Module II : Financing Decision

Weightage 30 percent

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 Topics
❑ Leverage Analysis (EBIT-EPS analysis)
▪ Operating Leverage
▪ Financial Leverage
▪ Combined Leverage
❑ Computation of Cost of Capital
▪ Cost of Debt
▪ Cost of Preference Share
▪ Cost of Equity
▪ Cost of Retain Earning
❑ Computation of WACC & WMCC
❑ Capital Structure Theories
▪ Net Income Approach,
▪ Net operating Income Approach,
▪ Traditional approach
▪ Modigliani Miller Model
▪ Trade off Models
▪ Pecking order theory.
❑ Factors determining the optimum capital Structure 2
 What is Leverage?
Leverage reflects the responsiveness or influence of one financial variable over some
other financial variable.

% Change in dependent variable

Degree of Leverage =
% Change in independent variable

The two variables, for which the relationship is to be established and measured, should
be interrelated, otherwise, the leverage study may not have any useful purpose
 Leverage refers to the use of fixed costs to magnify the potential return to a firm

Fixed Cost

Fixed Fixed Financial

Operating Cost Cost

Fixed Operating costs e.g.- rent, depreciation

Fixed Financial costs e.g.- interest costs on long term debt (Debentures) ; Preference Dividend
Degree of Operating Leverage reflects the responsiveness or influence of Change in Sale on
Change in EBIT
% Change in EBIT 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Degree of Operating Leverage = ; OL =
% Change in Sales 𝐸𝐵𝐼𝑇

Degree of Financial Leverage reflects the responsiveness or influence of Change in EPS on

Change in EBIT
% Change in EPS 𝐸𝐵𝐼𝑇
Degree of Financial Leverage = ; FL =
% Change in 𝐸𝐵𝐼𝑇 𝐸𝐵𝑇 −𝑃𝑟𝑒𝑓 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑/(1−𝑡)

Degree of Combined Leverage reflects the responsiveness or influence of Change in EPS on

Change in Sales
% Change in EPS 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Degree of Financial Leverage = ; CL=
% Change in Sales 5 𝐸𝐵𝑇 −𝑃𝑟𝑒𝑓 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑/(1−𝑡)
 Classification of Leverage

Operating Financial Combined

Leverage Leverage Leverage

Sales & EBIT EBIT & EPS Sales & EPS

Contribution/EBIT EBIT/EBT Contribution/EBT

 Remember
✓ When Sales level increases or decreases, the EBIT
also changes. Sales
✓ Change in EBIT impacts the EPS accordingly
✓ The “Operating Leverage” measures the relationship EBIT
between the sales revenue and the EBIT.
✓ The “Financial Leverage” measures the relationship EPS
between EBIT and EPS
 Leverage –Double Edge Sword
✓It magnifies profits as well as losses
✓An aggressive or highly leveraged firm has a
relatively high break-even point (and high fixed
costs)
✓A conservative or non-leveraged firm has a
relatively low break-even point (and low fixed
costs)
Numerical Questions

Q1. A firm has sales of Rs.10,00,000, Variable Cost of Rs. 7,00,000 and fixed costs of Rs.
2,00,000 and debt of Rs. 5,00,000 @ 10% rate of Interest.

i. Calculate Operating Leverage.

ii. What will be increase in the EBIT if Sales are increased by 20%
iii. If the firm wants to double its earnings before Interest and tax, how much of a rise in sales
would be needed on a percentage basis?

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Q2. ABC company has currently an all-equity capital structure consisting of 15000 equity
shares of Rs.100 each. The management is planning To raise another 25 lakhs to finance a
major Programme of expansion And is considering three alternative method of financing:

i. To issue 25000 equity shares of Rs.100 each.

ii. To issue 25000, 8% debenture of Rs.100 each
iii. To issue 25000, 8% preference share of Rs.100 each.

The company’s expected earnings before interest and taxes will be Rs.8 Lakhs. Corporate
tax rate is 50%. Analysis the options and suggest the Best alternative with reasons.

