Even though the cost of equity rises with increased debt the advantages of debt

Even though the cost of equity rises with increased

This preview shows page 11 - 21 out of 39 pages.

Even though the cost of equity rises with increased debt the advantages of debt would outweigh the increased cost of equity. Beyond a certain level of leverage the cost of equity starts rising disproportionately, more than offsetting the advantage of debt, raising the overall cost of capital for the firm. Since cost of capital falls initially and then starts rising there exists a point where cost of capital would be least. This point of least cost of capital would maximise the value of the firm and is the optimal capital structure. 18 Capital Structure - Theory
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TRADITIONAL APPROACH Scenario A Scenario B Scenario C Project Cost 1,000.00 1,000.00 1,000.00 Sources of Finance Equity (Book Value) 900.00 500.00 100.00 Debt (Book Value) 100.00 500.00 900.00 Capitalisation Rate Debt 10% 11% 12% Equity 20% 20% 30% EBIT 500.00 500.00 500.00 Interest (I) 10.00 55.00 108.00 EBT 490.00 445.00 392.00 19 Capital Structure - Theory
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TRADITIONAL APPROACH EBT 490.00 445.00 392.00 Taxes Assumed no taxes Earnings available to 490.00 445.00 392.00 shareholders (EAT) Market value of debt 100.00 500.00 900.00 (I/r d ) Market value of Equity 2,450.00 2,225.00 1,307.00 (EAT/r e ) Value of the Firm, V 2,550.00 2,725.00 2,207.00 Capitalisation rate, WACC 19.61% 18.35% 22.65% (EBIT/V) 20 Capital Structure - Theory
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Traditional Approach k e k o k d D e b t C o s t With increasing level of debt the overall cost of capital falls initially because cost of debt is less than the cost of equity, thereafter it rises because equity holders expect greater returns due to increasing perceived risk from the debt holders.
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NET OPERATING INCOME APPROACH Net Operating Income (NOI) approach - assumes that value of the firm remains constant because overall capitalisation rate remains constant Net operating income approach states that value of the firm is determined by the earning capacities of the assets and not by how are they acquired. 12
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NET OPERATING INCOME APPROACH Scenario A Scenario B Scenario C Project Cost 1,000.00 1,000.00 1,000.00 Sources of Finance Equity (Book Value) 900.00 500.00 100.00 Debt (Book Value) 100.00 500.00 900.00 Capitalization Rate Debt 10% 10% 10% Overall 20% 20% 20% EBIT 500.00 500.00 500.00 Interest (I) 10.00 50.00 90.00 EBT 490.00 450.00 410.00
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NET OPERATING INCOME APPROACH EBT 490.00 450.00 410.00 Taxes Assumed no taxes Earnings available to 490.00 450.00 410.00 shareholders (EAT) Market value of debt 100.00 500.00 900.00 (I/r d ) Market value of firm 2,500.00 2,500.00 2,500.00 (EBIT/r) Value of equity (E) 2,400.00 2,000.00 1,600.00 Equity capitalisation rate 20.42% 22.50% 25.63% (EAT/E) 14 Capital Structure - Theory
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NET OPERATING INCOME APPROACH Under net operating income approach the cost of equity rises so as to compensate the reduced cost of debt keeping the overall capitalisation rate constant. D r = r + (r - r ) e 0 0 d E Scenario A : r e = 20 + (20 - 10) x 100/2400 = 20.42% Scenario B : r e = 20 + (20 - 10) x 500/2000 = 22.50% Scenario C : r e = 20 + (20 - 10) x 900/1600 = 25.63% 15 Capital Structure - Theory
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NET OPERATING INCOME APPROACH k e k o k d D e b t C o s t Under net operating income approach no capital structure is optimal, alternatively all capital structures are optimal.
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MODIGLIANI AND MILLER (MM) THEORY - WITHOUT TAXES MM Proposition I without taxes Capital structure is irrelevant.
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