Page 107 - DMGT409Basic Financial Management

Basic Financial Management

Notes The position of Mr.X is summarized as below.

Firm L
Investment amount (10% holding) 18,750
Dividend income (10% of 30000) 3,000
Return on funds 3000 = 16%
18,750
Firm U
Investment amount (18,750 + 50,000) = 68,750
(50,000 borrowed at 10%)
68,750
Totalincome × 80,000 = 8,593.75
6,40,000

Less: Interest on loan 5,000
Return on investment 3,593.75
3,593.75
ROI = = 19.16%
18,750
So Mr. X gets a higher income after shifting his investment to company U (Rs 3,000 and 3,593.75)
His ROI increases from 16% to 19%. The other investors will also wish to make profi t out of

arbitrage. This increases the demand for securities of the firm U and will lead to increase in
its price. At the same time, the price of the security of the fi rm L will decline due to the selling
pressure. This will continue till the prices of the securities of the firms become identical.

!

Caution Impact of the corporate taxes
MM argues that the value of the firm will increase and cost of capital will decrease with

leverage. Interest paid on the debt is tax deductible and therefore, effective cost of debt is
less than the coupon rate of interest. Therefore, levered firm would have a greater market

value than the unlevered firm (cost capital of levered firm would be lower).

Symbolically:
VL = VU + BT
VL = Value of levered fi rm

Vu= Value of unlevered fi rm
6.6 Optimum Capital Structure

In taking a fi nancing decision, the financial manager’s job is to come out with an optimum

capital structure. Optimum capital structure is that capital structure at that level of debt - equity
proportion, where the market value per share is maximum and the cost of capital is minimum.
The same to quote, Ezra, “optimum leverage is that mix of debt and equity which will maximise
the market value of the company and minimise the company’s overall cost of capital.”
The optimum capital structure keeps balance between share capital and debt capital. The primary
reason for the employment of debt by an enterprise can be stated as upto a certain point, debt
is from the point of view of the ownership, a less expensive source of funds than equity capital.
Hence, optimum capital structure keeps a balance between debt capital and equity capital.

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