Capital structure

 It is the types of securities to be

issued and proportionate amounts
that make up the capitalization.
 Capital gearing:- the relationship
between ownership capital and
creditor ship capital
 Highly geared when cc> oc
 Low geared when co>cc
Factors affecting capital structure

Trading
On equity or
Financial
leverage
Cost of
control
financing

Capital factors Flexibility of

market financial
conditions structure

Statutory Period of
requirements financing
 Financial structure and capital structure

 FS = long term + short term

liabilities
 Capital structure = long term
liabilities
 Approaches – capital structure

 Approaches to determine the firm’s

capital structure:-

– Ebit eps analysis

– Cost of capital
– Cash flow analysis
 CS planning

 It implies selecting the desired debt equity mix

 The min rate of return expected by the supplier of

finance is called the COST OF CAPITAL
 It depends on the degree of risk assumed by the
investors
 Debt holders assume less risk than shareholders
 The tax deductibility of interest charges further
decreases the cost of debt.
 The firm will always like to employ debt as a SOURCE
OF FINANCE
if cost of capital is a CRITERION for financing
decisions
 OPTIMUM CAPITAL STRUCTURE

 The relationship of debt and equity which maximizes

the value of the firm’s share in the stock exchange.
 Theories of capital structure

 Net income approach

 Net operating income

 Traditional approach

 Modigliani- Miller approach

 RELATION BETWEEN FINANCIAL LEVERAGE
AND VALUE OF THE FIRM

 DEBT EQUITY MIX---- FINANCIAL LEVERAGE

 VALUE OF THE FIRM- DEBT + EQUITY

 ASSUMPTIONS:-
 ONLY TWO TYPES OF CAPITAL EMPLOYED:-- DEBT AND EQUITY
 TOTAL ASSETS REMAIN THE SAME
 NO RETAINED EARNINGS
 PERPETUAL LIFE
 FIRM’S OPERATIVE EARNINGS ( EBIT) REMAINS CONSTANT
 FIRMS’ BUSINESS RISK REMAINS THE SAME
 TOTAL FINANCING OF THE FIRM REMAINS THE SAME
 NO TAX
RELATIONSHIP
CAPITAL
STRUCTURE
COST OF
CAPITAL
VALUE OF
THE FIRM
 Net income approach
 Net operating income approach
 Traditional approach
 Modigliani miller approach

 Total market value of equity (E)

 Total MV of debt (D)
 Total MV of the firm (V)
 Total interest on debt capital(I)
 Net operating income available to the equity shareholders
 Cost of equity Ke = EBIT – I / E
 Ke = eps/P
 Value of equity = E = ebit-I / Ke
 Cost of debt Kd = I / D
 Value of debt = I/Kd
 V=E+D
 Kw = Wd Kd + We Ke
 Wd = proportion of debt to total value
 NET INCOME APPROACH

 Suggested by DAVID DURAND

 Value of the firm depends on its
capital structure decision
 High debt content in the CS =
high FL Enhance
High debt
Value of
 V=E+D content
FIRM
 E= EBIT-I / Ke
 D= I/Kd
 In the light of the graph it is clear
that as D/E enhances . Kw
decreases because the proportion
of debt enhances in the CS
Reduction
Overall
Cost of capital
 A ltd is expecting an annual EBIT of rs 2 lakh. The co.. has 8%
debentures of rs5 lakh. The cost of capital is 10%. Compute
the total value of the company and overall cost of capital.
 EBIT 200000
less interest 40000
EBT 160000 earnings available to ESH
Ke 10%
Market value of equity (E) = EBIT – I /Ke
16,00,000
total value of the company = 16L + 5L
overall COC Kw = EBIT / V = 9.5%
 Net operating income approach

 Advocated by David Durand

 Value of a firm depends on its NOI and business risk
 Change in the degree of leverage a firm cannot change its
NOI and Business risk
 It brings variation in the distribution of income and risk
between debt and equity without affecting the total income
and risk which influences the market value of the firm.
 Optimum CS
 When there is 100% debt content
 Assumptions:-
– Kw is constant for all degree of leverage
– NOI is capitalized at an overall capitalization rate to find out the
total market value of the firm. Thus the split between D & E is
irrelevant.
 The use of low cost debt enhances the risk of equity
share holders, enhancing the equity capitalization rate.
Thus the benefit of DEBT is nullified by the increase in the
EQUITY CAPITALIZATION RATE.

