MBA SEM II

Financial Management
Unit - IV

(Syllabus - Cost of Different sources of Raising Capital, Weighted Average Cost of Capital;
Capital Structure Theories and Optimum Capital Structure. Operating Leverage,
Financial Leverage & Combined Leverage)

Introduction to Cost of Capital

The various sources from which the long term requirement of the capital can be met. Each of these
sources involves some cost. The cost of capital can be defined as ‘”the rate of which an organization
must pay to the suppliers of capital for the use of their funds”.

Meaning of Cost of Capital

It is a rate of returns expected by the investors i.e., K = ro + b + f. i.e., the cost of capital includes the
rate of return at zero risk + premium for business risk + premium for financial risk.

It is the minimum rate of return the firm earns as its investment in order to satisfy the expectations of
investors, who provide funds to the firm.

Cost of capital is the measurement of the sacrifice made by the investors in order to the capital
formation with a view to get a fair return on investment.

For Investor:
Cost of capital is the measurement of disutility of funds in the present as compared to the return
expected to future.

For Company:
Cost of capital is the required rate of return to justify the use of capital so that expected rate of return
can be maintained on equity shares and the market value of share remains unchanged or should not be
reduced at cost. When a company collects funds by issuing debentures, bonds and preference shares it
has to earn at least a rate of return on investment which is equal to the cost of raising them. So that
market value of equity shares remains unchanged. The cost of capital is a minimum rate of return
required to be earned on investment to keep the market value of the shares unchanged.

Definitions of Cost of Capital

The concept of the cost of capital plays an important role in corporate finance – theory and practice.
The term cost of capital is defined by various authors in different ways, some of which are
stated below:
Milton H. Spencer says “cost of capital is the minimum required rate of return which a firm requires
as a condition for undertaking an investment.”

According to Ezra Solomon, “the cost of capital is the minimum required rate of earnings or the cut-
off rate of capital expenditure.”

Concepts of Cost of Capital

Besides the general concept of cost of capital, the following concepts are also used frequently:
(a) Component Cost and Composite Cost:
Component cost refers to the cost of individual components of capital viz., equity shares, preference
shares, debentures and so on. Composite cost of capital refers to the combined or weighted average
cost of capital of the various individual components. For capital budgeting decisions, it is the com-
posite cost of capital which is considered.

(b) Average Cost and Marginal Cost:

The average cost refers to the weighted average cost of capital. Marginal cost refers to the
incremental cost attached with new funds raised by the company.

(c) Explicit Cost and Implicit Cost:

Explicit cost is the one which is attached with the source of capital explicit or apparently. Implicit
cost is the hidden cost which is not incurred directly. E.g. In case of the debt capital, the interest
which the company is required to pay on the same is explicit cost of capital.

However, if the company introduces more and more doses of debt capital in the overall capital
structure, it makes the investment in the company a risky proposition. As such, the expectations of the
investors in terms of return on their investment may increase and share prices of the company may
decrease.

These increased expectations of the investors or the decreased share prices may be considered to be
an implicit cost of debt capital.

Importance of Cost of Capital

The term cost of capital is important for a company basically for following purposes:
(1) The concept of cost of capital is used as a tool for screening the investment proposals. E.g. In case
of the net present value method, the cost of capital is used as the discounting rate for discounting the
future inflow of funds. Any project resulting into positive net present value only will be accepted.

All other projects will be rejected. Similarly, in case of Internal Rate of Return Method (IRR), the
resultant IRR is compared with the cost of capital. It is expected that if a project is to be accepted,
IRR resulting from the same should be more than cost of capital. If a project generates ERR which is
less than cost of capital, the project will be rejected.

(2) The cost of capital is used as the capitalisation rate to decide the amount of capitalisation in case
of a new concern.

(3) The concept of cost of capital provides useful guidelines for determining the optimal capital
structure. Optimal capital structure is the one where overall cost of capital is minimum and the overall
valuation of the firm is maximum.

Significance of Cost of Capital

1. It Helps in Capital Budgeting
2. It Helps in Designing the Capital Structure Decisions (i.e., Capital Mix Decisions)
3. It Helps in Selecting the Sources of Finance (i.e., Method of Financing)
4. It Helps for Optimum Mobilisation of Resources
5. It Helps to Evaluate the Financial Performance of the Top Management:

Factors Affecting Cost of Capital

The cost of capital is largely dependent on the sources of finance. It is important to understand the
factors that affect the cost of capital in order to minimize the overall cost of capital. There are several
factors that may be controlled by the firm and many more that may be beyond the control of the
business enterprise.

