STRATEGIC FINANCIAL

MANAGEMENT

COMC006 | Masters of Commerce – Semester II | Delhi University

UNIT II · COMPREHENSIVE STUDY NOTES

✦ 1. Corporate Strategy & Financial Policy – Interrelationship

✦ 2. Capital Structure – Concepts, Measures, Financial Leverage & EPS
✦ 3. EBIT-EPS Analysis – Indifference Point, Operating & Financial Risk
✦ 4. Operating, Financial & Combined Leverage (DOL, DFL, DCL)
✦ 5. Capital Structure Theories – NI Approach, Traditional View
✦ 6. MM Hypothesis without Taxes – Proposition I & II, Arbitrage
✦ 7. MM Hypothesis with Taxes – Interest Tax Shield, Levered Firm Value
✦ 8. Trade-Off Theory – Costs of Financial Distress, Agency Costs
✦ 9. Pecking Order Theory & Information Asymmetry
✦ 10. Debt Overhang, Short-Sighted Investment, Asset Substitution
✦ 11. Ross Signalling Argument & Information Asymmetry
✦ 12. Capital Structure Policy & Practical Considerations

I.M. Pandey – Financial Management, 11th Ed. | Brealey, Myers & Allen – Principles of
References: Corporate Finance
TABLE OF CONTENTS
Section Topic Pg

1 Corporate Strategy & Financial Policy – Interrelationship 3

2 Capital Structure – Meaning, Measures, Financial Leverage 4

3 EPS & ROE Analysis – Financial Plan Comparison 6

4 EBIT-EPS Analysis – Indifference Point & Risk 8

5 Operating, Financial & Combined Leverage 10

6 Capital Structure Theories – NI & Traditional Approaches 13

7 MM Hypothesis Without Taxes – Propositions I & II & Arbitrage 15

8 MM Hypothesis With Corporate Taxes – Interest Tax Shield 19

9 Corporate & Personal Taxes – Miller's Model 21

10 Trade-Off Theory – Financial Distress & Agency Costs 23

11 Agency Problems – Debt Overhang, Asset Substitution, Short-Sighted Investment 26

12 Pecking Order Theory & Signalling (Ross) 28

13 Capital Structure Policy – FRICT Framework & Practical Factors 30

14 Master Formula Sheet & Key Concepts 34

SECTION 1: CORPORATE STRATEGY & FINANCIAL POLICY
– INTERRELATIONSHIP

1.1 The Nexus Between Strategy and Finance

Every time a firm makes an investment decision, it simultaneously makes a financing decision.
Capital structure – the mix of debt and equity – is not an isolated financial choice; it is deeply
intertwined with the firm's competitive strategy, growth ambitions, and risk appetite.

Financial Policy Dimension Linkage to Corporate Strategy

Capital Structure (Debt-Equity Mix) Determines risk capacity, constrains investments, affects competitive flexibility.

Sets the hurdle rate for strategic investments; lower WACC enables more
Cost of Capital (WACC)
projects to create value.

Determines internal financing available for growth; affects signalling to

Dividend / Retention Policy
markets.

Financial Leverage Amplifies returns under favourable conditions; magnifies losses in downturns.

Financial Flexibility (Slack) Critical during economic shocks; enables opportunistic investment.

Debt Covenants Can restrict acquisitions, capex, dividends – constraining strategy execution.

1.2 Key Questions in Financing Decisions

• Should a firm use equity, debt, or both? In what proportion?
• Does the financing mix affect the firm's value?
• How does debt affect shareholders' risk, return, and market value of shares?
• Is there an optimum financing mix that maximises the firm's value?
• What practical factors determine capital structure decisions?

SYLLABUS FOCUS: Unit II covers the interrelationship between corporate strategy and financial policy,
capital structure theories (Trade-off, Agency, Pecking Order, Signalling), and all problems related to
leverage, MM hypothesis, and capital structure determination.
SECTION 2: CAPITAL STRUCTURE – MEANING, MEASURES
& FINANCIAL LEVERAGE

2.1 Definitions
Financial Structure: The complete left-hand side of the balance sheet – all sources of financing
including short-term and long-term debt, and equity.

Capital Structure: The long-term financing mix – specifically the proportionate relationship between
long-term debt and equity. Equity = Paid-up share capital + Share premium + Retained earnings.

Capital Structure = Long-term Debt (D) + Equity (E)

2.2 Measures of Financial Leverage

Financial leverage (also called gearing or trading on equity) refers to the use of fixed-cost sources
(debt, preference capital) alongside equity. Three key measures:

Measure Formula Interpretation

Proportion of total capital financed by debt. Ranges 0 to

Debt Ratio D / V where V = D + E
1.

Debt-Equity Ratio D/E Most popular; compared to industry norms. Can be > 1.

Interest Coverage (Times EBIT / Interest OR EBITDA /

Capacity to meet fixed interest payments. Higher = safer.
Interest Earned) Interest

Debt Ratio = D/V = D/(D+E) Debt-Equity Ratio = D/E Interest Coverage = EBIT / INT

Relationship between measures: Debt Ratio = 1 + Debt-Equity Ratio (in fraction terms). Both rank
firms identically; Debt Ratio more specific (bounded 0-1).

Market value measures are theoretically superior but difficult to compute. Book value measures are widely
used in practice.

2.3 Concept of Financial Leverage (Trading on Equity)

Financial leverage is intended to earn a higher return on fixed-charge funds than their cost. The
surplus increases shareholders' return; any deficit reduces it. It is a double-edged sword.

Situation Condition Effect on ROE/EPS

Favourable Leverage ROI > Interest Rate (i) ROE/EPS INCREASES with more debt

Unfavourable Leverage ROI < Interest Rate (i) ROE/EPS DECREASES with more debt

Neutral Leverage ROI = Interest Rate (i) ROE/EPS UNCHANGED regardless of debt level

ROE = [r + (r − i) × D/E] × (1 − T)
Where: r = Before-tax return on assets (EBIT/V) | i = Interest rate on debt | D/E = Debt-Equity ratio | T
= Tax rate
The second term (r − i) × D/E × (1−T) is the leverage gain/loss. When r > i, this term is positive and
ROE exceeds the unlevered ROE.

2.4 Interest Tax Shield

Interest charges are tax-deductible. This creates a tax shield that increases total income available to
all investors (shareholders + debtholders) compared to an all-equity firm.

