Topic -2

Cost of Capital and Capital Structure Decision

Specific Cost:

The cost of each component of capital, viz., equity shares, preference shares,
debentures, loans etc., is termed as specific or component cost of capital
which is the most appealing concept. While determining the average cost of
capital, it requires consideration about the cost of specific methods for
financing the projects.

This is particularly useful where the profitability of the project is evaluated

on the basis of the specific source of funds taken for financing the said
project. For instance, if the estimated cost of equity capital of a firm
becomes 12%, that project which are financed by the equity shareholders’
fund, will be accepted provided the same will yield at least a return of 12%.

Cost of a specific source of fund is termed as specific cost of capital Cost of

debt, cost of preference capital, cost of equity and cost of retained earnings
are all examples of specific cost of capital. Thus specific cost of capital is
the cost that a company incurs for the funds raised through a specific source.

The cost of each component of capital is known as the specific cost of

capital. A firm raises capital from different sources- such as equity,
preference, debentures, and so on. The cost of equity, the cost of debt, cost
of preference capital and cost of retained earnings are examples of the
specific costs of capital.

The cost of capital of each component, when appropriately averaged

becomes a representative measure of the cost of capital. The specific costs
are used to appraise the profitability of a project when it is financed from a
specific source of finance.

Weighted Average Cost of Capital (WACC)

This is the most commonly used measure of a company's overall cost of capital.
It considers the relative proportions of debt and equity financing used by the
company and takes a weighted average of the cost of debt and cost of
equity. Cost of debt and cost of capital is very important.

Calculation: WACC = (Cost of Debt * Debt Ratio) + (Cost of Equity * Equity

Ratio)
Weighted average cost of capital (WACC) is a company's average after-
tax cost of capital from all sources, including common stock, preferred stock,
bonds, and other forms of debt. It represents the average rate that a company
expects to pay to finance its business.

WACC is a common way to determine the required rate of return

(RRR) because it expresses, in a single number, the return that bondholders and
shareholders demand in return for providing the company with capital. A
company's WACC is likely to be higher if its stock is relatively volatile or if its
debt is considered risky because investors will want greater returns to
compensate them for the level of risk.

Weighted Marginal Cost of Capital (WMCC)

The cost of capital of a company represents the opportunity costs of the funds
available to it for investing in different projects. Similarly, it can be defined as
the required rate of return, which is a vital part of the capital budgeting
process of a company. Companies need the cost of capital to evaluate different
projects and select ones that are feasible and worthwhile. Usually, the cost of
capital is an internal metric that companies use for decision-making purpose.
This decision-making relates to the long-term objectives of a company. It is a
crucial concept in both accounting and economics.
The cost of capital of a company mainly depends on its capital structure. The
capital structure of a company is the mixture of its equity and debt finance. To
calculate its cost of capital, the company must calculate the Weighted Average
Cost of Capital (WACC). The WACC represents the average cost of equity
and cost of debt of the company based on the portions of those sources of
finance. Every company must calculate its WACC to use in its decision-making
process. However, sometimes, the company may also calculate the Weighted
Marginal Cost of Capital instead of the WACC.

The Weighted Marginal Cost of Capital is the marginal cost of capital of a

company weighted according to the proportion of each type of finance in its
capital structure. The marginal cost of capital represents the weighted average
cost of every $1 new capital that a company raises. It is the composite rate of
return that shareholders and debt instrument holders of a company require for
new investments in it. The marginal cost of capital is different from the average
cost of capital, which focuses on equity and debt that the company has already
obtained.

Theories of capital structure –

 Capital Structure means a combination of all long-term sources of finance. It
includes Equity Share Capital, Reserves and Surplus, Preference Share capital,
Loan, Debentures, and other such long-term sources of finance. A company has
to decide the proportion in which it should have its finance and outsider’s
finance, particularly debt finance. Based on the ratio of finance, WACC and
Value of a firm are affected. There are four capital structure theories: net
income, net operating income, and traditional and M&M approaches.

Capital structure is the proportion of all types of capital viz. equity, debt,
preference, etc. It is synonymously used as financial leverage or financing mix.
Capital structure is also referred to as the degree of debts in the financing or
capital of a business firm.

1. Net Income Theory –

Net Income Approach

Durand suggested this approach, and he favored the financial leverage decision.
According to him, a change in financial leverage would lead to a change in the
cost of capital. In short, if the ratio of debt in the capital structure increases, the
weighted average cost of capital decreases, and hence the value of the firm
increases.

The Net Income Approach suggests that the value of the firm can be increased
by decreasing the overall cost of capital (WACC) through a higher debt
proportion. There are various theories that propagate the ‘ideal’ capital
mix/capital structure for a firm. Capital structure is the proportion of debt and
equity in which a corporate finances it’s business. The capital structure of a
company/firm plays a very important role in determining the value of a firm

Durand presented the Net Income Approach. The theory suggests increasing the
firm’s value by decreasing the overall cost of capital which is measured in terms
of the Weighted Average Cost of Capital. This can be done by having a higher
proportion of debt, which is a cheaper finance source than equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of
equity and debts, where the weights are the amount of capital raised from each
source.