The former may be referred to as internal factors and later as external factors. The internal factors
include composition of capital structure, dividend policy, and amount of financing and operating
conditions.

(a) Capital Structure Composition:

The composition of capital structure, that is, debt- equity mix affects the cost of capital of a firm. As
the debt proportion increases, the average cost of capital decreases because debt funds are cheaper as
they also offer tax advantages. However, this happens only up to a certain point (called optimum
level).

Thereafter, the cost of the capital starts increasing. This is because when a higher proportion of debt
is chosen, the cost of debt must factor in the risk that the firm may fail to meet its payment
obligations.

In case of large investment projects, due to cost and time overruns, the costs of servicing debt may
become more than the revenues, thus, making it difficult for the firm to pay interest and principal
amount of debt.

Also, higher levels of debt can cause a wider variation in earnings due to higher fixed obligations that
must be paid (interest to debt holders). This is referred to as financial risk. The equity owners may
also require higher returns to compensate for increased risk, thereby causing the cost of equity fund to
increase.

(b) Dividend Policy:

The cost of equity is also influenced by a company’s dividend policy. When a company makes
profits, it can distribute them to the shareholders as dividends or reinvest them into the company as
retained earnings or it can do both by deciding the dividend pay-out ratio.

The firm may use retained earnings to retire costly debts, hence changing its overall cost of capital
and debt equity ratio. Although retained earnings have an implicit cost, yet they are considered to be a
cheaper source of finance.

(c) Amount of Financing:

The cost of funds also depends on the level of financing that the firm requires. As the financing
requirements of the firm become larger, the weighted cost of capital increases for several reasons. For
instance, as more securities are issued, additional floatation costs are incurred, which in turn tend to
cause a rise in the cost of capital.

Also, as management approaches the market for large amounts of capital relative to the firm’s size,
the investors require a higher rate of return. This is because the suppliers of capital become hesitant to
grant relatively large sums without evidence of management’s capability to absorb this capital into
the business.
Also, as the size of the issue increases, there is greater difficulty in placing it in the market without
reducing the price of the security, which also increases the firm’s cost of capital.

(d) Business Risk:

Business risk occurs from operating activity of a firm. It is influenced largely by the amount of fixed
costs that are incurred by a firm. The higher the fixed costs, the greater will be the business risk and
vice versa. For example, higher fixed costs tend to result in wider variations to operating income from
numerous factors- increased competition, slower economic growth and so on.

It is one of the important factors that influence the determination of cost of capital. The more the
business risk, the higher will be the cost of capital because the providers of funds raise their required
rate of return by charging risk premium to compensate for increase in risk.

Besides the above, there are external factors- economic conditions, tax considerations, market
conditions and marketability of securities that affect the cost of capital.

 Economic Condition
 Tax Consideration
 Market Condition
 Marketability of Securities

Measurement of Specific Cost of Capital

(a) Cost of Debt:
The debts may be either short term debts or long term debts. Very naturally, the cost of capital in the
form of debt is the interest which the company has to pay. But this is not the real cost attached with
debt capital. The real cost is something less than the rate of interest which the company has to pay.

This is due to the fact that the interest on debt is a tax deductible expenditure. If the amount of
interest is considered as a part of expenses, the tax liability of the company reduces proportionally.
As such, while computing the cost of debt, adjustments are required to be made for its tax impact.
E.g. Suppose a company issues the debentures having the face value of Rs. 100 and bearing the rate
of interest of 10% p.a.

If the tax rate applicable to the company is 50%, the cost of debentures is not 10% which is the rate of
interest, but it is to be duly reduced by the tax benefit available for this interest. The tax benefit is
50% of 10%, hence the cost of debentures is only 5%. Further, the interest payable on the debentures
has to be viewed from the angle of the amount actually received on their issue.
E.g. A company issues 1000 debentures of Rs. 100, each bearing interest @ 8% p.a. Company
incurred the expenses in connection with the issue of debentures to the extent of Rs. 10,000 (These
expenses may be in the form of discount allowed, underwriting commission, advertisement etc.)
Thus, the company will have to pay the annual interest of Rs. 8,000 on the net amount received to the
extent of only Rs. 90,000 (i.e. Rs. 1,00,000 minus Rs. 10,000).

Cost of debentures in this case works out to around 8.89% and assuming that the tax rate applicable is
50%, the tax benefit makes the cost of debentures equal to 4.45%. However, the debt capital has a
hidden cost also.

