FINANCE DECISIONS

UNIT IV
 INTRODUCTION

As we know finance is very important to every business. It is interlinked with

all the activities performed by the business. So if its not properly managed the
whole business will suffer.
Capital
Capital refers to the funds borrowed from different sources of finance by the
business firm to acquire firm’s assets to be used in the operations of a firm.
 CAPITAL STRUCTURE

• Capital structure of a firm refers to the composition or components of its

capitalisation and it includes all long-term capital resources. It is made up of
debt and equity.
• It is the relationship between the various long-term sources of financing
such as equity capital, preference share capital and debt capital.
• Deciding the suitable capital structure is the important decision of the
financial management because it is closely related to the value of the firm.
 DEFINITIONS

• According to the definition of Gerestenbeg, “Capital Structure of a company

refers to the composition or make up of its capitalization and it includes all
long-term capital resources”.
• According to the definition of James C. Van Horne, “The mix of a firm’s
permanent long-term financing represented by debt, preferred stock, and
common stock equity”.
 FINANCIAL STRUCTURE

• The term financial structure is different from the capital

structure. Financial structure shows the pattern of total
financing. It measures the extent to which total funds are
available to finance the total assets of the business.
• Financial Structure = Total liabilities
EXAMPLE
 Optimum capital structure

• Optimum capital structure is the capital structure at which the weighted

average cost of capital is minimum and thereby the value of the firm is
maximum.
• Optimum capital structure may be defined as “The capital structure or
combination of debt and equity that leads to the maximum value of the
firm.”
 Equity Shares only Equity and Preference Shares

Forms of capital
structure
Equity Shares, Preference Shares
Equity Shares and Debenture and Debentures.
 What to choose?
• Issue of share means sharing the ownership of the company.
• Dividend on equity is paid from the profits.
• Debt is a liability on which interest has to be paid irrespective of the
company’s profits, while shares are owner’s funds on which payment of
dividend depends upon the company’s profit.
• issue of debentures should not exceed 20% of gross current assets.
• Debt equity ratio in issue of debentures should not exceed 2:1.
• High portion of debt is risky for the company. However, raising funds
through debt is cheaper. This is because interest on debt is allowed as an
expense for tax while dividend has no tax benefit.
• Thus raising funds by borrowing is cheaper resulting in higher profits to
shareholders and thereby increases EPS.
• A company’s capital structure consists of the following:
Equity shares of Rs.100 each Rs.20 Lakhs
9% Preference Shares Rs.12 Lakhs
7% Debentures Rs.8 Lakhs
Retained earnings Rs.10 Lakhs

The company earns 12% on its capital, the income tax rate is 50%. The company requires a sum
of Rs.25 Lakhs to finance its expansion programme for which following alternatives are
available to it:
a) Issue of 20000 equity shares at a premium of Rs.25 per share.
b) Issue of 10% preference shares
c) Issue of 8% debentures.
It is estimated that the P/E ratio in the case of Equity, preference and debenture financing
would be 21.4, 17 and 15.7 respectively.
Which of the 3 financing alternatives would you recommend and why?
 Homework
• MBD co. has currently an all equity structure consisting of 15000 equity
shares of Rs.100 each. The management is planning to raise Rs.25 lakhs to
finance a major expansion. It is considering 3 alternative methods:
a. To issue 25000 equity shares of Rs.100 each
b. To issue 25000 8 % debentures of Rs.100 each
c. To issue 25000 10% preference shares of Rs.100 each

The company’s EBIT will be 8 lakhs. Assuming a corporate tax of 50%,

determine earnings per share in each alternative.
CAPITAL STRUCTURE THEORIES
 1. Net Income Approach (NI theory)
• This theory was suggested by David Durand.
• According to this theory, the value of the firm is increased by increasing the
debt portion to the maximum.
• This is because:
• a. Interest rates are lower than dividend rates
• B. Interest on dividend is tax exempted.
 Assumptions

• The cost of debt is always lower than the cost of equity.