WACC = Required Rate of Return x Amount of Equity + Cost of debt x Amount of Debt
 Total Amount of Capital (Debt + Equity)

According to Net Income Approach, a change in the financial leverage of a firm

will lead to a corresponding change in the Weighted Average Cost of Capital
(WACC) and the company’s value. The Net Income Approach suggests that
with the increase in leverage (proportion of debt), the WACC decreases, and the
firm’s value increases

the other hand, if there is a decrease in the leverage, the WACC increases,
thereby decreasing the firm’s value.

For example, vis-à-vis the equity-debt mix of 50:50, if the equity-debt mix
changes to 20: 80, it would positively impact the value of the business and
increase the value per share.
Assumptions of Net Income Approach
The Net Income Approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no
sources of finance like Preference Share Capital and Retained Earnings.
 All companies have a uniform dividend payout ratio; it is 1.
 There is no flotation cost, no transaction cost, and corporate dividend tax.
 The capital market is perfect; it means information about all companies is
available to all investors, and there are no chances of overpricing or
underpricing of security. Further, it means that all investors are rational.
So, all investors want to maximize their return by minimizing risk.
 All sources of finance are for infinity. There are no redeemable sources of
finance.
Example
Consider a fictitious company with the below figures—all figures in USD.

Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

Cost of Equity = 14%

Calculating the value of a company

EBIT = 100,000

Less: Interest cost (10% of 300,000) = 30,000

Earnings (since tax is assumed to be absent) = 70,000

Shareholders’ Earnings = 70,000

Market value of Equity (70,000/14%) = 500,000

Market value of Debt = 300,000

Total Market value = 800,000

Overall cost of capital = EBIT/(Total value of the firm)

 = 100,000/800,000

= 12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000, and
everything else remains the same.

(EBIT) = 100,000

Less: Interest cost (10% of 400,000) = 40,000

Earnings (since tax is assumed to be absent) = 60,000

Shareholders’ Earnings = 60,000

Market value of Equity (60,000/14%) = 428,570 (approx)

Market value of Debt = 400,000

Total Market value = 828,570

EBIT/(Total value
Overall cost of capital =
of the firm)

= 100,000/828,570
 = 12% (approx)

Net Operating Income Approach

Durand also provides this approach. It is the opposite of the Net Income
Approach if there are no taxes. This approach says that the weighted average
cost of capital remains constant. It believes in the fact that the market analyses a
firm as a whole and discounts at a particular rate that has no relation to the debt-
equity ratio. If tax information is given, it recommends that WACC reduces
with an increase in debt financing, and the firm’s value will start increasing.
Net Operating Income Approach (NOI Approach)
This approach was put forth by Durand and totally differs from the Net Income
Approach. Also famous as the traditional approach, Net Operating Income
Approach suggests that the change in debt of the firm/company or the change in
leverage fails to affect the total value of the firm/company. As per this
approach, the WACC and the total value of a company are independent of the
company’s capital structure decision or financial leverage.

As per this approach, the market value is dependent on the operating income
and the associated business risk of the firm. Both these factors cannot be
impacted by financial leverage. Financial leverage can only impact the share of
income earned by debt holders and equity holders but cannot impact the
operating incomes of the firm. Therefore, a change in the debt to equity ratio
cannot change the firm’s value

It further says that with the increase in the debt component of a company, the
company is faced with higher risk. To compensate for that, the equity
shareholders expect more returns. Thus, with an increase in financial leverage,
the cost of equity increases.
Assumptions / Features of Net Operating Income Approach
1. The overall capitalization rate remains constant irrespective of the degree
of leverage. At a given level of EBIT, the value of the firm would be
“EBIT/Overall capitalization rate.”
2. Value of equity is the difference between total firm value and less value
of debt, i.e., Value of Equity = Total Value of the Firm – Value of Debt.
3. WACC (Weightage Average Cost of Capital) remains constant, and with
the increase in debt, the cost of equity increases. An increase in debt in
the capital structure results in increased risk for shareholders. As
compensation for investing in the highly leveraged company, the
shareholders expect higher returns resulting in a higher cost of equity
capital.
Example explaining Net Operating Income Approach to Capital Structure
Consider a fictitious company with the below figures. All figures in USD.

Earnings before Interest Tax (EBIT) = 100,000

Bonds (Debt part) = 300,000

Cost of Bonds issued (Debt) = 10%

WACC = 12.5%

Calculating the value of the company:

(EBIT) = 100,000

WACC = 12.5%

Market value of the company = EBIT/WACC

= 100,000/12.5%

= 800,000

Total Debt = 300,000

Total market
Total Equity = value – total
debt

= 800,000-300,000

= 500,000

EBIT-interest
Shareholders’ earnings =
on debt

= 100,000-10% of 300,000

= 70,000

Cost of equity = 70,000/500,000

= 14%
Now, assume that the proportion of debt increases from 300,000 to 400,000, and
everything else remains the same.

(EBIT) = 100,000

WACC = 12.5%

Market value of the company = EBIT/WACC

= 100,000/12.5%

= 800,000

Total Debt = 400,000

Total Equity = Total market value – total de

= 800,000-400,000

= 400,000

Shareholders’ earnings = EBIT-interest on debt

= 100,000-10% of 400,000

= 60,000

Cost of equity = 60,000/400,000

= 15%

Traditional Approach
This approach does not define hard and fast facts, and it says that the cost of
capital is a function of the capital structure. The unique thing about this
approach is that it believes in an optimal capital structure. Optimal capital
structure implies that the cost of capital is minimum at a particular ratio of debt
and equity, and the firm’s value is maximum.