Interest Tax Shield = Tax Rate (T) × Interest (INT) = T × kd × D

Illustration: Brightways Ltd. Total assets = ■5,00,000; EBIT = ■1,20,000; Tax = 50%:

Item All-Equity (■) Debt + Equity (■)

EBIT 1,20,000 1,20,000

Interest (15% on ■2,50,000 debt) 0 37,500

PBT 1,20,000 82,500

Tax @ 50% 60,000 41,250

PAT 60,000 41,250

Total Income to Investors (PAT + INT) 60,000 78,750

Interest Tax Shield — 18,750 (= 0.50 × 37,500)

The levered firm distributes ■78,750 vs ■60,000 – an advantage of ■18,750 = the interest tax shield.
SECTION 3: EPS & ROE ANALYSIS – EFFECT OF
ALTERNATIVE FINANCIAL PLANS

3.1 EPS and ROE Formulas

EPS = (EBIT − INT)(1 − T) / N [with debt]
EPS = EBIT(1 − T) / N [no debt]
ROE = (EBIT − INT)(1 − T) / E (Equity base)

3.2 Impact of Financial Leverage on EPS & ROE – Brightways Ltd

Illustration
Total assets = ■5,00,000; EBIT = ■1,20,000; Tax = 50%. Four financing plans considered:

Item Plan I: No Debt Plan II: 25% Debt Plan III: 50% Debt Plan IV: 75% Debt

Equity ■5,00,000 ■3,75,000 ■2,50,000 ■1,25,000

Debt (@ 15%) Nil ■1,25,000 ■2,50,000 ■3,75,000

No. of Shares 50,000 37,500 25,000 12,500

Interest Nil ■18,750 ■37,500 ■56,250

PBT ■1,20,000 ■1,01,250 ■82,500 ■63,750

Tax @ 50% ■60,000 ■50,625 ■41,250 ■31,875

PAT ■60,000 ■50,625 ■41,250 ■31,875

EPS (■) 1.20 1.35 1.65 2.55

ROE (%) 12.0% 13.5% 16.5% 25.5%

With EBIT = ■1,20,000 (ROI = 24% > cost of debt = 15%), higher debt increases EPS and ROE.
The financial leverage is favourable.

3.3 When Leverage is Unfavourable – Low EBIT Scenario

If EBIT falls to ■60,000 (ROI = 12% < 15% cost of debt):

Plan EPS (■) ROE (%) Direction

No Debt (Plan I) 0.60 6.0%

50% Debt (Plan III) 0.45 4.5% ↓ Lower than Plan I

75% Debt (Plan IV) 0.15 1.5% ↓ Further lower

EPS and ROE decline with more debt when ROI < cost of debt. Financial leverage is unfavourable.

3.4 Variability of EPS and Financial Risk

For a given level of EBIT variability, financial leverage increases the variability (range) of EPS. More
debt = wider EPS swings = higher financial risk.
 Standard Deviation Coefficient of
Debt Ratio Expected EPS (■) Risk Level
(σ) of EPS Variation (CV)

Base operating risk

0% 1.20 0.6281 0.5234
only

25% 1.35 0.8361 0.6193 Financial risk added

50% 1.65 1.2562 0.7613 Higher financial risk

75% 2.55 2.5124 0.9852 Highest financial risk

Increasing debt increases both expected EPS AND its standard deviation. The risk-return trade-off
must be evaluated carefully.
KEY INSIGHT: At ROI = 15% (= cost of debt), EPS is identical under all financial plans. This is the
indifference EBIT level.
SECTION 4: EBIT-EPS ANALYSIS – INDIFFERENCE POINT &
RISK

4.1 EBIT-EPS Chart

EPS is a linear function of EBIT for any given financial plan. The EBIT-EPS chart plots this linear
relationship for alternative financial plans. All lines intersect at the indifference point (EBIT-EPS
break-even point) where EPS is the same under all financing alternatives.

EPS = a + b × EBIT where a = −(1−T)/N × INT and b = (1−T)/N

Key Features of EBIT-EPS Chart:

• The slope of each EPS line increases with more debt (steeper = more leveraged plan).
• Above the indifference EBIT: more leveraged plans give higher EPS.
• Below the indifference EBIT: less leveraged plans give higher EPS.
• The crossover point (indifference point) represents the EBIT at which the firm is indifferent between
the two plans.

4.2 Indifference Point Formula

The EBIT-EPS break-even (indifference) point between two financing alternatives is found by setting
their EPS formulas equal:

(1−T) × EBIT / N■ = (1−T)(EBIT − INT) / N■ [Equity vs Debt+Equity]

Simplified: EBIT* = [N■ / (N■ − N■)] × INT

For Equity vs Preference Share comparison:

EBIT* = [N■ / (N■ − N■)] × PDIV/(1−T)

For Two Debt Plans comparison:

EBIT* = [N■×INT■ − N■×INT■] / (N■ − N■)

Indifference Point Illustration:

Plan I: All equity – 1,00,000 shares @ ■10. Plan II: 25% debt (■2,50,000 @ 15%) + equity. Tax =
50%.

INT = 2,50,000 × 0.15 = ■37,500; N■ = 1,00,000; N■ = 75,000

EBIT* = [1,00,000 / (1,00,000 − 75,000)] × 37,500 = 4 × 37,500 = ■1,50,000

At EBIT = ■1,50,000, both plans give the same EPS. Above this level, Plan II (debt) is better.

4.3 Operating Risk vs Financial Risk

 Dimension Operating Risk Financial Risk

Variability of EBIT (or RONA)

Definition Variability of EPS/ROE caused by financial leverage
due to business conditions

Nature of business, cost Amount of debt and fixed financial charges in capital
Source
structure, industry, competition structure

Standard deviation / CV of EPS (additional variability due

Measured by Standard deviation / CV of EBIT
to debt)

Partially avoidable (improve

Avoidable? Completely avoidable (use no debt)
operations, diversify)

Leverage type Operating leverage (DOL) Financial leverage (DFL)

Sales variability + proportion of

Affected by Proportion of debt in capital structure
fixed to variable costs

A firm with zero debt faces operating risk only. As debt is added, financial risk (additional EPS variability) is
layered on top of operating risk. Combined risk = both types together.
SECTION 5: OPERATING, FINANCIAL & COMBINED
LEVERAGE (DOL, DFL, DCL)

5.1 Degree of Operating Leverage (DOL)

DOL measures the sensitivity of EBIT to changes in sales. It arises from fixed operating costs –
higher fixed costs mean higher DOL.

