This e-Lecture was Recorded on:

January 28, 2015

Intermediate (IPC) Course Paper 3B Financial

Management Chapter 4 Unit 2

CA. Nikhil Jand

© The Institute of Chartered Accountants of India

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 Capital structure refers to the mix of a firm capitalisation
(i.e. mix of long term sources of funds such as debentures,
preference share capital, equity share capital and retained
earnings for meeting total capital requirement).

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 Owners
Debt
Equity

Equity Loans

Pref.
Debentures
Shares

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 Minimises
Cost of
Capital
and

Optimum
Capital Structure

Maximises
the
Owners
Return

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 Others
Pref. Capital

Equity
Debt

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 Only Debt

Only Equity capital

Only Preference capital

Options to Raise Funds
Debt & Equity

Debt, Equity & Preference

Majorly Debt & Preference

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 What factors What is
What is the
affect the target business risk?
optimal capital
capital What is financial
structure?
structure? risk?

Theories
Understanding
relating to
the indifference
capital structure

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 Target capital structure Optimal capital structure

Mix of debt, preferred

Balances risk and return
stock, and common stock

Set equal to estimated Maximizes the firm’s

optimal capital structure stock price

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 Business risk

Taxes

Financial flexibility

Managerial conservatism or aggressiveness

Growth opportunities

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 Uncertainty Uncertainty Uncertainty
about demand about output about input
(unit sales). prices. costs.

Product and Degree of

other types of operating
liability. leverage (DOL).

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 Operating leverage is the use of fixed
costs rather than variable costs.

The higher the proportion of fixed costs

within a firm’s overall cost structure, the
greater the operating leverage.

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 • How do we distinguish between
Valuation: good investment projects and bad
ones?
• How should we finance the
Financing: investment projects we choose to
undertake?

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 Real investment policies imply funding needs
• We have tools to forecast the funding needs to follow a given
real investment policy (from Wilson Lumber)
But what is the best source of funds?
• Internal funds (i.e., Cash)?
• Debt (i.e., borrowing)?
• Equity (i.e., issuing stock)?
Moreover, different kinds of …
• Internal funds (e.g., cash reserves vs. cutting dividends)
• Debt (e.g., Banks vs. Bonds)
• Equity (e.g., VC vs. IPO)

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 • It should minimize the cost of
Profitability: financing and maximise earning per
equity share.

• The capital structure should be such

Flexibility: that company can raise funds
whenever needed.

• The capital structure should be such

Solvency: that the firm does not run the risk of
becoming insolvent.

• There should be minimum risk of

Control: loss or dilution of control of the
company.
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 Considerations

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 Risk

Cost

Control

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 Cost of
Risk Control
Capital
Enough revenue Issue of equity
Minimise Risk & to meet Cost of dilutes
Cost capital & controlling
Finance growth interest

Do not dilute Important

Control Consideration

Financial Risk &

Business Risk

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 Business risk:
• Uncertainty in future EBIT.
• Depends on business factors such as competition, operating
leverage, etc.
Financial risk:
• Additional business risk concentrated on common stockholders
when financial leverage is used.
• Depends on the amount of debt and preferred stock financing.

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 One of the basic objective of financial management is to
maximise the value or wealth of the firm.

Optimum capital structure deals with the issue of right mix of

debt and equity in the long-term capital structure of a firm.

Optimum capital structure should maximise the wealth of the

firm.

Equity
Debt

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 Is there an “optimal” capital structure, i.e., an optimal mix
between debt and equity?

More generally, can you add value on the RHS of the

balance sheet, i.e., by following a good financial policy?

If yes, does the optimal financial policy depend on the

firm’s operations (Real Investment policy), and how?

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 Used to determine when debt financing is advantageous and when
equity financing is advantageous.

Can be illustrated graphically since the relationship between EBIT

and EPS is linear.

EPS (debt financing) = EPS (equity financing)

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 The EBIT-EPS indifference point is a calculation used in determining optimal capital
structures. What that means is firms typically finance their operations with two primary
means, equity and debt.

Algebraically and graphically when the earnings per share for debt and equity financing
alternatives are equal, you have the EBIT-EPS indifference point.

In other words a firm can finance their operations at the same cost, with either debt or
equity, at the indifference point.

