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PRESENTATION

ON
CAPITAL STRUCTURE OF A
COMPANY

SUBMITTED TO:
MRS. RASHMI CHOUDHARY
SUBMITTED BY:
TANUPRIYA
H-2008-MBA-41
DEFINITION :

“Capital structure of a company refers to the


composition or make up of its capitalization and it
includes all long term capital resources viz: loans,
reserves, shares and bonds.”
The capital structure is made up of debt and equity
securities and refers to permanent financing of a firm .
It is composed of long-term debt, preference share
capital and shareholder’s fund.
 CAPITALIZATION, CAPITAL STRUCTURE
AND FINANCIAL STRUCTURE

1)Capitalizationrefers to the total amount of securities


issued by a company. Its is computed as follows

Rs
Equity Share Capital 10,00,000
Preference Share Capital 5,00,000
Long-term Loans and Debentures 2,00,000

Capitalization
17,00,000
2) Capital structure refers to the proportionate
amount that makes up capitalisation, is computed as
below:
Rs Proportion/
Mix
Equity Share Capital 10,00,000 58.82%
Preference Share Capital 5,00,000 29.41%
Long-term Loans and Debentures 2,00,000 11.77%

17,00,000 100%
3)Financial structure refers to all the financial
resources , short as well as long-term and is calculated
as: Rs Proportion/Mix
Equity Share Capital 10,00,000 40%
Preference Share Capital 5,00,000 20%
Long-term Loans and 2,00,000 8%
Debentures 6,00,000 24%
Retained Earnings 50,000 2%
Capital surplus 1,50,000 6%
Current Liabilities
25,00,000 100%
 FORMS/PATTERNS OF CAPITAL
STRUCTURE
The capital structure of a new company may consist
of the following forms:
a) Equity Shares only
b) Equity and Preference Shares
c) Equity Shares and Debentures
d) Equity Shares, Preference Shares and Debentures.
 THEORIES OF CAPITAL STRUCTURE
The important theories of capital
structure are:
1) Net Income Approach
2) Net Operational Income Approach
3) The Traditional Approach
4) Modigliani and Miller Approach
1) NET INCOME APPROACH
The theory propounds that a company can increase its value
and reduce the overall cost of capital by increasing the proportion
of debt in its capital structure. A firm can minimise the weighted
average cost of capital & increase the value of the firm as well as
market price of equity shares by using debt financing to the
maximum possible extent. This approach is based on the
following assumptions:
i. The cost of debt is less than the cost of equity.
ii. There are no taxes.
iii. The risk perception of investors is not changed by the use of debt.
The total market value of a firm on the basis of Net Income Approach
can be ascertained as:
V= S + D
Where, V= Total market value of a firm
S= Market value of equity shares
= Earnings Available to Equity Shareholders (NI)/Equity
Capitalisation Rate
D= Market value of debt.
And, Overall Cost of Capital or Weighted Average Capital can be
calculated as:
K = EBIT/ V
Illustration
A company expects a net income of Rs. 80,000. it has Rs. 2,00,000, 8%
debentures. The equity capitalisation rate of the company is 10%.
Calculate the value of the firm and overall capitalisation rate according to
the net income approach.
Calculation of the value of the
Firm
Rs
Net Income 80,000
Less: Interest on 8% Debentures of Rs. 2,00,000 16,000
Earnings available to equity shareholders
64,000
Equity Capitalisation Rate
10%
Market Value of equity(S)= 64,000*100/10
6,40,000
Market Value of Debentures(D)
2,00,000
Value of the Firm (S+D) 8,40,000
Overall Cost of Capital(k)= Earnings/ Value of the Firm
(EBIT/V)
= 80,000/8,40,000 * 100 = 9.52%
2) Net Operating Income Approach.
This approach says that change in the capital structure of a company does not affect
the market value of the firm and the overall cost of capital remains constant
irrespective of the method of financing. It implies that the overall cost of capital
remains the same whether the debt-equity mix is 50:50 or 20:80.
This theory presumes that:
i. The market capitalises the value of the firm as a whole;
ii. The business risk remains constant at every level of debt equity mix;
iii. There are no corporate taxes.
The reason propounds for such assumptions are that the increased use of debt increases
the financial risk of the equity shareholders and hence the cost of equity increases.
On the other hand the cost of debt remains the constant with the increasing
proportion of debt as the financial risk of the lenders is not effected.
The value of the firm on the basis of Net Operating Income Approach can be determined
as:
V= EBIT/K
Where , V= Value of a firm
EBIT= Net Operating Income or Earning before interest and tax
Ko= Overall cost of Capital
The market value of Equity is
S=V-D
Where, S= Market value of equity
V= total market value of a firm
D= market value of debt
Illustration
A co. expects a net operating income of Rs. 1,00,000. it has Rs. 5,00,000 , 6%
Debentures. The overall capitalisation rate is 10%. Calculate the value of the firm
and the equity capitalisation rate according to Net Income Operating Approach.
Solution: Net operating income = Rs.1,00,000
Overall cost of capital =10%
Market value of the firm(V)=net operating income/ overall cost of capital
[EBIT/k]
=1,00,000 * 100/10 = Rs. 10,00,000
Market value of firm =Rs 10,00,000
Less: market value of debentures =Rs. 5,00,000

