1
V = Market Value of Firm D = Market Value of Debt
E = Market Value of Equity
xD = Fraction of Debt = A Measure of Leverage
In the next lecture we shall continue this discussion and do more examples to see the impact of
capital structure on value of firm.
150
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios