Financial Management

Lecture No. 29
Weighted Average Cost of Capital
(WACC)

Copyright: M. S. Humayun 1
 WACC %
• Weighted % Cost of Bond (Debt): WACC = rDxD + rExE + rPxP
– rD XD . Where rD is the Average Rational Investors’ Required
ROR for investing in the Bond. XD is the Weight or Fraction of
Total Capital value raised from Bonds = Bond Value / Total
Capital
• Weighted % Cost of Common Equity
– rE XE . Where rD is the Average Rational Investors’ Required
ROR for investing in Common Share. XD is Weight or Fraction
of Total Capital raised from Common Equity. Note that rE is
Not the WACC and Not the ROE (=NI / common stock)
• Weighted % Cost of Preferred Equity
– rP XP . Where rP is the Average Rational Investors’ Required
ROR for investing in Preferred Share. XP is Weight or Fraction
of Total Capital raised from Preferred Equity.
Copyright: M. S. Humayun 2
 Weighted Cost of Debt
• Weighted Cost of Debt % = rD XD .
• Required ROR for Debt
– Bond YTM = Interest Yield + Capital Gain Yield = Expected (or
Theoretical) ROR. It becomes Required ROR when you use
Actual Observed Market Price of Bond as PV in the Bond Pricing
Formula.
• Cost of Debt Capital = rD
– Practically speaking, Bonds are Issued (or sold) in the Market at a
Premium (above Par Value) or Discount (below Par Value).
AND, the Issuance of Bonds has Transaction Costs. These
transaction costs include Legal, Accounting, and Marketing and
Sales fees. Both these are factored into the Market Price of the
Bond used in PV Formula to calculate the Pre-Tax Cost of
Debt Capital = rD* . So, rather than using Market Price of Debt,
use the NET PROCEEDS = Market Price – Transaction Costs.
Copyright: M. S. Humayun 3
– Finally, Debt becomes less Costly because Additional
Interest creates a new form of Tax Saving or Tax Shield.
– After Tax Cost of Debt = rD = rD* ( 1 - TC ) where TC is
the Marginal Corporate Tax Rate on the Net Income of the
Firm.

Copyright: M. S. Humayun 4
 Example - Cost of Debt
• Company ABC issues a 2 Year Bond of Par Value Rs 1000
and a Coupon Rate of 10% pa (and annual coupon payments).
Company ABC pays an Investment Bank Rs 50 per Bond to
structure and market the bond. They decide to sell the Bond
for Rs 950 (ie. At a Discount). At the end of the first year,
Company ABC’s Income Statement shows the Coupon
Interest paid to Bondholders as an expense. Interest
represents a Tax Saving or Shield. Based on the Net Income
and Industry Standard, the Marginal Corporate Tax Rate is
30% of Net Income.
• Assuming that the 2 Year Bond represents the ONLY form of
Capital, calculate the After-Tax Weighted Average Cost of
Capital (WACC) % for Company ABC.

Copyright: M. S. Humayun 5
 Example - Cost of Debt
• Step 1: Calculate Required ROR using Bond Pricing or PV
Formula
– PV = 100/(1+r*) +100/(1+r*)2 +1000/(1+r*)2
= 100/(1+r*) + 1100/(1+r*)2
= NET PROCEEDS = NP = Market Price -Transaction Costs
= 950 - 50 = Rs 900
Solve the Quadratic Equation for Pre-Tax Required ROR = r*
Using the Quadratic Formula: r* = 16% AND r = - 5 % (!)
• Step 2: Calculate After Tax Cost of Debt
– rD = rD* ( 1 - TC ) = 0.16 ( 1 - 0.30) = 0.16 (0.70) = 11 . 2 %
• Step 3: Calculate Weighted Cost of Capital (WACC)
– WACC = rD XD .+ rP XP + rE XE . = rD XD + 0 + 0
Copyright: M. S. Humayun 6
= 11.2 (1) = 11.2 %
Weighted Cost of Preferred Equity
• Weighted Cost of Preferred Equity % = rP XP .
• Required ROR for Preferred Equity
– Use the Perpetuity Formula for Perpetual Investment & Constant Div
– PV = Present Price = Po= DIV1 / r . So r = DIV1 / Po. If you use the
Actual Observed Market Price for Po then r = Required ROR
• Cost of Preferred Equity Capital = rP
– Practically speaking, the process of Legally Structuring, Printing, and
Marketing Preferred Share Certificates costs money in the form of
Flotation Costs (including Brokerage and Underwriting Fees). These
Costs are factored directly into the PV or Observed Market Price.
– PV = Net Proceeds = Market Price - Flotation Costs
– Preferred Stock Dividends are paid out from Net Income AFTER
TAXES. So they are NOT Tax Deductible (unlike Bond Interest
Payments).

Copyright: M. S. Humayun 7
Example - Cost of Preferred Stock
• Company ABC wants to issue a Preferred
Stock of Face Value Rs 10. The Board of
Directors have agreed to fix the Annual
Dividend at Rs 2 per share. The Lawyer’s
fee and Stock Brokers’ Commissions will
cost Rs 1 per share. The Preferred Share is
floated at Face Value.
• What is the Cost of Capital to Company
ABC for raising money through Preferred
Stocks?
Copyright: M. S. Humayun 8
 Example - Cost of Preferred Stock
• Use Perpetuity Formula to Compute the
Required ROR
– r = DIV1/ Po = Rs 2 / Rs 10 = 20%
• Minor Change in Perpetuity Formula to
Compute the Cost of Preferred Equity Capital
– Net Proceeds = NP =Price-Flotation Costs =10-1= Rs 9
– r = DIV1/ NP = Rs 2 / Rs 9 = 22%
– Flotation Costs ADD TO COST of Company
Issuing the Preferred Equity Capital
Copyright: M. S. Humayun 9
 Weighted Cost of Common Equity
• Weighted Cost of Common Equity % = rE XE .
• Required ROR for Common Equity (or Shares): 2
Approaches
– Dividend Growth Model: Gordon Formula (simplified PV
Formula) for Perpetual Investment & Constant Growth in
Dividends
• r = DIV1 / Po + g. If you use the Actual Observed
Market Price for Po then r = Required ROR. Now 2
Approaches for Proceeding to calculate Cost of Capital.
– CAPM (SML Equation) Assuming Efficient Markets
• r = rRF + Beta (rM - rRF ). Advantage: does not rely on
Divident Forecast

Copyright: M. S. Humayun 10
Cost of Common Equity Capital = rE
MOST COMPLEX COST OF CAPITAL TO
CALCULATE.
Required ROR on Common Equity NEITHER
observable NOR certain unlike Bond Coupon Interest &
Preferred Dividends both of which are fixed
Equity Capital can be raised in 2 Ways and Required ROR and
Costs are different for each: (1) Retained Earnings and (2)
Issue of New Common Stock. You can use rE for New Stock or
Retained Earnings (which is lower).
Common Stock Dividends are paid out from Net Income
AFTER TAXES. So they are NOT Tax Deductible (unlike
Bond Interest Payments).

Copyright: M. S. Humayun 11
Example - Cost of Common Equity Capital
• Company ABC wants to issue more Common
Stock of Face Value Rs 10. Next Year the Dividend is
expected to be Rs 2 per share assuming a Dividend
Growth Rate of 10% pa. The Lawyer’s fee and Stock
Brokers’ Commissions will cost Rs 1 per share.
Investors are confident about Company ABC so the
Common Share is floated at a Market Price of Rs 16
(ie. Premium of Rs 6).
• If the Capital Structure of Company ABC is entirely
Common Equity, then what is the Company’s WACC?
Use 2 Approaches and Compare the Results.

Copyright: M. S. Humayun 12
Example - Cost of Common Equity Capital
Dividend Growth Model
• Step 1: Calculate Required ROR for Common Stock using
Gordon’s Formula (Perpetual Investment and Constant
Growing Dividend):
– Approach I: Retained Earnings Approach (use Market Price)
• r =(DIV1/Po) + g = 2/16 + 0.10 =0.125 +0.1 =0.225 = 22.5%
– Approach II: New Stock Issuance Approach
• Net Proceeds = Flotation Price - Flotation Costs = 16 - 1 = 15
• r =(DIV1/NP) + g = 2/15 + 0.10 = 0.133 + 0.1 =0.233 = 23.3%
– Cheaper for Company ABC to Raise Equity Capital
through Retained Earnings than to incur costs of issuing
New Equity.
– Problem: Which Cost to Pick ?
Copyright: M. S. Humayun 13
Example - Cost of Common Equity Capital
CAPM Model (SML) Efficient Market
• Given some additional data: T-Bill ROR =
10% pa. Market ROR = 20%. Beta for ABC
Common Stock = 1.25
– r = rRF + Beta (rM - rRF ) = 10% + 1.25 (20%-10%)
= 10% + 12.5% = 22.5%
– Same answer as Retained Earnings Approach in
Dividends Growth Model. Advantage: Don’t
need to Forecast Dividends in CAPM Approach.
– CAPM matches Dividends Model if No Flotation
/ Transaction Costs and Market is Efficient.
Copyright: M. S. Humayun 14
 Cost of Capital & Required ROR
• Required ROR (or Opportunity Cost) %
– CAPM Theory (SML for Efficient Markets) & NPV
– Minimum ROR required to attract investor into buying a
Security (ie. Stock or Bond …)
– Opportunity Cost: Investor Sacrifices the ROR available
from the 2nd best investment.
• Cost of Capital %
– Weighted Average Cost of Capital (WACC)
– Combined costs of all sources of financing used by Firm
(ie. Debt and Equity)

Copyright: M. S. Humayun 15
– Similar to Required ROR BUT Takes into account some
Practical Factors:
• TAXES: Interest Payments are P/L Expenses and NOT
Taxed.
• TRANSACTION COSTS: Brokerage, Underwriting,
Legal, and Flotation Costs incurred when a Firm issues
Stocks or Bond Securities

Copyright: M. S. Humayun 16
 Summary of Formulas
TOT RISK = MKT RISK + COMPANY SPECIFIC RISK

2 + 2 2 2
+
NPV Bond Pricing Equation:
Bond Price = PV = C1/(1+rD) + C2 (1+rD)2 + C3 / (1+rD)3 +
….. + PAR / (1+rD)3

Gordon’s Formula for Share Pricing:

rCE = (DIV 1 / Po) + g = Dividend Yield + Capital Gains Yield

SML Equation (CAPM Theory)

r = rRF + Beta (rM - rRF )
Copyright: M. S. Humayun 17
 Financial Management
Lecture No. 30
Business Risk faced by FIRM &
Operating Leverage (OL), Breakeven
Point & ROE
Prelude to Capital Structure.

Copyright: M. S. Humayun 1
 Debt vs Equity
From FIRM’s Point of View
• Need Capital to Start a New Business or to Expand
Operations
• Capital can be raised in basically 2 ways. Look at each
from FIRM’S (or Company’s) Point of View:
– Issuing Debt (or Leverage)
• Advantages of Issuing Debt:
– Limited fixed Interest payment - no share in profits
– Limited Life
– Interest Payment is an Expense ie. Tax Deductible
– Can Improve (or Amplify) the Return on Equity (ROE)
• Disadvantages
– Debt adds to Company-specific Risk
– If company doesn’t pay Interest, it can be closed down
– Issuing Equity (generally Common Equity or Ownership)
• Advantages of Issuing Equity:
– Not required to pay fixed regular Dividends
• Capital Structure is a Firm’s Mix of Debt & Equity
Copyright: M. S. Humayun 2
 Risks Faced by FIRM
• Total Stand-Alone Risk of a STOCK (from Risk
and CAPM Theory).
– Stock’s Total Stand Alone Risk = Diversifiable + Market
– Company-specific Risk: Unique, Diversifiable
– Market Risk: Systematic, Not Diversifiable
• Total Stand-Alone Risk of a FIRM (New)
– Firm’s Total Stand Alone Risk = Business + Financial
– Business Risk: Risk of All Assets & Operations
(without debt). Includes Both Company-Specific (or
Diversifiable) & Market Risks.
– Financial Risk: Additional Risk faced by Common
Stockholders if Firm takes Debt. Pure Debt-related
Risk.
Copyright: M. S. Humayun 3
 Financial Risk – Concept
INVESTOR’S Point of View
• Suppose Firm ABC had a Capital Structure of 100%
Common Equity. Then the Management and Board of
Directors of Firm ABC then decides to Reduce Half of
the Equity and take a Loan (or Debt) instead. This
affects the distribution of Risk & Return to the Common
Equity holders (or Owners).
– In other words, the Management of Firm ABC has added a New
Kind of Investor. The Debt Holder faces almost no risk because he
is “guaranteed” the Interest payment at all costs whether or not the
Firm is making profit or whether or not the Equity Owners are paid
Dividend. Debt Holders eat away at the Owners’ (or Equity
Holders’) money at almost no risk.
– So, naturally, the RISK faced by Equity Holders INCREASES
because same Business Risk is now shouldered by Fewer Equity
Shares. Risk per Share Increases. Generally Speaking,
Increasing Debt Shifts More Risk Upon the Shareholders.
Therefore REQUIRED ROR demanded by the Common Equity
Holder also INCREASES (based on CAPM Theory)
Copyright: M. S. Humayun 4
 Firm’s Total Stand Alone Risk
Uncertainty in ROA & ROE
• Firm’s Total Stand Alone Risk measured by the Uncertainty
or Fluctuations in Possible Outcomes for Firm’s Future
Overall ROR.
• If Business has Debt & Equity (ie. LEVERED FIRM):
– Firm’s Overall ROR = ROA = Return on Assets = Return to
Investors / Assets = (Net Income + Interest) / Total Assets
– Note: Total Assets = Total Liabilities = Debt + Equity
• If Business is 100% Equity (or UN-LEVERED FIRM) No
Debt and No Interest.
– Firm’s Overall ROR = Net Income / Total Assets. For 100% Equity
Firm, Total Assets = Equity. So Overall ROR = Net Income / Equity
= ROE ! Note: Net Income is also called Earnings.
– Note: ROE Does NOT Equal rE (Required Rate of Return). ROE is
Expected Book Return on Equity. Used in Stock Valuation
Formula to calculate “g” & “PVGO”
– Fluctuations in ROE = “Basic Business Risk”
• Review Financial Accounting Ratios
Copyright: M. S. Humayun 5
 Basic Business Risk
(Not Considering Debt)
• Causes of High “Basic Business Risk” or Uncertainty or
Volatility or “Instability” or “Shocks”
– Large changes in Customers’ Demand (seasonality)
– Unstable Selling Price (unstable markets and retailers)
– Uncertainty in Input Costs (raw material, labor, utilities)
– Inability of Management to Change Operational Tactics
and Strategy to Meet Changing Environment
• Ineffective Price Stabilization
• Poor Product R&D and Planning
– High Operating Leverage (OL)
– Many other causes.

Copyright: M. S. Humayun 6
 Operating Leverage (OL)
• Formula:OL = Fixed Costs / Total Costs
• Concept: High OL Increases Risk: Customer
Demand Falls but Fixed Costs remain High. So,
Small Decline in Sales Can Cause Large
Decline in ROE.
• Fixed Costs Across Different Industries:
– Plant, Machinery, Equipment ie. Power Plant,
Cement, Steel, Textile Spinning
– New Product Development, R&D Costs ie. Pharma,
Auto, IT
– Highly Specialized & Skilled Workers ie. IT
• OL used in Capital Budgeting & Capital
Structuring Decisions
Copyright: M. S. Humayun 7
 Operating Leverage Application
to Capital Budgeting
• Example: Comparing 2 Types of Technologies for Cement
Manufacturing: (1) Wet Process and (2) Dry Process.
Different Total & Fixed Costs, Different OL.
– Applications to Capital Budgeting
• Different OL’s, Different Breakeven Points, Different
Risks, Different Required ROR’s. So Different
Discount Rates for 2 Technologies. Affects
Computation of NPV Investment Criterion.
– Breakeven Point: Quantity of Sales at which EBIT = 0
therefore ROE = 0. EBIT = Op Revenue - Op Costs = Op
Revenue - Variable Costs - Fixed Costs = PQ - VQ - F.
Where P= Product Price (Rs), Q= Quantity or # Units Sold,
V= Variable Cost (Rs), F= Fixed Cost (Rs). So IF EBIT = 0
then PQ-VQ-F = 0 so Breakeven Q = F / ( P - V )
Copyright: M. S. Humayun 8
 Visualizing Operating Leverage (OL)
Impact on Breakeven Point & Capital Budgeting
Revenues & Sales REVENUE Line
Costs (Rupees) Total COST Line
Technology A:
Technology A: Larger Higher OL
OPERATING LOSS
(Cost > Revenue). Total COST Line
More Risky Technology B

Fixed Costs A
Breakeven A: Higher.
Fixed Costs B More Risky
Sales Quantity
QB* QA* (# of Units)
Copyright: M. S. Humayun 9
Operating Leverage Application
to Capital Structure
• Applications to Capital Structure
– Example of 2 Types of Cement Manufacturing
Technologies: Different OL’s has 2 Impacts:
• Different Risks so Different Betas (CAPM
Approach to Cost of Equity Capital), Different
WACC’s for 2 Technologies. Affects Choice of
Capital Mix (or Capital Structure)
• Different Fixed Costs, Different EBIT & NI,
Different ROE’s so Different Dividend Growth
Rates “g,” (Gordon-Dividends Approach to
Cost of Equity Capital). So Different WACC’s.
Affects Choice of Capital Mix.
Copyright: M. S. Humayun 10
Visualizing Operating Leverage (OL)
Impact on ROE & Capital Structure
Technology B: Lower OL:
Low Risk & Low ROE

Technology A: High OL,

Risk B High Risk & High ROE.
Higher WACC

Risk A

Expected ROE Expected ROE

= <ROE>B = <ROE>A
Return on Equity ( ROE)%
Copyright: M. S. Humayun 11
 SML – WACC Graph
Required
FEASIBLE REGION (where SML Line
ROR rCE (%) IRR of investment or project (EXTERNAL
is more than SML and
WACC)
MARKET
criterion)

IRR < SML

1
WACC
Firm’s own
3 WACC
IRR < WACC 2
rRF = T- (INTERNAL
Bill rate IRR <WACC < SML
criterion)

Beta Risk
Copyright: M. S. Humayun 12
 Financial Management
Lecture No. 31
Firms - Operating Leverage, Financial
Risk, & Intro to Financial Leverage

Copyright: M. S. Humayun 1
 Recap of Business Risk & OL
• Total Risk Faced by FIRM
– Total Risk = Business Risk + Financial Risk
– Business Risk (from Operations except Debt)
• Uncertainty & Fluctuations in Prices & Costs. Specific &
Market Causes.
• Higher Operating Leverage (OL = Fixed Cost / Total Cost)
causes:
– Higher Breakeven Point
– Higher but Riskier Expected Return on Equity <ROE>
– Financial Risk
• Created when Firm takes Loan or Debt or issues Bonds –
this is Financial Leverage (FL = Debt / Total Assets = D /
(D+E))
Copyright: M. S. Humayun 2
 Financial Risk
• Definition: Increase in Risk faced by Common Stock Holders (or
Equity Holders or Owners) when a Firm takes on more Debt or
Financial Leverage.
• Increase in Debt Shifts More Risk on Common Stock Holders.
Risk Per Share Increases.
• Example: Suppose a Firm ABC has Total Assets of Rs 1000 and is
100% Equity based (ie. Un-levered). There were 10 equal Owners and
5 of them want to leave. So the Firm takes a Bank Loan of Rs 500 (at
10%pa Mark-up) and pays back the Equity Capital to the 5 Owners
who are leaving. Now, half of the Equity Capital has been replaced
with a Loan from a Bank (ie. Debt). What impact does this have
on Risk & Return as measured by ROE?
• Assuming Business Risk is unchanged, then RISK PER SHARE
Rises because Equity is HALVED. So, more Risk is transferred to
Common Shareholders.