EPS (debt financing) = EPS (equity financing)

EPS Indifference Point

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 Capital Structure

Debt
Equity
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 Balance Sheet
Current Current
Assets Liabilities

Debt Financial
Fixed Preference
Structure
Assets shares

Ordinary
shares

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 Balance Sheet
Current Current
Assets Liabilities

Debt
Fixed Preference
Assets shares Capital
Structure
Ordinary
shares

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 Debt-holders are limited
to a fixed return – so
Interest is tax deductible
stockholders do not
(lowers the effective
have to share profits if
cost of debt)
the business does
exceptionally well

Debt holders do not

have voting rights

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 Higher debt ratios lead to greater risk and higher required
interest rates (to compensate for the additional risk)

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 Two questions:

1. Why exactly should stockholders care about maximizing firm value?

Rationally, they should be interested in maximizing shareholder value.

2. What is the ratio of debt-to-equity that maximizes the shareholder Rs.s

value?

As it turns out, under certain assumptions, changes in capital

structure benefit stockholders if and only if the total value of the firm
increases

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 Sales
Operating – Variable costs
Leverage – Fixed costs
EBIT
– Interest expense
Financial Earnings before taxes
Leverage – Taxes
Net Income

EPS = Net Income

No. of Shares
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 Net operating Modigliani-
Net income Traditional
income Miller
approach approach
approach approach

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 Capital Structure
Capital Structure
doesnot affect
affects WACC
WACC

Net Operating
Net Income
Income
Approach
Approach

Modigiliani &
Traditional
Miller
Theory
Approach

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 There are only two sources of funds viz., debt and equity.
[No Preference Share Capital]

The Total Assets of a firm and its Capital Employed are fixed.
[No. change in capital Employed]. However, debt equity
mix can be changed:

All earnings are distributed to equity shareholders. [No

retained earnings]

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 The firm earns operating profits and it is expected
to grow. [No losses]

The business risk is assumed to be constant and

is not affected by the financing mix decision.

[No change in fixed costs or operating risks]

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 A corporate can finance its business mainly by 2 means i.e. debts and
equity.

The proportion of each of these could vary from business to business.

A company can choose to have a structure which has 50% each of

debt and equity or more of one and less of another.

Capital structure is also referred to as financial leverage, which strictly

means the proportion of debt or borrowed funds in the financing mix of
a company.

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 Debt structuring can be a handy option because the
interest payable on debts is tax deductible (deductible
from net profit before tax).

Hence, debt is a cheaper source of finance. But increasing

debt has its own share of drawbacks like increased risk of
bankruptcy, increased fixed interest obligations etc.

For finding the optimum capital structure in order to

maximize shareholder’s wealth or value of the firm,
different theories (approaches) have evolved.

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 An Intro.

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 According to this approach, the
capital structure decision is
relevant to the valuation of the
Net income
firm. In other words, a change in
approach suggested by the
the capital structure leads to a
Durand
corresponding change in the
overall cost of capital as well as
the total value of the firm.

Assumptions

There are no corporate taxes.

The cost debt is less than the cost of equity.

The use of debt does not change the risk perception of the investor.

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 This means that a
change in the financial
According to this
leverage will
approach, the capital
automatically lead to a
structure decision is
corresponding change
relevant to the
in the overall cost of
valuation of the firm.
capital as well as the
total value of the firm.

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 According to NI approach, if the financial leverage
increases, the weighted average cost of capital
decreases and the value of the firm and the market
price of the equity shares increases.

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 If the financial leverage decreases, the weighted average
cost of capital increases and the value of the firm and the
market price of the equity shares decreases.

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 Similarly, if the financial leverage decreases, the
weighted average cost of capital increases and the
value of the firm and the market price of the equity
shares decreases.

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 Debt is a cheaper source of finance than equity due to tax saving effect
and investor's risk expectations.

Hence, as the degree of financial leverage increases, the WACC will

decline with every increase in he debt content in total funds employed.

Since Value of Firm = EBIT / WACC, the value of firm will increase for
every decline in WACC.

Where debt content is reduced, the reverse will happen, i.e. WACC will
increase thereby reducing the value of the firm.

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 Thus, a firm can increase its value and lower the overall cost of
capital by increasing the proportion of debt in the capital structure.