 V = EBIT / Kw

 An increase in the use of debt funds is offset by an

increase in the equity capitalization rate. This occurs
because the equity investors seek more
compensation as they are exposed to higher risk
arising from increase in the degree of leverage.
 AB ltd has an EBIT of 2 L. the company has 8% debentures of
Rs 5L. Presuming the overall capitalisation rate as 10%,
compute the total value of the company and equity
capitalisation rate

– EBIT 200000
– Kw 10%
– Mkt value of the company 200,000/10% = 20,00,000
– Total value of debt 500,000
– Market value of equity 15,00,000
– Ke = EBIT – I / D * 100 = 10.67%
 If the company increases the debt content by
decreasing the equity content, the total value
of the company would remain unchanged but
the capitalization rate will increase.
 TRADITIONAL APPROACH

 COST OF CAPITAL IS DEPENDENT ON THE CAPITAL STRUCTURE

 THE MAIN PROPOSITIONS OF THIS APPROACH ARE:-
– COST OF DEBT CAPITAL REMAINS CONSTANT UPTO A CERTAIN
DEGREE OF LEVERAGE AND THERE AFTER RISES

– COST OF EQUITY CAPITAL REMAINS CONSTANT MORE OR LESS OR

RISE GRADUALLY UPTO A CERTAIN DEGREE OF LEVERAGE AND
THEREAFTER INCREASES RAPIDLY.

– THE AVERAGE COST OF CAPITAL REDUCES UPTO A CERTAIN POINT

AND REMAINS MORE OR LESS UNCHANGED FOR MODERATE
INCREASE IN LEVERAGE AND THERE AFTER RISES AFTER
ATTAINING A CERTAIN POINT.
 IT ACCEPTS THAT CAPITAL STRUCTURE OF A FIRM AFFEECTS THE
COC AND ITS VALUATION

 IT DOES NOT SUBSCRIBE TO THE CONCEPT THAT THE VALUE OF THE

FIRM WILL NECESSARILY ENHANCE WITH ALL LEVELS OF LEVERAGE.
 MODIGLIANI MILLER APPROACH

 Total market value of the firm and cost of capital are

independent of the capital structure

 WACC does not make any change with a proportionate change

in debt –equity mix in the total capital structure of the firm

 It provides operational justification for irrelevance of the

capital structure in the valuation of the firm.
 Propositions

 COC AND MARKET VALUE OF THE FIRM ARE INDEPENDENT OF ITS

CAPITAL STRUCTURE.

 COST OF CAPITAL = CAPITALISATION RATE OF EQUITY

 TOTAL MARKET VALUE OF THE FIRM IS DETERMINED BY

CAPITALISING THE EXPECTED NOI BY THE RATE APPROPRIATE
FOR THE RISK CLASS.

 Ke – Kd = premium for financial risk

 Increased Ke is offset by the use of cheaper debt

 The cut off rate for investment is always independent of the way
in which an investment is financed.
 Criticism of MM hypothesis

 Different rates of interest

 Corporate taxes

 Questions :-
 What do you understand by capital structure of a
firm?
 Explain the approaches in capital structure
 Cost of capital

 IT IS THE RATE OF RETURN THE FIRM REQUIRES

FROM INVESTMENT IN ORDER TO INCREASE THE
VALUE OF THE FIRM IN THE MARKET PLACE.

 SIGNIFICANCES:-
– Device an optimum capital structure
– Serve as a discount rate for selecting projects.
 MEANING

 COST OF RAISING FUNDS REQUIRED TO FINANCE THE

PROPOSED PROJECT.- THE BORROWING RATE OF THE FIRM.

 WEIGHTED AVERAG COST OF EACH TYPE OF CAPITAL

 IS A HURDLE RATE

 ASCERTAINED ON THE BASIS OF ACTUAL COST OF VARIOUS

COMPONENTS OF CAPITAL

. MINIMUM RATE OF RETURN

 THREE COMPONENTS OF COC

 RETURN AT ZERO RISK LEVEL------ NO FINANCIAL OR BUSINESS

RISK

 BUSINESS RISK PREMIUM--- VARABILITY IN OPERATING PROFIT

BY
VIRTUE OF CHANGES IN SALES

. FINANCIAL RISK PREMIUM– RELATES TO THE PATTERN OF

CAPITAL

STRUCTURE
 Significance of cost of capital

 Capital budgeting decisions

 Capital structure decisions

 COMPUTATION OF COST OF CAPITAL

 COST OF DEBT:-
– RATE OF RETURN EXPECTED BY THE LENDERS
– INTEREST RATE SPECIFIED AT THE TIME OF ISSUE
– ISSUED AT PAR,PREMIUM OR DISCOUNT