DOL = % Change in EBIT / % Change in Sales = ∆EBIT/EBIT ÷ ∆Sales/Sales

DOL = Q(s − v) / [Q(s − v) − F] = Contribution / EBIT = 1 + (Fixed Cost / EBIT)

Where: Q = units sold | s = unit selling price | v = unit variable cost | F = total fixed costs

DOL Illustration:
Brightways Ltd: Sales = 1,00,000 units @ ■8; VC = ■4/unit; FC = ■2,80,000:

Contribution = 1,00,000 × (8−4) = ■4,00,000; EBIT = 4,00,000 − 2,80,000 = ■1,20,000

DOL = 4,00,000 / 1,20,000 = 3.33
Interpretation: A 1% change in sales leads to a 3.33% change in EBIT.

With high automation (VC = ■2; FC = ■4,80,000):

Contribution = 1,00,000 × 6 = ■6,00,000; EBIT = ■1,20,000

DOL = 6,00,000 / 1,20,000 = 5.0 (Higher because of more fixed costs)

5.2 Degree of Financial Leverage (DFL)

DFL measures the sensitivity of EPS to changes in EBIT. It arises from fixed financial charges
(interest).

DFL = % Change in EPS / % Change in EBIT = ∆EPS/EPS ÷ ∆EBIT/EBIT

DFL = EBIT / (EBIT − INT) = EBIT / PBT = 1 + (INT / PBT)

DFL = Q(s−v) − F / [Q(s−v) − F − INT] = EBIT / PBT

DFL Illustration:
DFL =
Plan Debt Ratio Interest (■) EBIT (■) PBT (■)
EBIT/PBT

I 0% 0 1,20,000 1,20,000 1.000

II 25% 18,750 1,20,000 1,01,250 1.185

III 50% 37,500 1,20,000 82,500 1.455

IV 75% 56,250 1,20,000 63,750 1.882

Plan IV: DFL = 1.882 → A 1% change in EBIT causes a 1.882% change in EPS.
5.3 Degree of Combined Leverage (DCL)
DCL (Total Leverage) combines both operating and financial leverage to show the total sensitivity of
EPS to changes in sales.

DCL = DOL × DFL = % Change in EPS / % Change in Sales

DCL = Q(s−v) / [Q(s−v) − F − INT] = Contribution / PBT
DCL = 1 + (F + INT) / PBT

DCL Illustration:
Low automation (DOL = 3.33) + 50% debt (DFL = 1.455):

DCL = 3.33 × 1.455 = 4.85

→ A 10% increase in sales leads to a 48.5% increase in EPS.

Technology Debt Level DOL DFL DCL Risk Level

Low Automation No debt 3.33 1.000 3.33 Low total risk

Low Automation 25% debt 3.33 1.185 3.95 Moderate

Low Automation 50% debt 3.33 1.455 4.85 Higher

Low Automation 75% debt 3.33 1.882 6.27 High

Higher (op.
High Automation No debt 5.00 1.000 5.00
leverage)

High Automation 50% debt 5.00 1.455 7.28 Very High

High Automation 75% debt 5.00 1.882 9.41 Extreme

WARNING: The combination of HIGH operating leverage (5.0) + HIGH financial leverage
(DFL=1.882) gives DCL = 9.41. This means any 10% decline in sales causes a 94.1% collapse in
EPS. Avoid this combination unless sales are highly stable.

5.4 Summary – Leverage Formulas

Measure Formula 1 (Definition) Formula 2 (Operational) Decision Implication

DOL ∆EBIT%/∆Sales% Contribution / EBIT Higher DOL = greater operating risk

DFL ∆EPS%/∆EBIT% EBIT / PBT Higher DFL = greater financial risk

DCL ∆EPS%/∆Sales% Contribution / PBT Higher DCL = greater total risk

KEY: High operating leverage + high financial leverage can be justified ONLY if the firm has stable,
predictable sales (e.g., utilities, infrastructure). Consumer goods with volatile sales should use low
combined leverage.
SECTION 6: CAPITAL STRUCTURE THEORIES – NI
APPROACH & TRADITIONAL VIEW
The central question in capital structure theory is: Does the way a firm finances itself affect its
total value (V) and weighted average cost of capital (WACC/k■)? Four approaches are
examined:

Relevance of Capital
Theory/Approach Optimum Capital Structure?
Structure?

YES – firm value increases with

1. Net Income (NI) Approach 100% debt (extreme)
debt

YES – up to a moderate level of

2. Traditional View At minimum WACC (saucer/U-shaped)
debt

NO – firm value is independent

3. MM – No Taxes (NOI) Does NOT exist
of capital structure

4. MM – With Corporate YES – tax advantage of debt

Theoretically 100% debt
Taxes increases value

YES – balancing tax benefit vs

5. Trade-Off Theory Where MB = MC of debt
distress costs

No fixed target – uses internal

6. Pecking Order No fixed optimum
funds first

6.1 Net Income (NI) Approach

Assumption: Both cost of equity (ke) and cost of debt (kd) remain CONSTANT with leverage. Since
kd < ke, replacing expensive equity with cheap debt continuously lowers WACC and increases firm
value.

V = E + D = NI/ke + INT/kd
WACC (k■) = ke × (E/V) + kd × (D/V) → decreases as D/V increases
Value of Firm: V = NOI/k■ → increases as k■ falls

NI Approach Illustration:
NOI kd (%) ke (%) Debt (D) k■ (WACC) V=E+D

■100 5 10 ■0 10.0% ■1,000

■100 5 10 ■200 9.1% ■1,100

■100 5 10 ■400 8.3% ■1,200

■100 5 10 ■600 7.7% ■1,300

■100 5 10 ■1,000 6.7% ■1,500

■100 5 10 ■2,000 5.3% ■1,900

Conclusion: As debt increases, WACC falls, firm value rises continuously. Optimal structure = 100%
debt (extreme prediction).
CRITICISM: NI approach ignores risk. As debt rises, equity holders face greater financial risk,
which should cause ke to rise. Constant ke is unrealistic.

6.2 The Traditional View (Net Operating Income = Moderate View)

The Traditional View is a compromise between NI and MM. It argues that a judicious mix of debt and
equity reduces WACC up to an optimal point, beyond which WACC rises again.

Stage Description Effect on WACC Effect on Firm Value

Moderate debt added. ke rises

Stage 1: Increasing
slightly but less than the benefit WACC falls Firm value increases
Value
of cheap debt.

At the optimal D/E, WACC is

WACC at
Stage 2: Optimum minimum. Benefits of debt Firm value maximum
minimum
exactly offset rising ke.

Excessive debt. ke rises

sharply; kd also rises. Financial
Stage 3: Declining Value WACC rises Firm value falls
risk penalty exceeds debt
benefit.

The WACC curve is U-shaped (or saucer-shaped). The optimal capital structure occurs at the bottom
of the U – the minimum WACC point.