Copyright: M. S. Humayun 3
 • Debt Investors (ie. Lenders and Bond Holders) face
MINIMAL RISK because (1) Guaranteed Regular Interest
Income and (2) 1st Claim on Assets in event of Bankruptcy

Impact of Financial Leverage (Loan) on

Balance Sheet
Un-Levered Firm Levered Firm
(100% Equity) (50% Equity - 50% Debt)
Assets Liabilities Assets Liabilities
Debt: 500
Equity:1000 Equity: 500
Tot: 1000 Tot: 1000 Tot: 1000 Tot: 1000

Note: Total Assets = Total Liabilities = Debt + Equity

Copyright: M. S. Humayun 4
 Impact of Financial Leverage (Loan) on
Income Statement & ROE
Un-Levered Levered
(100% Equity) (50% Equity)
Expected EBIT 300 300
Interest (10% of 500) 0 50
EBT 300 250
Tax (30%) 90 75
Net Income (NI) 210 175
Expected ROE (=NI/Equity) 210/1000= 21% 175/500=35%
Total Return 210 175+50=225
• Increase in Debt Improved or Leveraged Up the ROE to 35% !
• Increase in Debt also Increased the Total Return to Investors = NI +
Interest. Increased from Rs 210 to 225 (175+50) . Remember that
Investors include BOTH Shareholders and Debt Holders !
• So, why not keep adding more Debt ? Because, Debt has Increased the
RISK ie. The Standard Deviation or Uncertainty of ROE.
Copyright: M. S. Humayun 5
 Financial Leverage (Debt)
Increases ROE Risk
• Increase in Debt Increases Chances of Net Loss if EBIT
falls and Firm can NOT make Interest Payment. Financial
Leverage = FL = Debt / Total Assets = D / (D+E)
• Increase in Debt Increases Uncertainty in ROE. Range or
Spread of Possible future values of ROE increases. Risk
faced by Common Stock Holders Increases.
• Total Stand Alone Risk of Firm = Business Risk +
Financial Risk
– Total Stand Alone Risk = Standard Deviation of ROE
of Levered Firm
– Business Risk = Standard Deviation of ROE for Un-
levered Firm

Copyright: M. S. Humayun 6
 Financial Leverage (FL) &
Operating Leverage (OL)
• Effect of Financial Leverage & Operating Leverage on Risk & Return
(as measured by ROE) are Similar.
– High Operating Leverage: OL = Fixed Cost / Total Cost. High
Fixed Costs so small changes in Quantity Sold cause larger
changes in Net Income & ROE
• Risky if Firm’s Sales < Breakeven Point BUT
• Multiplies Increase in Mean ROE when Sales > Breakeven
– High Financial Leverage: FL = Debt / Total Assets = D / (D+E).
High Debt & Interest Payments so small changes in EBIT cause
large changes in Net Income & ROE
• Risky if Firm’s Overall Return is low and can NOT pay Interest on time
BUT
• Multiplies Increase in Mean ROE and Total Return (to Equity & Debt
Holders) when Firm’s Overall Return is Higher than Cost of Debt

Copyright: M. S. Humayun 7
 Financial Leverage
ROE Volatility & Risk
EBIT Interest EBT Tax Net Income ROE
(Rs50) (30%) (=NI/Equity)
Un-Levered 600 0 600 180 420 42%
300 0 300 90 210 21%
50 0 50 15 35 3.5%

Levered 600 50 550 165 385 77%

300 50 250 75 175 35%
50 50 0 0 0 0%
• Leverage (or Debt) Increases the Spread or Range of Possible ROE
thereby Increasing Uncertainty and Risk.

Copyright: M. S. Humayun 8
 Visualizing Financial Leverage (FL)
Impact on ROE & Capital Structure
LEVERED (Debt
ROE (%) & Equity) Firm:
77% Higher Slope.
ROE more
sensitive to
42% changes in EBIT

35% = <ROE>L
UN-LEVERED
21% = <ROE>UL (100% Equity)
Firm. Safer
Capital Structure
3.5% at Low EBIT’s
0% EBIT (Rs)
50 300 600
Copyright: M. S. Humayun 9
Visualizing Impact of Financial Leverage
on ROE & Capital Structure
Un-Levered (100% Equity):
Lower ROE and Lower Risk.

Levered (Debt & Equity):

Risk Higher ROE but Higher
Risk also.

Risk

Expected ROE Expected ROE

<ROE>Un-Levered <ROE>Levered =
= 21% 35%
Return on Equity ( ROE)%
Copyright: M. S. Humayun 10
 Operating Leverage (OL)
(Attachment from Lecture No. 30 – Insert After
Slide No. 2 Lecture 31)

• Formula:OL = Fixed Costs / Total Costs

• Concept: High OL Increases Risk. Small Decline in
Sales Can Cause Large Decline in ROE (when sales
are below Breakeven Point)
• Fixed Costs Across Different Industries:
– Capital Intensive Industries: ie. Power Plant,
Cement, Steel, Textile Spinning
– High New Product Development, R&D Cost
Industries ie. Pharma, Auto, IT
– Highly Specialized & Skilled Workers that Need to
be Retained ie. IT, Software House, Semiconductor
and Microprocessor Manufacturers

Copyright: M. S. Humayun 11
 Operating Leverage Application to
Capital Budgeting
(Attachment from Lecture No. 30 – Insert After
Slide No. 2 Lecture No. 31)
• Application of Operating Leverage to Capital Budgeting
– Different OL’s, Different Breakeven Points, Different Risks,
Different Required ROR’s. So Different Discount Rates. Affects
Computation of NPV Investment Criterion.
– Breakeven Point: Quantity of Sales at which EBIT = 0
therefore ROE = 0.
– EBIT = Op Revenue - Op Costs = Op Revenue - Variable
Costs - Fixed Costs = PQ - VQ - F. Where P= Product Price
(Rs), Q= Quantity or # Units Sold, V= Variable Cost (Rs), F=
Fixed Cost (Rs). So IF EBIT = 0 then PQ-VQ-F = 0
– Breakeven Quantity Q = F / ( P - V )
Copyright: M. S. Humayun 12
 Visualizing Operating Leverage (OL)
Impact on Breakeven Point & Capital Budgeting
(Attachment from Lecture No. 30 – Insert After Slide
No. 2 Lecture No. 31) Total COST Line
Revenues & Sales REVENUE Line
Costs (Rupees) Technology A:
Higher OL
Technology A: Larger
OPERATING LOSS
(Cost > Revenue). Total COST Line
More Risky Technology B
Fixed Costs A

Fixed Costs B
Breakeven A: Higher.
More Risky
Sales Quantity
Copyright: M. S. Humayun 13
QB* QA* (# of Units)
 Operating Leverage Application to
Capital Structure
(Attachment from Lecture No. 30 – Insert After
Slide No. 2 Lecture No. 31)
• Application of Operating Leverage to Capital Structure
• Different Risks so Different Betas (CAPM Approach to
Cost of Equity Capital), Different WACC’s for 2
Technologies. Affects Choice of Capital Mix (or Capital
Structure)
• Different Fixed Costs, Different EBIT & NI, Different
ROE’s so Different Dividend Growth Rates “g,”
(Gordon-Dividends Approach to Cost of Equity
Capital). Means Different WACC’s. So, OL Affects
Choice of Capital Mix.

Copyright: M. S. Humayun 14
Visualizing Operating Leverage (OL)
Impact on ROE & Capital Structure
(Attachment from Lecture No. 30 – Insert After
Slide No. 2 Lecture No. 31)
Technology B: Lower OL:
Low Risk & Low ROE

Technology A: High OL,

Risk B High Risk & High ROE.
Higher WACC

Risk A

Expected ROE Expected ROE

= <ROE>B = <ROE>A
Return onCopyright:
Equity ( ROE)%
M. S. Humayun 15
 SML – WACC Graph
(Attachment from Lecture No. 30 – Insert After
Slide No. 2 Lecture No.31)
Required SML Line
ROR rCE (%) FEASIBLE REGION (where (EXTERNAL
IRR of investment or project MARKET
is more than SML and
WACC)
criterion)

WACC
Firm’s own
WACC
rRF = T- (INTERNAL
Bill rate
criterion)

Copyright: M. S. Humayun Beta Risk16

 Formulas Recap
• “Return on Equity”
– ROE = Net Income / Equity = NI / E
– Financial Accounting Ratio
• “Required Return for Equity Holders (or Shareholders)”
– rE = (DIV1 / Po) + g (Gordon’s Formula for Share Price)
– Market and Risk – Oriented Financial Management Parameter. Depends on Investor
Risk Profile and Market Risk (Beta). Linked to CAPM Theory.
• “Overall Return for Firm”
– ROA = Total Return / Total Assets = (Net Income + Interest) / (Debt + Equity) = (NI +
Int) / (D+E)
– Total Return includes Net Income & INTEREST. (1) Equity Investors (ie.
Shareholders) get a part of the Net Income in the form of Dividends and (2) Debt
Investors (ie. Bond Holders, Lenders, Banks) get the Interest.
– Get NI and Interest from P/L Statement. Get D & E from Balance Sheet.
• “Cost of Capital for Firm”
– WACC = rDxD + rPxP + rExE
– Market & Risk Oriented Financial Management Parameter. Because Required
Returns like rE depend on Risk Profile and Market Premium and Beta.
– Practical Parameter. Takes Taxes, Transaction & Flotation Costs into account. Use
NP = Market Price – Transaction Costs

Copyright: M. S. Humayun 17
 Financial Management

Lecture No. 32
Financial Leverage &
Introduction to Capital Structure Theory

Copyright: M. S. Humayun 1
Recap of WACC, Business Risk, & Leverage
• WACC % = rD XD + rE XE + rP XP . (Debt,Common Equity, Preferred
Equity)
– Where “r” is ACTUAL COST which can be calculated from
REQUIRED ROR after accounting for Taxes & Transaction Costs.
– Equity Capital: If Not Enough Retained Earnings then Equity
Capital must be financed by New Stock Issuance which is more
costly.
• Total Risk Faced by FIRM
– Total Risk = Business Risk + Financial Risk
• Standard Deviation of ROE (Levered Firm ABC) = Standard
Deviation (if Firm ABC is Un-Levered) + Financial Risk (from
Debt)
– Business Risk (from Operations except Debt)
• Uncertainty & Fluctuations in Prices & Costs. Specific & Market
Causes.
Copyright: M. S. Humayun 2
 • Higher Operating Leverage (OL = Fixed Costs /
Total Costs)
Higher Mean ROE WHEN FIRM’S SALES >
BREAKEVEN POINT
Higher Fixed Costs means Higher Breakeven Point
and More Chances of Operating Loss. Risk of Large
Drop in Return on Equity <ROE> so Higher Risk.
- Financial Risk (from Debt, Bonds, or Loan)
Created when you take Loan or Debt or Financial
Leverage (FL = Debt / (Debt + Equity)
Financial Risk = Std Dev of ROE (Levered) - Std Dev of
ROE (Un-levered)
Example: If Total Risk = 30% and Business Risk =
20% then Financial Risk = 30% - 20% = 10%

