IMPACT OF CAPITAL STRUCTURE ON THE

VALUE OF THE FIRM

MBA-2 (A)
DOON BUSINESS SCHOOL

Submitted By:
Menka Rawat
Rishav Basak
Satya Prakash
Aarohi Saxena
Amit Kumar Jha
 INTRODUCTION

HDFC Bank Ltd is one of India's premier banks. Headquartered in Mumbai HDFC Bank is a
new generation private sector bank providing a wide range of banking services covering
commercial and investment banking on the wholesale side and transactional/branch banking on
the retail side. As of 31 December 2020, the bank's distribution network stood at 5485 branches
and 15541 ATMs & Cash Deposit Machines (CDMs) across 2866 cities and towns. HDFC Bank
also has one overseas wholesale banking branch in Bahrain a branch in Hong Kong and two
representative offices in UAE and Kenya. The Bank has two subsidiary companies namely
HDFC Securities Ltd and HDB Financial Services Ltd.
HDFC Bank Ltd Was incorporated on August 30 1994
by Housing Development Finance Corporation Ltd. In
the year 1994 Housing Development Finance
Corporation Ltd was amongst the first to receive an 'in
principle' approval from the Reserve Bank of India to
set up a bank in the private sector as part of the RBI's
liberalization of the Indian Banking Industry. HDFC
Bank commenced operations as a Scheduled
Commercial Bank in January 1995. Ramon House
Church gate branch was inaugurated on 16 January
1995 as the first branch of the bank. In March 1995 HDFC Bank launched Rs 50-crore initial
public offer (IPO) (5 crore equity shares at Rs 10 each at par) eliciting a record 55 times
oversubscription. HDFC Bank was listed on the Bombay Stock Exchange on 19 May 1995. The
bank was listed on the National Stock Exchange on 8 November 1995.
The Bank has three primary business segments namely banking wholesale banking and treasury.
The retail banking segment serves retail customers through a branch network and other delivery
channels. This segment raises deposits from customers and makes loans and provides other
services with the help of specialist product groups to such customers. The wholesale banking
segment provides loans non-fund facilities and transaction services to corporate public sector
units government bodies financial institutions and medium-scale enterprises. The treasury
segment includes net interest earnings on investments portfolio of the Bank.

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In this assignment we, are here to discuss the ‘Impact of Capital Structure on the Value of the
Firm’
There are certain parameters of the discussion of the topic:

 COST OF CAPITAL
 MARKET PRICE OF SHARE
 EARNING PER SHARE (EPS)
 VALUE OF THE FIRM

COST OF CAPITAL
Cost of capital is the required return necessary to make a capital budgeting project, such as
building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they
typically mean the weighted average of a firm's cost of debt and cost of equity blended together.
The cost of capital metric is used by companies internally to judge whether a capital project is
worth the expenditure of resources, and by investors who use it to determine whether an
investment is worth the risk compared to the return. The cost of capital depends on the mode of
financing used. It refers to the cost of equity if the business is financed solely through equity, or
to the cost pf debt if it is financed solely through debt.

A firm's cost of capital is typically calculated using the weighted average cost of capital formula
that considers the cost of both debt and equity capital. Each category of the firm's capital is
weighted proportionately to arrive at a blended rate, and the formula considers every type of debt
and equity on the company's balance sheet, including common and preferred stock, bonds, and
other forms of debt.

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 Cost of debt
Cost of debt = (Interest Expense/ Total Debt) (1-T)
Where:
Interest expense: Int. paid on the firm’s current debt
T: the company’s marginal tax rate
Cost of debt Low High
Selected Long-term Debt 4.0% 4.5%
Tax Rate 32.0% 32.0%
After-tax Cost of Debt 2.72% 3.06%

Cost of Equity
The cost of equity is the return a company requires to decide if an investment meets capital
return requirements. Firms often use it as a capital budgeting threshold for the required rate of
return.
Cost of Equity = (DPS /CMV) + GRD
where:
DPS = dividends per share, for next year
CMV = current market value of stock

Cost of Equity Low High

Selected Beta 1.15 1.25
Country Market Risk 6.9% 6.9%
Premium
Adjusted Market Risk 7.9% 8.6%
Premium
Risk-free Rate 2.25% 2.50%
Additional Risk Adjustments 0.13% 0.25%
Cost of Equity 10.25% 11.25%
GRD = Growth rate of dividend
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Weighted Average

(WACC) is used by analysts and investors to assess an investor's returns on an investment in a

company. As the majority of businesses run on borrowed funds, the cost of capital becomes an
important parameter in assessing a firm’s potential for net profitability. WACC measures a
company’s cost to borrow money, where the WACC formula uses both the company’s debt and
equity in its calculation.

WACC = {(E/V) * Re} + {(D/V) * Rd * (1-T)}

Were, E=Market value of the firm’s equity
D = Market value of the firm’s debt
V = E+D
Re = Cost of Equity
Rd = Cost of Debt
Tc = Corporate Tax Rate

Cost Estimates Low High

Cost of Equity 10.25% 11.25%
After-tax Cost of Debt 2.72% 3.06%
Weights
Equity % of Capital 100.0% 100.0%
Debt % of Capital 0.0% 0.0%
WACC Range 10.25% 11.25%

Selected WACC = 10.75%

WACC is one of the most important financial indicators. It represents the expense of raising
money—so the higher it is, the lower a company’s net profit.
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MARKET PRICE OF THE SHARE

Market price per share simply refers to the most recent price of a single share in a publicly-
traded stock. This is not a fixed price—it fluctuates throughout the trading day as various market
forces push the price in different directions. Unlike the book value per share, the market price per
share has no specific relation to the value of the company's assets or any other balance
sheet information.
The market price of the share of HDFC Bank is ₹ 1,490.25, with the market capitalization of
₹ 8,22,326.57 Cr. The P/E ratio is 26.43 with Dividend Yield 0.17%.