The Traditional View implies: There EXISTS an optimum capital structure. The optimal D/E ratio varies by
industry and firm (depending on operating risk, asset tangibility, growth prospects). Firms should target
this range to maximise value.

Criticism of Traditional View: No rigorous theoretical basis for why ke remains nearly constant at low
leverage but rises sharply at high leverage. This arbitrary threshold is not well-defined.
SECTION 7: MM HYPOTHESIS WITHOUT TAXES –
PROPOSITIONS I & II & ARBITRAGE

7.1 MM's Perfect World Assumptions

Assumption Description

No transaction costs; securities freely traded; rational investors; no bankruptcy

Perfect Capital Markets
costs.

Firms in same industry have identical business risk (same expected NOI, same
Homogeneous Risk Classes
variability).

Firms AND individuals borrow at the same rate – personal leverage = corporate
Equal Borrowing Rates
leverage.

No Taxes No corporate income tax; interest is NOT tax-deductible.

Full Payout 100% dividend payout; all net income distributed to shareholders.

No Information Asymmetry All investors have same information as managers.

7.2 MM Proposition I – Capital Structure Irrelevance

In a perfect capital market without taxes, a firm's total market value is determined solely by its
expected net operating income and the risk of its assets – NOT by how it is financed.

Vl = Vu (Value of Levered Firm = Value of Unlevered Firm)

V = NOI / k■ where k■ = opportunity cost of capital for the firm's risk class
WACC = k■ = k■ = constant regardless of leverage

Logic: Financing changes only how NOI is divided between equity holders and debt holders. It does
not change the total NOI or the firm's operating risk. Therefore, the total value cannot change.

7.3 The Arbitrage Process – Why Proposition I Must Hold

If two identical firms (same NOI, same risk) have different market values due to different capital
structures, arbitrage will restore equilibrium. Investors can create 'homemade leverage' by borrowing
on personal account.

Case: Levered Firm Overvalued (Vl > Vu)

Investor X holds 10% of levered firm L's shares. Return = 10% × (NOI − INT).

Alternative strategy: Sell L's shares, borrow personally (at same rate as L), buy 10% of U's shares.

Result: Same return from U, same personal debt as corporate debt of L, BUT with spare cash left
over.

All rational investors switch from L to U → L's price falls, U's price rises → Equilibrium: Vl = Vu.

Illustration (Arbitrage Example): Firm U (unlevered) and Firm L (levered) with same NOI:
 Item Firm U (Unlevered) Firm L (Levered)

NOI ■10,000 ■10,000

Interest (6% on ■50,000 debt) 0 ■3,000

Net Income ■10,000 ■7,000

Cost of Equity (ke) – Traditional 10% 11.7%

Market Value of Equity (E) ■1,00,000 ■60,000

Market Value of Debt (D) ■0 ■50,000

Total Value (V) ■1,00,000 ■1,10,000

WACC 10% 9.1% (lower – traditional view)

MM argue: Vl = ■1,10,000 > Vu = ■1,00,000 cannot persist. Arbitrageurs will sell L, buy U. As more
investors switch: L's price falls, U's price rises, until Vl = Vu = ■1,00,000.

Arbitrage Proof – General Form:

If Vl > Vu: Investors hold α fraction of L → Switch to U with personal borrowing of α×D → Same
return, lower cost → Equilibrium forces Vl = Vu.

If Vu > Vl: Investors hold α of U → Switch to L (buy shares + debt of L) → Same return, lower cost →
Equilibrium forces Vu = Vl.

7.4 Criticisms of MM's Arbitrage Process

Criticism Explanation

Firms borrow at lower rates than individuals (corporate credit > personal
1. Borrowing Rate Discrepancy
credit). Homemade leverage is more expensive.

Corporate leverage has limited liability; personal leverage has unlimited

2. Limited vs Unlimited Liability
liability. They are NOT perfect substitutes.

Buying and selling securities involves costs → Arbitrage is incomplete and

3. Transaction Costs
costly.

Many institutional investors (insurance companies, pension funds) CANNOT

4. Institutional Restrictions
engage in personal leverage.

Interest IS tax-deductible in reality → Levered firms have higher after-tax

5. Corporate Taxes Ignored
income → Vl > Vu in practice.

7.5 MM Proposition II
While Proposition I states that the firm's total value is unchanged by leverage, Proposition II explains
what happens to the cost of equity as leverage increases.

ke = k■ + (k■ − kd) × D/E [MM Proposition II]

Where: ke = cost of equity of levered firm | k■ = opportunity cost of capital (= WACC, constant) | kd =
cost of debt | D/E = financial leverage
 Component Explanation

Unlevered firm's cost of equity = opportunity cost of capital (constant, reflects

k■
business risk)

(k■ − kd) × D/E Financial risk premium – rises linearly with D/E ratio

Shareholders face financial risk in addition to operating risk. They demand higher
Why ke rises?
return for leverage-induced risk.

Rising ke exactly offsets the advantage of cheaper debt – they cancel out, leaving
Why WACC stays constant?
WACC = k■.

Proposition II Illustration:
ITL is all-equity firm. ke = ka = 15%. Company borrows ■60,000 at 6% and uses money to buy back
shares. D/E = 1.

ke = 0.15 + (0.15 − 0.06) × 1 = 0.15 + 0.09 = 0.24 or 24%

EPS increases from ■1.80 to ■2.88 (60% increase) due to leverage – but ke also rises to 24%,
leaving WACC unchanged at 15%.

PROPOSITION II IMPLICATION: Financial leverage benefits shareholders in the form of higher EPS
– but this is EXACTLY offset by the higher required return demanded by shareholders for the
financial risk. Net effect on wealth = ZERO (without taxes).
SECTION 8: MM HYPOTHESIS WITH CORPORATE TAXES –
INTEREST TAX SHIELD

8.1 The Tax Advantage of Debt

MM (1963) relaxed the no-tax assumption. Interest on debt is tax-deductible; dividends are NOT. This
gives debt a tax advantage that creates value for shareholders. The levered firm's investors receive
more total after-tax income.

Income Firm U (Unlevered) Firm L (Levered)

NOI (EBIT) ■2,500 ■2,500

Interest (10% on ■5,000 debt) ■0 ■500

Taxable Income ■2,500 ■2,000

Corporate Tax @ 50% ■1,250 ■1,000

After-tax Income (PAT) ■1,250 ■1,000

Total to ALL Investors (PAT + INT) ■1,250 ■1,500

INTEREST TAX SHIELD — ■250 = 0.50 × ■500

Relative Advantage of Debt 1.00 1.20 (20% more income to investors)

The levered firm distributes ■250 MORE to investors per year – this is the interest tax shield.