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Q3.The following information for the year ending 31st March 2024 is available
Interest on Debt $400000; Tax Rate is 40 percent
Preference Dividend $200000
Calculate the degree of financial Leverage if
i. EBIT is $1000000 and
ii. EBIT is $1500000

Q4. Consider the following figures:

Net Sales are Rs.16 Crores
EBIT as a percentage of sales is 10%
Corporate tax rate is 40%
Equity shares @ of Rs.10 each is Rs 4 Crores
10% preference share @ of Rs 100 each Rs 3 Crores
12% secured debenture @ of Rs 100 each Rs. 2 Crores
You are required to calculate
(a) EPS (b) percentage change in EPS if EBIT increases by 10%
Q5. Consider the following information of Pearson Ltd.
Selling price per unit Rs.200
Variable cost per unit Rs.120
Fixed Cost Rs.2000000
Interest on Debt Rs.1200000
Preference Dividend Rs.800000
Tax rate 40%
No of units produce 120000
Calculate the combine leverage & percentage change in EPS if sales are increased by 5%
Q6. ZOOP Ltd had the following Balance Sheet for the year ended 31st March 2024

Liabilities Asset

Equity Capital (@Rs.10each) 1000000 Fixed Asset (net) 2500000

Reserve and Surplus 200000 Current Assets 1500000
15% debenture 2000000
Current Liabilities 800000
40,00,000 40,00,000

Additional information
Fixed cost (excluding interest payment) Rs.800000
Variable operating cost ratio 80%
Total Asset turnover ratio is 3times
Income tax Rate is 50%
You are required to calculate i. EPS ii. OL iii. FL iv. Combined leverage.
Q7. The following are the operating result of a firm:
Sales (units) 25000
Interest p.a. Rs.30000
Selling price unit Rs.24
Tax Rate 50%
Variable cost Rs.16 per unit
No. of equity shares 10000
Fixed Cost p.a. Rs.80000
Compute the followings:
i. Break even sales
ii. EBIT
iii. EPS
iv. Operating Leverage
v. Financial Leverage
vi. Combined Leverage.
Q8. The following details of ABC ltd is available as on 31st March 2024. you are
require to prepare the Income Statement of the company.

Operating leverage 3
Financial leverage 2
Interest charge p.a. Rs.20 Lakhs
Taxes 50%
Variable cost as a percentage of sales is 60%

Q9. You are a finance manager of Gel pen Ltd. The degree of operating leverage of Your company
is 5. The degree of financial leverage is 3. Director of your company Has found that the degree of
operating leverage & degree of financial leverage of your Nearest competitor INK pen Ltd are 6 &
4 respectively.
In his opinion the Ink pen ltd Is better than that of Gel pen ltd. because of high value of degree of
leverages.
Do you agree to your managing Director? Justify.
Q10.X corporation has estimated that for a new product its Break-even point is 2000 units If the item is
sold for Rs.14 per unit; the variable cost is Rs. 9 per unit.
Calculate the Degree of operating leverage for sales volume of 2500 units and 3000 units
.
Q11. The capital structure of a company consists of ordinary share capital of Rs10,00,000 (shares of Rs
100 each) and Rs 10,00,000 of 10% debenture. The selling price is Rs 10 per unit; Variable costs
amount to Rs 6 per unit and fixed Expenses amounted to Rs 2,00,000. The income tax is assumed to be
50%. The sales Level are expected to increase from 1,00,000 units to 1,20,000 units.
You are required to calculate the degree of operating, financial leverage

Q12. A firm’s sales, variable costs and fixed cost amount to Rs 75,00,000, Rs 42,00,000
And Rs 6,00,000 respectively. It has borrowed Rs. 45,00000 at 9% and its equity capital Totals Rs
55,00,000.
What is firms ROI?
Does it have favorable financial leverage
Calculate operating, financial & combined leverage.
Q13. Installed Capacity is 20,000 units, Actual Production and sales is 75% of installed Capacity, selling price
per unit Rs 10, Fixed cost Rs 30,000, Total operating cost 80%.
Calculate operating leverage

Q14 Prepare Income Statement from the following information provided by M/S Bell Limited
Price Earnings Ratio 3 times
Market Price per Equity Share is Rs 18
10,000 Equity Shares of Rs 10 each
1000, 12% Preference shares of Rs 100 Each
Degree of Financial Leverage 2
Degree of Operating Leverage 2
Tax Rate is 40%
Variable cost as % of sales are 60%
Rate of Interest on Debt Fund is 10%

