Unit 1, Capital Structure (Imsfm2) - Unlocked

Capital structure
Unit I
Text Books:
Pandey, I.M., Financial Management
Khan, M.Y. and Jain, P.K., Financial Management
Content (5 lectures)
• Conceptual aspects
• Net income and Traditional approach
• Net operating income approach and MM hypothesis
• Other capital structure theories
• Capital structure planning & policy and determinants
• Capital Structure Analysis (EBIT-EPS Analysis)
• Leverage: Operating leverage, financial leverage, combined
leverage, use of leverage
22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 2
Conceptual Aspects (What and Why???)
• Proportion of debt, preference and equity shares
• Weighted average cost of capital is minimum and maximum
firm value (Theories).
• Maximise the shareholder’s wealth.
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• To finance its assets, day-to-day operations, and future
growth
• Levered and unlevered firms.
Capital Structure Theories
1. Net Income Approach (NI)
2. Net Operating Income Approach (NOI)
3. MM (Modigliani-Miller) Approach
4. Traditional Approach

Capital Structure Theories
Assumptions
1. Only two sources of finance
2. No corporate taxes
3. Dividend payout ratio is 100. No retained earnings.
4. Total assets do not change
5. Total financing remains same
6. Business risk is constant
7. Perpetual life of firm
Capital Structure Theories (cont.)
1. Net Income Approach
Assumptions:
a) No tax benefits
b) kd will always less than ke
c) Use of debt will not change risk perception of investors.

EBIT or NOI is Rs 500
Interest Payment is Rs 200
Cost of equity (ke) is 12.5 %
Cost of debt (kd) is 10 %
Value of the firm is sum of all the securities (debt and equities)
Page 19.5, Khan
Value of equity = Net income / Cost of equity

= Rs 2400
Value of debt = interest / Cost of debt

= Rs. 2000
Value of the firm = Rs 4400
Firm’s cost of capital (or WACC) = NOI / FV

= 11.36%
WACC = ke * E/V + kd * D/V

Increase in Value
Interest payment: Rs 300

Increase in Value
= Rs 1600

= Rs. 3000
22-02-2019 WACC = 10.9 % Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 11
Decrease in Value

Decrease in Value
= Rs 3200

= Rs. 1000
22-02-2019 WACC = 11.9 % Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 13
Impact on Share Price
Assume that firm has Rs 2000 as debt and 24 equity shares.
M.P. of Shares (Case 1) = 2400/24 = Rs 100


2. Net Operating Income Approach (given by Durand)
a) Capital structure is irrelevant. (Opposite of NI approach)
b) It has no effect on firm value, overall cost of capital as well as
market price of the shares.
c) There is nothing like optimum capital structure.
Propositions
a) Weighted average cost of capital is constant
b) Cost of equity capital (ke) increases with degree of financial
leverage (financial risk).
2. Net Operating Income Approach

Overall capitalisation Rate (k0) is 12.5 %
Total Debt is Rs 20000
Page 19.9, Khan

Market value of the firm is EBIT/k0
Market value of the equity is
Cost of equity or equity capitalization rate is

(EBIT-I)/ market Value of equity

Rs. 40000
Rs. 40000 – Rs 20000
Rs 20000
15 percent

Total Debt increases from Rs 20000 to Rs 30000



Rs. 40000
Rs. 40000 – Rs 30000
Rs 10000
20 percent

Total Debt decreases from Rs 20000 to Rs 10000
Cost of equity is 13.3 percent

3. Modigliani Miller Approach (without tax)
• Similar to NOI approach
• But NOI approach lacks behavioural significance.
Example:
• Two firms of same sector, having identical assets and have equal
market share. (No tax) (Proposition 1)
Value of levered firm = Value of unlevered firm
Will the financing mix has an impact on firm value and share
price?
Arbitrage Process (Proposition 1)
Two firms U and L have identical assets and expected NOI of

Rs 10,000.
Firm U: market value of equity is Rs. 100,000, no debt
Firm L: market value of equity is Rs. 60,000, employs 6 % Rs
50,000 debt.
22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) Page 348, Pandey 26
Firm U Firm L
NOI 10,000 10,000
Interest
Net income
Market value of equity
ke 10% 11.7%
Market value of debt
Market value of firm
WACC
Firm U Firm L
NOI 10,000 10,000
Interest 0 3,000
Net income 10,000 7,000
Market value of equity 1,00,000 60,000
ke 10% 11.7%
Market value of debt 0 50,000
Market value of firm 100,000 1,10,000
WACC 10% 9.1%
22-02-2019 Nikhil Kaushik, IM28S Ghaziabad Faculty (PGDM) 28
Arbitrage will bring the stock prices of the firms into
equilibrium. How?????
Suppose A owns 10 % of L’s shares (Rs. 60,000) and 10 % of