If the debt content in the capital structure of a company exceeds the optimum level, the investors start
considering the company as too risky and their expectations from equity shares increase. This is the
hidden cost of debt.

(b) Cost of Preference Shares:

The cost of capital preference shares is the dividend rate payable on them. As in case of debentures,
the cost of capital is adjusted for the amount excess or less received on the issue of preference shares.
E.g. Suppose, a company issues 1,000 preference shares of Rs. 100 each at the value of Rs. 105 each.

Rate of dividend is 10% and the expenses involved with the issue of preference shares amount to Rs.
10,000. Thus the net amount received works out to Rs. 95,000 whereas the amount of the dividend is
Rs. 10,000. Here, the cost of capital works out to-

As the amount of dividend payable on preference shares is not a tax- deductible expenditure, there is
no question of further adjustment for tax benefit.

(c) Cost of Equity Shares:

Computation of cost of equity shares is the most complex procedure. It is due to the fact that unlike
preference shares or debentures, equity shares do not have either the interest or dividend to be paid at
a fixed rate. The cost of equity shares basically depends upon the expectations of the equity
shareholders.

There are following approaches to compute the cost of equity shares:

(1) D/P Approach:
According to this approach, before an investor pays a certain price for purchasing equity shares of the
company, he expects a certain return on the investment which is in the form of the dividend. This
expected rate of dividend is the cost of equity shares.

This means that the investor calculates the market price of the shares by capitalising the present
dividend rate which is expected to be the same for all times to come at a given level. E.g. If the
market price of Equity shares of a company (Face value Rs. 10) is Rs. 15 and if the company at
present is paying the dividend @ 20% which is expected to be continued in future also, the cost of
equity shares will be –

However, it can also be argued that the cost of equity shares may be 20%, because on the expectation
of a rate of dividend at 20%, market price of the shares is Rs. 15.

This approach is objected to on certain grounds. Firstly, this presupposes that an investor looks
forward only to receiving a dividend on equity shares. This may not always be correct. He may also
look forward to capital appreciation in the value of his shares.

Secondly, this approach assumes that the company will not earn on its retained earnings and that the
retained earnings will not result in either appreciation of the market price or increase in dividends.
This assumption can be a wrong assumption which may lead to wrong conclusions.

(2) E/P Approach:

According to this approach, the cost of equity shares is based upon the stream of unchanged earnings
earned by a company. This approach holds that each investor expects a certain amount of earnings
whether distributed by way of dividend or not, from the company in whose shares he invests.

Thus, if an investor expects that the company in which he is investing should have at least a 20% rate
of earnings, cost of equity shares will be calculated on that basis. If a company is expected to earn
30%, he will be prepared to pay Rs. 150 for one share of Rs. 100 each.

This approach can be objected to on the following grounds. Firstly, it wrongly assumes that the
earnings per share will remain constant in future. Secondly, the market prices of the shares will not
remain constant as the shareholders will expect capital gains as a result of reinvestment of retained
earnings. Thirdly, all the earnings may not be distributed among the shareholders by way of dividend.

(3) D/P + G Approach:

According to this approach, the investor is prepared to pay the market price of the shares as he
expects not only the payment of the dividend but also expects a growth in the dividend rate at a
uniform rate perpetually.

(4) Realised Yield Approach:

According to this approach, the cost of equity shares may be decided on the basis of yields actually
realised over the period of past few years which may be expected to be continued in future also.
This approach basically considers the D/P + G approach, but instead of considering the future
expectations of dividends and growth factor, the actual yields in the past are considered.
(d) Cost of Retained Earnings:
Many times, it is argued that the retained earnings do not cost anything to the company. This is
argued like this as there is no obligation, either formal or implied, to pay return on retained earnings
even though they constitute one of the major sources of funds for the company. In case of debt, the
company has a fixed obligation to pay interest on it.
Almost similar obligation exists in case of preference shares also. In case of equity shares, though
there is no legal obligation, the expectations of the shareholders at least provides a starting point for
computing the cost of equity shares. The retained earnings do not involve any of such obligations,
either, formal or implied.
As such, it may be felt that retained earnings involve no cost as they are not raised from outside
source. But this contention is not correct. Retained earnings involve cost and this cost is in the form
of the opportunity cost in terms of dividends foregone by or withheld from the equity shareholders.
 E.g. Assuming that the profits earned by the company are not retained but are distributed among
shareholders by way of dividend. These amounts of dividends which would have been received by
the shareholders, after due adjustments for tax deducted at source, could have been invested by the
shareholders elsewhere to earn some return.
The company, by retaining the profits, prohibits the shareholder from earnings these returns. As
such, the company is required to earn on the retained earnings at least equal to the rate which would
have been earned by the shareholders if they were distributed to them. This is the cost of retained
earnings.