The traditional approach to capital structure suggests an optimal debt to equity

ratio where the overall cost of capital is the minimum and the firm’s market
value is the maximum. On either side of this point, changes in the financing mix
can bring positive change to the firm’s value. Before this point, the marginal
cost of debt is less than the cost of equity, and after this point, vice-versa.

Capital Structure Theories and their different approaches put forth the
relationship between the proportion of debt in the financing of a company’s
assets, the weighted average cost of capital (WACC), and the company’s market
value. While the Net Income Approach and Net Operating Income
Approach are the two extremes, the traditional approach, advocated by Ezta
Solomon and Fred Weston, is a midway approach, also known as the
“intermediate approach.”

The traditional approach to capital structure advocates that there is a right

combination of equity and debt in the capital structure, at which the market
value of a firm is maximum. As per this approach, debt should exist in
the capital structure only up to a specific point, beyond which any increase in
leverage would result in a reduction in the value of the firm.

It means that there exists an optimum value of debt to equity ratio at which the
WACC is the lowest and the firm’s market value is the highest. Once the firm
crosses that optimum value of debt to equity ratio, the cost of equity rises to
give a detrimental effect on the WACC. Above the threshold, the WACC
increases, and the firm’s market value starts a downward movement.
Assumptions under Traditional Approach
1. The interest rate on the debt remains constant for a certain period, and
after that, it increases with an increase in leverage.
 2. The expected rate by equity shareholders remains constant or increases
gradually. After that, the equity shareholders start perceiving a financial
risk, and then from the optimal point, the expected rate increases
speedily.
3. As a result of the activity of rate of interest and expected rate of return,
the WACC first decreases and then increases. The lowest point on the
curve is optimal capital structure.
Example Explaining Traditional Approach
Consider a fictitious company with the following data.

Case Cas
Particulars Case 1 Case 2 Case 3
4 e5

Weight of debt 10% 30% 50% 70% 90%

Weight of equity 90% 70% 50% 30% 10%

Cost of debt 10% 11% 12% 14% 16%

Cost of equity 17% 18% 19% 21% 23%

16.1 16.7
WACC 16.3% 15.9% 15.5%
% %

From case 1 to case 3, the company increases its financial leverage, and as a
result, the debt increases from 10% to 50%, and equity decreases from 90% to
50%. The cost of debt and equity also rises, as stated in the table above, because
of the company’s higher exposure to risk. The new WACC is decreased from
16.3% to 15.5%.

As observed, with the increase in the company’s financial leverage, the overall
cost of capital reduces, despite the individual increases in the cost of debt and
equity, respectively. The reason is that debt is a cheaper source of finance.
Traditional Approach
This approach does not define hard and fast facts, and it says that the cost of
capital is a function of the capital structure. The unique thing about this
approach is that it believes in an optimal capital structure. Optimal capital
structure implies that the cost of capital is minimum at a particular ratio of debt
and equity, and the firm’s value is maximum.

Capital Structure Theory – Traditional Approach

The traditional approach to capital structure suggests an optimal debt to equity
ratio where the overall cost of capital is the minimum and the firm’s market
value is the maximum. On either side of this point, changes in the financing mix
can bring positive change to the firm’s value. Before this point, the marginal
cost of debt is less than the cost of equity, and after this point, vice-versa.

Capital Structure Theories and their different approaches put forth the
relationship between the proportion of debt in the financing of a company’s
assets, the weighted average cost of capital (WACC), and the company’s market
value. While the Net Income Approach and Net Operating Income
Approach are the two extremes, the traditional approach, advocated by Ezta
Solomon and Fred Weston, is a midway approach, also known as the
“intermediate approach.”

The traditional approach to capital structure advocates that there is a right

combination of equity and debt in the capital structure, at which the market
value of a firm is maximum. As per this approach, debt should exist in
the capital structure only up to a specific point, beyond which any increase in
leverage would result in a reduction in the value of the firm.

It means that there exists an optimum value of debt to equity ratio at which the
WACC is the lowest and the firm’s market value is the highest

Assumptions under Traditional Approach

1. The interest rate on the debt remains constant for a certain period, and
after that, it increases with an increase in leverage.
2. The expected rate by equity shareholders remains constant or increases
gradually. After that, the equity shareholders start perceiving a financial
risk, and then from the optimal point, the expected rate increases
speedily.
 3. As a result of the activity of rate of interest and expected rate of return,
the WACC first decreases and then increases. The lowest point on the
curve is optimal capital structure.
Example Explaining Traditional Approach
Consider a fictitious company with the following data.

Case Case
Particulars Case 1 Case 2 Case 3
4 5

Weight of debt 10% 30% 50% 70% 90%

Weight of equity 90% 70% 50% 30% 10%

Cost of debt 10% 11% 12% 14% 16%

Cost of equity 17% 18% 19% 21% 23%

WACC 16.3% 15.9% 15.5% 16.1% 16.7%

From case 1 to case 3, the company increases its financial leverage, and as a
result, the debt increases from 10% to 50%, and equity decreases from 90% to
50%. The cost of debt and equity also rises, as stated in the table above, because
of the company’s higher exposure to risk. The new WACC is decreased from
16.3% to 15.5%.