Q15. From the following information calculate the percentage of change in EPS if Sales are increased by 5%
EBIT Rs.1120
EBT Rs.320
Fixed Cost Rs.700
Cost of Capital

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 Meaning
Cost of Capital means cost of obtaining funds i.e.
average rate of return that the investors in a firm
would expect for supplying funds to the firm.
OR
It is the minimum rate of return which a firm, must
and is expected to earn on its investments so as to
maintain the market value of its shares
 Significance of Cost of capital

• Helpful in capital Budgeting

• Helpful in capital structure decisions
• Helpful in evaluating the financial performance
• Basis for other financial decisions like dividend policy,
working capital decisions etc.
 Cost of Debt

Cost of
Preference
Cost of Specific Share
Source of
Finance
Cost of Equity

Cost of Retained
Computation of Cost
Earning

WACC
Composite Cost
of Capital
MWACC
 Cost of Debt
✓ Debt may be in the form of debenture, bond and term loan from the financial.
✓ On Debt, Interest is paid to the Investors & payment of interest is a Fixed obligation.

Debenture

Loan

Cost of
Debt

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 Cost of Debenture

In case of Irredeemable debt

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 (𝟏−𝒕)
Kd =
𝑵𝒆𝒕 𝑷𝒓𝒐𝒄𝒆𝒆𝒅𝒔
Debenture
Cost of Redeemable debt

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝟏−𝒕 +[𝑹𝑽−𝑵𝑷∗/𝒏]

Kd =
𝑹𝑽+𝑵𝑷∗ /𝟐

RV – Redeemable Value Irredeemable Redeemable

NP – Net Proceeds
* If Market Price is given MP will be used
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 Cost of Preference Capital
In case of Irredeemable Preference
Share

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
Kp =
𝑵𝒆𝒕 𝑷𝒓𝒐𝒄𝒆𝒆𝒅𝒔
Preference
Share
Cost of Redeemable Preference Shares

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅+[𝑹𝑽−𝑵𝑷∗/𝒏]
Kp =
𝑹𝑽+𝑵𝑷∗ /𝟐

RV – Redeemable Value
Irredeemable Redeemable
NP – Net Proceeds
* If Market Price is given MP will be used
 Cost of Equity Share Capital

(i)
(iii)

Dividend Yield Model EPS Model

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐸𝑃𝑆
Ke = Ke =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒

(ii)
(iv)

Dividend Yield Plus Growth Model Capital Asset Pricing Model

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Ke = (Rm-Rf) β + Rf
Ke = +g
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
Test your Understanding
Q1. Rayon Steel ltd. has issued 30000 irredeemable 14% debentures of Rs.150 each. The cost of floating of
Debenture is 5% of the total issued amount. The company’s taxation rate is 40%. Calculate the cost of Debt.

Q2. Surya Industries has raised fund through issue of 10,000 debenture of Rs. 150 each at a discount of Rs 10 per
debenture with 10 years maturity. The coupon rate is 16%.The floatation cost is Rs.5 per debenture. The
Debenture are redeemable with 10% premium. Corporate tax is 40%.Calculate the cost of Debt.
Q3. A company recently made an issue of Nonconvertible debenture for Rs.400 Lakhs. The terms of the issue are
as follows;
Each Debenture has a face Value of Rs.100 and carries a rate of Interest of 14%.
the debenture is redeemable at a premium of 5% after 10 yrs.
if the company realized Rs.97 per debenture and the corporate tax rate is 50%
What is cost of Debt?

Q5. N ltd has raised a term loan of Rs.2 Crores from a commercial bank on a prime Lending rate plus 4%. The
prime lending rate of the bank is 12%. The company’s Corporate rate of tax is 40%. Calculate cost of debt raised
from the bank
Q6. Green field Ltd has issued 10,00,000 irredeemable preference shares of Rs 150 each At a dividend of 14%.
The issue expenses are Rs.15 per share. Calculate the cost of Preference share.

Q7. The term of the Preference share is made by Cola Ltd are as follows;
Each preference share has a face Value of Rs.100 and carries a rate of Dividend of 14%. The share is
redeemable after 12 yrs. at par. If the net amount realized per share is Rs.95, what is cost of preference shares.