EARNING PER SHARE

Earnings per share or EPS is an important financial measure, which indicates the profitability
of a company. It is calculated by dividing the company’s net income with its total number of
outstanding shares. It is a tool that market participants use frequently to gauge the profitability of
a company before buying its shares.
EPS = (NET INCOME - PREFERANCE DIVIDEND)/ WEIGHTED AVERAGE SHARES
OUTSTANTANDING
The Earning per Share of HDFC Bank is ₹ 56.39.
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VALUE OF THE FRIM

A business valuation is a general process of determining the economic value of a whole

business or company unit. Business valuation can be used to determine the fair value of a
business for a variety of reasons, including sale value, establishing partner ownership,
taxation, and even divorce proceedings. Owners will often turn to professional business
evaluators for an objective estimate of the value of the business. A firm’s value, also known as
Firm Value (FV), Enterprise Value (EV) is an economic concept that reflects the value of a
business. It is the value that a business is worthy of at a particular date. Theoretically, it is an
amount that one needs to pay to buy/take over a business entity. Like an asset, the value of a firm
can be determined on the basis of either book value or market value. But generally, it refers to
the market value of a company. EV is a more comprehensive substitute for market capitalization.

HDFC Bank Ltd. retains a regular real

value of 1197.86 per share. The prevalent
price of the firm is 1479.4. At this time, the
firm appears to be overvalued. Our model
calculates the value of HDFC Bank Ltd.
from inspecting the firm fundamentals such
as Return On Asset of 1.90%, operating
margin of 54.09% and Return On Equity of
16.49% as well as reviewing its technical
indicators and Probability Of Bankruptcy. In
general, we encourage picking up undervalued assets and discarding overvalued assets since, in
the future, asset prices and their ongoing real values will come together.
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Project Assignment Questions

1. How does Debt ratio affect EPS?

Ans. The more debt financing a company uses, the higher its financial leverage. A high degree
of financial leverage means high interest payments, which negatively affect the company’s
bottom-line earnings per share (EPS). As a company increases debt and preferred equities,
interest payment increases, reducing EPS. As a result, risk to shareholders return in increased. A
company should keep its optimal capital structure in mind when making financing decision to
ensure any increases its debt preferred equity increase the value of the company.
According to HDFC Bank latest twelve months degree of operating leverage (dol) is 1.31. HDFC
Bank's degree of operating leverage (dol) decreased in 2019 (1.12, -3.7%) and 2020 (0.76, -
32.1%) and increased in 2017 (1.09, +11.3%), 2018 (1.16, +6.8%) and 2021 (1.31, +72.0%) and
the he Earning per Share of HDFC Bank is ₹ 56.39.

2. If a firm is financed with one mix of securities rather than another, is the value of the
firm affected?
Ans. Raising money by selling new shares of stock has no impact on a firm's profitability, but it
can dilute existing shareholders' holdings because the company's net income is divided among a
larger number of shares. If a firm raises funds through debt financing, there is a positive item in
the financing section of the cash flow statement as well as an increase in liabilities on the balance
sheet. HDFC Bank’s shareholders have no reason to complain even though they might be irked if
they are a customer. But regular and prolonged snags are sure to bother shareholders at a time
when digital prowess is a big growth enabler. In fact, HDFC Bank was pulled up by the regulator
for such slips and is barred from launching any new digital campaigns or even issuing credit
cards to new customers until it fixes these bugs. Despite all this, the stock has gained a decent
8% since the December, when the digital troubles surfaced.

3. Does it matter, the way in which investment proposals are financed?

Ans. Yes it does matter the way in which investment proposals are financed.

4. Does capital structure have any effect on corporate performance?

Ans. The capital structure is not a major determinant of firm performance. Hence, the study
recommends that managers should be careful while using debt as a source of finance since a
negative impact exist between the capital structure and corporate firm's performance. The
purpose of this topic is to empirically investigate the impact of capital structure on Profitability
with Special Reference to HDFC Bank. Multiple regression analysis is used to study the impact
of capital structure on Profitability.

5. What is the optimal capital structure for a firm?

Ans. The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital. In theory, debt
financing offers the lowest cost of capital due to its tax deductibility.

6. How may corporation establish proper capital mix?

Ans. The relative proportion of various sources of funds used in a business is termed as financial
structure. Capital structure is a part of the financial structure and refers to the proportion of the
various long-term sources of financing. It is concerned with making the array of the sources of
the funds in a proper manner, which is in relative magnitude and proportion.
The capital structure of a company is made up of debt and equity securities that comprise a
firm’s financing of its assets. It is the permanent financing of a firm represented by long-term
debt, preferred stock and net worth. So, it relates to the arrangement of capital and excludes
short-term borrowings. It denotes some degree of permanency as it excludes short-term sources
of financing.
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