Computation of Cost of Capital

Computation of cost of capital consists of two important parts:
1. Measurement of specific costs/individual capital cost

2. Measurement of overall cost of capital

1. Computation of Cost of Individual Capital Components:

A company has a capital structure with the different components. Each component carries its own
importance as well as burden over the firm. In order to compute the overall cost of the firm, the
finance manager must determine the cost of each type of funds needed in the capital structure of the
firm.

Each firm has an ideal capital mix of various sources of funds – external sources (debt, preference
share and equity share) and internal sources (reserves and surplus).

The followings are the different sources of capital:

i) Cost of Debt Capital:
In debt generally we include term loans, bonds and debentures. The debts always carry a fixed rate of
interest as a charge for the users which a firm is ready to pay to maximize its profitability and wealth.

The rate adjoined with the debt as generally shown (as 10% or 12%. Debenture) is the rate of interest
to be paid over the Debenture/debt but this is not only the cost for the issue of debt, the actual cost
may differ from this rate.

To find the actual charge (real cost of debt), it is required to know the relation of interest over the
actual amount realized (Net Proceed).

The Net Proceed is that amount which is actually realized after adjusting discount or premium on the
face value of loan or debentures after charging floatation costs.
Net Proceeds will be calculated as follows –
Face value of Debenture + Premium on issue (if any) – discount on issue (if any) – floatation cost.

Floatation costs include all types of charges or expenses incurred to obtain such loan like –
Advertisements Charges, Postage Stationery & Printing, Stamp duty, Brokerage Underwriting
commission etc.

Debt-capital can be classified into the following two types:

a) Perpetual or Irredeemable Debt:
These are the debts which are not repayable during the life of the company. They are repayable only
on the liquidation of the company. For calculating the cost of this type of debt-capital, the amount of
interest payable on it is divided by the net proceeds from its issue.

b) Redeemable Debt:
Mostly debentures are repayable within a stipulated time period. In the calculation of cost of such
debts, the time period of their redemption is very important.

The formula for calculating the cost of debenture-capital can be adapted as follows:

For calculating after tax cost of debt capital, the amount of interest is to be adjusted as follows:
ii) Cost of Preference Share Capital:
Preference shares are also fixed cost bearing securities like debentures. The rate of dividend payable
on these shares is fixed. Since dividend is not an admissible deduction in the computation of taxable
income, unlike debentures, cost of preference share capital is ‘after tax cost’ of capital which may be
converted into before tax cost by applying the following formula –

(1)
Preference Share can be classified into the following two types:
(a) Perpetual or Irredeemable Preference share
(b) Redeemable Preference share
(a) Cost of Irredeemable Preference Share Capital:
Cost of such preference shares is the ratio of annual dividend burden on each such share to its net
proceeds.

As per formula:

If dividend tax is paid, the formula will be as follows:

Note:
The only difference between the cost of debt and preference share is that in preference share we will
take preference dividend instead of interest, as we paid dividend on preference share and in
preference share first we will get after tax cost and then we will convert it to before tax.

(b) Cost of Redeemable Preference Share Capital:

Such shares are redeemed after a specified period. Cost of such shares is calculated in the same way
as discussed in the case redeemable debentures. Necessary adjustments will have to be made for
terms of issue, terms of redemption and floatation charges.

The following formula may be used for this purpose:

iii) Cost of Equity Share Capital:

The calculation of cost of equity share capital is a relatively difficult task because like preference
share capital there is neither any prefixed rate of dividend payable on these shares nor there is any
legal obligation to pay dividend on them. But it does not mean that equity share capital is cost-free.

The cost of such capital is equal to that expectation of equity shareholders, which they expect to be
fulfilled by the management to maintain their company.

Following are the three approaches of estimating the cost equity share capital:
(a) Dividend Yield Method:
This is also called the Dividend/Price Ratio Method or D/P Ratio Method. This Method is based on
the thinking that when an investor invests his savings in a company, he expects a dividend at least at
the current rate of return. As such cost of equity capital is calculated on the basis of the future stream
of dividends which the shareholders expect to receive from a company.