Q8. Dell Ltd has Rs 100 preference share redeemable at a premium of 10% with 15 yrs maturity. The dividend
rate is 12%. Floatation cost is Rs.5. Sales price is Rs. 95. Calculate the Cost of Preference share

Q9. A firm has issued preference shares of the face value of $100 with the promised Dividend of $12 per annum after
incurring a floating cost of 2%. What is the cost of Preference share to the company.

Q10.Excel Co. Ltd has preference share having face value of $100 per share. The rate of preference dividend is 12 per cent
p.a. Shares are redeemable after 10 years at par. The net amount realized per share is $90. Determine the cost of preference
share capital.
Q11. X ltd issued 10,000 equity share of Rs.10 each at a premium of Rs 2 each. The Company has incurred issue
expenses of Rs. 5000. The equity shareholders expects the Rate of dividend to 18%. Calculate the cost of equity
share capital. Will your answer be Different if the current market price of share is Rs 21?.

Q12. The equity of Y ltd are traded in the market at Rs.90 each. The expected current year Dividend per share is
Rs.18. the subsequent growth in dividend is expected at the rate of 6%.
(i) Calculate the cost of equity.
(ii) In the above question if the dividend of Rs.18 is the last year dividend then calculate the cost of equity

Q13.ENY has its equity share of Rs10 each quoted in a stock exchange has a market price of Rs.56. A constant
expected annual growth rate is 6% and a dividend of Rs.3.60 per Share has been paid by the company in the
previous year. Calculate cost of equity.

Q14. The market price per share of Dash Ltd is Rs.125. the dividend declared per share is Rs 12 per share and the
DPS is expected to grow at a constant rate of 8%
Calculate the cost of equity.

Q15.Y ltd has 50,000 equity shares of Rs 10 each and its current market price is Rs 45 each The after-tax profit of
the company is Rs. 9,60,000. calculate the cost of equity capital Based on earning per share method
Q16.M Ltd share beta factor is 1.40. The risk-free rate of interest on government securities is 9%. The
expected rate of return on company equity share is 16%. Calculate the cost of Equity based on CAPM model.

Q17. The share of the company are selling at Rs.40 per share and it had paid a dividend of Rs.4 per share last
year. The investor’s market expects a growth rate of 5% per year. Compute the company’s equity cost of
capital;

Q18.Jaguar plastic corporation expects to pay $6 dividend this year to common shareholders. The past record
shows that dividend has grown by 2 per cent each year. Jaguar’s shares has a Current market price of $45 Per
share. Determine the cost of capital.

Q19. New Alliance Ltd gives dividend to its shareholders of $2 per share. The growth rate of Dividend is 5
per cent and is expected to remain constant. The current market price per share is $60 and floating cost per
share is $2. calculate the cost of new issue

Q20. Micro corporation has equity stock with listed Beta of 1.35.
The estimated market return is 12 per cent and the risk-free rate based on government
bond is 6.5 per cent. Calculate the cost of equity.
Numerical on Weightage Average Cost Of Capital

Q21. A firm has the following capital structure and after-tax cost for the different sources of funds used

Source of funds Amount After tax cost

Debt Rs 15,00,000 8%
Preference shares Rs 12,00,000 10%
Equity shares Rs 18,00,000 15%
Retained Earnings Rs 15,00,000 11%

You are required to calculate the Weightage Average cost of Capital

(1) Book Value Based
(2) Market value based if the firm has 18000 equity shares of Rs 100 each outstanding
and the current market price is Rs 300 per share.
Q22. JK cements Ltd has the following Capital Structure:

Particulars Market value Book Value Cost (after tax)

Equity Share 80 lakhs 120 lakhs 18%
Preference share 30 lakhs 20 lakhs 15%
Debenture 40 lakhs 40 lakhs 14%
Calculate the company’s weighted Average Cost of Capital based on book value &
Market value

Q23.ANZ has a gearing ratio of 40%. Its cost of equity is 21% and cost of debt is 15%. Calculate the
company’s WACC

