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It is the types of securities to be
issued and proportionate amounts that make up the capitalization. Capital gearing:- the relationship between ownership capital and creditor ship capital Highly geared when cc> oc Low geared when co>cc
Factors affecting capital structure
Trading On equity or Financial leverage
Cost of financing
Capital market conditions
Flexibility of financial structure
Statutory Period of requirements financing
Financial structure and capital structure
FS = long term + short term
liabilities Capital structure = long term liabilities
Approaches – capital structure
Approaches to determine the firm’s
capital structure:– Ebit eps analysis – Cost of capital – Cash flow analysis
It implies selecting the desired debt equity mix The min rate of return expected by the supplier of
finance is called the COST OF CAPITAL It depends on the degree of risk assumed by the investors Debt holders assume less risk than shareholders The tax deductibility of interest charges further decreases the cost of debt. The firm will always like to employ debt as a SOURCE OF FINANCE if cost of capital is a CRITERION for financing decisions
OPTIMUM CAPITAL STRUCTURE
The relationship of debt and equity which maximizes
the value of the firm’s share in the stock exchange.
Theories of capital structure
Net income approach Net operating income Traditional approach Modigliani- Miller approach
RELATION BETWEEN FINANCIAL LEVERAGE AND VALUE OF THE FIRM
DEBT EQUITY MIX---- FINANCIAL LEVERAGE VALUE OF THE FIRM- DEBT + EQUITY ASSUMPTIONS: ONLY TWO TYPES OF CAPITAL EMPLOYED:-- DEBT AND EQUITY TOTAL ASSETS REMAIN THE SAME NO RETAINED EARNINGS PERPETUAL LIFE FIRM’S OPERATIVE EARNINGS ( EBIT) REMAINS CONSTANT FIRMS’ BUSINESS RISK REMAINS THE SAME TOTAL FINANCING OF THE FIRM REMAINS THE SAME NO TAX
COST OF CAPITAL VALUE OF THE FIRM
Net income approach Net operating income approach Traditional approach Modigliani miller approach Total market value of equity Total MV of debt (D) Total MV of the firm (V) Total interest on debt capital
(I) Net operating income available to the equity shareholders Cost of equity Ke = EBIT – I / E
Ke = eps/P Value of equity = E = ebit-I / Ke Cost of debt Kd = I / D Value of debt = I/Kd V=E+D Kw = Wd Kd + We Ke Wd = proportion of debt to total value
NET INCOME APPROACH
Suggested by DAVID DURAND Value of the firm depends on its
capital structure decision High debt content in the CS = high FL V=E+D E= EBIT-I / Ke D= I/Kd In the light of the graph it is clear that as D/E enhances . Kw decreases because the proportion of debt enhances in the CS
Enhance Value of FIRM
High debt content
Reduction Overall Cost of capital
A ltd is expecting an annual EBIT of rs 2 lakh. The co.. has 8%
debentures of rs5 lakh. The cost of capital is 10%. Compute the total value of the company and overall cost of capital. EBIT 200000 less interest 40000 EBT 160000 earnings available to ESH Ke 10% Market value of equity (E) = EBIT – I /Ke 16,00,000 total value of the company = 16L + 5L overall COC Kw = EBIT / V = 9.5%
Net operating income approach
Advocated by David Durand Value of a firm depends on its
NOI and business risk
Change in the degree of leverage a firm cannot change its
NOI and Business risk It brings variation in the distribution of income and risk between debt and equity without affecting the total income and risk which influences the market value of the firm. Optimum CS When there is 100% debt content Assumptions:– Kw is constant for all degree of leverage – NOI is capitalized at an overall capitalization rate to find out the total market value of the firm. Thus the split between D & E is irrelevant.
The use of low cost debt enhances the risk of equity
share holders, enhancing the equity capitalization rate. Thus the benefit of DEBT is nullified by the increase in the EQUITY CAPITALIZATION RATE.