Total market value of equity = Rs. 5,00,000


Equity Capitalisation rate or Cost of Equity
= earnings available to equity shareholders/total market value of equity shares or
(EBIT – I/V-D)
= 1,00,000-30,000/10,00,000-5,00,000 * 100
= 70,000/5,00,000* 100
= 14%
3) The Traditional approach
It is the compromise between two extremes of net income approach and the
net income operating approach. According to this theory, the value of the firm
can be increased initially or the cost of capital can be decreased by using more
debt as the debt is a cheaper source of funds than equity. Thus optimum
capital structure can be reached by a proper debt-equity mix. Overall cost of
capital according to this theory decreases upto certain point, remains more or
less unchanged for moderate increase in debt thereafter ; and increases or
rises beyond a certain point.
Illustration
Compute the market value of the firm, value of shares and the average cost of
capital from the following:

Rs.
Net operating Income 2,00,000
Total investment 10,00,000
Equity capitalisation rate:
a)If the firm uses no debt 10%
b)If the firm uses Rs.4,00,000 11%
debentures 13%
c)If the firm uses Rs.6,00,000
Assume that Rs. 4,00,000 deb. Can be raised @ 5% ROI where as Rs. 6,00,000
debentures
deb. Can be raised @ 6% ROI
Computation of Market value of firm, value of shares & the
average cost of capital
(a) No Debt (b)Rs.6,00,000 (c) Rs.6,00,000
5% debentures 6% debentures
Net operating income
Less: Interest i.e., cost of
equity
Rs.2,00,000 Rs.2,00,000 Rs.2,00,000
Earning available to
2,00,000 36000
equity shareholders
Equity capitalisation rate Rs.2,00,000 Rs.1,80,000 Rs.1,64,000

Market value of shares 10% 13%


11%
2,00,000*100/ 1,64,000*100/
10 1,80,000*100/ 13
Market value of =Rs.20,00,000 11 =Rs.12,61,538
debt(deb.) - =Rs.16,36,363 6,00,000
Market value firm 4,00,000

Average cost of capital


Earnings/value of firm or
EBIT/V
20,00,000 20,36,363 18,61,538
4) Modigliani and Miller Approach
M&M hypothesis is identical with the net operating income
approach if taxes are ignored. However, when corporate taxes are
assumed to exist, their hypothesis similar to the net income approach.
a) In the absence of taxes
Illustration:
A co. has retained earnings before interest and taxes of Rs.1,00,000. it
expects a return on its investment @ 12.5%. Find out total value of the
firm.
Solution:
Total value of the firm= earnings before interest and tax/overall
cost of capital
or V= EBIT/Ko
=1,00,000/12.5 / 100
=1,00,000*100/12.5
= Rs.8,00,000.
b) When the corporate taxes are assumed to exist
Value of unlevered firm(Vu) = Earnings before interest &taxes/Overall cost of capital
i.e. EBIT/Ko (1-t)
And, value of levered firm is:
Vl= Vu+tD
Where Vu is unlevered firm and tD is discounted present value of the taxes savings
resulting from tax deductibility of the interest charges, t is the rate of tax and D
the quantum of debt used in mix.
Illustration: there are 2 firms X & Y which are exactly identical except that X does
not use any debt in its financing, while Y has Rs.1,00,000 5% deb. In its financing.
Both the firms have earning before interest and tax of Rs.25,000 and the equity
capitalization rate is 10%. Assuming the corporation tax of 50% calculate the
value of firm.
Solution: The market value of firm X which does not use any debt
Vu = EBIT/Ko(1-t)
= 25,000/0.10*0.5 = Rs. 1,25,000
The market value of firm Y which uses debt financing of Rs. !,00,000
Vl = Vu+ tD
=Rs.1,25,000+0.5*1,00,000
=Rs.1,25,000+50,000
=Rs.1,75,000
 ESSENTIAL FEATURES OF A SOUND
CAPITAL STRUCTURE

A sound or an appropriate capital structure should have the


following essential features:
a) Maximum possible use of leverage.
b) The capital structure should be flexible.
c) To avoid undue financial/business risk with the increase of debt.
d) The use of debt should be with in the capacity of a firm. The firm
should be in a position to meet its obligation in paying the loan
interest charges as and when due.
e) It should involve minimum possible risk of loss of control.
f) It must avoid undue restrictions in agreement of debt.
 FACTORS DETERMINIG THE CAPITAL
STRUCTURE

The factors determining the capital structure are:


 Growth and stability of sales
 Cost of capital
 Nature and size of a firm
 Control
 Flexibility
 Requirements of investors
 Capital market condition
 Assets structure
 Purpose of financing. etc