Copyright: M. S. Humayun 3
 SML – WACC Graph

Required
ROR rCE (%) SML Line
FEASIBLE REGION (where (EXTERNAL
IRR of investment or project MARKET
is more than SML and
WACC)
criterion)

WACC
Firm’s own
WACC
rRF = T- (INTERNAL
Bill rate
criterion)

Copyright: M. S. Humayun Beta Risk

4
 Financial Leverage Concept
• Created when you take Loan or Debt or Financial Leverage
(FL).
• Financial Leverage (%) =Debt /Total Assets =D/A = Debt
/ Debt + Equity = D / (D+E)
• If Firm has Rs 1000 of Total Assets and Rs 500 Debt then it
has 50% (=50/1000) Financial Leverage
• Practically, Firms increase Financial Leverage by:
– Issuing New Debt (ie. Taking New Loans and Increase
Debt) OR
– Replacing Equity with New Debt ( Increasing Debt
AND DECREASING EQUITY too)

Copyright: M. S. Humayun 5
 Financial Leverage
Impact on Risk & Return of Firm
• Financial Leverage (or Debt Financing) Generally Increases Overall
Risk & Return of a Firm:
• Increases Return (Mean ROE):
– When EBIT /Total Assets > Interest Cost then Financial Leverage
is Good. Small Increase in EBIT can create much LARGER Increase
in ROE.
– If Equity (and number of shares) Reduced then Return (NI) per
Share Increases
• Increases Risk (Standard Deviation in ROE): Fixed Interest Dues so
Higher Chances of Losses, No Dividends for Shareholders. Possibility
of Large Drop in ROE. Possibly Default. More Risk Transferred to
Stockholders.
– If Equity (and number of shares) Reduced then Risk per Share
Increases. Copyright: M. S. Humayun 6
 Financial Leverage
ROE Volatility & Risk
EBIT Interest EBT Tax Net Income ROE
(Rs50) (30%) (=NI/Equity)
Un-Levered 600 0 600 180 420 42%
300 0 300 90 210 21%
50 0 50 15 35 3.5%

Levered 600 50 550 165 385 77%

300 50 250 75 175 35%
50 50 0 0 0 0%
• Leverage (or Debt) Increases the Spread or Range of Possible ROE thereby
Increasing Uncertainty and Risk.

Copyright: M. S. Humayun 7
 Visualizing Financial Leverage (FL)
Impact on ROE & Capital Structure
LEVERED (Debt
ROE (%) & Equity) Firm:
77% Higher Slope.
ROE more
sensitive to
42% changes in EBIT
35% = <ROE>L
UN-LEVERED
21% = <ROE>UL (100% Equity)
Firm. Safer
Capital Structure
3.5% at Low EBIT’s
0%
EBIT (Rs)
50 300 600
Copyright: M. S. Humayun 8
Visualizing Impact of Financial Leverage
on ROE & Capital Structure
Un-Levered (100% Equity):
Lower ROE and Lower Risk.

Levered (Debt & Equity):

Risk Higher ROE but Higher Risk

Risk

Mean ROE Mean ROE

<ROE>Un-Levered <ROE>Levered =
= 21% 35%
Return on Equity ( ROE)%
Copyright: M. S. Humayun 9
 Capital Structure Theory
• Financial Leverage (FL = D / (D+E)):
– Increases Overall Return (Mean ROE) when EBIT/Total
Assets > Interest (or Cost of Debt then Leverage is Good
because small Increase in EBIT causes much LARGER Increase
in ROE.
– Increases Overall RISK (Standard Deviation of ROE) of FIRM.
Leverage will always MAGNIFY or AMPLIFY a small
change in EBIT into a LARGER change in ROE.
• Fundamental Principle in Risk-Return: Rational Investors in
Efficient Markets will only take Extra Risk if they are Compensated
by Sufficient Extra Return.
• Should the Management of a Firm undertake Financial Leverage? If
So, then how much Debt should a Firm have?
– Answer provided by Capital Structure Theory
Copyright: M. S. Humayun 10
 Modigliani - Miller: Fathers of Corporate
Finance
• “Cost of Capital, Corporate Finance, and The Theory of Investment” -
Revolutionary Article Published by Professors Modigliani & Miller in
American Economic Review in June 1958. Won Nobel Prize.
• “Pure M-M” (or Modigliani-Miller) Model - IDEAL CASE:
– Major Assumptions: No Taxes, No Bankruptcy Costs, Efficient Markets,
Equal Information Available to All Investors
– Major Conclusions:
• Capital Structure has NO AFFECT on VALUE of a FIRM ! Capital
Structure is Irrelevant !
• It does NOT matter how a firm finances its operations, how much debt
it has because is has NO bearing on a Firm’s Overall Value as
calculated using NPV !
• Corporate Financing & Capital Structure Decisions have no bearing on
Investment (or Capital Budgeting) Decisions.
• Capital Budgeting can be carried out without knowing the exact Capital
Structure of a Firm - you can assume 100% Equity (Un-levered) Firm.
Copyright: M. S. Humayun 11
 Modified MM - With Taxes
• Modigliani-Miller (With Corporate Tax)
– In most countries, a FIRM’s Interest Payments to Bond Holders
are NOT Taxed. But Dividend Payments to Equity Holders are
Taxed.
– Based on CORPORATE TAXES, FIRMS should prefer to
raise Capital using DEBT Financing.
• Merton-Miller (With Personal Tax)
– In most countries, INVESTORS pay a higher Personal Income
Tax on Interest Income from Bonds than on Dividend Income
from Equity (or Stocks).
– Based on PERSONAL TAXES, INVESTORS should prefer
to invest in STOCKS (or Equity).
• Uncertain Conclusion: Difficult to determine Net Effect. But,
practically speaking, Corporate Tax Effect is generally stronger so
Based on Taxes alone, Firms should prefer Debt.
Copyright: M. S. Humayun 12
Financial Management
Lecture No. 33
Capital Structure
Miller Modigliani- MM Theory
& Other Theories

Copyright: M. S. Humayun 1
 Recap of WACC, Business Risk, & Leverage
• WACC % = rD XD + rE XE + rP XP . (Debt,Common Equity, Preferred
Equity)
– Where “r” is ACTUAL COST which can be calculated from REQUIRED
ROR after accounting for Taxes & Transaction Costs.
• Use Net Proceeds (NP = Market Price – Transaction Costs) instead of
Market Price (Po) when calculating rD and rE.
• Two ways to calculate Cost of Equity rE: (1) Use Gordon’s Formula:
rE = (DIV 1 / Po) + g or (2) Use CAPM Theory: rE = rRF + (rM –
rRF) x Beta
– Equity Capital: If Not Enough Retained Earnings then Equity Capital
must be financed by New Stock Issuance which is more costly.
• Total Risk Faced by FIRM
– Total Stand Alone Risk of Firm = Business Risk + Financial Risk
• Standard Deviation of ROE (if Firm is Levered) = Standard Deviation of
ROE (if Firm is Un-Levered) + Financial Risk (from Debt)
• Note: Stand Alone Risk of Stock = Diversifiable ( or Company Specific)
Risk + Market Risk Copyright: M. S. Humayun 2
– Business Risk (from Operations and Assets but not Debt)
• Uncertainty & Fluctuations in Prices & Costs. Specific &
Market Causes.
• Higher Operating Leverage (OL= Fixed Costs / Total Cost)
– Good when FIRM’S SALES > BREAKEVEN POINT.
Small increase in sales can lead to large increase in
ROE.
– Bad if Sales < Breakeven Point. Higher Fixed Costs
means Higher Breakeven Point and More Chances of
Operating Loss. Risk of Large Drop in Return on Equity
<ROE> so Higher Risk.
– Financial Risk (from Debt, Bonds, or Loan ie. Leverage)
• Created when you take Loan or Debt or Financial Leverage
(FL = Debt / (Debt + Equity))

Copyright: M. S. Humayun 3
 Recap of Financial Risk
• Financial Risk is created when you take Loan or Debt or Issue Bonds ie.
Financial Leverage (FL). FL = Debt / (Debt + Equity). FL magnifies
small changes in EBIT (and sales) into large changes in ROE.
• Financial Risk = Standard Deviation of ROE (if Firm is Levered) -
Standard Deviation of ROE (if Firm is Un-levered)
• Financial Leverage (Debt Financing)
– FL =Debt / Total Assets =D/ A = Debt / (Debt+Equity) =D/(D+E)
– Good if it Increases Overall Return (Mean ROE) when EBIT/Total
Assets > Interest (or Cost of Debt then Leverage is Good because
small Increase in EBIT causes much LARGER Increase in ROE.
– Bad when it Increases Financial Risk and therefore the Overall RISK
(Standard Deviation of ROE) of FIRM. Leverage will always
MAGNIFY or AMPLIFY a small change in EBIT into a
LARGER change in ROE.
Copyright: M. S. Humayun 4
 Modigliani - Miller:
Fathers of Corporate Finance
• “Cost of Capital, Corporate Finance, and The Theory of Investment” -
Revolutionary Article Published by Professors Modigliani & Miller in
American Economic Review in June 1958. Won Nobel Prize later.
• “Pure M-M” (or Modigliani-Miller) Model – Case of an IDEAL
FINANCIAL WORLD:
– Major Assumptions of Pure MM Theory: No Taxes, No Bankruptcy
Costs, Equal Information, Efficient Markets
– Major Conclusions of Pure MM Theory:
• According to Pure MM Theory, Capital Structure has NO AFFECT
on VALUE of a FIRM ! It only affects the way a Firm decides to
distribute or split its cash outflows between the Equity Holders and
the Debt Holders.

Copyright: M. S. Humayun 5
 • It does NOT matter how a firm finances its operations, how much debt
it has because is has NO bearing on a Firm’s Overall Value of Firm
Value of Firm can be calculated using NPV Formulas from Capital
Budgeting
Value of Firm = Price of One Share x Number of Shares Outstanding
• According to Pure MM Theory, Corporate Financing & Capital
Structure Decisions have no bearing on Investment (or Capital
Budgeting) Decisions.
• Capital Budgeting can be carried out without knowing the exact
Capital Structure of a Firm - you can assume 100% Equity (Un-
levered) Firm when analyzing Project Investment Decisions and
Capital Budgeting.

