- (a) What will be the impact of taxation on MM Theory on capital structure?
- X Ltd. has Rs. 10,00,000 in 10% Debentures. The equity capitalization rate is 12%. The company is expecting an annual earnings before interest and taxes of Rs. 25,00,000.
You are required to:
- Calculate the value of the firm and overall cost of capital using NI Approach (Ignore Tax).
- Re-calculate the value of the firm and overall cost of capital if the company decides to:
- Raise Rs. 25,00,000 by issue of 10% Debentures and use the proceeds to redeem some of the equity shares.
- Re-calculate the value of the firm and overall cost of capital if the company decides to:
Raise Rs. 25,00,000 by issue of equity shares and use the proceeds to redeem some of the debentures.
(a) The impact of taxation on the Modigliani-Miller (MM) theory of capital structure is that it introduces a tax shield on interest payments, which can affect the optimal capital structure of a firm. The tax shield refers to the reduction in taxable income due to deducting interest expenses from taxable earnings.
Under the MM theory without taxes, the capital structure of a firm is irrelevant, meaning that the value of the firm and its cost of capital are unaffected by the mix of debt and equity financing. However, when taxes are considered, the presence of the tax shield can make debt financing more advantageous compared to equity financing.
The tax shield benefits arise because interest payments on debt are tax-deductible expenses. This reduces the taxable income of the firm, resulting in a lower tax liability. As a result, the after-tax cash flows to equity holders increase, leading to an increase in the value of the firm.
In the presence of taxation, the MM theory suggests that the optimal capital structure for a firm involves a higher proportion of debt financing to maximize the tax shield benefits. However, it’s important to note that excessive debt can increase financial risk and financial distress costs, which need to be considered in practice.
(b) (i) Calculation using the NI (Net Income) Approach (Ignore Tax): Value of the firm = EBIT / k Value of the firm = Rs. 25,00,000 / 0.12 = Rs. 2,08,33,333.33
Overall cost of capital = EBIT / Value of the firm Overall cost of capital = Rs. 25,00,000 / Rs. 2,08,33,333.33 = 0.12 or 12%
(ii) (A) Raising Rs. 25,00,000 by issuing 10% Debentures and using the proceeds to redeem some equity shares: The value of the firm remains the same since there is no change in the EBIT. The overall cost of capital also remains the same at 12% since the cost of equity and debt remain unchanged.
(B) Raising Rs. 25,00,000 by issuing equity shares and using the proceeds to redeem some debentures: The value of the firm remains the same since there is no change in the EBIT. The overall cost of capital will decrease. However, the exact calculation requires additional information such as the cost of equity and the new capital structure after the redemption of debentures. Without this information, the impact on the overall cost of capital cannot be determined accurately.
It’s important to note that in practice, taxes play a significant role in capital structure decisions. Considering the tax shield benefits, the actual impact of issuing debt or equity and redeeming securities will depend on various factors such as tax rates, costs of debt and equity, and financial risk considerations.
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