L’s corporate debt (Rs. 50,000). Ke is 10%. Interest rate is 6%.
EBIT is Rs. 1000
Equity Return: Rs 700.
Financial risk involved in firm L is high as compared to firm U.
Sell his holdings in firm L and invest in U.
Equity capital of Rs 10,000 (10 % of 1,00,000) in U.
Borrow amount equal to corporate debt on personal account
(Rs. 5000 at 6 %)
You have Rs 11,000.
Equity Return: Rs 700.
You have Rs 1000 extra
• Arbitrage would work in opposite direction also.
• Example has to be done by students
• Assumptions and criticism:
a) Perfect capital markets
b) Business risk is same for all firms in similar operating
environment.
c) DP ratio is 100 percent
d) No tax
Proposition 2
ke will increase to offset cheaper cost of debt so that ka will not

change.

Limitations:
a) Risk perception
b) Convenience
c) Transaction Cost
d) Institutional restrictions
e) Double leverage
f) Corporate taxes
3.1 Modigliani Miller Approach (tax included)
ValueL = ValueU + Bt
B is amount of debt and t is tax rate. Interest tax is perpetual.
Firm U Firm L
NOI 2500 2500
Debt 0 Rs 5000 at 10%
Corporate Tax 50% 50%
Page 353, Pandey
Firm U Firm L
NOI 2500 2500
Interest
Taxable income
Tax (50%)
Total income to investors

Firm U Firm L
NOI 2500 2500
Interest 0 500
Taxable income 2500 2000
Tax (50%) 1250 1000
Total income to shareholders 1250 1000
Total income to investors 1250 1500
4. Traditional Approach
It is in between NI and NOI approach.
WACC decreases upto a certain limit of financial leverage and

after reaching the minimum level, it will start increasing with
financial leverage.
Three Stages:
a) First stage – Increasing value
b) Second stage – Optimum value
c) Third stage – Decreasing value

Other Capital Structure Theories
5. Trade-off theory
• The top curve shows the tax

shield gains of debt
financing,
• The bottom curve includes
that minus the costs of
bankruptcy.
• Area under the blue line
indicates value of unlevered
firm.
Other Capital Structure Theories (cont.)
6. Signaling Theory
• Asymmetric information
• Impact of Bad and Good news.
7. Pecking–order theory
The firm will prefer internal financing or retained earning as
compared to external financing.

Capital Structure Planning and Policy
1. Elements of Capital Structure
2. Framework of Capital Structure (FRICT analysis)
3. Approaches to establish Capital Structure
Pandey, I.M., Financial Management, Page number: 363

Capital Structure Planning and Policy (cont.)
1. Elements of Capital Structure
a) Capital mix
b) Maturity and priority
c) Terms and conditions
d) Currency
e) Financial innovations
f) Financial market segments

2. Framework of Capital Structure (FRICT analysis)
a) Flexibility
b) Risk
c) Income
d) Control
e) Timing

3. Approaches to establish Capital Structure
a) EBIT-EPS analysis
b) Valuation approach
c) Cash flow analysis

Determinants of Capital Structure
Pandey, I.M., Financial Management, Page number: 370

Numerical 1
X and Y are identical in al respect except that company X
uses debt while company Y does not. The levered firm has
Rs. 9,00,000 debentures carrying 10 % rate of interest. Both
firms earn 20% operating profit on their total assets of Rs. 15
lakhs. Tax rate is 35%. Equity capitalisation rate is 15%.
(a) Compute the value of firm X and Y under NI approach.
(b) Compute the value of firm X and Y under NOI approach.
(c) Using NOI, calculate k0 for firms X and Y.
(d) Which of these firms has optimum capital structure under
NOI approach?
Numerical 2
Firm A and B are similar except that A is unlevered while
B has Rs. 2,00,000 of 5% debentures outstanding. Assume
the tax rate is 40%, NOI is Rs. 40,000 and ke 10%.
(i) Calculate the value of the firms according to MM
approach.
(ii) Suppose VB = Rs. 360,000. According to MM, do
these represent equilibrium values? How will the
equilibrium be set? Explain.
Leverage
Leverage is employment of an asset/ source of finance for
which firm pays fixed cost/ fixed returns.
In simple terms, leverage refers to debt or to borrowing

funds to finance the purchase of inventory, equipment and
other company assets.
Explanation of interest on debt, preference share dividend and

ordinary shares dividend????????
Leverage (cont.)
Leverage is of two types:
1) Operating leverage is caused due to fixed operating
expenses in a firm.
The firm’s ability to use fixed operating costs to
magnify the effects of change in sales on its EBIT.
2) Financial leverage is caused due to fixed financial costs.