The formula is:

(b) Earnings Yield Method:
This is also known as Earnings/Price Ratio Method or E/P Ratio Method. This method is based on the
assumption that the market price of the shares is based on earning per share and so shareholders
capitalize the expected future earnings (as distinguished from dividends) in order to evaluate their
shareholders.

Hence, cost of equity capital is found by relating earnings per share with its market price.

The formula is as follows:

(2)
(c) Dividend Yield + Growth in Dividend Method:
This method is also known as Dividend/ Price + Growth in Dividend Method or D/P + G Method.
This method is based on the thinking that each equity shareholder is not satisfied with the present rate
of dividend only, he wants an increase in it each year based on his expectations of increase in future
earnings of the company.

In this method, cost of equity share capital is found by making appropriate adjustments in the current
rate of dividend on the basis of probable rate of increase in future earnings of the company.

This rate of increase is termed as growth rate:

1) When dividends are expected to grow at a uniform rate perpetually:
In this case, the yearly growth rate in dividend is added to the cost of equity capital as ascertained in
accordance with the D/P ratio method.

The formula is:

2) When dividends grow at different rates:
In such a case, the constant growth equation mentioned above is to be modified to take into account
two or more growth rates.

iv) Cost of Retained Earnings:

That part of earnings of a company which remains with it after distribution on dividend among the
shareholders is called ‘retained earnings’. They are commonly known as internal equity of the
concern. There is no explicit cost of this type of profits because there is no formal or implied
obligation on the company to pay any return on this amount. But it is not correct to treat them as cost
free.

In fact, cost of this source of finance is its opportunity cost. If retained earnings were not retained,
they would have been paid out to the shareholders as dividend and the shareholders should have
invested it in some alternative investments and should have earned return.

When earnings are retained, the shareholders are forced to forego such return. Hence, the expected
return foregone by the shareholders on forgone dividends may be treated as the cost of retained
earnings.

The following formula will be applied for calculating cost of retained earnings:
Notes:
Cost of retained earnings calculated by the above formula is after tax cost.

It can, however, be converted into before tax cost by applying the following formula –

2. Overall Cost of Capital:

A company finances its projects by different sources, although the specific cost of each source of
finance is different. Some are cheaper and some are dearer. There are two objectives of this policy –
firstly, to balance the capital structure, and secondly to increase the return of equity shareholders.

These objectives can be achieved only when the firm’s average cost of financing is lower than its
return on investment. This requires the computation of overall or average cost of capital. Overall cost
of capital may be defined as the average cost of the specific costs of different sources of financing.
This is used as acceptance/ rejection criterion in capital expenditure decisions.

The average can be a simple average or weighted average. However, a weighted average is more
reasonable and appropriate as it gives due emphasis to different sources of capital in the capital
structure of a firm.

Computation of Weighted Average Cost of Capital:

In involves the following four steps:
i) The computation of specific costs of various sources.

ii) Assignment of weights to each type of funds.

iii) Each specific cost is multiplied by the corresponding weight and in this way the weighted cost of
each source is determined.

Assignment of Weights:
This involves the determination of share of each source of capital in the total capital structure of the
company.

Weighted Average Cost of Capital

After calculating the cost of capital of different sources of financing, we need to know the overall cost
of capital, which will serve as the discount rate for investment decisions. Since, in a project, we have
to use a variety of sources to meet our entire capital requirement, the overall cost of capital for the
entire project would be the weighted average cost of capital (WACC).

The WACC depends upon two factors – one, the cost of capital of each individual source and two, the
share of each source in the total. If the cost of capital of an individual source is high, but its share in
the total is low, it will have little impact on the total and if its share is high it will increase the WACC
quite substantially.

Illustration:
A company is planning an investment of Rs. 10, 00,000 in a project.

They are planning to raise this amount through the following financing plan:

The tax rate is 40%. Calculate the weighted average cost of capital.

Solution:
We first calculate the cost of capital of each source:
If we are using the IRR method, then the WACC, calculated above, should be compared with the IRR
of the project. If the project IRR is greater than the WACC, the project should be accepted. If the IRR
is less than this rate, then it implies that the cost is higher than the return and the project is not
acceptable. For example, if the IRR is 12 percent only, then the project may not be accepted.