• The risk perception of the investor does not change by the excess use of
debt
• The company pays 100% of its earnings as dividend.
• There is no corporate tax.
 Formula
According to NI :-
V = S+D
Where,
V- value of the firm, S – market value of eq shares and D - market value of
debt.
Also:-
S= NI/Ke
Where,
NI – net income available to eq shareholders
Ke – cost of equity.
 Question

• 1. X ltd is expecting an EBIT of Rs.1 lakhs. It has 4

lakhs 10% debentures and the cost of equity is
12.5%.
i. Calculate the value of the firm as per the NI
theory.
ii. What will be changed if debenture is increased
by 2 lakhs?
 2. Net Operating Income Theory
• This theory was also proposed by David Durand, and is
dramatically opposite of the NI theory. According to this theory
the total market value of the firm is not affected by the change in
the capital structure of the firm, and the overall cost of capital
remains constant irrespective of the debt-equity ratio. Instead
the value of a firm depends on its EBIT and Weighted Average
Cost of Capital (WACC).
• WACC is the rate that a company is expected to pay on average
to all its security holders to finance its assets.
 Assumptions

• The cost of debt (Kd) is constant at any level of financial

leverage.
• The cost of equity (Ke) is higher than the cost of debt at
any level of financial leverage.
• The WACC is constant and irrelevant of capital structure.
 Formula
• V = EBIT/ Ko
• Where Ko – overall cost of capital.
• Also
• Ke = EBIT –I * 100
V-D
• Where D- market value of debt
 Problem

• A co. has a net operating income of ₹1,00,000. It has ₹ 5 lakh 6%

debentures and its overall capitalisation rate is 10%.
i. Calculate value of the firm and cost of equity based on NOI approach
ii. If the debenture value is increased to ₹ 750000 what effect will it have on
the value of the firm and equity?
 3. Traditional Approach

• It is a mix of NI and NOI approach. It is also known as the

intermediate approach.
• According to this theory initially the value of the firm can be
increased, or cost of capital can be decreased by using more
debt, as the debt is a cheaper source of fund than equity.
• But after a certain point if the proportion of debt is increased, the
overall cost of capital starts increasing and the market value will
decline.
 Assumptions

• There are only 2 sources of funds, shares and debentures

• Firm pays 100% of its earnings as dividends
• The operating profits are not expected to grow
• Investors behave rationally
 Problem
• XY ltd. Has to raise ₹ 30 lakhs for starting a new factory. It is expected to
generate ₹ 5 lakhs operating income. Their objective of financial plan is to
maximise EPS. The company proposes to raise a debt of ₹3 lakhs or ₹ 10
lakhs or ₹15 lakhs, and issue shares for the rest. The current market price of
the share is ₹250 which will drop to ₹200 if the total borrowings of the firm
goes beyond ₹12 lakhs. The debt can be raised in the following manner:-
• - upto ₹3 lakhs 8%
• - 3-12 lakhs 10%
• - above ₹12 lakhs 15%.
• The company pays a corporate tax @ 50%. Advice the company.
 Homework

• The Operating income of a firm is ₹3 lakhs. The company has a debenture of

₹5 lakhs. The cost of debt is 5%. WACC is 10 %.
• Calculate the market value of the firm and the cost of equity.
 4. Modigliani-Miller approach

• The MM theory of Capital structure was devised in 1950s. It supports the NoI
theory. This theory suggests that the value of the firm is irrelevant to its
capital structure. MM theory is also called the Irrelevant theory.
• The MM approach further states that the market value of the firm depends on
its operating income and the debt equity composition does not effect the
market value of the firm. This is because whatever benefit the company
might make by issuing more of debt, it has to pay it to the equity holders. If
the company issues more debt, it increases its risk and so the equity holders
will ask for higher returns on their share.
 Assumptions

Investors are free to buy and sell securities.

All firm within the same class will have the same degree of risk
There is 100% dividend pay out ratio.
There is no corporate tax
Investors behave rationally
 SUPPOSE

• The firms A and B are identical except that the firm A has
10% ₹50000 debentures. Both the firms have EBIT
₹10000. the equity capitallistion is 16% for A and 12.5%
for B.
PARTICULARS FIRM A FIRM B

EBIT 10000 10000

LESS INTEREST 5000 -

EARNINGS AVAILABLE FOR EQ SHARES 5000 10000

MARKET VALUE OF EQUITY 31250 80000

A= 5000/16%
B = 10000/12.5%
MARKET VALUE OF DEBT 50000 -

VALUE OF FIRM 81250 80000

• Here the market value of firm A is higher in the initial time, but the earnings
available for the equity shareholders is comparatively lower. So the
shareholders will sell their shares in firm A and buy shares of firm B. This will
lead to a reduction in the market price of shares of Firm A and increase in
the Firm B’s share price. Thus, it will eventually lead to increase in the value
of the firm.
 Arbitrage Process

• The term ‘Arbitrage’ refers to the act of buying an

asset or security in one market having lower price
and selling it in another market having higher
price.
 Cost Of Capital

• Cost of capital refers to the minimum rate of return a firm must earn on its
investments so that the market value of the company’s equity share does
not fall.
• It can be defined as “ the rate of return the firm requires from investment in
order to increase the value of the firm in the market place.”- John J
Hampton.
 Classification