8.2 Valuing the Interest Tax Shield

If debt is permanent (perpetual), the interest tax shield is a perpetuity. The appropriate discount rate
is the cost of debt (kd) since the risk of ITS = risk of interest payments.

Interest Tax Shield (Annual) = T × kd × D

PV of Interest Tax Shield (PVINTS) = T × kd × D / kd = T × D

Example: T = 50%, kd = 10%, D = ■5,000 → Annual ITS = 0.50 × 0.10 × 5,000 = ■250

PVINTS = ■250 / 0.10 = ■2,500 = T × D = 0.50 × 5,000 = ■2,500

8.3 Value of the Levered Firm Under MM with Taxes

The value of a levered firm equals the value of an equivalent unlevered firm PLUS the present value
of the interest tax shield:

Vl = Vu + T×D [MM with Corporate Taxes]

Vu = NOI(1−T) / k■ [Value of unlevered firm]

Item Value

NOI ■2,500

ka (unlevered opportunity cost of capital) 12.5%

 Item Value

Vu = NOI(1−T)/ka = 1,250/0.125 ■10,000

T × D = 0.50 × 5,000 ■2,500 (PV of Tax Shield)

Vl = Vu + TD = 10,000 + 2,500 ■12,500

The levered firm is worth ■2,500 MORE than the unlevered firm – entirely due to the interest tax
shield.

KEY IMPLICATION: Since Vl = Vu + TD, and T > 0, value increases CONTINUOUSLY with debt. This
implies firms should use 100% debt to maximise value – an extreme and unrealistic conclusion.
Explains why we need the Trade-Off Theory.

8.4 Cost of Capital Under MM with Taxes

With corporate taxes, the WACC of a levered firm is LOWER than that of an unlevered firm:

WACC = k■ × (1 − T × D/V) OR WACC = ke × E/V + kd(1−T) × D/V

As debt increases, WACC falls continuously (in MM's tax world). Firms use WACC as the hurdle rate
for investment decisions.

Without Taxes (MM 1958) With Corporate Taxes (MM 1963)

Vl = Vu (irrelevance) Vl = Vu + TD (debt adds value)

WACC = constant = ka WACC = ka(1 − T×D/V) → falls with debt

ke = ka + (ka−kd)×D/E ke adjusted for tax benefits

Optimal structure: None exists Optimal structure: 100% debt (theory)

SECTION 9: CORPORATE & PERSONAL TAXES – MILLER'S
MODEL

9.1 The Effect of Personal Taxes on Debt Advantage

Personal taxes reduce the advantage of corporate borrowing. While interest reduces corporate taxes,
debt-holders pay personal tax on interest income. The net tax advantage depends on corporate tax
rate (T), personal tax on interest (Tpd), and personal tax on equity income (Tpe).

Net Tax Advantage of Debt = (1 − Tpd) − (1 − T)(1 − Tpe)

= T − Tpd + Tpe(1 − T) [Simplified]

Scenario Net Tax Advantage Implication

No personal taxes (Tpd = Tpe =

= T (corporate rate) Full MM tax advantage applies.
0)

Tpd = T (interest tax = corporate

= 0 if Tpe = 0 Advantage disappears completely.
tax)

Tpd > Tpe (interest taxed more

< TD Partial advantage; less than MM predicts.
than equity)

Tpd = Tpe (same personal rate

= T(1−Tp) Personal tax reduces advantage proportionally.
for all income)

Tpe = 0, Tpd = T =0 Miller equilibrium – no advantage for any firm.

9.2 Miller's Model (1977)

Miller extended MM to include both corporate and personal taxes. His key insight: as firms borrow
more, they must offer higher interest rates to attract investors in higher tax brackets. Eventually, the
corporate tax saving equals the personal tax loss – eliminating the advantage of debt.

Vl = Vu + [1 − (1−T)(1−Tpe)/(1−Tpd)] × D [Miller's Formula]

Implication Description

There is an optimal amount of debt for the entire economy, determined by T, Tpd,
Economy-wide equilibrium debt
Tpe.

At equilibrium, all tax-exempt and low-tax investors already hold debt. A single firm
No optimum for individual firm
gains nothing from additional borrowing.

To attract high-tax-bracket investors, firms must raise interest rates. Borrowing

Interest rate rises with borrowing
becomes self-limiting.

Practical significance: Personal taxes significantly reduce (but do NOT eliminate) the advantage of
corporate borrowing. The trade-off theory fills the gap.
In India: Corporate tax = ~30%; dividend distribution tax applies; interest income taxed at marginal rate;
capital gains taxed favourably. Net advantage of debt is positive but less than T × D.
SECTION 10: THE TRADE-OFF THEORY – FINANCIAL
DISTRESS & AGENCY COSTS

10.1 The Trade-Off Theory Framework

The Trade-Off Theory recognises that while debt provides a tax shield, it also creates costs –
primarily costs of financial distress and agency costs. The optimal capital structure is where the
marginal benefit of debt (tax shield) equals its marginal cost (financial distress + agency costs).

Vl = Vu + PV(Interest Tax Shield) − PV(Financial Distress Costs) − PV(Agency Costs)

At Optimum: MB (tax shield) = MC (financial distress + agency costs)

10.2 Financial Distress

Financial Distress occurs when a firm fails to meet – or is at risk of not meeting – its contractual
obligations to debt-holders (interest and principal payments). At extreme, it leads to
insolvency/bankruptcy.

Direct Costs of Financial Distress:

• Legal and administrative costs of bankruptcy – legal fees, court costs, advisor fees.
• Loss of asset value during insolvency – assets may deteriorate while not in use; sold at distress
prices far below market value.
• Delays in resolution – conflicting interests of creditors and shareholders prolong the process.
• Opportunity cost of management time – diverted to managing distress instead of operating.

Indirect Costs of Financial Distress (Often Larger than Direct Costs):

Stakeholder Impact of Financial Distress

Employees Demoralization, declining productivity, best employees leave. Quality deteriorates.

Customers Fear liquidation; worried about after-sales service, warranties, product continuity. Sales fall.

Suppliers Cut or eliminate trade credit. Demand cash-in-advance. Input costs rise.

Investors Unwilling to provide new capital; demand very high rates. Profitable investments foregone.

May encourage excessive risk-taking ('asset substitution'). Limited liability creates moral
Shareholders
hazard.

Short-term focus; may cut R&D; and maintenance; pass up profitable long-term investments;
Managers
perquisite consumption increases.