V = EBIT / Kw An increase in the use of debt funds is offset by an
increase in the equity capitalization rate. This occurs because the equity investors seek more compensation as they are exposed to higher risk arising from increase in the degree of leverage.
AB ltd has an EBIT of 2 L. the company has 8% debentures of
Rs 5L. Presuming the overall capitalisation rate as 10%, compute the total value of the company and equity capitalisation rate – – – – – – EBIT 200000 Kw 10% Mkt value of the company 200,000/10% = 20,00,000 Total value of debt 500,000 Market value of equity 15,00,000 Ke = EBIT – I / D * 100 = 10.67%
If the company increases the debt content by
decreasing the equity content, the total value of the company would remain unchanged but the capitalization rate will increase.
COST OF CAPITAL IS DEPENDENT ON THE CAPITAL STRUCTURE THE MAIN PROPOSITIONS OF THIS APPROACH ARE:
– COST OF DEBT CAPITAL REMAINS CONSTANT UPTO A CERTAIN DEGREE OF LEVERAGE AND THERE AFTER RISES COST OF EQUITY CAPITAL REMAINS CONSTANT MORE OR LESS OR RISE GRADUALLY UPTO A CERTAIN DEGREE OF LEVERAGE AND THEREAFTER INCREASES RAPIDLY. THE AVERAGE COST OF CAPITAL REDUCES UPTO A CERTAIN POINT AND REMAINS MORE OR LESS UNCHANGED FOR MODERATE INCREASE IN LEVERAGE AND THERE AFTER RISES AFTER ATTAINING A CERTAIN POINT.
IT ACCEPTS THAT CAPITAL STRUCTURE OF A FIRM AFFEECTS THE COC AND ITS VALUATION IT DOES NOT SUBSCRIBE TO THE CONCEPT THAT THE VALUE OF THE FIRM WILL NECESSARILY ENHANCE WITH ALL LEVELS OF LEVERAGE.
MODIGLIANI MILLER APPROACH
Total market value of the firm and cost of capital are independent of the capital structure WACC does not make any change with a proportionate change in debt –equity mix in the total capital structure of the firm It provides operational justification for irrelevance of the capital structure in the valuation of the firm.
COC AND MARKET VALUE OF THE FIRM ARE INDEPENDENT OF ITS CAPITAL STRUCTURE. COST OF CAPITAL = CAPITALISATION RATE OF EQUITY TOTAL MARKET VALUE OF THE FIRM IS DETERMINED BY CAPITALISING THE EXPECTED NOI BY THE RATE APPROPRIATE FOR THE RISK CLASS. Ke – Kd = premium for financial risk Increased Ke is offset by the use of cheaper debt The cut off rate for investment is always independent of the way in which an investment is financed.
Criticism of MM hypothesis
Different rates of interest Corporate taxes Questions : What do you understand by capital structure of a
firm? Explain the approaches in capital structure
Cost of capital
IT IS THE RATE OF RETURN THE FIRM REQUIRES
FROM INVESTMENT IN ORDER TO INCREASE THE VALUE OF THE FIRM IN THE MARKET PLACE.
SIGNIFICANCES:– Device an optimum capital structure – Serve as a discount rate for selecting projects.
COST OF RAISING FUNDS REQUIRED TO FINANCE THE PROPOSED PROJECT.- THE BORROWING RATE OF THE FIRM. WEIGHTED AVERAG COST OF EACH TYPE OF CAPITAL IS A HURDLE RATE ASCERTAINED ON THE BASIS OF ACTUAL COST OF VARIOUS COMPONENTS OF CAPITAL MINIMUM RATE OF RETURN
THREE COMPONENTS OF COC
RETURN AT ZERO RISK LEVEL------ NO FINANCIAL OR BUSINESS RISK BUSINESS RISK PREMIUM--- VARABILITY IN OPERATING PROFIT BY VIRTUE OF CHANGES IN SALES FINANCIAL RISK PREMIUM– RELATES TO THE PATTERN OF CAPITAL STRUCTURE
Significance of cost of capital
Capital budgeting decisions
Capital structure decisions
COMPUTATION OF COST OF CAPITAL
COST OF DEBT:– RATE OF RETURN EXPECTED BY THE LENDERS – INTEREST RATE SPECIFIED AT THE TIME OF ISSUE – ISSUED AT PAR,PREMIUM OR DISCOUNT
– ISSUED AT PAR:– Kd = R( 1- T) – T= tax rate – R= interest rate
= annual interest / net proceeds * 100
A company issues 10% debentures for 100,000.
