Effect of Leverage on Shareholders
The total income to both debt holders and equity holders of levered Company L is higher. The reason is that while debt-holders receive interest without tax-deduction at the corporate level, equity-holders of Company L have their incomes after tax-deduction. As a result, total income to both types of investors increases by the interest payment times the rate, that is. Rs 3,00,000 x 0.35 = Rs 1,05,000.
Assuming further that the debt employed by Company L is permanent, the advantage to the firm equivalent to the present value of the tax shield, that is Rs 7 lakh (Rs 1.05.000/0.15). Alternatively, it can be determined with reference to Equation 15.15.
It may be noted that value of levered firm (as shown by equation 15.14) reckons this tax shield due to debt.
The implication of MM analysis in this case is that the value of the firm is maximized when its structure contains only debt. In other words a firm can lower its cost of capital continually increased leverage. However, the extensive use of debt financing would expose business to high probabilities of default, it would find it difficult to meet the promised payments of interest and principal. Moreover, the firm is likely to incur cost and suffer penalties if it fails to make payments of interest and principal when they become due. Legal expenses, disruption of operations, and loss of potentially profitable opportunities may result it. As the amount of the capital structure increases so does the probability of incurring these cost. Consequently, there are disadvantages of debt, and may cause a rise in the cost of capital owing to the increased financial risk and may reduce the value of the firm. Again, we find that proposition is unjustified when leverage is extreme, that is, when the firm uses 100 per cent debt and no equity. Clearly. the optimal capital structure is not one which has the maximum amount of debt but, one which has the desired amount of debt, determined at a point and/or range where that, overall cost of capital is minimum, Modigliani are also recognize that extreme leverage increases financial risk as also the cost of capital. They suggest that firms should adopt the ratio, as not to violate limits of leverage imposed of the creditors. This suggestion indirectly admits that there is a safe limit for the use of cost and firms should not use debt beyond that limit/point. It implies that the cost of capital rises beyond a certain level on the use of debt. There, is, therefore, an optimal capital structure.