10.3 The Trade-Off Model – Optimum Capital Structure

• At low debt levels: PV of ITS grows with debt; financial distress costs are minimal → firm value
rises.
• At moderate debt: Distress costs begin to appear but ITS benefit still dominates → value still
increasing but at slower rate.
• At high debt levels: Distress costs escalate rapidly; marginal ITS benefit shrinks → firm value
begins to fall.
• Optimum point: Where marginal tax benefit = marginal financial distress cost → value is
maximised.

This is why firms in practice DON'T use 100% debt. Companies have 'target' D/E ratios that balance the
tax shield against distress risk. Industries with stable cash flows (utilities) use more debt; industries with
volatile earnings or high growth (tech, biotech) use less.

10.4 Factors Affecting Optimal Debt Level

Factor Effect on Optimal Debt Level

Higher tax rate Higher optimal debt (larger tax shield benefit)

Stable, predictable cash flows Higher optimal debt (lower distress risk)

High proportion of tangible assets Higher optimal debt (better collateral, lower distress costs)

High business risk (volatile EBIT) Lower optimal debt (higher distress probability)

High intangible asset value Lower optimal debt (intangibles lose value rapidly in distress)

High growth opportunities Lower optimal debt (growth options destroyed in distress)

Low non-debt tax shields Higher optimal debt (fewer alternatives to save taxes)
SECTION 11: AGENCY PROBLEMS – DEBT OVERHANG,
ASSET SUBSTITUTION & SHORT-SIGHTED INVESTMENT

11.1 Agency Costs Overview

Agency costs arise from conflicts of interest among three parties: shareholders, debt-holders, and
managers. These conflicts cause sub-optimal decisions that destroy value and influence capital
structure choices.

Conflict Parties Nature of Problem

Shareholders vs Shareholders (via Shareholders transfer wealth from debt-holders

Debt-holders managers) vs Lenders through risky decisions (moral hazard)

Shareholders (principals) vs Managers may not act in shareholders' best interests;

Shareholders vs Managers
Managers (agents) consume perquisites, avoid risk

External investors vs Managers may issue overvalued securities; investors

All Investors vs Company
Management discount firm's securities

11.2 Debt Overhang (Under-Investment Problem)

When a firm is in financial distress with high debt, shareholders may refuse profitable investments
(positive NPV projects) because most of the gains will go to debt-holders, not to them. The debt
burden 'overhangs' the firm and discourages new equity investment.

Debt Overhang Illustration:

• Firm has assets worth ■100 cr. Outstanding debt = ■120 cr (already in distress – equity worth = 0).
• New project available: Invest ■20 cr today; generates ■30 cr certain cash flow.
• NPV = +■10 cr – clearly valuable.
• But: If equity holders invest ■20 cr, the ■30 cr goes first to debt-holders (who are owed ■120 cr).
Shareholders get NOTHING.
• Result: Shareholders refuse to fund the project even though it has positive NPV.
• This is the DEBT OVERHANG PROBLEM – existing debt prevents new value-creating
investments.

Solution: Debt restructuring (reduce outstanding debt so new investment is worthwhile to

shareholders).

11.3 Asset Substitution (Risk-Shifting Problem)

Shareholders of a highly levered firm have an incentive to substitute safe assets/projects with
risky ones, even if the risky projects have negative NPV. This is because shareholders have limited
liability (call option on firm value) while debt-holders bear the downside.

Asset Substitution Illustration:

Firm has ■100 cr outstanding debt. Shareholders prefer the RISKY project:
 Success Failure Value if
Scenario Investment Exp. NPV S/H Get D/H Get
(P=0.2) (P=0.8) Success

Safe
■100 cr ■120 cr ■105 cr +■4 cr ■120 cr ■20 cr ■100 cr
Project

Risky
■100 cr ■400 cr ■0 cr −■20 cr ■400 cr ■300 cr ■100 cr
Project

Even though risky project destroys total value (NPV = −■20 cr), shareholders prefer it because on
success, they get ■300 cr; on failure, debt-holders bear the loss (equity = 0 anyway). Shareholders
have already 'lost' their equity – the 'gamble for resurrection'.

Response: Debt-holders anticipate this problem and impose covenants restricting risky investments,
demand higher interest rates, or limit debt availability → This REDUCES firm value and represents an
agency cost.

11.4 Short-Sighted Investment (Short-Termism)

Managers under financial distress make short-term decisions that sacrifice long-term firm value in
order to generate immediate cash or avoid insolvency. Examples:

• Cut R&D; spending – saves cash today but destroys future innovation and competitive position.
• Sell productive long-term assets ('sale of the family silver') – improves short-term liquidity but
reduces earning capacity.
• Defer maintenance – reduces cash outflow immediately but increases future costs and asset
deterioration.
• Accept lower-quality customers (to boost short-term revenue) – increases future bad debt
losses.
• Avoid risky but positive-NPV projects – managers protect their jobs by being overly
conservative.

These decisions are collectively called 'managerial myopia' under financial distress and represent
significant indirect costs of financial distress that increase with leverage.

11.5 Agency Costs of Monitoring

To mitigate agency problems, debt-holders and shareholders impose monitoring mechanisms:

• Restrictive Covenants: Loan agreements restrict dividends, new debt, capex, working capital
levels. These protect debt-holders but reduce management flexibility.
• Monitoring by Experts: Debt-holders hire auditors, credit analysts to evaluate firm health.
• Equity Monitoring: Shareholders create board oversight, performance-linked compensation,
independent directors.
• Signalling: Managers commit to paying regular dividends or taking high debt levels as signals of
confidence.

Total agency costs = monitoring costs + bonding costs + residual loss. These are borne by equity
holders (as rational debt-holders price them into interest rates or loan terms up-front).
Agency costs reduce the optimal D/E ratio below what pure tax calculations would suggest. High-growth
firms with many investment options have higher agency costs of debt → lower optimal leverage.
SECTION 12: PECKING ORDER THEORY & ROSS
SIGNALLING ARGUMENT

12.1 Information Asymmetry – The Foundation

Managers have MORE information about their firm's true prospects than outside investors. This
information asymmetry is the foundation of both the Pecking Order Theory and the Signalling
Argument. It explains observed capital structure choices that tax models alone cannot.

12.2 Pecking Order Theory (Myers & Majluf, 1984)

Because of information asymmetry, managers signal their beliefs about the firm's prospects through
financing choices. The theory proposes a hierarchy (pecking order) of financing preferences:

Rank Financing Source Reason for Preference

1st (Most Internal Finance No adverse signalling; avoids issue costs; no information leakage; not
Preferred) (Retained Earnings) taxed at personal level until distributed.

Safe Debt Low adverse signalling; interest tax-deductible; lenders protected by

2nd
(Secured/Low Risk) collateral.

