AFM Theories

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Kartik Venkateshwaran -

 Venkatesh Chary -Chirag Karunakar -

Sneha Shenoy -

 Annie Nadar -

Ruchi Bhattu -

Priya Mani -

Preeti Singh -

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Net Income ApproachCapital Structure decision is relevant to the valuation

of the firm.

In other words, a change in the financial leverage willlead to a corresponding change in the overall cost of capital as well as the total value of the firm.

If therefore the degree of financial leverage as

measured by the ratio of debt to equity is increased,the WACC will decline, while the value of the firm as well as the market price of share will increase and vice versa.

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Assumption in Net Income

Approach

First there are no taxes.

Second the cost of debt is less than the cost of equity.

Third the use of debt does not change the risk perceptionof investor.

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Example 1

 A company’s expected annual EBIT is Rs. 50000. The

company has Rs 2,00,000, 10% debenture. The cost of 

equity of the company is 12.5%. 

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SolutionNet Operating Income (EBIT) Rs 50,000

Less: Interest on debentures (I) 20,000

Earnings available to equity holders (NI) 30,000

Equity Capitalization Rate (ke) 0.125

Market Value of Equity (E) = NI/Ke 2,40,000Market Value of Debt (D) 2,00,000

Total Value of the firm (E+D) = V 4,40,000

Overall cost of capital = Ke = EBIT/V (%) 11.36

 Alternatively: Ko = Ki (D/V) + Ke (E/V)

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Example 2 There are 2 firms A and B similar in all aspects in

degree of leverage employed by them. Financial data isas follows

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SolutionFirm A Firm B

Operating Income (O) 10000 10000

Interest on Debt (I) 0 3000

Equity Earnings (P) 10000 7000Cost of equity capital (rE) 10% 10%

Cost of debt capital (rD) 6% 6%

Market value of equity (E) 100000 70000

Market value of debt (D) 0 50000Total value of the firm (V) 100000 120000

 Average Cost of Capital(r A ) = rD(D/V)+rE(E/V) 

10% 8.33%

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Net Operating Income Approach Introduced by Mr. David Durand.

The Essence of this approach is that the capital

structure decision of a firm is irrelevant. Change in leverage does not lead to any change in

total value of the firm and the market prices of theshares

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Assumptions The overall cost of capital (K) remains constant for

all degrees of debt- equity mix.

The market capitalises the value of the firm as a whole and therefore , the spilt between debt andequity is not relevant .

The low cost debt increases the risk of equity 

shareholders , this results in increase in equity capitalization rate .

 An increase in the use of debt is offset by an

increase in the equity capitalization rate . 9

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Example of NOI ApproachGiven:

EBIT/NOI = Rs.50,000

Total debt outstanding = Rs.2,00,000

Cost of debt = 10%

Overall cost of capital = 12.5%

 Ans:

 Value of the firm = EBIT/ overall cost of capital

= 50,000/12.5%

= 4,00,000

 Value of equity = Value of the firm – value of debt

= 4,00,000 – 2,00,000

= 2,00,000

Cost of equity = (EBIT- Int.)/ value of equity 

= (50,000 – 20,000) / 2,00,000 * 100

= 15%

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Case 1: 

If the debt is increased to 3,00,000.

 Value of the firm = 4,00,000……remains constant  Value of equity = 4,00,000 – 3,00,000

= 1,00,000

Cost of equity = (50000- 30000)/ 1,00,000* 100

= 20%Case 2:

If the debt is decreased to 1,00,000.

 Value of the firm= 4,00,000….. remains constant 

 Value of equity = 4,00,000 – 1,00,000

= 3,00,000

Cost of equity = (50000- 10000)/ 3,00,000 * 100

= 13.33%

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TRADITIONAL APPROACHMain propositions are – 

Cost of debt remains more or less constant upto a

certain degree of leverage and then remains stable andthereafter rises at an increasing rate.

Cost of equity remains more or less constant upto acertain degree of leverage and rises sharply thereafter.

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The average cost of capital as the consequence of theabove behavior of cost of debt and cost of equity is asfollows – 

a) Decreases upto a certain point

b) Remains more or less unchanged for moderateincreases in leverage

c) Rises beyond that at an increasing rate.

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SOLUTION

R 

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SOLUTION

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EXAMPLE 2

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SOLUTION

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SOLUTION

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 THANK YOU

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