As observed, with the increase in the company’s financial leverage, the overall
cost of capital reduces, despite the individual increases in the cost of debt and
equity, respectively. The reason is that debt is a cheaper source of finance.

Modigliani-Miller (M-M) Approach

Contents:

1. Proposition of M-M Approach

2. Assumptions of M-M Approach
 3. Interpretation of M-M Approach
4. Proof of M-M Approach
5. Criticisms of M-M Approach
6. M-M Approach with Corporate Taxes and Capital Structure

1. Proposition of M-M Approach:

The following propositions outline the MM argument about the relationship

between cost of capital, capital structure and the total value of the firm:

i) The cost of capital and the total market value of the firm are independent
of its capital structure. The cost of capital is equal to the capitalisation rate
of equity stream of operating earnings for its class, and the market is
determined by capitalizing its expected return at an appropriate rate of
discount for its risk class.

(ii) The second proposition includes that the expected yield on a share is
equal to the appropriate capitalisation rate for a pure equity stream for that
class together with a premium for financial risk equal to the difference
between the pure-equity capitalisation rate (K.) and yield on debt (K d). In
short, increased K e is offset exactly by the use of cheaper debt.

(iii) The cut-off point for investment is always the capitalisation rate which
is completely independent and unaffected by the securities that are invested.

2. Assumptions of M-M Approach:

The MM proposition is based on the following assumptions:

(a) Existence of Perfect Capital Market:

It includes that:

(i) There is no transaction cost;

(ii) Floatation cost is neglected;

(iii) No investor can affect the market price of shares;

(iv) Information is available to all without cost;

(v) Investors are free to purchase and sale of securities.

(b) Homogeneous Risk Class/Equivalent Risk Class:

It means that the expected yield/return have the identical risk factor, i.e.,
business risk is equal among all firm having equivalent operational
condition.

(c) Homogenous Expectation:

All the investors should have identical estimate about the future rate of
earnings of each firm

(d) The Dividend Pay-out Ratio is 100%:

It means that the firm must distribute all of its earnings in the form of
dividend among the shareholders/investors, and

(e) Taxes do not Exist:

That is, there will be no corporate tax effect (although this was removed at a
subsequent date).

3. Interpretation of M-M Approach:

The MM Hypothesis reveals that if more debt is included in the capital

structure of a firm, the same will not increase its value as the benefits of
cheaper debt capital are exactly set off by the corresponding increase in the
cost of equity, although debt capital is less expensive than the equity capital.

So, according to M-M, the total value of a firm is absolutely unaffected by

the capital structure (debit-equity mix) when corporate tax is ignored.

4. Proof of M-M Approach: The Arbitrage Mechanism:

MM has suggested an arbitrage mechanism in order to prove their

argument.
They argued that if two firms differ only in two points viz.
(i) The process of financing and
(ii) Their total market value, the shareholders/investors will dispose of
share of the over-valued firm and will purchase the share of under-
valued firms and naturally this process will be going on till both of
them will attain the same market value.
 As such, as soon as the firms will reach at the identical position, the
average cost of capital and the value of the firm will be equal So, total
value of the firm (V) and Average Cost of Capital K w are independent.
It can be explained with the help of the following illustration:

Let there are two firms, viz., Firm-‘A’ and Firm-‘B’. They are similar in all
respects except in the composition of capital structure. Assuming that
Firm-‘A’ is financed only by equity whereas Firm-‘B’ is financed by a debt-
equity mix.

The following particulars are presented below:

From the table presented above, it is learnt that value of the levered firm ‘B’
is higher than the unlevered firm ‘A’. According to MM, such situation
cannot persist long as the investors will dispose of their holding 01 firm ‘B’
and purchase the equity from the firm ‘A’ with personal leverage. This
process will be continued till both the firms will have same market value.

Suppose, Ram, an equity shareholder, has 1% equity of firm-‘B’. He will

do the following:

(i) At first, he will dispose of his equity of firm-‘B’ for Rs. 3,333.

(ii) He will take a loan of Rs. 2,000 at 5% interest from personal account.
(iii) He will purchase by having Rs. 5,333 (i.e., Rs. 3,333 + Rs. 2,000)
1.007% of equity from the firm ‘ A’.

By this, his net income will be increased as under:

Obviously, this net income of Rs. 433 is higher than that of the firm ‘B” by
disposing of 1% holding.

It is needless to say that when the investors will sell the shares of the firm
‘B’ and will purchase the shares from the firm ‘A’ with personal leverage,
this market value of the share of firm ‘A” will decline and consequently the
market value of the share of firm ‘B’ will rise and this will be continued till
both of them attain the same market value.

We have explained that the value of the levered firm cannot be higher than
that of the unlevered firm (other thing being equal) due to the arbitrage
process. We will now highlight the reverse direction of the arbitrage process.

Consider the following illustration:

In the above circumstances, equity shareholders of the firm ‘A’ will sell his
holdings and by the proceeds he will purchase some equity from the firm ‘B’
and invest a part of the proceeds in debt of the firm ‘B’.