Copyright: M. S. Humayun 6
 Modified MM - With Taxes
• Modigliani-Miller (With Corporate Tax)
– In most countries, a FIRM’s Interest Payments to Bond Holders are NOT
Taxed. Therefore, Interest Expenses (shown on P/L Statement)
provide Tax Shield or Tax Shelter. However, Dividend Payments to
Equity Holders ARE Taxed.
– Based on CORPORATE TAXES, FIRMS should prefer to raise
Capital using DEBT Financing.
• Merton-Miller (With Personal Tax)
– In most countries, INVESTORS pay a higher Personal Income Tax on
Interest Income from Bonds than on Dividend Income from Equity (or
Stocks).
– Based on PERSONAL TAXES, INVESTORS should prefer to invest
in STOCKS (or Equity).
• Impact of Taxes is Uncertain: Difficult to determine Net Effect of Taxes on
Optimal Capital Structure. But, practically speaking, Corporate Tax Effect is
generally greater and so Based on Taxes alone, Firms should prefer to
raise capital in the form of Debt.
Copyright: M. S. Humayun 7
Modified MM - With Bankruptcy Cost
• Bankruptcy: when a Firm is forced to close down because of continual
Losses and Net Cash Outflows, or Default on Interest Payments.
• Bankruptcy Costs Real Money - Companies Do Not Die in Peace !
Fees paid to Lawyers and Accountants, possible penalties and Legal
Claims by Suppliers, Buyers, & Partner Firms, and Loss on Sale of
Assets because Firm is forced to quickly Liquidate its Assets and repay
the Debt Holders (such as Banks) first.
• Even the THREAT or RUMOR of Bankruptcy can create problems for
a Firm. Suppliers refuse to supply raw materials and cancel Trade
Credit facilities. Banks demand higher Interest Rates. Customers
cancel Purchase Orders so sales fall.
• If Firm is EXCESSIVELY LEVERAGED (or has a Lot of Debt)
then there is a HIGHER Chance of Bankruptcy.
• For Certain Types of Firms, Debt is More Likely to Cause Bankruptcy:
– Firms with High Operating Leverage or high Fixed Costs
– Firms with Non-Liquid Assets that are difficult to sell quickly for cash
– Firms whose EBIT (or Earnings) Fluctuate a Lot
Copyright: M. S. Humayun 8
 Tradeoff Theory of Capital Structure
With Tax & Bankruptcy
• Decision regarding how much Debt (or Financial Leverage) is based on
Tradeoff between the Advantage of Debt & Disadvantage of Debt.
– Advantage of Debt over Equity: Interest Payments are Not Taxed.
Known as Interest Tax Saving or Tax Shield or Tax Shelter
– Disadvantage of Too Much Debt: Firm becomes more Risky so Lenders
and Banks Charge Higher Interest Rates and Greater Chance of
Bankruptcy
• When 100% Equity Firm adds a Small Amount of Debt, the Value of its
Stock Goes Up at first because Total Return Increases. Total Return = Net
Income (paid to Equity Holders) + Interest (paid to Debt Holders). But
if the Firm keeps adding too much debt then the Chance of Bankruptcy will
Offset the Initial Benefit and the Stock Value will Fall.
• Value of Firm = Price of One Share x Number of Shares Outstanding
• A range for the Optimal Capital Structure or Debt/Equity Mix can be
calculated in theory. This is where the Firm has Maximum Value and
Minimum WACC. Practically speaking it varies across industries and
companies. Optimal D/E can range from 20/80 to 70/30 and keeps
changing with time depending on the firm’s financial health and
growth strategy.
Copyright: M. S. Humayun 9
 Tradeoff Theory Graph
Leverage & Optimal Capital Structure
Slightly Leveraged Firm: Interest Tax
Shield Benefit. Total Return to Investors
Rises so Stock Value Rises. Total Return = Excessively Leveraged Firm:
Net Income (paid to Shareholders) + Threat of Bankruptcy has Real
Value of Interest (paid to Debt Holders) Costs. Less Investor
Firm or Confidence and Lower Share
Price of Price.

Stock
Firm Remains 100%
Equity (Un-Levered)

Financial Leverage =
OPTIMAL Capital
Structure - MAXIMUM Debt / Assets =
VALUE & MINIMUM
Copyright: M. S. Humayun D/(D+E) 10
WACC
Signaling Theory of Capital Structure
Improvement on Tradeoff Theory
• Signaling Theory: Practically speaking, NOT all Investors have equal
amount of information. A Firm’s Owners & Managers (Insiders) know
more about it than Ordinary Outside Investors.
• Signaling Theory: “Insiders (Managers & Owners) Know Better”
– When Firm’s Future genuinely looks Good (ie. High forecasted
Cash Flows, Earnings, NI, ROE…) then Managers will Choose to
raise financing through Debt (or Bonds or Loan) because they do
not want to share the Financial Gain with More Shareholders.
Rather They Prefer to Take On Debt and pay a small interest to the
Debt Holders. There is almost no risk of Default.
– When Firm’s Outlook looks Bad, then Managers will Choose to
raise capital by Issuing Equity (or Stock) to be able to share the
Likely Losses amongst more Shareholders (Owners). If they took
Debt and couldn’t repay it, they might Default and be forced to go
Bankrupt.
Copyright: M. S. Humayun 11
 Signaling Theory - Conclusions
• Practically speaking, Firms should maintain LESS Leverage than the
Optimal Level from Tradeoff Theory.
• Firms Should Save Some Reserve Debt Financing Capacity in case they
find a Great Project or Investment Opportunity. They should finance the
Project using Debt for 2 reasons:
– they don’t have to share the Financial Gains with more shareholders
AND
– they give the Right Signal to the Market of Investors about the good
health of their Firm !
– Debt Financing brings Financial Discipline and tighter cash control on
some Managers that waste Shareholders’ money
• News of New Equity Financing: Signals bad news. Investors will sell
stock and Market Price (Po) of Stock will fall. Therefore, Required ROR
(r = DIV/Po + g) will Rise and WACC will Increase. Now more difficult
for Projects and Investments to meet this Firm’s Capital Budgeting Criterion
by showing positive NPV (= Sum of {Cash Flows / (1+r)t }.
Copyright: M. S. Humayun 12
 Financial Management

Lecture No. 34
Optimal Capital Structure – Impact of Debt
on Firm Value & WACC Graphs

Copyright: M. S. Humayun 1
 Recap of WACC & Firm Risk
• WACC % = rD XD + rE XE + rP XP . 3 Basic Forms of Raising Capital:
D=Debt, E=Common Equity, & P=Preferred Equity. Uses Required ROR’s
adjusted by Taxes and Transaction Costs. “x” represent fractions of
MARKET VALUES of Debt or Equity. Should NOT use the Book Values
from Financial Statements used in Financial Accounting.
– Two Ways to Raise Equity Capital: (1) Retained Earnings which is
cheap way to raise equity AND (2) New Stock Issue which is more costly
– Two Ways to Calculate rE (Required ROR on Equity): (1) Gordon’s
Formula for Stock Pricing : rE = (DIV1/Po) + g AND (2) CAPM Theory
/ SML : rE = rRF + (rM – rRF)Beta
• Total Stand Alone Risk of Firm = Business Risk + Financial Risk
• Business Risk = Standard Deviation of ROE of Un-levered Firm
– Operating Leverage (OL) = Fixed Cost / Total Cost. OL increases
Business Risk. Small Change in Sales Causes Large Change in Operating
Income & ROE. OL can be Good when Sales > Breakeven.
Copyright: M. S. Humayun 2
• Financial Risk = Total Risk for Levered Firm - Business Risk
– Financial Leverage = Market Value of Debt / Market Value of
Total Assets = D / (D+E): FL increases Financial Risk. Small
Change in EBIT Causes Large Change in ROE. FL can be Good
when EBIT/Assets > Interest.
– Leverage Rises. Financial Distress & Higher chance of
Bankruptcy. Banks charge Higher Interest Rates. Higher Cost
of Debt. Higher Risk. Higher Beta. Higher Required Return on
Equity ( rE ). Higher Cost of Equity.

Copyright: M. S. Humayun 3
 Recap of Capital Structure Theories
• Miller Modigliani (MM) Theory – Case of Ideal World & Efficient
Markets
– Capital Structure, DEBT, & Corporate Financing have NO AFFECT
on Capital Budgeting, MARKET VALUE OF FIRM (V), NPV, &
Investment Decisions
– Remember that in Efficient Markets, the Fair Value of a Firm (calculated
using NPV) is approximately equal to the Market Value. The Firm’s
Value is determined by the Future Cash Flows generated by the Firm (or
Real Assets) and NOT by the way the cash flows are split or divided
amongst the Debt and Equity Holders.
– Market Value of Firm = V = EBIT / WACC . As Debt Increases, Risk
Increases so rD and rE and WACC should increase. BUT Debt is
cheaper than equity (recall Risk Theory) so as Debt Increases, WACC
should decrease ! Net Effect is No Change in WACC and No Change in
Value !
– Major Assumptions: No Taxes, No Bankruptcy Costs, Equal Information,
Efficient Markets
Copyright: M. S. Humayun 4
• MM Theory with Taxes
– Corporate Tax favors Debt Financing because of Interest Tax Shield. Personal
Tax favors Equity Capital. Net Effect is that Taxes favors raising Capital
through Debt Financing.
• Tradeoff Theory (With Taxes & Financial Distress / Bankruptcy)
– When Excessive Leverage (Debt or Borrowing) then Bankruptcy Costs begin
to Outweigh Benefits of Interest Tax Shield or Savings. At first, Firm’s Value
Rises because of Interest Tax Savings but as Debt increases, the Value reaches
a Maximum Point (where WACC is minimum) and then at excessive Debt
levels, the Value begins to fall.
• Signaling Theory (Market Signals)
– New Equity Issue gives signal to Market Investors that Firm’s financial future
looks bad so Market Price of Stock often falls. Cost of Equity and Required
ROR on Equity (rE ) increases.
– Debt Financing signals strong future earnings. Firms should save some Spare
or Reserve Debt Capacity in case they find an attractive Project or Investment.
– Save Some Spare or ReserveDebt Capacity for good investment opportunity.
Give right signal to market.
Copyright: M. S. Humayun 5
 Effect of Leverage on Cost of Debt & Equity
• Effect of Financial Leverage (or Debt) on Cost of Debt (rD):
– At Low Leverage, Increase in Leverage leads to Slight Increase in
Overall Risk and Return of Firm.
– At Higher Leverage, Risk of Financial Distress & Bankruptcy. Banks
Raise Interest Rate Charges. Cost of Debt Rises Faster. Required ROR
of Firm’s Debt Holders (rD ) Rises Faster.
• Effect of Financial Leverage (or Debt) on Cost of Equity (rE):
– Firm’s Total Risk Rises Slowly at Low Leverage and Faster when
Leverage becomes Excessive and Risk of Financial Distress arises.
Firm’s Stock Beta Rises. Firm’s Stock Required ROR (rE ) Rises.
• WACC = rDxD + rExE (assuming no Preferred Equity):
– Effect of Debt on WACC changes depending on choice of Theory.
– Pure MM Theory: WACC does Not Change. WACC curve is Flat.
– Traditionalist Theory (and Tradeoff Theory): WACC curve is broad U-
shaped Parabola with Minimum WACC point.