The firm’s ability to use fixed financial charges to
magnify the effects of change in EBIT on the EPS.
Leverage (cont.)
1) Operating leverage (due to fixed operating expenses)
Three categories of operating costs:

a) Fixed costs (don’t vary with sales)
b) Variable costs (vary with sales)
c) Semi-variable costs (partly varies with sales)

Leverage (cont.)
1) Operating leverage (cont.)
Example: A firm sells products for rupees 100 per unit, variable operating
costs Rs. 50 per unit and fixed operating costs Rs. 50000 per year. Show
various levels of EBIT for sales (a) 1000 units (b) 2000 units (c) 3000
units.
Case 2 Base Case 1
Sales in units 1000 2000 3000
Sales revenue
Variable operating Cost
Contribution
Fixed operating cost
EBIT
Leverage (cont.)
Example: A firm sells products for rupees 100 per unit, variable operating
costs Rs. 50 per unit and fixed operating costs Rs. 50000 per year. Show
various levels of EBIT for sales (a) 1000 units (b) 2000 units (c) 3000
units.
Case 2 Base Case 1
Sales in units 1000 2000 3000
Sales revenue 100,000 200,000 300,000
Variable operating Cost 50,000 100,000 150,000
Contribution 50,000 100,000 150,000
Fixed operating cost 50,000 50,000 50,000
EBIT Zero 50,000 100,000
Leverage (cont.)
OR
Contribution = sales – variable cost

OR = EBIT + Fixed Cost
Leverage (cont.)
2) Financial leverage is caused due to fixed financial costs.
It is also defined as the firm’s ability to use fixed financial

charges to magnify the effects of changes in EBIT on EPS.
Types of fixed financial charges are bonds, debentures and

preference shares.

Leverage (cont.)
2) Financial leverage (cont.)
ABC has Rs 100,000, 10% debentures and 5,000 equity shares.
Three level of EBIT (a) Rs 50,000 (b) Rs 30,000 (c) Rs 70,000.
Calculate the change in EPS. Tax rate is 35 %.
Case 1 Base Case 2
EBIT 30,000 50,000 70,000
Less interest
EBT
Less Tax
EAT
EPS
Leverage (cont.)
ABC has Rs 100,000, 10% debentures and 5,000 equity shares.
Three level of EBIT (a) Rs 50,000 (b) Rs 30,000 (c) Rs 70,000.
Calculate the change in EPS. Tax rate is 35 %.
Case 1 Base Case 2
EBIT 30,000 50,000 70,000
Less interest 10,000 10,000 10,000
EBT 20,000 40,000 60,000
Less Tax 7,000 14,000 21,000
EAT 13,000 26,000 39,000
EPS 2.6 5.2 7.8
Leverage (cont.)
OR
OR OR ( )
( ) ( )
Leverage (cont.)
Measures of Financial Leverage

a) Debt Ratio: D/V
b) Debt to Equity ratio: D/E
c) Interest coverage ratio: EBIT/Interest

Leverage (cont.)
EBIT - EPS analysis
Comparison of alternative methods of financing at various levels of
EBIT.
Numerous ways of financing are
(a) Exclusively use of equity capital
(b) Exclusively use of debt
(c) Exclusively use of preference capital
(d) Combination of (a) and (b)
(e) Combination of (b) and (c)
(f) Combination of (a) and (c)
(g) Combination of (a), (b) and (c)
Leverage (cont.)
Example: EBIT – EPS Analysis
Suppose a firm has a capital structure comprising of ordinary shares
amounting to Rs. 10,00,000. Now the firms wishes to raise
additional Rs 10,00,000 for expansion. The firm has four alternative
financial plans. EBIT is Rs. 1,20,000, Tax rate is 35%, outstanding
ordinary shares 10,000 and Market price of shares Rs. 100.
a) Raise entire amount in the form of equity capital.
b) Raise 50% as equity capital and 50% as debt (5%)
c) Raise entire amount as 6% debt.
d) Raise 50% as equity capital and 50% as preference capital (5%)
Leverage (cont.)
A B C D
EBIT 1,20,000 1,20,000 1,20,000 1,20,000
Less: Interest
EBT
Less: Tax
EAT
Less: Preference div.
Earning to Ord. share
No. of shares
EPS 22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 61
Leverage (cont.)
A B C D
EBIT 1,20,000 1,20,000 1,20,000 1,20,000
Less: Interest 0 25,000 60,000 0
EBT 1,20,000 95,000 60,000 1,20,000
Less: Tax 42,000 33,250 21,000 42,000
EAT 78,000 61,750 39,000 78,000
Less: Preference div. 0 0 0 25,000
Earning to Ord. share 78,000 61,750 39,000 53,000
No. of shares 20,000 15,000 10,000 15,000
EPS 3.9 4.1 3.9 3.5
Leverage (cont.)
What is the financial break even in Case A, B, C, D?