Q24. The required rate of return on equity is 16% and the cost of Debt is 12%. The firm has a capital
structure mix of 60% equity and 40% debt. What should be the overall rate of Return of the firm to
maintain it’s market value
Q25. Sun pharma ltd has the following capital structure:
Particulars (Rs. crore)
Equity Capital (1crore Shares @ Rs 10 each) 10
Preference Share Capital, 11% (1lakh @ Rs.100) 1
Retained earnings 12
Debenture, 13.5%(500000 debenture @100) 5
Term Loan, 12% 8
Total 36

The next expected dividend per share is Rs.1.50. The Dividend per share is expected to grow @ 7%. The
market price per share is Rs.20. Preference stock, redeemable after 10 years is currently selling for Rs.75 per
share. Debentures, redeemable after 6 years are selling for Rs.80 per debenture. The tax rate for the company
is 50%.
Calculate the WACC using
i. Book Value proportions
ii. Market Value proportions
Q26. You are required to determine the weighted average cost of capital using
(i) Book value Weights & (ii) Market Value weights.
The following information is available for your perusal. The capital structure is……
Debenture (Rs 100 per debenture) Rs 8,00,000
Preference Shares ( Rs 100 per share) Rs 2,00,000
Equity Shares ( Rs 10 per share) Rs 10,00000
All these securities are traded in the capital markets.
Recent prices are debenture @ Rs 110, Preference shares @ Rs.120 & equity @ Rs 22.
Anticipated external financing opportunities are;
Rs 100 per debenture redeemable at par; 20-year maturity, 8% coupon rate, 4% flotation Costs, sale price Rs 100
Rs 100 preference share redeemable at par: 15 yrs maturity, 10% dividend rate 5% Flotation Costs, sales price Rs
100
Equity shares Rs 2 per share flotation costs, sales price Rs 22. In addition, the dividend. Expected on the equity
share at the end of the year Rs 2. per share, the anticipated growth Rate in dividend is 5% & company pay all
its earnings in the form of dividend. Tax rate is 50%
Q27. Hindustan Ltd has paid up equity capital 600000 equity share of Rs.10 each. The current market price of
share is Rs 24. During the current year, the company has declared a Dividend of Rs.6 per share. The company has
also previously issued 14% irredeemable Preference share of Rs.10 each aggregating to Rs.30 lakhs and 13%
50000 debentures of Rs.100 Each. The company’s corporate tax rate is at 40%, the growth in dividends on equity
share is Expected at 5%. In case of preference share the company has received only 95% of the face value of
shares after deducting issue expenses. Calculate the weighted average cost of capital.

Q28. M/S WXY ltd has the following capital structure:

10% Debenture ₹300000
9% preference shares ₹200000.
Equity 5000 shares of ₹100 each ₹500000
The equity shares of the are quoted at ₹110 and the company is expected to declare a dividend of ₹11 per share
which is expected to grow at the rate of 8%. Assuming the tax rate applicable to the company is 50%
a. calculate the weighted average cost
b. If the company raise additional term loan at 12% for ₹500000 to finance its expansion plan calculate the
revised WACC. The company’s assessment is that it will be in position to Increase the dividend from ₹11 per
share to ₹13 per share, but the business risk associated. With the new financing way bring down the market price
from ₹110 to ₹94 per share's
Capital Structure Decision
 Introduction
➢ Financing decision is raising the necessary funds to meet our investment
expenditures.
➢ Most of the investment is done through borrowed funds.
➢ So, while making an investment decision it is necessary to see whether
adequate funds are available or not.
➢ Because without a financing decision investment decision is not possible
and without investment decision financing decision has no purpose
 Optimum Capital Structure
A capital structure decision can influence the value of the firm through the cost of capital and
trading on equity. The optimum capital structure may be defined as “ that capital structure or
combination of debt and equity that leads to the maximum value of the firm”.
Factors Affecting Capital Structure
➢ Simplicity
➢ Flexibility
➢ Minimum Cost of Capital
➢ Adequate Liquidity
➢ Minimum Risk
➢ Legal Requirements
➢ Control
➢ Floatation Cost
 Theories of Capital Structure

Net income Approach:

According to this approach, a firm can minimize the weighted average cost of capital and
increase the value of firm as well as market price of equity of shares by using debt
financing to the maximum possible extent

Assumption

✓ The cost of debt is less than the cost of equity.