Risky Debt
3rd Higher signalling risk; more restrictive covenants; higher cost.
(Unsecured/Hybrid)

4th (Least Strongest adverse signal – market interprets as overvaluation. Share price
New Equity Issue
Preferred) typically falls on announcement.

Why Does Equity Issue Signal Bad News?

• If managers KNOW the firm is undervalued, they issue DEBT (not equity) – preserving the upside
for existing shareholders.
• If managers issue EQUITY, rational investors infer: managers must think shares are overvalued →
price falls.
• Empirical evidence: Stock prices typically fall 2-3% on announcement of new equity issues.
• Profitable firms use internal funds, have LOW debt ratios – NOT because they target low debt but
because they don't NEED external finance.

Pecking Order vs Trade-Off Theory:

Dimension Pecking Order Theory Trade-Off Theory

Target D/E Ratio? No fixed target YES – firms have targets they revert to

Most Profitable LOWEST debt (use internal

Higher debt (have more to gain from tax shield)
Firms? funds)

Last resort – signals

Equity Issue? Can be preferred if leverage is too high
overvaluation

Asymmetric information is
Information Information asymmetry is secondary
central
 Dimension Pecking Order Theory Trade-Off Theory

Explains cross-sectional
Empirical Support? Explains mean reversion to target leverage
variation well

12.3 Ross Signalling Argument (1977)

Ross proposed that managers signal their confidence in the firm's future by choosing a high debt
level. Only firms with genuinely strong prospects can afford to take on high debt (and commit to fixed
interest payments). Weak firms cannot mimic this signal without risking bankruptcy.

Ross Signalling – Key Points:

• Signal = High Debt: Choosing high leverage is a credible signal of managerial confidence
because distressed firms cannot sustain it.
• Why credible? A manager of a poor-quality firm who mimics high debt will face bankruptcy and
lose compensation/reputation. This self-selection separates good firms from bad.
• Implication for Markets: Debt announcement → share price rises (positive signal). Equity issue →
share price falls (negative signal).
• Commitment Device: Debt acts as a disciplining mechanism that forces managers to generate
sufficient cash flows.
• Jensen's Free Cash Flow Hypothesis (related): High debt reduces free cash flow, preventing
managers from wasting it on negative-NPV projects or empire-building.

Signal Market Interpretation Share Price Effect

Firm announces large debt Management is confident; only

↑ Positive
issue healthy firm can sustain debt

Management thinks shares are

Firm announces equity issue ↓ Negative
overvalued; prospects uncertain

Firm initiates/increases Management confident in sustained

↑ Positive
dividends earnings

Firm reduces or eliminates Cash flows insufficient; prospects

↓ Strongly Negative
dividends poor

Management believes shares

Firm buys back shares ↑ Positive
undervalued

EXAM NOTE: Both Pecking Order and Signalling theories are grounded in INFORMATION ASYMMETRY.
Pecking Order focuses on COST of different financing sources; Signalling focuses on what financing
CHOICES REVEAL to the market.
SECTION 13: CAPITAL STRUCTURE POLICY – FRICT
FRAMEWORK & PRACTICAL FACTORS

13.1 Three Approaches to Capital Structure Analysis

Approach Focus Method Limitation

Compute EPS under

Impact of debt on EPS Ignores time value; based on
EBIT-EPS Analysis alternative plans; find
and ROE accounting profits; ignores risk
indifference EBIT

Estimate WACC and firm

Impact of debt on Difficult to quantify distress costs;
Valuation Approach value under alternative
share/firm value requires precise ke, kd
D/E

Project cash flows over

Ability to service debt Difficult to predict all scenarios; not
Cash Flow Analysis many years including
without distress a guarantee
adverse scenarios

13.2 The FRICT Framework for Capital Structure Evaluation

FRICT is a comprehensive qualitative-quantitative framework for evaluating a firm's capital structure
policy across five dimensions:

Element Meaning Key Considerations

Ability to raise funds

Unused debt capacity, financial slack, liquid assets, absence of
F – Flexibility quickly and cheaply
restrictive covenants
in future

Business and
Stability of EBIT, probability of distress, operating leverage, economic
R – Risk financial risk of the
sensitivity
firm

Impact on returns to
I – Income EPS effect, ROE effect, tax benefit of interest, effect on WACC
shareholders

Concern about
Debt has no voting rights; equity issue dilutes ownership; covenants
C – Control dilution of ownership
restrict management freedom
control

Optimal time and

Market conditions (equity issue in bull market; debt in favourable rate
T – Timing method to raise
environment), sequencing
capital

13.3 Practical Factors Influencing Capital Structure

Factor Impact on Capital Structure

Firms with more tangible fixed assets → higher optimal debt (better collateral, lower
Asset Tangibility
distress costs). Intangible-heavy firms → lower debt.

High-growth firms (high market/book ratio) → lower debt. Growth options are
Growth Opportunities
destroyed in financial distress; debt restricts flexibility.

More profitable firms generate more internal cash → less external financing needed →
Profitability
lower debt (consistent with Pecking Order).
 Factor Impact on Capital Structure

High operating risk (volatile EBIT) → lower financial leverage (to avoid combined risk
Business Risk
becoming unbearable).

Firms with large depreciation, investment tax credits, loss carryforwards → less
Non-Debt Tax Shields
benefit from interest tax shield → lower debt.

Desire to maintain financial slack (unused debt capacity) for future opportunities or
Financial Flexibility
emergencies → lower current debt.

Closely held firms avoid equity to maintain control → prefer debt. Widely held firms
Control Concerns
less concerned.

Issue equity when market is overvaluing; issue debt when interest rates are
Market Timing
favourable.

Firms often maintain D/E ratios close to industry averages (institutional pressure, peer
Industry Norms
comparison, signalling).

Cost of issuing securities – debt is cheaper to issue than equity. Larger issues have
Flotation Costs
lower unit costs.

Banks and FIs impose restrictive covenants and maximum D/E ratios. Regulatory
Lender Restrictions
capital requirements (banks) also constrain leverage.

Large firms access more diverse funding sources at lower cost; small firms depend
Size of Firm
more on bank debt and retained earnings.

13.4 Debt Capacity and Cash Flow Analysis

Debt Capacity: The amount of debt a firm can comfortably service even under adverse economic
conditions, without threatening solvency or operational flexibility.