Leverage (cont.)
What is the financial break even in Case A, B, C, D?
Case A: Not Applicable
Case B: Rs. 25000
Case C: Rs 60,000
Case D: Rs. 38,462 = 25000/(1 - 0.35)
If both debt and preference share are included then financial

break even is I + Dp / (1-t)
Leverage (cont.)
Indifference Point or EBIT – EPS break even point: is the
EBIT level beyond which the financial leverage begin to
operate with respect to EPS.
(i) Equity shares vs debentures
(ii) Equity shares vs preference shares
(iii) Equity shares vs preference shares with tax on DP
(iv) Equity shares vs preference shares and debentures

Leverage (cont.)
Indifference Point or EBIT – EPS break even point:
(i) Equity shares vs debentures
(ii) Equity shares vs preference shares
(iii) Equity shares vs preference shares with tax on DP

Leverage (cont.)
Indifference Point or EBIT – EPS break even point:
(iv) Equity shares vs preference shares and debentures

Leverage (cont.)
Numerical: Indifference Point Khan, M.Y. and Jain, P.K., Financial Management, Page 18.14
Various financial plans to finance Rs. 30,00,000 through various

capital budgeting projects are as below:
(i) Equity capital of Rs 30,00,000 or Rs 15,00,000 at 10%
debentures and Rs 15,00,000 equity
(ii) Equity capital of Rs 30,00,000 or 13% preference shares of Rs
10,00,000 and Rs 20,00,000 equity
(iii) Equity capital of Rs 30,00,000 or 13% preference shares of Rs
10,00,000 (Dp of 10%), Rs 10,00,000 at 10% debentures and Rs
10,00,000 equity
Determine the indifference point for each case, assuming 35% tax
and face value of equity shares is Rs 100.
Leverage (cont.)
Numerical: Indifference Point (cont.)

Leverage (cont.)
(3) Combined Leverage
Total risk associated with the leverage.
DCL = DOL * DFL
OR

Leverage (cont.)
Numerical Khan, M.Y. and Jain, P.K., Financial Management, Page 18.27
Consider the following information about X Ltd.

EBIT Rs 12,00,000
EBT Rs 3,00,000
Operating Fixed Cost Rs. 24,00,000
Preference Dividend Rs. 60,000
Tax rate (%) 40
Calculate DOL, DFL and DCL. By what percentage the operating
profits would increase, if sales increased by 10%?

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Capital structure

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 4

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 6

Value of equity = Net income / Cost of equity

Value of debt = interest / Cost of debt

Firm’s cost of capital (or WACC) = NOI / FV

WACC = ke * E/V + kd * D/V

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 9

Value of debt = interest / Cost of debt

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 10

Value of debt = interest / Cost of debt

Value of debt = interest / Cost of debt

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 12

Value of debt = interest / Cost of debt

M.P. of Shares (Case 1) = 2400/24 = Rs 100

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 14

EBIT or NOI is Rs 5000

Page 19.9, Khan

Market value of the equity is

Cost of equity or equity capitalization rate is

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 18

EBIT or NOI is Rs 5000

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 20

Market value of the equity is

Cost of equity or equity capitalization rate is

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 21

EBIT or NOI is Rs 5000

Cost of equity is 13.3 percent

Two firms U and L have identical assets and expected NOI of

Suppose A owns 10 % of L’s shares (Rs. 60,000) and 10 % of

ke will increase to offset cheaper cost of debt so that ka will not

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 32

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 35

WACC decreases upto a certain limit of financial leverage and

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 38

• The top curve shows the tax

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 40

Pandey, I.M., Financial Management, Page number: 363

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 41

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 42

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 43

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 44

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 45

In simple terms, leverage refers to debt or to borrowing

Explanation of interest on debt, preference share dividend and

2) Financial leverage is caused due to fixed financial costs.

Three categories of operating costs:

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 50

Contribution = sales – variable cost

It is also defined as the firm’s ability to use fixed financial

Types of fixed financial charges are bonds, debentures and

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 54

Measures of Financial Leverage

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 58

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 63

If both debt and preference share are included then financial

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 65

(ii) Equity shares vs preference shares

(iii) Equity shares vs preference shares with tax on DP

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 66

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 67

Various financial plans to finance Rs. 30,00,000 through various

22-02-2019 Nikhil Kaushik, IMS Ghaziabad Faculty (PGDM) 69