1. Explicit and Implicit Cost

2. Future cost and Historical cost
3. Specific cost and Combined cost
4. Average cost and Marginal cost
COMPUTATION OF SPECIFIC COSTS
 1. COST OF DEBT

• Debt may be issued at par, at premium or discount. It may also be perpetual

or redeemable.
Debt issued at par:
Kd = (1-T) R
Where Kd – cost of debt
T – marginal tax rate
R – Debenture interest rate
• Debt issued at Premium or discount :

Kd = I/NP (1-T) x 100

I – Annual interest payment ( in ₹)

NP – net proceeds of debenture
T – tax rate
 Problem

• A company issues 10% irredeemable debentures of ₹1 lakh. The company is

in 55% tax bracket. Calculate cost of debt if debentures are issued
i) At par
ii) 10% discount
iii)10% premium
• Solution
(i) Kd = 10000/100000 ( 1- 0.55)
= 4.5%
(ii) Kd = 10000/90000 (1-0.55)
= 5%
(iii) Kd = 10000/110000 (1-0.55)
= 4.1%
 Cost of Redeemable debt
Before Tax
Kd = I +(P-NP)/n
(P+NP) / 2
Where,
I – Annual Interest, P – par value of debenture, NP – net proceeds
N – no.of years to maturity.
After Tax
Kd = Kd (before tax) x (1-T)
 Cost of Preference Share
Kp= Dp/NP x 100
Where,
Dp – fixed dividend and NP – Net proceeds

Cost of Redeemable shares

KP = Dp + (P-NP) /n x 100
(P+NP) /2
Where,
Dp- fixed preference dividend, P – Principle amount
 Problems

1. A company raises preference share of Rs.1,00,000 of 10%. Calculate cost of

preference capital when
(i) Issued at a premium of 10%
(ii) Issued at discount of 10%
 Answer

(i) Kp = Dp /NP x 100

= 10000/110000 x 100
= 9.09 %
(ii) Kp = 10000/90000 x 100
= 11.11%.
 Cost of Equity

• It is quite difficult to calculate the cost of equity. There is an argument that

the equity shares does not involve cost, because the company is not legally
bound to pay any dividend. But the investors buy the shares of any company
with an expectation of returns. Thus the market price of the equity shares
depends upon the returns expected by the equity shareholders.
• Cost of equity can be defined as the minimum rate of return that a firm must
earn on the equity financed portion of an investment project in order to
leave unchanged the market price of such shares.
 1. Dividend Price Approach

• Under this method the cost of equity is the discount rate that equates the
present value of all expected dividends per share with the net proceeds of
the sale of a share.
Formula:
Ke = D/P x 100
Where,
D – Dividend per share
P – Market price of share
 2. Dividend Capitalisation Model

• This is also called Dividend price plus growth approach. Here the cost of
equity is determined on the basis of expected dividend rate plus rate of
growth in the dividend.
Formula
Ke = (D/P + g) x 100
 Example

• The shares of AB Ltd. is quoted at Rs. 20 currently. The company pays a

dividend of Re.1 per share and the investors market expects a growth rate of
5%.
i. Compute the cost of equity.
ii. If the company’s cost of capital is 8% and the anticipated growth rate is
6%, what will be the market price of shares.
 Solution
i. Ke = (D/P + g) x 100
= (1/20 + 0.05) x 100
= 10%.
ii. Calculating market price
P = D/ (Ke – g)
Ke – 8% , D – 1 , g – 0.06
P = 1/(0.08 – 0.06)
= 50.
 3. Earning Price Approach

• According to this method the market price per share depends upon the
earnings per share. This approach, therefore takes into account both dividend
as well as retained earnings.
Formula
Ke = E/P x 100
Where,
E – Earnings per share
 Problem

• TM Ltd. has Rs. 1 lakhs equity shares of Rs.100 each. Its current earnings are
Rs. 10 lakhs per annum. If the company plans to issue more shares with a
floatation cost of 10%. Calculate cost of capital.
 Solution

Ke = E/ P x 100
E = 10,00,000 / 1,00,000 = 10.
P = 100 – (10% of 100) [ 10% float is to be deducted from share price]
= 90
Ke = 10/90 x 100
= 11 %
 4. Realised Yield Approach

• In the realized yield approach, an investor expects to earn the same amount
of dividend, which the organization has paid in past few years.
This approach is based on the following assumptions:
a. Risk factor remains constant in an organization. Returns in the given risk
remain the same as per the expectations of shareholders.
b. Realized yield is equivalent to the reinvestment opportunity rate for
shareholders.
The cost of equity is the discount rate which equates the present value of the
dividend received and the sale price of the shares to the purchase price of the
share.
 Example