– ISSUED AT PAR:-
– Kd = R( 1- T)

– T= tax rate
– R= interest rate = annual interest / net proceeds * 100
 A company issues 10% debentures for 100,000.
rate of tax 50%. Calculate the cost of debt (after
tax) when issued at PAR ,10% PREMIUM AND 10%
DISCOUNT

 At par:- 10,000/100000 (1-50%) = 5%

 At premium:- 10,000/110000 (1-50%)= 4.5%

 At discount:- 5.6%
 COST OF PREFERENCE SHARE CAPITAL

 Kp = Dd / P
 CONTROL OF THE COMPANY ISSUE

 COST OF PREFERENCE CAPITAL IS HIGHER THAN

THE COST OF DEBT
 A COMPANY RAISES PSC OF RS 100000 BY
ISSUING 10% PREFERENCE SHARES OF RS100
EACH. COMPUTE THE COST OF PC WHEN THEY
ARE ISSUED AT 1)10% PREMIUM 2) 10%
DISCOUNT

Kp= cost Of PS
10000/110000

10000/90000
 COST OF EQUITY SHARES

 THE MARKET VALUE OF EQUITY SHARES DEPENDS

ON THE RETURN EXPECTED BY THE
SHAREHOLDERS

 COST OF EQUITY CAPITAL IS DEFINED AS THE

MINIMUM RATE OF RETURN THAT A FIRM MUST
EARN ON THE EQUITY –FINANCED PORTION OF AN
INVESTMENT PROJECT INORDER TO LEAVE
UNCHANGED THE MARKET PRICE OF ITS STOCK
 RATE OF RETURN ON EQUITY 13%
 COST OF DEBT 10%
 COMPANY POLICY TO FINANCE 70% EQUITY 30%
DEBT
 THE REQUIRED RATE OF RETURN ON THE
PROJECT:-
– 1 3%* 0.70 + 10% * 0.30 = 12.1%

– 50000 INVESTMENT IN A PROJECT------6050 ANNUAL

RETURN. SO THE ROR ON THE EQUITY FINANCED
PORTION IS
 50000 EQUITY = 35000 DEBT 15000

 TOTAL RETURN 6050

 LESS INTEREST IN DEBT 1500
 AMT AVAILABLE TO ESH 4550
 RATE OF RETURN ON EQUITY

• 4550 * 100 / 35000 = 13%

 COST OF EQUITY = DIVIDEND / PRICE
 THAT RATE OF EXPECTED DIVIDEND WHICH WILL
MAINTAIN THE PRESENT MARKET PRICE OF
EQUITY SHARES

 D/P + G

 EARNINGS / PRICE EPS/MPS

 COST OF RETAINED EARNINGS
– = COST OF EQUITY ( 1-T) (1-COMMISSION)
 WACC

 CALCULATE THE COST OF EACH SPECIFIC SOURCE

OF FUNDS
 ASSIGN PROPER WEIGHTS TO SPECIFIC COSTS
 MULTIPLY THE COST OF EACH SOURCE BY THE
APPROPRIATE WEIGHT
 DIVIDE THE TOTAL WEIGHTED COST BY THE TOTAL
WEIGHTS TO GET THE OVERALL COC
 THE COC AFTER TAX :-
– COST OF DEBT 4%
– COST OF PS 11.5%
– COST OF EC 15.50%
– COST OF RE 14.5%
– CAPITAL STRUCTURE:-
• DEBT 3,00,000
• PSC 4,00,000
• ESC 6,00,000
• RE 2,00,000
CALCULATE WACC ANS 12%
SOURCES AMOUNT PROPORTION AFTER TAX WEIGHTED
COST COST

DEBT 300000 20% 0R .2 4% 0.008

0.04
PSC 400000 26.7% OR 11.5% 0.0307
0.267 0.115
ESC 600000 40% 15.5% 0.0620
0.40 0.155
RE 200000 13.3% 14.5% 0.0193
0.133 0.145
1500000 1.00 0.1200