The Value of the Firm will be maximum at a point where WACC is

minimum

The theory suggests total or maximum possible debt financing for

minimising the cost of capital.

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 • Procedure
Step

• Determine EBIT
1

• Compute EBT (Net Income) = EBIT less Interest on Debt Funds

2

• Compute Market Value of Equity(S)= EBT (Net Income) / Cost of Equity (Ke)
3

• Compute Market Value of Debt (D)= Interest/Cost of Debt (Kd)

4

• Compute Market Value of Firm(V)= S+D =Market Value of Equity+ Market Value of Debt
5

• Compute Overall Cost of Capital (Ko)= Ebit/ value of Firm(V)

6

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 The Value of the firm on the basis of net income approach can be ascertained as
follow:
V= S+D
Where,
V= Value of the firm
S= Market Value of Equity
D= Market Value of Debt
Market Value of Equity(S)= NI /Ke
Where,
NI= Earning Available Equity Shareholder
Ke= Equity Capitalisation rate

Under , NI approach, the value of the firm will be maximum at a point where weightage average
cost of capital is minimum. Thus, the theory suggest total or maximum possible debt financing
for minimising the capital of cost. The overall cost of capital under this approach is:

Overall cost of capital= EBIT/ Value of the firm

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 Net Operating Income Approach was also suggested by Durand. This
approach is of the opposite view of Net Income approach.

This approach suggests that the capital structure decision of a firm is irrelevant
and that any change in the leverage or debt will not result in a change in the
total value of the firm as well as the market price of its shares.

This approach also says that the overall cost of capital is independent of the
degree of leverage.

NOI means earnings before interest and tax. According to this approach,
capital structure decisions of the firm are irrelevant.

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 Net Operating Income Approach was also suggested by Durand. This
approach is of the opposite view of Net Income approach.

This approach suggests that the capital structure decision of a firm is irrelevant
and that any change in the leverage or debt will not result in a change in the
total value of the firm as well as the market price of its shares.

This approach also says that the overall cost of capital is independent of the
degree of leverage.

NOI means earnings before interest and tax. According to this approach,
capital structure decisions of the firm are irrelevant.

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 At all degrees of leverage (debt), the overall capitalization
rate would remain constant. For a given level of Earnings
before Interest and Taxes (EBIT), the value of a firm would
be equal to EBIT/overall capitalization rate.

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 The value of equity of a firm can be determined by
subtracting the value of debt from the total value of the firm.

This can be denoted as follows:

• Value of Equity = Total value of the firm - Value of debt

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 Cost of equity increases
with every increase in debt
and the weighted average
cost of capital (WACC)
remains constant. When
the debt content in the
capital structure increases,
it increases the risk of the
firm as well as its
shareholders.
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To compensate for the
higher risk involved in
investing in highly levered
company, equity holders
naturally expect higher
returns which in turn
increases the cost of equity
capital.
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 Modigliani and Miller – No Tax Case

M&M began looking at capital structure in a very simplified

world so that we would know what does or does not
matter.
• Assume no taxes
• No transaction costs
• Including no bankruptcy costs
• Investors can borrow/lend at the same rate (the same as the firm).
• No information asymmetries
• A fixed investment policy by the firm

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  A change in capital structure does not matter to
the overall value of the firm.

Debt Equity,
$300, $400, Debt
Equity,
Equity, $1000, Equity, 30%, $600,
40%,
$1000,
100% $700, 60%,
100% 70%,

Total Firm Value = S+B

Does not change (the pie is the same size in each case, just the slices are
different).

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 The NOI approach is definitional or conceptual and lacks behavioural
significance. It does not provide operational justification for irrelevance of
capital structure

Modigliani-Miller approach provides behavioural justification for constant

overall cost of capital and, therefore, total value of the firm.

Assumptions

Capital markets Firms can be

are perfect. All grouped into
information is All investors are ‘Equivalent risk
freely available rational. classes’ on the
and there are no basis of their
transaction costs business risk.

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 Total market value of a firm is equal to its expected
net operating income dividend by the discount rate
appropriate to its risk class decided by the market.

The expected yield on equity is equal to the risk-

free rate plus a premium determined as per the
following equation: Kc = Ko + (Ko– Kd) B/S

Average cost of capital is not affected by financial

decision.

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