For instance, an equity shareholder holding 1% equity in the firm ‘A’

will do the following:

(i) He will dispose of his 1% equity of firm ‘A’ for Rs. 6,250.
(ii) He will buy 1 of equity and debt of the firm ‘B’ for the like amount.

(iii) As a result, he will have an additional income of Rs. 86.

Thus, if the investors prefer such a change, the market value of the equity of
the firm ‘ A” will decline and consequently the market value of the shares of
the firm-‘B’ will tend to rise and this process will be continued till both the
firms attain the same market value i.e., the arbitrage process can be said to
operate in the opposite direction.

5. Criticisms of the M-M Approach:

We have seen (while discussing M-M Hypothesis) that M-M Hypothesis is

based on some assumptions. There are some authorities who do not
recognise such assumption as they are quite unrealistic, viz. the assumption
of perfect capital market. We also know that most significant element in this
approach is the arbitrage process forming the behavioural foundation of the
M-M Hypothesis.

As the imperfect market exist, the arbitrage process will be of no use and as
such, the discrepancy will arise between the market value of the unlevered
and levered firms. The followings are the shortcomings for which arbitrage
process fails to bring the equilibrium condition.

(i) Existence of Transaction Cost:

The arbitrage process is affected by the transaction cost. While buying

securities, this cost is involved in the form of brokerage or commission etc.
for which extra amount is to be paid which increase the cost price of the
shares and requires a greater amount although the return is same. As such,
the levered firm will enjoy a higher market value than the unlevered firm.

(ii) Assumption of Borrowing and Lending by the Firms and the

Individual at the Same Rate of Interest:

The above proposition, that is, the firms and the individuals can borrow or
lend at the same rate of interest, does not hold good in reality. Since a firm
holds more assets and credit reputation in the open market in comparison
with an individual, the former will always enjoy a better position than the
later.
As such, cost of borrowing will be higher in case of individual than the firm.
As a result the market value of both the firms will not be equal.

(iii) Institutional Restriction:

The arbitrage process is retarded by the institutional investor e.g., Life

Insurance Corporation of India, Commercial bank. Unit Trust of India etc.,
i.e., they do not encourage personal leverage. At present these institutional
investors dominate the capital market

(iv) “Personal or Home-made, leverage” is not the perfect substitute

for “Corporate leverage.”

M-M Hypothesis assumes that “personal leverage” is a perfect substitute

for “corporate” leverage which is not true as we know a firm may have a
limited liability whereas there is unlimited liability in case of individuals.
For this purpose, both of them have a different footing in the capital market.

(v) Incorporation of Corporate Taxes:

If corporate taxes are considered (which should be taken into consideration)

the M-M approach will be unable to discuss the relationship between the
value of the firm and the financing decision. For example we know that
interest charges are deducted from profit available for dividend i.e., it is tax
deductible.

In other words, the cost of borrowing funds is comparatively less than the
contractual rate of interest which allows the firm regarding tax advantage.
Ultimately, the benefit is being enjoyed by the equity holders and debt
holders.

According to some critics the arguments which were advocated by M-M, are
not valid in the practical world. We know that cost of capital and the value
of the firm are practically is the product of financial leverage.

6. M-M Approach with Corporate Taxes and Capital Structure:

The M-M Hypothesis is valid if there is perfect market condition. But in the
real world capital market, imperfection arises in the capital structure of a
firm which affect the valuation. Because; presence of taxes invites
imperfection.
We are, now, going to examine the effect of corporate taxes in the capital
structure of a firm along with the M-M Hypothesis. We also know that when
taxes are levied on income, debt financing is more advantageous as interest
paid on debt is a tax-deductible item whereas retained earnings or dividend
so paid on equity share are not tax deductible.

Thus, if debt capital is used in the total capital structure, the total income
which is available for equity shareholders and/or debt holders will be more.
In other words, the levered firm will have a higher value than the unlevered
firm for this purpose, or, it can alternatively be stated that the value of the
levered firm will exceed the unlevered firm by an amount equal to debt
multiplied by the rate of tax.

The same can be explained in the form of the following equation:

Illustration:

Solution:
Thus, a firm can lower its cost of capital continuously due to the tax
deductibility of interest charges. So, a firm must use the maximum amount
of leverage in order to attain the optimum capital structure although the
experience that we realise is contrary to the opinion.

In real world situation, however, firms do not take a larger amount of debt
and creditors/ lenders also are not interested to supply loan to highly levered
firms due to the risk involved in it.

Trade off theory-

The trade-off theory is based on the assumption that corporations should

optimize the mix of debt and equity in their capital structure to minimize their
weighted average cost of capital (WACC).
The optimal capital structure of a firm is attained when the percentage
contribution from debt and equity is optimized to maximize the value of a firm,
while the cost of capital is minimized.

The trade-off theory states that the optimal capital structure is a balancing
act between reaping the marginal benefit of the interest tax shield and the
risk of financial distress.
If illustrated on a graph, the optimal capital structure is the point at which the
weighted average cost of capital (WACC) is at its lowest point (and the firm
valuation is at its peak).

Since the cost of capital (WACC) is the blended minimum required rate of
return representative of all stakeholders, such as equity shareholders and
lenders, a lower WACC causes the valuation of a firm to increase (and vice
versa for a higher WACC).
In short, the trade-off theory is the notion that corporations should strive to
achieve the right balance in capital weights to maximize their firm value and
create positive stakeholder value.

