Capital Structure Theories^267
VL = VU = o,L ke,L
EBIT
kEBIT=Here the subscript L is used to denote Leveraged firm and subscript U is used to
denote Unleveraged firm.
Since the V (Value of the firm) as established by the above equation is a constant, then
under the MM model, when there are no taxes, the value of the firm is independent of
its leverage. This implies that the weighted average cost of capital to any firm is completely
independent of its capital structure and the WACC for any firm, regardless of the
amount of debt it uses, is equal to the cost of equity of unleveraged firm employing no
debt.
Proposition II
The expected yield on equity, Ke is equal to Ko plus a premium. This premium is equal
to the debt-equity ratio times the difference between Ko and the yield on debt, Kd.
This means that as the firm's use of debt increases, its cost of equity also rises, and in
a mathematically precise manner.
Proposition III
The cut-off rate for investment decision making for a firm in a given risk class is not
affected by the manner in which the investment is financed. It emphasises the point
that investment and financing decisions are independent because the average cost of
capital is not affected by the financing decision.
Example
Let us take the case of two firms X and Y, similar in all respects except in their capital
structure. Firm X is financed by equity only; firm Y is financed by a mixture of equity
and debt. The financial parameters of the two firms are as follows :
Financial particulars of Firms X and Y
Firm X Firm Y
Total Capital Employed(Rs.) 1,000,000 1,000,000
Equity Capital(Rs.) 1,000,000 600,000
Debt (Rs.) nil 400,000
Net operating Income (Rs.) 100,000 100,000
Debt Interest (Rs.) 0 20,000
Market Value of Debt (Rs.)
(Debt Capitalisation is 5%)
0 400,000Equity earnings (Rs.) 100,000 80,000
Equity capitalisation rate 10% 12%
Market value of equity (Rs.) 1,000,000 666,667
Total market value of the firm 1,000,000 1,066,667
Average cost of capital 10% 9.37%
Debt-Equity ratio 0 0.6