Copyright: M. S. Humayun 6
 Effect of Leverage on WACC
• WACC: Effect of Debt on WACC Changes.
– Pure MM View (Ideal Efficient Markets): No Taxes
and No Bankruptcy Costs. Debt increases Risk BUT is
also Cheaper than Equity so NO Net Effect on WACC.
So, Change in Debt has no effect on WACC and
Value. WACC curve is Flat.
– Traditionalist View (Tradeoff Theorists, Real Markets):
Combined Effect of Taxes and Financial Distress /
Bankruptcy Costs is a Flat U-Shaped WACC Curve
with a Minimum Point which represents the Optimal
Capital Structure (ie. Best Debt Ratio for the Firm).

Copyright: M. S. Humayun 7
 Pure MM Theory - Ideal Markets
WACC
Financial Risk.
Graph
Cost of Higher Required rE = Cost of Equity
Capital Return on Equity.
=WACC+D/E (WACC-rD)
Higher rE
(%)

WACC =
rE rDxD + rExE
rD rD = Cost
of Debt

Debt / Equity =
100% D/E = xD / ( 1- xD )
Equity Copyright: M. S. Humayun 8
Firm
 MM View - Ideal Markets Example
• A 100% Equity Firm (or Un-levered) has Total Assets of Rs 1000. It has a
WACCU of 21% (= rE,U ) and rD,U of 10%. It then adds Rs 400 of Debt.
Financial Risk increases rD,L of Levered Firm to 13%. What is the Levered
Firm’s rE,L and WACCL ?
• Assuming Pure MM View - Ideal Markets. Total Market Value of Assets of
Firm (V) is UNCHANGED. VU = VL . Also, WACC UNCHANGED by
Capital Structure and Debt. WACCU = WACCL = 21%

• rE,L =WACC + D/E (WACC - rD,L) = 21% + 400/600 (21% -

13%) = 26.3%
• rE,L= (WACC - rD,L xD)/ xE = (21% - 13% (400/1000)) /
(600/1000) = 26.3%
• Cost of Equity for Levered Firm = rE,L = Risk Free Interest Rate +
Business Risk Premium + Financial Risk Premium. rE,L Increases because
Required ROR for Stock Increased because of Financial Risk

Copyright: M. S. Humayun 9
 Pure MM Ideal Markets - Example
• Example: Assuming Pure MM Theory with Ideal Efficient Markets where Total
MARKET VALUE of Assets of Firm (V =D+E) is UNCHANGED by the
Capital Structure (and Leverage). Given the following Data on Leverage and
Cost of Capital:
Debt (D) Interest (rD) Equity Cost of Equity
(E = V-D) (rE= (WACC- rD xD)/ xE)
Rs 0 (=V) 0 Rs 1000 21% (=WACC) Un-Levered
Rs 200 10% (rRF) Rs 800 (21% - 10%(0.2))/0.8 =
23.75%
Rs 300 11% Rs 700 (21% - 11%(0.3))/0.7 = 25.3%
Rs 400 13% Rs 600 (21% - 13%(0.4))/0.6 = 26.3%
Rs 500 15% Rs 200 (21% - 15%(0.8))/0.2 = 45%
• Problem: In Real Markets, Total Market Value of Firm (V) DOES CHANGE
as Leverage Increases.

Copyright: M. S. Humayun 10
 Tradeoff Theory Graph –
Linked to Traditionalist Theory of
Leverage & Optimal Capital Structure
Slightly Leveraged Firm: Interest Tax
Shield Benefit. Total Return to Investors
Rises so Stock Value Rises. Total Return = Excessively Leveraged Firm:
Net Income (paid to Shareholders) + Threat of Bankruptcy has Real
Value of Interest (paid to Debt Holders) Costs. Less Investor
Firm or Confidence and Lower Share
Price of Price.

Stock
Firm Remains 100%
Equity (Un-Levered)

Financial Leverage =
OPTIMAL Capital Debt / Assets =
Structure - MAXIMUM
VALUE & MINIMUM
Copyright: M. S. Humayun D/(D+E) 11
WACC
 Traditionalist Theory - Real Markets
Bankruptcy Risk &WACC Graph
Cost of Costs. Higher
Required Return on
Capital Equity. Steeper Rise. rE,L = Cost of Equity = WACCU
(%) + xD(WACCU -rD) (1-TC)

WACCL = rD(1-Tc)xD + rExE

rE
rD = Cost of Debt
rD
Interest Tax Shield
Advantage

100% Optimal Debt / Equity =

Equity Capital D/E = xD / ( 1- xD )
Firm Structure
Copyright: M. S. Humayun
Note: xD = D / (D+E)
12
 Traditionalist View - Example
• Same Example: A 100% Equity Firm (or Un-levered) had Total Assets of Rs
1000. It had a WACCU of 21% (= rE,U ). It then added Rs 400 at a Cost of
Debt rD,L (for Levered Firm) of 13%. What is the Levered Firm’s rE,L and
WACCL ? Given Data for rE , Corporate Tax Rate of 30% on EBT, and
EBIT = Rs 300.
• Traditionalist View is based on Practical Reality. Leverage provides
Interest Tax Savings (or Shield) but also Increases Financial Risk.
Excessive Leverage leads to Bankruptcy Risk. Increase in Risk will Change
Value of Firm and WACC.
• Now rE is based on Observed Data. And Equity Value (E) is Based on
Simple Income Statement Formulas.

Copyright: M. S. Humayun 13
Traditionalists Formulas for Equity: E = NI / rE,L
Note: NI = EBIT - Interest - Tax = EBT - Tax
NI = (EBIT - xD rD ) (1 - Tc).
rE,L = WACCu + xD (WACCu - rD ) (1 - Tc).

Traditionalists Formula for WACC: WACCL = xD rD (1 - Tc) + xE rE .

(1-Tc) is the Tax Discount Factor.
Note: V = D + E
xD = D /V = D / (D+E)
xD + xE = 1
V = Market Value of Firm
D = Market Value of Debt
E = Market Value of Equity
xD = Fraction of Debt = A Measure of Leverage

Copyright: M. S. Humayun 14
 Financial Management

Lecture No. 35
Applied Capital Structure Numerical Examples,
NI & Tax Shield Approaches,
& Firm Beta

Copyright: M. S. Humayun 1
 WACC Recap
• Debt increases Financial & Bankruptcy Risk BUT it is a Practical Necessity: (1) Emergency
Financing, (2)_If Equity Not Available, (3) For Very Large Infrastructural Projects, and (4) To
improve short term ROE provided EBIT/Total Assets > Firm’s Cost of Debt (5) Interest Tax
Shield Benefit for Companies in Highest Tax Bracket. So Most Firms keep a MIX of Capital
BOTH in the form of Equity & Debt.
• WACC % = rD XD + rE XE + rP XP .
– 3 Basic Forms of Raising Capital: D=Debt, E=Common Equity, & P=Preferred Equity. Uses
Required ROR’s adjusted by Taxes and Transaction Costs. “x” represent fractions of MARKET
VALUES of Debt or Equity. Should NOT use the Book Values from Financial Statements used in
Financial Accounting.
• Effect of Debt (and Capital Structure) on WACC Depends on Choice of Theory:
– Pure MM Theory: WACC does Not Change. WACC curve is Flat. No Taxes and No Bankruptcy
Costs. Debt increases Risk BUT is also Cheaper than Equity so NO Net Effect on WACC. So,
Change in Debt has no effect on WACC and Value. WACC curve is Flat.
– Traditionalist Theory (and Tradeoff Theory): Combined Effect of Benefit from Interest Tax Shield
and Cost of Financial Distress & Risk of Bankruptcy is a Flat U-Shaped WACC Curve with a
Minimum Point which represents the Optimal Capital Structure (ie. Best Debt Ratio for the
Firm).
• Miller Modigliani (MM) Theory – Case of Ideal World & Efficient Markets
– Capital Structure, DEBT, & Corporate Financing have NO AFFECT on Capital Budgeting,
MARKET VALUE OF FIRM (V), NPV, & Investment Decisions. The Firm’s Value is
determined by the Future Cash Flows generated by the Firm (or Real Assets) and NOT by the way
the cash flows are split or divided amongst the Debt and Equity Holders. Major Assumptions:
No Taxes, No Bankruptcy Costs, Equal Information, Efficient Markets
Copyright: M. S. Humayun 2
 Pure MM Theory - Ideal Markets
WACC
Financial Risk.
Graph
Cost of Higher Required rE = Cost of Equity
Capital Return on Equity.
=WACC+D/E (WACC-rD)
Higher rE
(%)

WACC =
rE rDxD + rExE

rD rD = Cost
of Debt

Debt / Equity =
100% Measure of Leverage
Equity = D/E = xD / ( 1- xD )
Copyright: M. S. Humayun 3
Firm
 Tradeoff Theory Graph –
Linked to Traditionalist Theory of
Leverage & Optimal Capital Structure
Slightly Leveraged Firm: Interest Tax
Shield Benefit. Total Return to Investors
Rises so Stock Value Rises. Total Return = Excessively Leveraged Firm:
Net Income (paid to Shareholders) + Threat of Bankruptcy has Real
Value of Interest (paid to Debt Holders) Costs. Less Investor
Firm or Confidence and Lower Share
Price of Price.