Limitations of Cost of Capital

Some of the limitations of cost of capital are as follows:
1) For ascertaining cost capital, use of mathematical calculations and their results cannot be accurate
for practical use.
2) The decision maker should not put too much dependence or reliance on these financial
calculations.
3) From the calculations indicates that debt capital is cheaper than preference and equity shares
capital in case most of the enterprises.

Capital Structure Theories

and
Optimum Capital Structure
Definition:

Capital structure is the composition of long-term liabilities, specific short-term liabilities like bank
notes, common equity, and preferred equity which make up the funds with which a business firm
finances its operations and its growth. The capital structure of a business firm is essentially the right
side of its balance sheet.
Capital structure, broadly, is composed of the firm's debt and equity. There are considerations by
management and the stakeholders over what mix of debt and equity to use. Should more debt
financing be used in order to earn a higher return? Should more equity financing be used to avoid the
risk of debt and bankruptcy?
Examples:
The capital structure of XYZ, Inc. is 40% long-term debt (bonds), 10% preferred stock, and 50%
common stock.
Approaches

Net Income Approach:-

The essence of net income approach is that the firm can increase its value or lower the overall cost of
capital by increasing proportion of debt in capital structure.

The assumption of this approach are:-

1. The use of debt does not change the risk perception of investors, as a result equity capitalisation
rate (kc) & debt-capitalisation rate (kd) remain constant with changes in leverage.
2. The debt capitalisation rate is less than equity-capitalisation rate (i.e. kd
3. The corporate income taxes do not exist.
The first assumption implies that if ke & kd are constant, increased use of debt by magnifying the
shareholders earnings, will result in higher value of the firm via higher value of equity. Consequently,
overall or weighted average cost of capital, ko will decrease. The overall cost of capital is measured
by Eq-
Ko= _X__ =__Noi_
VV
Thus, with constant annual net operating income (NOI) overall cost of capital of capital would
decrease as the value of firm, V increases.

1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure

This theory gives the idea for increasing market value of firm and decreasing overall cost of capital.
A firm can choose a degree of capital structure in which debt is more than equity share capital. It will
be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt
is cheap source of finance because its interest is deductible from net profit before taxes. After
deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost
of capital.

For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the
market value of firm and its positive effect on the value of per share.

High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of
financial leverage will be helpful to for maximize the firm's value.

2nd Theory of Capital Structure

Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing the financial leverage
under NI approach. It means to change the capital structure does not affect overall cost of capital and
market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure

Name of Theory = Traditional Theory of Capital Structure

This theory or approach of capital structure is mix of net income approach and net operating income
approach of capital structure. It has three stages which you should understand:

Ist Stage

In the first stage which is also initial stage, company should increase debt contents in its equity debt
mix for increasing the market value of firm.

2nd Stage
In second stage, after increasing debt in equity debt mix, company gets the position of optimum
capital structure, where weighted cost of capital is minimum and market value of firm is maximum.
So, no need to further increase in debt in capital structure.

3rd Stage

Company can gets loss in its market value because increasing the amount of debt in capital structure
after its optimum level will definitely increase the cost of debt and overall cost of capital.

4th Theory of Capital Structure

Name of theory = Modigliani and Miller

MM theory or approach is fully opposite of traditional approach. This approach says that there is not
any relationship between capital structure and cost of capital. There will not effect of increasing debt
on cost of capital.

Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations
may be further affected by large numbers of other factors which have been ignored by traditional
theorem of capital structure.
Proposition I

This proposition says that the capital structure is irrelevant to the value of a firm. The value of two
identical firms would remain the same and value would not be affected by the choice of financing
adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is
when there are no taxes.

Proposition II

This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is
when tax information is available. While the Modigliani-Miller theorem is studied in finance, real
firms do face taxes, credit risk, transaction costs, and inefficient markets, which makes the mix of
debt and equity financing important.

Concept and Features of Optimal Capital Structure

The concept of optimal capital structure has drawn a great deal of attention in accounting and finance
literature. Capital structure means the proportion of debt and equity in the total capital of a firm. The
objective of a firm is to maximize the value of its business.
This is done by maximizing market value of the shares and minimizing the cost of capital of a firm.
An optimal capital structure is that proportion of debt and equity, which fulfils this objective of a
firm. Thus an optimal capital structure tries to optimize two variables at the same time: cost of capital
and market value of shares.

Concept of Optimal Capital Structure:

Every firm should aim at achieving the optimal capital structure and try to maintain it. Optimal
capital structure refers to the combination of debt and equity in total capital that maximizes the value
of the company. An optimal capital structure is designated as one at which the average cost of capital
is the lowest which produces an income that leads to maximization of the market value of the
securities at that income.
Optimal capital structure may be defined as that relationship of debt and equity which maximizes the
value of company’s share in the stock exchange.

