Capital Structure 146h2y

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 financing

control

Capital market conditions

factors

Flexibility of financial 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  Total MV of debt (D)  Total MV of the firm (V)  Total interest on debt capital

(E)

(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 V=E+D 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

Enhance Value of FIRM

High debt content

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 = 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 --- VARABILITY IN OPERATING PROFIT BY VIRTUE OF CHANGES IN SALES

.

FINANCIAL RISK – 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, 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% AND 10% DISCOUNT  At par:-

10,000/100000 (1-50%) = 5%

 At :- 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% 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

 TOTAL RETURN  LESS INTEREST IN DEBT  AMT AVAILABLE TO ESH  RATE OF RETURN ON EQUITY • 4550 * 100 / 35000

= 13%

DEBT

15000

6050 1500 4550

 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 COST

WEIGHTED COST

DEBT

300000

20% 0R .2 4% 0.04

0.008

PSC

400000

26.7% OR 11.5% 0.267 0.115

0.0307

ESC

600000

40% 0.40

15.5% 0.155

0.0620

RE

200000

13.3% 0.133

14.5% 0.145

0.0193

1500000 1.00

0.1200