Financial Management

Professional Level

Sk Md Tarikul Islam
FCA, MBA (UK), CBV (Canada)
Capital structure and cost of capital

By the end of this chapter, you should be able to

understand and apply:
 Capital structure
 Cost of equity
 Cost of debt
 WACC
 APV
Capital structure

Suitability of capital structure

 Stability of the company
 Matching assets with fund
 Long-term capital requirements for replacement and growth
 Signalling
 Clientele effect
 Domestic and international borrowing
 Cost and flexibility
 Optimal capital structure and the cost of capital
Capital structure

Acceptability of capital structure

 Risk attitudes
 Loss of control
 Costs
 Commitments
 Present source of finance
Capital structure

Feasibility of capital structure

 Lenders’ attitude
 Shareholder willingness to invest
 Future trends
 Restrictions in loan agreements
 Maturity date
Capital structure

Pecking order theory: Justification for

 Retained earnings
pecking order:
 Minimize issue cost
 Straight debt
 Minimise time and
 Convertible debt
expense in persuading
 Preference shares
outside investor
 Equity shares
 Existence of
asymmetrical
information
Capital structure

 Traditional view of gearing p. 256

 M&M 1958 without tax p. 258
 M&M 1963 with tax p. 259
Problems with high gearing:
- Bankruptcy cost
- Agency costs
- Tax exhaustion
Cost of capital

 Irredeemable debt capital: Cost of equity:

Kd = i(1-T)/ P0 p. 207 Gordon: g = r x b
𝑛
 Redeemable debt capital: ** D0 (1+g) = Dn
Kd = IRR (1-T) p. 208
 Dividend model
 Cost of Pref. Share:
Without growth
Kp = D/P0 p. 205 Ke= D0/ P0
 Cost of convertible debt
With Growth:
IRR method p. 210 K D1/ Po) + g
e= (
2
Conversion value= P0 (1+g) R p. 199-203
Cost of capital
 EIR Cost of equity:
𝑛
r= (1+i/n) -1 ii. CAPM p. 205
Ke= Rf + (Rm –Rf) βe
 WACC
WACC = ((E/V) * Re) + {(D/V) * Rd)}
Beta depends on:
- Sensitivity of cash flows
- Operating gearing
- Financial gearing
Cost of capital
Limitations of CAPM:
 Excess return – historic
 Risk free rate
 Errors in statistical analysis
 Beta may change over time
 Unable to forecast accurately returns for low PE ratios companies
 Use of sector wise beta instead of company specific
 Fails to take into account the ways returns are paid

Business Risk: Variability in EBIT in the sector

Financial Risk: Additional variability in returns as a result of fixed loan
Operating gearing : Fixed vs Variable cost
Financial gearing: Gearing ratio, Interest coverage ratio
Adjusted PV (APV)
Adjusted PV (APV)
Conclusion

After having solid grounding, review as many

questions as possible to avoid panic in the
exam !!!
Questions??

Thank You !!