Stock
Firm Remains 100%
Equity (Un-Levered)

Financial Leverage =
OPTIMAL Capital Debt / Assets =
Structure - MAXIMUM
MARKET
Copyright:VALUE &
M. S. Humayun D/(D+E) 4
MINIMUM WACC
 Traditionalist View - Real Markets
Bankruptcy Risk & WACC Graph
Cost of Costs. Higher
Required Return on
Capital Equity. Steeper Rise. rE,L = Cost of Equity = WACCU
(%) + xD(WACCU -rD) (1-TC)

WACCL = rD(1-Tc)xD + rExE

rE
rD = Cost of Debt
rD
Interest Tax Shield
Advantage

100% Debt / Equity =

Optimal Capital
Equity Structure Measure of Leverage
Firm MinimumCopyright:
WACC M. &S. Humayun D/E = xD / ( 1- xD )5
Maximum Market Value Note: xD = D / (D+E)
 Traditionalist View - Example
• Same Example: A 100% Equity Firm (or Un-levered) had Total Assets of Rs 1000. It
had a WACCU of 21% (= rE,U ). It then added Rs 400 at a Cost of Debt rD,L (for
Levered Firm) of 13%. What is the Levered Firm’s rE,L and WACCL ? Given Data for
rE , Corporate Tax Rate of 30% on EBT, and EBIT = Rs 300.
• Traditionalist View is based on Practical Reality. Leverage provides Interest Tax
Savings (or Shield) but also Increases Financial Risk. Excessive Leverage leads to
Bankruptcy Risk. Increase in Risk will Change MARKET Value of Firm and WACC.
• Now rE is based on Observed Data. And Equity Value (E) is Based on Simple Income
Statement Formulas.
• E = NI / rE Note: NI = EBIT - Interest - Tax = EBT - Tax
NI = (EBIT - xD rD ) (1 - Tc)
rE,L = WACCu + xD (WACCu - rD ) (1 - Tc).
• WACC = xD rD (1 - Tc) + xE rE . (1-Tc) =Tax Discount Factor
• Note: V = D + E xD = D /V = D / (D+E) xD + xE = 1
V = Market Value of Firm D = Market Value of Debt
E = Market Value of Equity
xD = Fraction of Debt = A Measure of Leverage
Copyright: M. S. Humayun 6
 Traditionalists -Real Markets Example
Debt (Rs.) rD (Interest) rE EBIT NI = EBT - Tax MV of Equity Market Value WACC (%)
(Given D) (Given) (Given (Rs.) (Rs.) ( E = NI / rE ) of Firm = D +E
)

300 – 30% of 300 210 / 0.21 0 + 1,000 21

0 0 21% 300 210 1,000 1,000

280 – 30% of 280 196 / 0.22 200 + 891 19.25

200 10% 22% 300 196 891 1,091

267 – 30% of 267 187 / 0.23 300 + 813 18.88

300 11% 23% 300 187 813 1,113

248 – 30% of 248 174 / 0.28 400 + 621 20.60

400 13% 28% 300 174 621 1,021

230 – 30% of 230 161 / 0.33 500 + 488 21.26

500 14% 33% 300 161 488 988

Copyright: M. S. Humayun 7
 Traditionalists -Real Markets Example
• Unlevered Case: D=0 , rE = 21% = WACC , MARKET VALUE of
Equity = E = V = MARKET VALUE of Firm (because No Debt) =
Rs1,000
• Leverage: Debt (and Leverage) is gradually increasing from Rs 200 to
Rs 500. Change in Leverage Changes the Firm’s Value. When
Market Value of Debt = Rs 400, Value has Increased to Rs 1021
whereas we assumed Value Fixed at Rs 1000 in Pure MM Ideal
Market Example.
• Optimal Capital Structure occurs when Market Value of Debt of
Rs 300 (ie. xD = D / V = Rs 300 / Rs 1113 = 0.2695. So a Financial
Leverage of 26.95% is the Best Capital Structure for this Firm.

Copyright: M. S. Humayun 8
 Traditionalists - Real Markets
Effect of Leverage on WACC
• Traditionalist Capital Structure Theory: Interest Tax Savings Increase, Cost
of Interest or Mark-up Increases, and Cost of Equity Increase. Depending
on the Rate of Increase, they can affect computation of Firm’s Market
Value (V) and WACC in different ways - either making them Increase
or Decrease.
• Traditionalist Capital Structure Theory: Effect of Increasing Leverage (as
measured by D/E or xD = D/V) on MARKET VALUE of Firm (V) is
Uncertain. Based on Combination of EBIT, Tax Rate, Leverage, and
Relative Costs of Debt & Equity.
• Traditionalist Capital Structure Theory: Practically speaking, Initially
Leverage adds Interest Tax Savings Benefit so Value (V) Rises but after
some point the Cost associated with Financial Distress and Bankruptcy
Risk makes the Value Fall. MARKET VALUE of Firm (V) typically
reaches a MAXIMUM VALUE where WACC is MINIMUM. This is
the Optimal Capital Structure.

Copyright: M. S. Humayun 9
 NI Approach for Calculating Numerical
WACC of Levered Firm - Example
• Starting Point for Calculating Numerical Value of WACC suing NI Approach is
EBIT of Firm = Rs 100 and Corporate Tax Rate Tc = 30%
– If the Firm is 100% Equity (or Un-Levered) and rE = 20% then what is the
WACCU of Un-levered Firm?
• NI = EBIT - Interest - Tax = 100 - 0 - 0.3(100) = Rs 70
• Market Value of Un-levered Equity = E u = NI / rE = 70 / 0.2 = Rs 350
• Market Value of Un-levered Firm = Vu = E + D = 350 + 0 = Rs 350
• WACC u = rE,U = 20%
– If the Firm takes Rs 100 Debt at 10% Interest or Mark-up then what is the
WACCL of Levered Firm ?
• NI = 100 - 10%(100) - Tax = 100 - 10 - 0.3(90) = Rs 63
• E = NI / rE = 63 / 0.2 = Rs 315 (Major Assumption: No change in rE)
• VL = E + D = 315 + 100 = Rs 415. (Increasing Debt ADDS Value!)
• WACCL = rD,L(1-Tc)xD + rE,LxE = 0.1(1-0.3)(100/415) + 0.2(315/415) = 16.9%
• Sequence of Steps: (1) Calculate NI = EBIT – Interest - Tax (2) Calculate E = NI /
rE (3) Calculate VL = E + D (4) Calculate WACC L
Copyright: M. S. Humayun 10
Tax Shield Approach (or NOI Approach) to
Calculating WACC of Levered Firm
• Relationships between Un-Levered Costs and Levered Costs of
Capital
• Sequence of Steps for NOI Approach for Calculating Numerical
Value of WACC for Levered Firm
– Step 1: Starting Point is Market Value of Levered Firm = VL =
VU + TC D. Unrealistic because VL should NOT keep increasing
with D
– Step 2: Tc x D = Tax Shield Advantage from Debt.
– Step 3: Market Value of Equity = E = VL - D .
– Step 4: Calculate rE,L = NI / E.
– Step 5: Calculate WACCL = rD,L(1-Tc)xD + rE,LxE
– Note: WACCL =WACCU (1-Tc) xD
• Use Either NI Approach or Tax Shield Approach depending on
what Data has been given to you.
Copyright: M. S. Humayun 11
Other Short-cut Formulas & Link
Between Capital Structure & Betas
• Cost of Equity (After Tax) Estimates and STOCK
BETAS
– rE,L = WACCU + xD (WACCU -rD) (1-TC)
– rE,L = rE,U + D/E (rE,U -rD) (1-TC)

– rE,U = rRF + BETAE ( rM - rRF ) Recall from

CAPM Theory
• WACC (After Tax) Estimates AND FIRM BETA
– WACCL = rD,L(1-Tc)xD + rE,LxE
– WACCL = rRF + BETAWACC,L ( rM - rRF )
– Note: Overall Beta for the Firm =
Copyright: M. S. Humayun 12
BETAWACC,L = BetaD xD + BetaE xE
 Financial Management
Lecture No. 36
Review of Capital Structure, Leverage,
WACC, & Betas

Copyright: M. S. Humayun 1
 Recap of WACC & Firm Risk
• WACC % = rD XD + rE XE + rP XP . 3 Basic Forms of Raising Capital:
D=Debt, E=Common Equity, & P=Preferred Equity. Uses Required ROR’s
adjusted by Taxes and Transaction Costs. “x” represent fractions of MARKET
VALUES of Debt or Equity. Should NOT use the Book Values from Financial
Statements used in Financial Accounting.
– Two Ways to Raise Equity Capital: (1) Retained Earnings which is cheap
way to raise equity AND (2) New Stock Issue which is more costly
– Two Ways to Calculate rE (Required ROR on Equity): (1) Gordon’s
Formula for Stock Pricing : rE = (DIV1/Po) + g AND (2) CAPM Theory /
SML : rE = rRF + (rM – rRF)Beta
• Total Stand Alone Risk of Firm = Business Risk + Financial Risk
• Business Risk = Standard Deviation of ROE of Un-levered Firm
– Operating Leverage (OL) = Fixed Cost / Total Cost. OL increases Business
Risk. Small Change in Sales Causes Large Change in Operating Income &
ROE. OL can be Good when Sales > Breakeven.

Copyright: M. S. Humayun 2
 • Financial Risk = Total Risk for Levered Firm - Business Risk
Financial Leverage = Market Value of Debt / Market Value of Total Assets
= D / (D+E): FL increases Financial Risk. Small Change in EBIT Causes
Large Change in ROE. FL can be Good when EBIT/Assets > Interest.
Leverage Rises. Financial Distress & Higher chance of Bankruptcy.
Banks charge Higher Interest Rates. Higher Cost of Debt. Higher
Risk. Higher Beta. Higher Required Return on Equity ( rE ). Higher
Cost of Equity.