Broadly put, there are two sources of funding used by corporations to fund their
operations, e.g. working capital needs and purchase of fixed assets (PP&E).
 Debt Capital → The borrowing of capital from lenders for a pre-determined
period in exchange for the obligation to meet periodic interest payments and
repay the original principal in full at maturity.
 Equity Capital → The issuance of shares that represent partial ownership in
the company’s common equity.
Each source of capital has advantages and disadvantages that must be carefully
considered by corporations.

In particular, the primary benefit of debt financing is the interest tax shield,
where the interest paid on debt is tax-deductible and reduces the pre-tax income
(EBT) on the income statement.
The drawback to using debt is that the financial obligations represent
contractual commitments with fixed costs. Therefore, the decision to rely on
leverage causes the risk of financial distress to rise proportionally.
Unlike debt financing, raising capital via equity financing does not place the
underlying issuer with any mandatory obligation to issue dividends to
shareholders – albeit the management team must act in the “best interests” of
their shareholders.
Therefore, debt financing is considered a “cheaper” source of capital, whereas
equity financing offers more flexibility and control over the existing ownership
structure to manage the risk of dilution.

With that said, the trade-off theory states that the optimal capital structure of a
corporation can be determined by balancing the tax-saving benefits from debt
and bankruptcy risk.

Hypothetically, if there were no financial distress costs or bankruptcy risk from

the use of debt, the optimal capital structure would be comprised of all debt.
However, that unfortunately is not the case in the real world.

The following graph illustrates the relationship between firm value and financial
leverage. Notably, the inflection point at which the maximum firm value is
reached reflects the trough of the cost of capital.
 The trade-off theory of capital structure states that the management team of a
company must consider the following factors to optimize their firm valuation:

 Interest Tax Shield (i.e. “Tax Savings”)

 Risk of Default

 Cost of Bankruptcy

 Financial Distress

 Operating Leverage
Given that corporations have the economic incentive to maximize their firm
valuation (and stock price), the interest-tax shield benefits are a method to
achieve that core objective.

But as mentioned earlier, the addition of debt into a company’s capital structure
increases its risk of default and potentially becoming distressed, which can
ultimately end in bankruptcy proceedings.
Once a company files for bankruptcy, the Court can decide whether
a reorganization or liquidation is appropriate. The decision of the Court is
contingent on which route is most beneficial to creditors in terms of their
recovery rates, i.e. recoup their initial capital.
If the percentage of debt in a company’s capitalization is low, the risk of default
is also low, so the minimal leverage enables the company to benefit from the
interest tax shield.
However, increasing the percentage of debt – where leverage becomes a more
significant source of financing – will inevitably reach an inflection point,
whereby the tax savings are offset by the heightening risk of financial distress.

For corporations with high credit risk – as determined by financial metrics like
the debt to equity ratio (D/E) and interest coverage ratio – the aforementioned
point is met sooner.
Thus, the firms deemed to be at a higher risk of default (e.g. low debt capacity,
low profitability, cyclical cash flows) have an optimal capital structure
composed of less leverage compared to firms with high credit ratings and strong
fundamentals.

What are the Components of the Trade-Off Theory?

The optimal capital structure is achieved when the allocation of debt and equity
maximizes the firm value and minimizes the cost of capital (WACC) per the
trade-off theory.

The process of incrementally increasing the financial leverage in the capital

structure of a company, and the impact on firm valuation (and WACC) are as
follows.

1. Initially, as a firm introduces debt into its capital structure, the value of the
firm increases from the interest tax shield.

2. Gradually, as more debt is placed on the company, the tax benefits continue
to rise.
3. But the tax shield is beneficial only until a certain point, which is when the
interest expense burden exceeds the borrower’s operating income (EBIT).

4. If a company’s interest expense equals its operating income, there is no

taxable income, assuming there are no non-operating items.

5. Since there are no tax savings from increasing the debt load – which
determines the interest expense – the benefits halt.

6. Beyond the inflection point, the company is now no longer benefiting from
the interest tax shield, and instead at greater risk of default, as the debt
burden might be unsustainable – hence, the cost of capital reverses course
and starts to rise in an upward trajectory (and firm value declines).
The stage at which the cost of capital (WACC) is at its lowest point reflects a
company’s optimal capital structure, which is the ratio of debt and equity that a
company should target in the long run.

The optimal debt and equity weights in the target capital structure are subjective
measures because risk and return are abstract concepts specific to the individual
– not to mention, the formula to calculate the cost of capital (WACC) requires
the market values of a company’s debt and equity

Pecking Order Theory

The Pecking Order Theory, also known as the Pecking Order Model, relates to a
company’s capital structure. Made popular by Stewart Myers and Nicolas
Majluf in 1984, the theory states that managers follow a hierarchy when
considering sources of financing. The pecking order theory states that managers
display the following preference of sources to fund investment opportunities:
first, through the company’s retained earnings, followed by debt, and choosing
equity financing as a last resort.

Illustration of the Pecking Order Theory

The following diagram illustrates the pecking order theory:

Understanding the Pecking Order Theory

The pecking order theory arises from the concept of asymmetric information.
Asymmetric information, also known as information failure, occurs when one
party possesses more (better) information than another party, which causes an
imbalance in transaction power.