rate of tax 50%. Calculate the cost of debt (after tax) when issued at PAR ,10% PREMIUM AND 10% DISCOUNT
10,000/100000 (1-50%) = 5%
At premium:- 10,000/110000 (1-50%)= 4.5% At discount:- 5.6%
COST OF PREFERENCE SHARE CAPITAL
Kp = Dd / P CONTROL OF THE COMPANY ISSUE COST OF PREFERENCE CAPITAL IS HIGHER THAN
THE COST OF DEBT
A COMPANY RAISES PSC OF RS 100000 BY ISSUING 10% PREFERENCE SHARES OF RS100 EACH. COMPUTE THE COST OF PC WHEN THEY ARE ISSUED AT 1)10% PREMIUM 2) 10% DISCOUNT Kp= cost Of PS 10000/110000 10000/90000
COST OF EQUITY SHARES
THE MARKET VALUE OF EQUITY SHARES DEPENDS
ON THE RETURN EXPECTED BY THE SHAREHOLDERS
COST OF EQUITY CAPITAL IS DEFINED AS THE
MINIMUM RATE OF RETURN THAT A FIRM MUST EARN ON THE EQUITY –FINANCED PORTION OF AN INVESTMENT PROJECT INORDER TO LEAVE UNCHANGED THE MARKET PRICE OF ITS STOCK
RATE OF RETURN ON EQUITY 13% COST OF DEBT 10% COMPANY POLICY TO FINANCE 70% EQUITY 30%
DEBT THE REQUIRED RATE OF RETURN ON THE PROJECT:– 1 3%* 0.70 + 10% * 0.30 = 12.1% – 50000 INVESTMENT IN A PROJECT------6050 ANNUAL RETURN. SO THE ROR ON THE EQUITY FINANCED PORTION IS
EQUITY = 35000
TOTAL RETURN LESS INTEREST IN DEBT AMT AVAILABLE TO ESH RATE OF RETURN ON EQUITY
• 4550 * 100 / 35000 = 13%
6050 1500 4550
COST OF EQUITY = DIVIDEND / PRICE THAT RATE OF EXPECTED DIVIDEND WHICH WILL
MAINTAIN THE PRESENT MARKET PRICE OF EQUITY SHARES
D/P + G EARNINGS / PRICE
COST OF RETAINED EARNINGS – = COST OF EQUITY ( 1-T) (1-COMMISSION)
CALCULATE THE COST OF EACH SPECIFIC SOURCE
OF FUNDS ASSIGN PROPER WEIGHTS TO SPECIFIC COSTS MULTIPLY THE COST OF EACH SOURCE BY THE APPROPRIATE WEIGHT DIVIDE THE TOTAL WEIGHTED COST BY THE TOTAL WEIGHTS TO GET THE OVERALL COC
THE COC AFTER TAX :– COST OF DEBT 4% – COST OF PS 11.5% – COST OF EC 15.50% – COST OF RE 14.5% – CAPITAL STRUCTURE:• • • • DEBT 3,00,000 PSC 4,00,000 ESC 6,00,000 RE 2,00,000 CALCULATE WACC
PROPORTION AFTER TAX COST
DEBT PSC ESC RE
300000 400000 600000 200000
20% 0R .2 4% 0.04 26.7% OR 11.5% 0.267 0.115 40% 0.40 13.3% 0.133 15.5% 0.155 14.5% 0.145
0.008 0.0307 0.0620 0.0193 0.1200
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