• Mr. Mehra Purchased a share of Alpha Limited for Rs.1000. he received

dividend for 5 years at the rate of 10%. At the end of 5th year, he sold the
share for Rs. 1128. compute the cost of equity.
 Solution
• The discount rate or IRR needs to be found using trial and error method
Year Dividend Discount factor Present Value
@12%
1 100 0.893 89.3

2 100 0.797 79.7

3 100 0.712 71.2

4 100 0.636 63.6

5 100 0.567 56.7

5 (sale) 1128 0.567 639.576

Total 1000.076
 CAPM

• Capital Asset Price Model (CAPM) helps in calculating the expected rate of
return from a share of equivalent risk in the market.
• The computation of cost of capital using CAPM is based on the condition
that the required rate of return on any share should be equal to the sum of
risk less rate of interest and premium for the risk.
 Formula

E = R1 +β (R2 – R1)
Where,
E – Required rate of return on asset
β – Beta coefficient
R1 – Risk free rate of return
R2 – Expected Market rate of return
 Explanation
• Risk-free rate of return – This is the return on a security that has no default
risk, no volatility, and beta of zero. The rate on Govt. bonds can be taken as
risk free rate.
• Beta – it is a statistical measure of the variability of a company’s stock price
in relation to the overall stock market. So if a company has high beta, it
is said to be more riskier.
• Risk premium – it is the measure of return that equity investors demand
over the risk-free rate of return to compensate them for the risk taken.
[ Market rate of return – Risk-free rate].
 Example

• The yield on % year govt. bond is 0.72%. The beta

coefficient of MR Ltd. is 1.86 and the expected return is
11.52%. Compute the cost of equity.
 Solution

E = R1 + β ( R2-R1)
= 0.72 + 1.86 x ( 11.52 – 0.72)
= 0.72 + 20.088
= 20.81%.
 Example 2

The required return on a particular stock is 14% according

to the CAPM. The stock’s beta is 1.5. What is the risk-free
rate if the expected return on the market portfolio equals
10%?
 Solution

E- 14% , β – 1.5 and R2- 10

So
E = R1 + β ( R2-R1)
14 = R1 + 1.5 (10-R1)
14 = R1 + 15 – 1.5R1
R1 = 2%.
 Cost of Retained Earnings
• The company generally does not distribute its entire profits as dividends.
The portion retained by the company for their future needs is called
retained earnings. It might be believed that it is free of cost, but that is not
the case. If the money so retained had been distributed to the shareholders,
they could get some earnings on them. Thus, the earnings foregone by the
shareholders is considered as the cost of retained earnings.
Formula:
Kr = Ke (1 - T) (1 - B)
 Example

• The cost of equity capital for Company X is 8.67%. The

average tax rate of the shareholders is 25% and the
brokerage costs amounts to 3%. Calculate the cost of
retained earnings.
 Solution

Kr = [0.0867 x (1-0.25) x (1-0.03) ] x 100

= [0.0867 x 0.75 x 0.97] x 100
= 6.31%
 Weighted Average Cost of Capital

• WACC is the blended cost of capital across all sources. It is determined by

multiplying the cost of each source of capital with its respective proportion
in the total capital.
 Computation

Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D) + (KR * R)

Where,
E = Proportion of equity capital in capital structure
P = Proportion of preference capital in capital structure
D = Proportion of debt capital in capital structure
R = Proportion of retained earnings in capital structure
 Example

• Mahendra Ltd. has 10,000 equity share of Rs.10,00,000;

10% preference shares of Rs.2,00,000 and 10%
debentures of Rs.6,00,000.
The shares of the organisation are currently sold at Rs.100.
The dividend provided is Rs.10 per share which would grow
at the rate of 10%. Assuming 50% corporate tax Calculate
WACC.
 Solution

• First we can calculate the cost of each security:-

1. Cost of debt
Kd = (1-T) x R
= (1 - .50) x .10
= 5%
Kp = Dp / Np x 100
= 20000/200000 x 100
= 10%
Ke (when growth rate is given) = [(D/Mp) + g] x 100
= [10/100 + .10] x 100
= 20%.
 Calculating weightage
• Total capital = 1000000 + 200000 + 600000
= 1800000
Weightage of Equity – 1000000/1800000 = 0.55
Weightage of Preference – 200000/1800000 = 0.11
Weightage of Debt – 600000/1800000 = 0.33
 Calculation of WACC

So WACC = 0.1395.
Thank You