Company managers typically possess more information regarding the

company’s performance, prospects, risks, and future outlook than external users
such as creditors (debt holders) and investors (shareholders). Therefore, to
compensate for information asymmetry, external users demand a higher return
to counter the risk that they are taking. In essence, due to information
asymmetry, external sources of finances demand a higher rate of return to
compensate for higher risk.

In the context of the pecking order theory, retained earnings financing (internal
financing) comes directly from the company and minimizes information
asymmetry. As opposed to external financing, such as debt or equity financing
where the company must incur fees to obtain external financing, internal
financing is the cheapest and most convenient source of financing.

When a company finances an investment opportunity through external financing

(debt or equity), a higher return is demanded because creditors and investors
possess less information regarding the company, as opposed to managers. In
terms of external financing, managers prefer to use debt over equity – the cost
of debt is lower compared to the cost of equity.

The issuance of debt often signals an undervalued stock and confidence that the
board believes the investment is profitable. On the other hand, the issuance of
equity sends a negative signal that the stock is overvalued and that the
management is looking to generate financing by diluting shares in the company.

When thinking of the pecking order theory, it is useful to consider the seniority
of claims to assets. Debtholders require a lower return as opposed to
stockholders because they are entitled to a higher claim to assets (in the event of
a bankruptcy). Therefore, when considering sources of financing, the cheapest
is through retained earnings, second through debt, and third through equity.

Example of the Pecking Order Theory

Suppose ABC Company is looking to raise $10 million for an investment

project. The company’s stock price is currently trading at $53.77. Three options
are available for ABC Company:

1. Finance the project directly through retained earnings;

2. One-year debt financing with an interest rate of 8%, although
management believes that 7% is the fair rate
3. Issuance of equity that will underprice the current stock price by 7%.
Market Timing

Market timing refers to an investing strategy through which a market participant

makes buying or selling decisions by predicting the price movements of a
financial asset in the future. Investors following the strategy aim to outperform
the market by taking a long position (buying) at market bottoms and a short
position (selling) at market tops.

The market timing strategy can be used to enter or exit markets or to choose
between different assets or asset classes while making trading decisions.

When is the Market Timing Strategy Used?

It can be very difficult to regularly and effectively execute a market timing

strategy. Despite the fact, it appeals to investors primarily because of its
potential to amass a fortune overnight as compared to the long time horizon
required by most other approaches of value investing or formula acquisition.

Market timing’s provided success for professional day traders, portfolio

managers and other financial professionals who can devote considerable time to
analyze economic forecasts and effectively predict market shifts with such
consistency. For the average investor, however, following the market daily is
rather inconvenient, and it is more profitable for them to focus on investing in
the long term.
How Does the Market Timing Strategy Work?

Market timing includes the timely buying and selling of financial assets based
on expected price fluctuations. The strategy can be applied to both long-term
and short-term time horizons, as per the risk and return preferences of the
investor.

Usually, the trader would buy stocks when the markets are bullish and sell them
off at the onset of a bear market. It involves recognizing when there would be a
change in the trajectory of the price movements.

To do it, the investor must speculate how the price shall increase or decrease in
the future, rather than examining the value of the financial product. An active
allocation strategy, the market timing strategy aims at reaping the maximum
benefits out of price inequities prevailing in the markets.

Analysis for Market Timing

Under the market timing strategy, any buying or selling decisions are based on
either of the following two analysis techniques:

1. Fundamental analysis

While performing fundamental analysis, an analyst takes into account certain

assumptions regarding variables that affect buying and selling decisions. Market
timing is the mathematical function of such variables. It is important to find out
the most accurate timing to make the decision. Fundamental analysis is used for
a mid-term to a long-term time horizon.

2. Technical analysis

In technical analysis, market timing becomes a function of the historical

performance of the stock and the history of investor behavior. Technical
analysis is generally used for a short-term to mid-term investment horizon.

Advantages of Using Market Timing Strategy

The benefits of the market timing strategy are as follows:

 Market timing is used to maximize profits and offset the associated risks
with high gains. It is the classic risk-return tradeoff that exists with
respect to investment – the higher the risk, the higher the return.
 It enables traders to curtail the effects of market volatility.
 It enables traders to reap the benefits of short-term price movements.
Disadvantages of Using Market Timing Strategy

Empirical research and real-life incidents show that the costs associated with the
market timing strategy greatly surpass the potential benefits given that:

 It requires a trader to consistently follow up on market movements and

trends.
 It entails higher transaction costs and commissions and includes a
substantial opportunity cost. Market timers exit the market during periods
of high volatility. Since most market upswings occur under volatile
conditions, active investors miss out on the opportunities and ultimately
earn less returns than buy-and-hold investors.
 An investor who succeeds in buying low and selling high must incur tax
consequences on their gain. In case the security was held for less than a
year, which is mostly true for market timers, the profit is taxed at the
short-term capital gains rate, which is higher than the long-term capital
gains rate.
 Precisely timing market entries and exits may be difficult.
Signaling Theory
Capital structure signaling theory is based on the idea that managers possess
more information about a firm’s future performance than outside investors.
Because of this information asymmetry, financing choices send signals to the
market.

