Financing Decision

Key Issues
• From where to raise the money?
• How much to raise from different sources?
• At what cost?
• Theories of capital structure
Key Decisions Under Financial Management
Working
Day to Day
Capital
Management
Management
of Capital
Decisions

Long-term Long-term Capital Capital

Financial Financial
Arrangement Investment Structure Budgeting
Management Management
of Capital of Capital Decisions Decisions

Management Dividend
of Profits Decisions
Long-term Source of Funds/Capital
Long-term
Source

Equity &
Preference
Debt/Loan Retained
Shares
Earnings

Long-term Liabilities of a Firm

Concept of Cost

For Investors For the Company/Firm

• For Investors the rate of return • For the company that same rate
on a security is a benefit of of return is a cost of raising
investing. funds that are needed to
operate the firm.

• Thus, the expectations of the investors become the cost for the company.
• In other words, the cost of raising funds is the firm’s cost of capital.
Cost of Capital
Let’s try to answer some key questions:
• Can we say that the cost of debt is cost of capital of the firm?
• Can we say that the cost of equity is cost of capital of the firm?
• Can we say that the cost of preference shares (if available) is cost of
capital of the firm?

Or
• Should we consider the weighted average cost of capital (WACC) as
cost of capital of the firm?
Importance of Cost of Capital in Decision
Making
• Cost of capital serve as basis for investing decisions of a firm.
• Cost of capital also carries implications for the valuation of the firm as
while valuing the firm, it is used as the basis for discount rate.
• The firm value is also dependent on overall cost of capital.
• The objective of the firm is to achieve the lowest cost of capital so
that value of the firm can be maximized (also referred as optimal
capital structure calculation).
Components of Cost of Capital Estimation
• Weights in Capital Structure
• Weight of debt
• Weight of equity & retained earnings
• Weight of preference
• Cost of Individual Source of Capital
• Cost of debt
• Cost of equity & retained earnings
• Cost of preference
Cost of Capital (WACC) Calculation
• Wd (Weight of Debt in Total Capital) *Kd (Cost of Debt After Tax)+
• We (Weight of Equity in Total Capital) *Ke (Cost of Equity) +
• Wp (Weight of Preference Shares in Total Capital) *Kp (Cost of
Preference Shares)

Or

WACC = Wd*Kd* (1-t) + We*Ke +Wp*Kp

Let’s Practice WACC Calculations
Source of Capital Capital Cost of Specific Source
(in Rs.)
Debt 100 Crore Kd = 8%

Equity 200 Crore Ke = 12%

Preference Shares 100 Crore Kp = 9%

Total 400 Crore

Compute the cost of capital considering tax rate as 25%.

Let’s Practice WACC Calculations
Source of Capital Capital Weights Cost of Specific Source
(in Rs.)
Debt 100 Crore Wd=100/400=0.25 or 25% Kd = 8%

Equity 200 Crore We=200/400=0.50 or 50% Ke = 12%

Preference Shares 100 Crore Wp=100/400=0.25 or 25% Kp = 9%

Total 400 Crore

WACC = Wd*Kd* (1-t) + We*Ke +Wp*Kp

WACC = 0.25*8*(1-0.25) + 0.5*12 + 0.25*9
WACC = 9.75%
Cost of Debt Calculation
𝐶1 𝐶2 𝐶 𝑛 + 𝑅𝑉 𝑛
𝑉 𝐵 𝑜𝑟 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝐵𝑜𝑛𝑑= + + …+
1+𝑘𝑑 ( 1+ 𝑘𝑑 ) 2
( 1+𝑘𝑑 )𝑛

𝑅𝑉 − 𝐼𝑃
𝐶 (1− 𝑇 )+( )
𝑛
𝐾𝑑=
𝑅𝑉 + 𝐼𝑃
( )
2
Example
• PPL issues a Rs. 1,000 par, 20 year bond paying the market rate of
10%. Coupons(interest) are annual. The bond will sell at par, but
flotation costs amount to Rs. 50 per bond. The tax rate is 34%.
• What is the pre-tax and after-tax cost of debt for Prescott
Corporation?
Example 2
• Vikas limited issues 14% debentures, Face value Rs.100. The net
amount realized per debenture is Rs.94. The debentures are
redeemable at par after 10 years. The firm pays 50% tax on its
income. What is the cost of debt?
Cost of Preference Share
𝐷1 𝐷2 𝐷𝑛 + 𝑅𝑉 𝑛
Vp= + + …+
1 +𝑘𝑝 ( 1+𝑘𝑝 ) 2
( 1+𝑘𝑝 ) 𝑛

𝑅𝑉 − 𝐼𝑃
𝐷 +( )
𝑛
𝐾𝑝=
𝑅𝑉 + 𝐼𝑃
( )
2
Example
• PPL issues preference shares for 10 years with face value of Rs. 100
per share issued at par. The issue will be redeemed at premium of 5%.
Compute the cost of preference if the dividend rate is 9%.