Recap of Capital Structure Theories

• Miller Modigliani (MM) Theory – Case of Ideal World & Efficient Markets
Capital Structure, DEBT, & Corporate Financing have NO AFFECT on
Capital Budgeting, MARKET VALUE OF FIRM (V), NPV, & Investment
Decisions
Remember that in Efficient Markets, the Fair Value of a Firm (calculated
using NPV) is approximately equal to the Market Value. The Firm’s Value is
determined by the Future Cash Flows generated by the Firm (or Real Assets)
and NOT by the way the cash flows are split or divided amongst the Debt
and Equity Holders. Copyright: M. S. Humayun 3
 – Market Value of Firm = V = EBIT / WACC . As Debt Increases,
Risk Increases so rD and rE and WACC should increase. BUT
Debt is cheaper than equity (recall Risk Theory) so as Debt
Increases, WACC should decrease ! Net Effect is No Change in
WACC and No Change in Value !
– Major Assumptions: No Taxes, No Bankruptcy Costs, Equal
Information, Efficient Markets
• MM Theory with Taxes
– Corporate Tax favors Debt Financing because of Interest Tax Shield.
Personal Tax favors Equity Capital. Net Effect is that Taxes favors
raising Capital through Debt Financing.
• Tradeoff Theory (With Taxes & Financial Distress / Bankruptcy)
– When Excessive Leverage (Debt or Borrowing) then Bankruptcy Costs
begin to Outweigh Benefits of Interest Tax Shield or Savings. At first,
Firm’s Value Rises because of Interest Tax Savings but as Debt
increases, the Value reaches a Maximum Point (where WACC is
minimum) and then at excessive Debt levels, the Value begins to fall.

Copyright: M. S. Humayun 4
• Signaling Theory (Market Signals)
New Equity Issue gives signal to Market Investors that Firm’s
financial future looks bad so Market Price of Stock often falls. Cost
of Equity and Required ROR on Equity (rE ) increases.
Debt Financing signals strong future earnings. Firms should save
some Spare or Reserve Debt Capacity in case they find an attractive
Project or Investment.
Save Some Spare or ReserveDebt Capacity for good investment
opportunity. Give right signal to market.

Copyright: M. S. Humayun 5
 Effect of Leverage on Cost of Debt & Equity
• Effect of Financial Leverage (or Debt) on Cost of Debt (rD):
– At Low Leverage, Increase in Leverage leads to Slight Increase in
Overall Risk and Return of Firm.
– At Higher Leverage, Risk of Financial Distress & Bankruptcy. Banks
Raise Interest Rate Charges. Cost of Debt Rises Faster. Required ROR
of Firm’s Debt Holders (rD ) Rises Faster.
• Effect of Financial Leverage (or Debt) on Cost of Equity (rE):
– Firm’s Total Risk Rises Slowly at Low Leverage and Faster when
Leverage becomes Excessive and Risk of Financial Distress arises.
Firm’s Stock Beta Rises. Firm’s Stock Required ROR (rE ) Rises.
• WACC = rDxD + rExE (assuming no Preferred Equity):
– Effect of Debt on WACC changes depending on choice of Theory.
– Pure MM Theory: WACC does Not Change. WACC curve is Flat.
– Traditionalist Theory (and Tradeoff Theory): WACC curve is broad U-
shaped Parabola with Minimum WACC point.

Copyright: M. S. Humayun 6
 Traditionalist View - Example
• FIRM’S VALUE = EBIT / COST OF CAPITAL (Also known as MM Proposition I)
• MORE LEVERAGE (OR DEBT) MEANS MORE RISK WHICH MEANS HIGHER
COST OF CAPITAL AND THEREFORE LOWER VALUE
• Traditionalist View is based on Practical Reality. Leverage provides Interest Tax Savings
(or Shield) but also Increases Financial Risk. Excessive Leverage leads to Bankruptcy
Risk. Increase in Risk will Change Value of Firm and WACC.
• Traditionalists Formulas for Equity: E = NI / rE,L
Note: NI = EBIT - Interest - Tax = EBT - Tax
NI = (EBIT - xD rD ) (1 - Tc).
rE,L = WACCu + xD (WACCu - rD ) (1 - Tc).
• Traditionalists Formula for WACC: WACCL = xD rD (1 - Tc) + xE rE .
(1-Tc) is the Tax Discount Factor.
• Note: V=D+E xD = D /V = D / (D+E) xD + xE = 1
V = Market Value of Firm D = Market Value of Debt
E = Market Value of Equity
xD = Fraction of Debt = A Measure of Leverage
Copyright: M. S. Humayun 7
 Tradeoff Theory Graph –
Linked to Traditionalist Theory of
Leverage & Optimal Capital Structure
Slightly Leveraged Firm: Interest Tax
Shield Benefit. Total Return to Investors
Rises so Stock Value Rises. Total Return = Excessively Leveraged Firm:
Net Income (paid to Shareholders) + Threat of Bankruptcy has Real
Value of Interest (paid to Debt Holders) Costs. Less Investor
Firm or Confidence and Lower Share
Price of Price.

Stock
Firm Remains 100%
Equity (Un-Levered)

Financial Leverage =
OPTIMAL Capital Debt / Assets =
Structure - MAXIMUM
VALUE & MINIMUM
Copyright: M. S. Humayun D/(D+E) 8
WACC
 Traditionalist Theory - Real Markets
Bankruptcy Risk &WACC Graph
Cost of Costs. Higher
Required Return on
Capital Equity. Steeper Rise. rE,L = Cost of Equity = WACCU
(%) + xD(WACCU -rD) (1-TC)

WACCL = rD(1-Tc)xD + rExE

rE
rD = Cost of Debt
rD
Interest Tax Shield
Advantage
Debt / Equity = A
100% Optimal Capital
Structure = Minimum Measure of
Equity
WACC and Leverage = D/E = xD
Firm MaximumCopyright:
Value M. S. Humayun / ( 1- xD ) 9
Note: xD = D / (D+E)
•
MM View - Ideal Markets Example
COST OF DEBT IS GENERALLY LESS THAN COST OF EQUITY. COST OF
EQUITY IS PROPORTIONAL TO RISK PREMIUM (Known as MM Proposition II)
• SO, MORE LEVERAGE (OR DEBT) MEANS LOWER WEIGHTED AVERAGE
COST OF CAPITAL.
• TRADITIONALISTS SAID THAT MORE LEVERAGE (OR DEBT) MEANS MORE
RISK AND HIGHER COST OF CAPITAL.
• MM COMBINED BOTH EFFECTS AND SAID THAT THE NET EFFECT IS NO
CHANGE IN COST OF CAPITAL AND VALUE !
• CHANGES IN CAPITAL STRUCTURE CAN’T AFFECT FIRM’S VALUE BECAUSE
OTHERWISE RATIONAL INVESTORS WOULD MAKE EASY MONEY FROM
ARBITRAGE.
• Assuming Pure MM View - Ideal Markets. Total Market Value of Assets of Firm (V) is
UNCHANGED. VU = VL . Also, WACC UNCHANGED by Capital Structure and Debt.
WACCU = WACCL
• rE,L =WACC + D/E (WACC - rD,L) AND rE= (WACC- rD xD)/ xE
• Cost of Equity for Levered Firm = Risk Free Interest Rate + Business Risk Premium +
Financial Risk Premium. rE,L Increases because Required ROR for Stock Increased
because of Financial Risk Copyright: M. S. Humayun 10
 Pure MM Theory - Ideal Markets
WACC
Financial Risk.
Graph
Cost of Higher Required rE = Cost of Equity
Capital Return on Equity.
=WACC+D/E (WACC-rD)
Higher rE
(%)

WACC =
rE rDxD + rExE
rD rD = Cost
of Debt
Debt / Equity = A
100% Measure of Leverage =
D/E = xD / ( 1- xD )
Equity Copyright: M. S. Humayun 11
Firm
 Traditionalists - Real Markets
Effect of Leverage on WACC
• Traditionalist Capital Structure Theory: Interest Tax Savings Increase, Cost
of Interest or Mark-up Increases, and Cost of Equity Increase. Depending
on the Rate of Increase, they can affect computation of Firm’s Market
Value (V) and WACC in different ways - either making them Increase or
Decrease.
• Traditionalist Capital Structure Theory: Effect of Increasing Leverage (as
measured by D/E or xD = D/V) on MARKET VALUE of Firm (V) is
Uncertain. Based on Combination of EBIT, Tax Rate, Leverage, and
Relative Costs of Debt & Equity.
• Traditionalist Capital Structure Theory: Practically speaking, Initially
Leverage adds Interest Tax Savings Benefit so Value (V) Rises but after
some point the Cost associated with Financial Distress and Bankruptcy
Risk makes the Value Fall. MARKET VALUE of Firm (V) typically
reaches a MAXIMUM VALUE where WACC is MINIMUM. This is the
Optimal Capital Structure.

Copyright: M. S. Humayun 12
 Capital Structure – 2 Approaches for
Estimating Numerical WACC & Value
• NI Approach
– Starting Point is EBIT (which is given)
– EBIT  NI (=EBIT–Interest–Tax)  EL (=NI/rE assuming no change
in rE levered or un-levered !)  VL (=EL+D where D is given)  WACCL
(=rD,L(1-Tc)xD + rExE ). Note WACCU = rE

• Tax Shield Approach (or NOI Approach)

– Starting Point is Market Value of Un-levered Firm Vu which is given
– VL (= VU + TC D. Assumes that VL will keep increasing with D ! TcD =
Tax Shield Advantage from Debt)  EL (=VL – D)  rE,L (= NI /E) 
WACCL (= rD,L(1-Tc)xD + rE,LxE . Note WACCL =WACCU (1-Tc) xD
Copyright: M. S. Humayun 13
 Other Short-cut Formulas & Link
Between Capital Structure & Betas
• Cost of Equity (After Tax) Estimates and STOCK BETAS
– rE,L = WACCU + xD (WACCU -rD) (1-TC)
– rE,L = rE,U + D/E (rE,U -rD) (1-TC)

– rE,U = rRF + BETAE ( rM - rRF ) Recall from CAPM

Theory
• WACC (After Tax) Estimates AND FIRM BETA
– WACCL = rD,L(1-Tc)xD + rE,LxE
– WACCL = rRF + BETAWACC,L ( rM - rRF )
– Note: Overall Beta for the Firm = BETAWACC,L
= BetaD xD + BetaE xE

Copyright: M. S. Humayun 14