Untitled-29

(^294) Financial Management
financing. In an attempt to modify MM's model to make it more consistent with actual
behaviour, many of their assumptions were relaxed in papers by other authors. In
particular, the possibility of financial distress drastically changed the MM results. In the
modified model, tax savings cause the value of a firm to rise as more and more debt is
used, but at some point (the optimal structure), the value of the firm begins to fall with
additional debt because the tax benefits are more than offset by the increasing costs of
potential financial distress.
The MM model as modified to include financial distress suggests to managers
l that a certain amount of debt is good
l that too much debt is bad, and
l that there is an optimal amount of debt for every firm.
Thus, the modified MM theory, which is called the trade-off theory of capital structure,
provides useful insights into the factors that affect a firm's optimal capital structure.
Here the marginal costs and benefits of debt financing are balanced against one another,
and the result is an optimal capital structure that fall somewhere between zero and
100% debt.
Tax Perspective
Both Debt or Equity require the company to service the same. Interest is paid on debt
and dividends on equity. Interest, which is 100% deductible for Income Tax purposes,
provides the company a tax shield for the amount of interest being charged.
Let us take an example to compare two modes of financing:
Case 1 Case 2
Company ABC Ltd. XYZ Ltd.
Equity (Rs. Mn) 10 30
Debt (Rs. Mn) 20 nil
Turnover (Rs. Mn) 100 100
Cost of Goods sold (Rs. Mn) 50 50
Other Expenses (Rs. Mn) 40 40
Interest (Rs. Mn) 2 Nil
Profit Before Tax (Rs. Mn) 8 10
Tax (Rs. Mn) 2.4 3.0
PAT (Rs. Mn) 5.6 7.0