Definition:

Kulkarni and Satyaprasad defined optimum capital structure as ‘the one in which the marginal real
cost of each available method of financing is the same’. They included both the explicit and implicit
cost under the term real cost.

According to Prof Ezra Solomon, ‘Optimal capital structure is that mix of debt and equity which will
maximize the market value of a company’.

Hence there should be a judicious combination of the various sources of long-term funds which pro-
vides a lower overall cost of capital and so a higher total market value for the capital structure.
Optimal capital structure may thus be defined as, the mixing of the permanent sources of funds used
by the firm in a manner that will maximize the company’s common stock price by minimizing the
firm’s composite cost of capital.

Introduction
 The capital structure of a firm is how the firm has elected to finance its assets
 It is the level or percentage of total assets financed by debt, preferred stock and common equity
(common stock and retained earnings)
 Each firm has an optimal level of debt and equity at which it can operate most efficiently and
profitability
 Goal: Maximize Value of Firm
 See Lecture Note on Value of Firm
 V = CF/R (In General)
 We Can Max. Numerator or Min. Denominator
 Optimal Capital Structure - that mix of debt and equity which maximizes the value of the firm or
minimizes the cost of capital

Features of Optimal Capital Structure:

The salient features of an optimal capital structure are described below:

1. The relationship of debt and equity in an optimal capital structure is made in such a manner that
the market value per equity share becomes maximum.
2. Optimal capital structure maintains the financial stability of the firm.
3. Under optimal capital structure the finance manager determines the proportion of debt and equity
in such a manner that the financial risk remains low.
4. The advantage of the leverage offered by corporate taxes is taken into account in achieving the
optimal capital structure.
5. Borrowings help in increasing the value of company leading towards optimal capital structure.
6. The cost of capital reaches at its minimum and market price of share becomes maximum at
optimal capital structure.

Constraints in Designing Optimal Capital Structure:

The capital structure of a firm is designed in such a manner that the cost of capital is kept at its lowest
and the value of the firm reaches its maximum. The firm maneuvers its debt-equity proportion to
reach the optimum level. However in practice, reaching the level of optimum capital structure is a
difficult task due to several constraints that appear on the way of implementing that structure.

The main constraints in designing the optimum capital structure are:

1. The optimum debt-equity mix is difficult to ascertain in true sense.

2. The concept of appropriate capital structure is more realistic than the concept of optimum capital
structure.
3. It is difficult to find an optimum capital structure as the extent to which the market value of an
equity share will fall due to increase in risk of high debt content in capital structure, is very
difficult to measure.
4. The market price of equity share rarely changes due to changes in debt-equity mix, so there
cannot be any optimum capital structure.
5. It is impossible to predict exactly the amount of decrease in the market value of an equity share
because market factors that influence market value of equity share are highly complex.

Optimal Capital Structure (Benchmark Case)

 No Taxes
 No Transaction Costs
 Information is symmetric
 No other market imperfections

Optimal Capital Structure (No Taxes)

 CF’s From Assets Unchanged
 Value of Firm ==> Circle
 Portfolio of Debt & Equity
 ‘PIE’ Idea
 Miller & Modigliani Proposition I (M&M I)
 The Financing Decision is Irrelevant

LEVERAGE
Leverage is generally defined as the ratio of the percentage change in profits to the percentage change
in sales. In other words, leverage is the multiplying effect that fixed costs have on profits when there
is any change in sales. As sales increases or decreases, it is only the variable costs that change
correspondingly, fixed costs remain constant. Profits therefore increase or decrease at a faster rate
than the rate of change in sales. This can be better understood with an example.
A hypothetical income statement for a firm is as follows:

Sales 2000
Less: Variable costs 800
------
Contribution 1200
Less: Fixed costs 500
------
Profits 700
------

If the sales of this firm is increased by 20%, the income statement will stand revised as follows:

Sales 2500 (increase of 25%)

Less: Variable costs 1000 (increase of 25%)
------
Contribution 1500 (increase of 25%)
Less: Fixed costs 500 (No change)
--------
Profits 1000
---------

With an increase in sales of 25% from Rs. 2,000 to Rs. 2,500, profits have increased from Rs. 700 to
Rs. 1000, an increase of 43%. This is the effect of leverage. If the firm had no fixed costs at all but all
its costs were variable, there would have been no leverage and the percentage change in sales would
have been the same as the percentage change in profits. It is fixed costs that introduce leverage into
the firm and higher the fixed cost, higher is the leverage.