✓ No Taxes
✓ The risk perception of investors is not changed by the use of debt.
 r

rE
rA =WACC

rD
D
V
 V=S+D
V=Total market value of a firm
S= Market value of equity shares
(S=Earnings Available to Equity Share holders (NI)/Equity capitalization rate)
D= Market value of Debt
𝑬𝑩𝑰𝑻
(Ko = )
𝑽

Numerical
A Company expects a net income of Rs.80,000. It has Rs.2,00,000, 8% Debentures. The Equity capitalization rate
of the company is 10%. Calculate the value of the firm and overall capitalization rate according to NI approach (
ignore taxes)
If the debenture is increased to RS.300000. what shall be the value of the firm and over all capitalization rate
 Net Operating Income Approach

➢ Suggested by Durand
➢ Opposite to NI Approach
➢ According to this: Change in capital structure of a company does not affect the market value
of the firm and the overall cost of capital remains constant irrespective of the method of
financing.
➢ It implies that the overall cost of capital remain same whether the Debt- equity is 50:50 or
20:80

NO OPTIMUM CAPITAL STRUCTURE, EVERY STRUCTURE IS OPTIMUM

 Assumptions of NOI Approach

➢ The market capitalizes the value of the firm as a whole;

➢ The business risk remains constant at every level of debt equity mix
➢ There are no corporate taxes

𝐸𝐵𝐼𝑇
V=
Ko
V = Value of a firm
EBIT=Net operating Income or Earnings before interest and taxes
Ko = Overall cost of capital
Example
A company expects a net operating income of Rs.100000. it has Rs.500000, 6% debenture.
The overall capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate according to Net operating income approach
If the debenture are increased to Rs.750000. what will be the effect on the value of the
firm and the equity capitalization rate?

Try yourself
REX Limited has all Equity capital Structure with a cost of capital of 15%. The company decided to raise
₹2,00,000 12% Debt. The expected level of EBIT is ₹90,000 which is expected to remain unchanged.
Assuming net income approach assumptions are applicable, calculate the Value of Equity, Value of Debt and
Value of firm before and after change in capital structure. Further what should be the minimum rate of return
the company must earn to maintain its value of firm.
 The Traditional Approach
➢ Intermediate Approach
➢ According to this: the value of firm can be increased initially, or the cost of capital can be
decreased by using more debt as the debt is a cheaper source of funds than equity. Beyond
a particular point, the cost of equity will start increases because increased debt increases
the financial risk of the equity shareholders and due to increase cost of Equity, the benefit/
advantage of cheap debt will be offset so the overall cost remain constant.
➢ After this there comes a stage, when the increased cost of equity cannot by offset by the
advantage of low-cost debt and the overall cost will start increasing.

Thus, overall cost of capital, decreases up to a certain point, remains unchanged for moderate
increase in debt and thereafter any increases beyond a certain point will increase the overall
cost of capital.
 Modigliani and Miller Approach
➢ In the absence of taxes
➢ Arbitrage Process
➢ Personal Leveraging
Modigliani and Miller concluded that the total market value of a firm and the cost of capital are
independent (exclusive of tax ) of the capital structure.

Their approach is based on the following assumption:

(i) All firms have equity capital
(ii) They are divided into “equivalent return class”
(iii) Information about the market condition is perfect
(iv) Investors acts rationally
(v) There is a perfect market
 Pecking Order Theory
According to this theory a company’s capital structure is more dependent on internal cash flow/cash dividend
payments and acceptable investment opportunities (i.e. NPV>0)
According to this theory a company link its dividend policy with its capital gearing and investment decisions.
The major assumptions of the theory are:
(i) No cost involved in using internally generated funds since no issue costs involved in using retained
profits.
(ii) Expensive to raise external funds
(iii)Raising of debt is cheaper to equity funds
(iv) Raising of term loans from banks is cheaper than issuing debt securities for raising finances
(v) Servicing of debt funds is cheaper than servicing of Equity funds.
In this theory no well defined target debt ratio exist. It is based on corporate intentions of relying on financing
to avoid the discipline of capital market

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 Trade-Off Theory

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

The trade-off theory assumes 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.
 What Factors Determine the Trade-Off Theory?

The optimal capital structure occurs at the point where the firm’s value is maximized, while
the weighted average cost of capital (WACC) is minimized.

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

48
 What are the Components of 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).
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