 Debt Issuance as a Positive Signal: When a firm issues debt, it signals

confidence in its future cash flows. The logic behind this is that managers
would not commit to fixed debt payments unless they believed the firm
could generate sufficient profits to service the debt.
 Equity Issuance as a Negative Signal: Conversely, issuing equity can
signal that the firm’s stock is overvalued. Investors may interpret this as a
lack of confidence from managers, leading to a decline in stock prices.
Key Assumptions of the Signaling Model

1. Information Asymmetry: Managers know more about the firm’s true

value than investors.
2. Cost of Financial Distress: Debt imposes a cost on firms in case of
financial distress. This ensures that only firms with strong prospects take
on debt.
3. Rational Market Participants: Investors correctly interpret signals and
adjust stock prices accordingly.
Comparison of Capital Structure Theories

Theory Key Concept Assumptions Implications

Capital structure is No taxes, bankruptcy

Modigliani & Financing choices do
irrelevant in a costs, or asymmetric
Miller (1958) not affect firm value
perfect market information

Firms balance tax

Trade-off benefits of debt Taxes and financial Optimal capital
Theory with bankruptcy distress costs exist structure exists
costs

Firms prefer
Information No target capital
Pecking internal financing,
asymmetry drives structure; firms follow
Order Theory then debt, then
financing choices a financing hierarchy
equity

Capital structure Managers have Debt signals

Signaling decisions convey private information; confidence; equity
Theory information to investors react to issuance may signal
investors signals overvaluation

Illustration of the Signaling Effect

Consider two companies, Firm A and Firm B. Both firms need to raise $50
million.

 Firm A chooses debt financing. Investors see this as a strong signal that
Firm A expects high future earnings. As a result, its stock price remains
stable or even rises.
 Firm B issues new equity. Investors interpret this as a sign that the
firm’s stock is overvalued. They sell off shares, causing a decline in Firm
B’s stock price.
Calculation Example: Market Reaction to Equity Issuance

Suppose Firm B has 10 million outstanding shares at $30 each, with a market
capitalization of $300 million. The firm needs $50 million and issues 1.67
million new shares at $30 per share.

Pre-Issue Market Cap: 10M×30=300M10M \times 30 = 300M

Post-Issue Market Cap (if stock price drops 10% due to negative
signaling): 11.67M×27=315M11.67M \times 27 = 315M

Here, the firm’s market capitalization only increases by $15 million despite
raising $50 million, illustrating the negative impact of equity issuance on stock
prices.

Empirical Evidence Supporting Signaling Theory

Research has shown that firms issuing debt generally experience positive
abnormal returns, while equity issuance often leads to negative abnormal
returns. Studies by Ross (1977) and Leland & Pyle (1977) support the idea that
managers use capital structure to signal private information.

Implications for Financial Managers

Financial managers must carefully consider how their financing decisions affect
investor perception. Over-reliance on equity financing can lead to stock price
declines, while excessive debt increases financial risk. The optimal strategy
balances signaling benefits with financial flexibility.

Financial Leverage -

Financial leverage is a critical concept in the world of finance, influencing how

companies make decisions about funding and growth. It involves using
borrowed capital to increase the potential return on investment, which can
significantly amplify both gains and losses.

Understanding financial leverage is essential for investors, business owners, and

financial analysts as it directly impacts profitability and risk.
Types of Financial Leverage

Financial leverage can be categorized into three main types: operating leverage,
financial leverage, and combined leverage. Each type plays a distinct role in a
company’s financial strategy and has unique implications for risk and return.

Operating Leverage

Operating leverage refers to the extent to which a company uses fixed costs in
its operations. High operating leverage means that a company has a larger
proportion of fixed costs relative to variable costs. This can lead to greater
profits as sales increase, but also higher losses if sales decline. For instance, a
manufacturing firm with significant investment in machinery and equipment
will have high operating leverage. The degree of operating leverage (DOL) can
be calculated by dividing the percentage change in operating income by the
percentage change in sales. Companies with high operating leverage benefit
from economies of scale, but they must maintain a high level of sales to cover
their fixed costs.

Financial Leverage

Financial leverage involves the use of borrowed funds to finance the acquisition
of assets. This type of leverage is measured by the degree to which a company
uses debt in its capital structure. The primary goal is to increase the return on
equity by using debt as a cheaper source of financing compared to equity. The
degree of financial leverage (DFL) can be calculated by dividing the percentage
change in earnings per share (EPS) by the percentage change in earnings before
interest and taxes (EBIT). While financial leverage can enhance returns, it also
increases the risk of insolvency, especially if the company faces declining
revenues or increased interest rates. Companies must carefully balance the
benefits and risks associated with financial leverage.

Combined Leverage

Combined leverage, also known as total leverage, is the cumulative effect of

both operating and financial leverage. It provides a comprehensive view of the
overall risk and return profile of a company. The degree of combined leverage
(DCL) can be calculated by multiplying the degree of operating leverage (DOL)
by the degree of financial leverage (DFL). This metric helps investors and
analysts understand how changes in sales will impact the company’s earnings
per share (EPS). A company with high combined leverage is more sensitive to
changes in sales, which can lead to significant fluctuations in profitability.
Understanding combined leverage is crucial for making informed investment
decisions and managing financial risk effectively.