Financial management differentiates between two types of leverages –

 Operating Leverage
 Financial Leverage.

Operating leverage is the leverage effect on account of all fixed costs other than interest.
The formulae for calculating the operating leverage and financial leverage are:

Operating leverage (DOL)

% change in PBIT
= ---------------------
% change in sales

Financial leverage is the leverage effect on account of the financial cost, interest.
Financial leverage (DFL)
 % change in PBT
= ---------------------
% change in PBIT

The leverage therefore gives the sensitivity of profit changes to changes in sales. In the method
indicated above for calculating the leverages, two sets of values of the income statement for two
levels are needed. However, by using the modified formula given below, the operating and financial
leverages can be calculated directly from the data in one income statement.
Contribution
Operating leverage = ----------------
PBIT

PBIT
Financial Leverage = ----------
PBT
Example

Table 13.2
Current Capital Structure: No Debt
Recession Expected Expansion
EBIT Rs.500,000 Rs.1,000,000 Rs.1,500,000
Interest 0 0 0
Net Income Rs.500,000 Rs.1,000,000 Rs.1,500,000
ROE 6.25% 12.50% 18.75%
EPS Rs.1.25 Rs.2.50 Rs.3.75

Proposed Capital Structure: Debt = Rs.4 million

Recession Expected Expansion
EBIT Rs.500,000 Rs.1,000,000 Rs.1,500,000
Interest 400,000 400,000 400,000
Net Income Rs.100,000 Rs.600,000 Rs.1,100,000
ROE 2.50% 15.00% 27.50%
EPS Rs.0.50 Rs.3.00 Rs.5.50

Leverage Effects

Variability in ROE
 Current: ROE ranges from 6.25% to 18.75%
 Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPS
 Current: EPS ranges from Rs.1.25 to Rs.3.75
 Proposed: EPS ranges from Rs.0.50 to Rs.5.50
The variability in both ROE and EPS increases when financial leverage is increased

Combined leverage factor:

If a firm uses a considerable amount of both operating and financial leverage, even small changes in
the level of sales will produce wide fluctuations in PBT. The effect of the superimposition of
financial leverage on operating leverage is obtained by multiplying the two leverages. The product is
called the combined leverage factor or the leverage multiplier.
Combined leverage factor = Operating leverage * Financial leverage

Contribution PBIT
= ---------------- * -------------
PBIT PBT
Contribution
= ----------------
PBT

A firm having a high operating leverage at a particular sales level means that its profits (PBIT) will
be very sensitive to change in sales. Small changes in sales will bring about a magnified change in
PBIT. This is both advantageous as well as disadvantageous. A small increase in sales will bring
about a greatly magnified increase in profits but a small decrease in sales might well put the firm into
losses.

The Effect of Leverage

• How does leverage affect the EPS and ROE of a firm?
• When we increase the amount of debt financing, we increase the fixed interest expense
• If we have a really good year, then we pay our fixed costs, and have more left over for our
stockholders
• If we have a really bad year, we still have to pay our fixed costs, and have less left over for our
stockholders
• Leverage amplifies the variation in both EPS and ROE

Factors affecting financial leverage:

Financial leverage is PBIT/ PBT. Therefore as interest increases, financial leverage will increase.
Interest, in turn, being the cost of borrowed funds, will increase with increase in the proportion of
debt used for financing assets. That is why; the ratio of borrowings to assets is also called financial
leverage. The higher the degree of financial leverage of a firm, the greater is the sensitivity of its
profits before tax to changes in PBIT. The combined leverage factor which is the product of operating
leverage and financial leverage determines the overall sensitivity of profits before tax to change in
sales. As income taxes are calculated as a percentage of profit before tax, the net profit will normally
be proportionate to the profit before tax. Therefore, fluctuations in profit before tax will bring about
corresponding fluctuations in net profits which in turn will bring about fluctuations in earnings per
share (EPS) as EPS equals net profit divided by the number of equity shares. Therefore, the combined
leverage factor influences the extent to which net profits and EPS will fluctuate for a given
fluctuation in sales.
It is important to remember that additional benefits will accrue only when the return on assets is
higher than the cost of borrowings. If however, the cost of borrowings is higher than the return on
assets; the return on net worth will be even less than the return on assets.