• PPL issues preference shares for 15 years with face value of Rs. 100
per share issued at premium of 10%. There is floatation cost of 5% per
share and the issue will be redeemed at par. Compute the cost of
preference if the dividend rate is 10%.
Perpetual Preference Share

Kp =

If PPL issues preferred capital, it will pay a dividend of Rs. 8 per year and should be
valued at Rs. 75 per share. If flotation costs amount to Rs. 1 per share, what is the
cost of preferred capital for PPL?
Cost of Equity (Using Dividend Discount Model)

Do (1  g )1 Do (1  g ) 2 Do (1  g ) n
P0  1
 2
 ... 
(1  ke ) (1  ke ) (1  ke ) n

D1
Po 
ke  g
Example
• Suppose that dividend per share of a firm is expected to be Rs.1 per
share and is expected to grow at 6% per year perpetually. Determine
the cost of equity capital, assuming the market price per share is Rs.
25
Cost of Equity using CAPM Model
E(Ri) = Rf + (Rm – Rf)*β
Or
Ke = Rf + (Rm – Rf)*β

Example:
The beta of Ricci Co.’s stock is 3.2, whereas the risk-free rate of return is 9 percent.
If the expected return on the market is 18 percent, then what is the expected
return on Ricci Co.?
Theories of Capital Structure

Relevance Irrelevance
Theory Theory
Net Operating
Net Income (NI)
Approach (NOI)

Traditional View
MM Hypothesis
MM Hypothesis (Without tax))
(with taxes)
Tradeoff Theory
• Why not to have 100% debt in capital structure ?
Due to financial distress
Personal tax on interest income earned
Chances of insolvency
Indirect costs
Employees
Customers
Suppliers
Investors
Shareholders
Managers
Optimum Capital Structure
• By creating minimum WACC and thus achieving maximum value for
the shareholders

Cost of Debt
Debt Weight Equity Weight After Tax DPS Cost of equity Value of Share WACC
0% 100.00% 4.80% Rs.2.40 12.00%
10% 90.00% 4.80% Rs.2.56 12.40%
20% 80.00% 5.00% Rs.2.75 12.90%
30% 70.00% 5.40% Rs.2.97 13.50%
40% 60.00% 6.00% Rs.3.20 14.40%
50% 50.00% 7.20% Rs.3.36 15.60%
60% 40.00% 9.00% Rs.3.30 17.40%
 Cost of Debt
Debt Weight Equity Weight After Tax DPS Cost of equity Value of Share WACC

0% 100.00% 4.80% Rs.2.40 12.00% Rs.20.00 12.00%

10% 90.00% 4.80% Rs.2.56 12.40% Rs.20.65 11.64%

20% 80.00% 5.00% Rs.2.75 12.90% Rs.21.33 11.32%

30% 70.00% 5.40% Rs.2.97 13.50% Rs.21.90 11.10%

40% 60.00% 6.00% Rs.3.20 14.40% Rs.22.22 11.04%

50% 50.00% 7.20% Rs.3.36 15.60% Rs.21.54 11.40%

60% 40.00% 9.00% Rs.3.30 17.40% Rs.18.97 12.36%

Pecking Order Theory
• Managers always prefers to use internal finance.
• When internal funds are nor available, they issue debt.
• First secured debt then unsecured debt followed by hybrid
securities i.e. convertible bonds.
• They give least preference to issue new equity in the market.
Information Signalling Theory
• Every corporate actions provide some signal to the end investors.
• The signalling theory was first coined by Ross (1977) who posits that if
managers have inside information, their choice of capital structure will
signal information to the market.
• Issuing debt is considered as positive sign that managers are confident
about future earnings.
• If managers believe that their firms are undervalued, they will issue
debt first and then issue equity as a last resort.
• Conversely, if management believes that their firm is overvalued, they
will issue equity first.
Thank You!