• Key metric: Debt Service Coverage Ratio (DSCR) = Net Operating Cash Flows / Fixed Financial
Charges. Higher ratio = greater debt capacity.
• Cash flow analysis covers operating flows (from P&L; projections), non-operating flows (capex,
WC changes), and financial flows (contractual obligations like interest, principal).
• Firms should maintain reserve debt capacity – not exhaust all borrowing ability at once. Unused
capacity provides flexibility for future emergencies or strategic investments.
• Companies in capital-intensive, volatile industries (e.g., airlines, steel, shipping) have gotten into
financial distress by excessive debt – case studies: Hindustan Shipyard (debt trap), NALCO (debt
burden under cash crunch).
• Setting debt capacity based on desired credit rating (e.g., 'we want to maintain BBB+ rating') is a
practical approach used by many firms.

The sustainable growth model (SGR = ROE × (1 − payout ratio)) helps determine the maximum growth
rate achievable without changing capital structure or issuing new equity. Growth above SGR requires
external financing.

13.5 Elements of Capital Structure to Analyse (from Pandey)

Element Key Questions

How heavily does the firm rely on debt? What types of debt? Is the level consistent
Capital Mix (D/E)
with operating risk?
 Element Key Questions

Do asset and liability maturities match? What is the priority of claims in distress?
Maturity & Priority
(Secured > Unsecured > Equity)

Fixed vs floating rate? Covenant restrictions? Prepayment options? Impact on

Terms & Conditions
operating flexibility?

Currency Domestic vs foreign currency debt? Exchange rate risk? Hedging in place?

Convertibles, warrants, hybrid securities – do they reduce cost or serve other

Financial Innovations
purposes (control, signalling)?

Bank debt, public debentures, commercial paper, bonds – which segments tapped?
Financial Market Segments
Why?
SECTION 14: MASTER FORMULA SHEET & KEY CONCEPTS

14.1 Capital Structure Measures

Formula Expression

Debt Ratio D / V (V = D + E)

Debt-Equity Ratio D/E

Interest Coverage EBIT / Interest (or EBITDA / Interest)

14.2 EPS, ROE & Leverage

Formula Expression

EPS (No Debt) EBIT(1−T) / N

EPS (With Debt) (EBIT−INT)(1−T) / N

ROE (EBIT−INT)(1−T) / E

ROE with leverage [r + (r−i)×D/E] × (1−T) where r=ROI, i=interest rate

Interest Tax Shield T × INT = T × kd × D

EBIT Indifference Point (Equity vs

EBIT* = [N■/(N■−N■)] × INT
Debt)

EBIT Indifference (Equity vs

EBIT* = [N■/(N■−N■)] × PDIV/(1−T)
Preference)

14.3 Leverage Measures

Measure Formula 1 Formula 2

DOL ∆EBIT%/∆Sales% Contribution/EBIT = 1 + F/EBIT

DFL ∆EPS%/∆EBIT% EBIT/PBT = 1 + INT/PBT

DCL ∆EPS%/∆Sales% Contribution/PBT = DOL × DFL

14.4 Capital Structure Theories – Formulas

Theory/Formula Expression

NI Approach – Firm Value V = E + D = NI/ke + INT/kd

WACC k■ = ke × E/V + kd × D/V

MM Proposition I (No Tax) Vl = Vu (capital structure irrelevance)

MM Proposition I (Formal) V = NOI / k■ (constant)

MM Proposition II ke = k■ + (k■ − kd) × D/E

Interest Tax Shield (Annual) INTS = T × kd × D

PV of Interest Tax Shield PVINTS = T × D (perpetual debt)

MM with Corporate Taxes Vl = Vu + T×D

 Theory/Formula Expression

Unlevered Firm Value Vu = NOI(1−T) / k■

WACC (with taxes) WACC = k■ × (1 − T × D/V)

Trade-Off Theory Vl = Vu + PV(ITS) − PV(FD) − PV(Agency)

Net Tax Advantage of Debt (1−Tpd) − (1−T)(1−Tpe)

Miller's Value of Levered Firm Vl = Vu + [1 − (1−T)(1−Tpe)/(1−Tpd)] × D

Sustainable Growth Rate SGR = ROE × (1 − Payout Ratio)

14.5 Complete Theory Comparison Table

Theory Assumptions Vl vs Vu Optimal D/E Key Mechanism

Vl > Vu always
NI Approach ke, kd constant 100% Debt Cheap debt lowers WACC
(debt adds value)

ke rises moderately Vl > Vu (then < Vu Exists (min

Traditional View U-shaped WACC
at first at excess debt) WACC)

Perfect markets, no Vl = Vu
MM No Tax None Arbitrage (homemade leverage)
taxes (irrelevance)

Vl = Vu + TD
MM With Corp Perfect markets, T >
(more debt = 100% Debt Interest tax shield
Tax 0
more value)

Interior
Trade-Off Distress costs exist Vl = Vu + TD − FD Tax benefit vs distress cost
optimum

Info asymmetry, no No fixed

Pecking Order No fixed target Financing hierarchy
target relationship

High debt →
Info asymmetry, Strategic
Signalling (Ross) higher value Debt as credibility signal
managerial comp signal
signal

14.6 Key Exam Points for Unit II

★ Financial leverage is favourable (boosts EPS/ROE) when ROI > Cost of Debt. Unfavourable
when ROI < Cost of Debt.
★ DOL = Contribution/EBIT; DFL = EBIT/PBT; DCL = DOL × DFL = Contribution/PBT.
★ MM Proposition I: Capital structure is irrelevant in perfect markets (no taxes). Vl = Vu.
★ MM Proposition II: Cost of equity rises linearly with D/E. ke = ka + (ka−kd)×D/E.
★ With corporate taxes: Vl = Vu + TD. Optimal = 100% debt (theory) – not observed in practice.
★ Trade-Off Theory: Optimal D/E where MB (tax shield) = MC (distress + agency costs).
★ Debt Overhang: Distressed firms reject positive-NPV projects (gains go to debt-holders, not
shareholders).
★ Asset Substitution: Shareholders of distressed firms prefer risky projects (limited liability = call
option).
★ Short-Sighted Investment: Financial distress causes myopic decisions – cut R&D;, sell assets,
defer maintenance.
★ Pecking Order: Internal finance > Debt > Equity (in order of preference). No fixed D/E target.
★ Ross Signalling: High debt = credible signal of managerial confidence. Equity issue = negative
signal.
★ FRICT analysis: Flexibility, Risk, Income, Control, Timing – evaluate capital structure across all
five dimensions.

These notes cover ALL topics of Unit II of COMC006 – Strategic Financial Management as per the Delhi
University [Link]. PGCF 2025 syllabus. Includes full theory, formulas, illustrations, and critical evaluations
for 20-mark answers. Sources: I.M. Pandey (Financial Management, 11th Ed.), Brealey/Myers/Allen, and
Course PPTs.