Capital Structure & Cost of Capital Capital Structure refers to the mix of sources from where the long term

funds required in a business may be raised.

Features of an Appropriate Capital Structure
Profitability : The most profitable capital structure is one that tends to minimize cost of finance and maximize earning per equity share. Flexibility : The Capital Structure should be such that company can raise funds whenever needed. Conservation:The debt content in the Capital Structure should not exceed the limit which the company can bear. Solvency: The Capital Structure should be such that firm does not run the risk of becoming insolvent. Control: The Capital Structure should be so devised that it involves minimum risk of loss of control of the company.

Major Considerations in Capital Structure Planning THREE FACTORS  Risk
Risk of Cash Insolvency Risk of Variation in the expected earnings available to equity share-holders ) ) Determine the ) Capital Structure of a ) Particular Business ) undertakng at a ) given point of time ) 

Cost
Cost of Capital 

Control

Major Considerations in Capital Structure Planning (CONTD..)

Capital Structure Theories There are broadly four approaches in this regard. These are: a. Net Income Approach (N.I. approach) b. Net Operating Income Approach (N.O.I. approach) c. Traditional Theory d. Modigliani and Miller Approach

Net Income Approach (N.I. approach) Net Income Approach is based on the following three assumptions: (i) There are no corporate taxes (ii) The cost of debt is less than cost of equity or equity capitalization rate (iii) The use of debt content does not change the risk perception of investors as a result both the Kd (debt-capitalization rate) and Ke (equity-capitalization rate) remains constant

Net Income Approach (N.I. approach) Contd..
The value of the firm on the basis of Net Income Approach can be ascertained as follows: V=S+D Where, V = Value of the firm S = Market value of equity D = Market value of debt Market value of equity (S) =

Where,

NI = Earnings available for equity shareholders Ke= Equity Capitalization rate

Net Income Approach (N.I. approach) Contd.. Under, NI approach, the value of the firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimising the cost of capital. The N.I. Approach can be illustrated with help of the following example, The overall cost of capital under this Approach is Overall cost of capital =

Net Income Approach (N.I. approach) Contd.. Illustration ABC, Ltd., is expecting an annual Earnings before the payment of Interest and Tax of Rs.2 lacs. The company in its capital structure has Rs.8 lacs in 10% debentures. The cost of equity or capitalisation rate is 12.5%. You are required to calculate the value of firm acording to NI Approach. Also compute the overall cost of Capital. Solution: Statement showing the value of firm and overall cost of capital Rs. Earnings before interest and tax (EBIT) 2,00,000 Less: Interest on debentures (10% of Rs.8,00,000) 80,000 Earnings available for equity shareholders (NI) 1,20,000 Equity Capitalisation rate (Ke) 12.5% Market value of equity (S) = {NI/Ke} 9,60,000

Market value of debt (D) Total value of the firm (V) Overall cost of capital = =

__8,00,000 _17,60,000

Net Operating Income (N.O.I.) approach

The value of equity can be detrmined by the following equation Value of equity (S) = V (Market value of firm) ± D (Market value of debt)

And the cost of equity

Net Operating Income (N.O.I.) approach (contd..)
The Net Operating Income Approach is based on the following assumption: (i) The overall cost of capital remains constant for all degree of debt equity mix. (ii) The market capitalizes the value of firm as a whole. Thus the split between debt and equity is not important. (iii) The use of less costly debt funds increases the risk of shareholders. This causes the equity capitalization rate to income. Thus, the advantage of debt is set off exactly by increases in equity capitalization rate. (iv) There are no corporate taxes (v) The cost of debt is constant Under NOI approach since overall cost of capital is constant, therefore there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal one. The NOI Approach can be illustrated with the help of example Illustration ABC Ltd., is expecting an Earning before interest & tax of Rs.4,00,000 and belongs to risk class of 10%. You are required to find out the value of firm & cost of equity capital if it employs 8% debt to the extent of 20%, 35% or 50% of the total financial requirement of Rs.20,00,000.

Net Operating Income (N.O.I.) approach (contd..)
Solution Statement showing value of firm and cost of equity capital

Net Operating Income (N.O.I.) approach (contd..)

Statement showing value of firm and cost of equity capital (Contd..) 20% Debt Rs. 4,00,000 Rs.36,00,000 Ko = ------------------ x 8% + ----------------- x 10.22% Rs.40,00,000 Rs.40,00,000 = 0.008 + 0.092 = 0.10 or 10% 35% Debt Ko Rs. 7,00,000 Rs.33,00,000 = ------------------ x 8% + ----------------- x 10.42% Rs.40,00,000 Rs.40,00,000

= 0.014 + 0.0859 = 0.0999 or10% 50% Debt Ko Rs. 10,00,000 = ------------------ x 8% + Rs.40,00,000 Rs.30,00,000 ----------------- x 10.66% Rs.40,00,000

= 0.02 + 0.07995 = 0.09995 or 10%

Traditional Approach The Traditional Approach is also called anintermediate approach as it takes a midway between NI approach (that the value of the firm can be increased by increasing financial leverage) and NOI approach (that the value of firm is constant irrespective of the degree of financial leverage). As per the Traditional Approach the cost of capital is a function of financial leverage and the value of the firm can be affected by the judicious mix of debt and equity in capital structure.

Traditional Approach(Contd..)
Illustration: XYZ Ltd., is expecting an EBIT or Rs.3,00,000. The company presently raised its entire fund requirement of Rs.20 lakhs by issue of equity with equity capitalisation rate of 16%. The firm is now contemplating to redeem a part of capital by introducing debt financing. The firm has two options-to-raise debt to the extent of 30% or 50% of total funds. It is expected that for debt financing upto 30% the rate of interest will be 10% and equity capitalisation rate is expected to increase to 17%. However, if firm opts for 50% debt then interest rate will be 12% and equity capitalisation rate will be 20%. You are required to compute value of firm and its overall cost of capital under different options. Solution ___________________________________________ 0% 30% Debt 50% Debt___ Total debt -Rs. 6,00,000 Rs. 10,00,000 Rate of Interest -10% 12% Earning before Interest & tax(Rs.) 3,00,000 3,00,000 3,00,000 Less : Interest -60,000 1,20,000 Profit after interest before tax 3,00,000 2,40,000 1,80,000 Equity capitalisation rate, Ke 16% 17% 20% Value of equity (E) 18,75,000 14,11,176 9,00,000 Value of debt (D) -6,00,000 10,00,000 Total value of firm (V) = (E) + (D) 18,75,000 20,11,176 19,00,000 Overall cost of 16% 14.91% 15.78% Capital (EBIT / Total value of firm) ____________________________________________

Traditional Approach(Contd..)

It is apparent from above computations that value of firm increases from Rs.18,75,000 to Rs.20,11,176 if firm increase its debt content from 0% to 30%. The overall cost of capital fall from 16% to 14.91%. However, if the debt content increase from 30% to 50% the value of the firm reduces from Rs.20,11,176 to Rs,19,00,000 and its overall cost of capital incrses from 14.91% to 15.78%

Modigliani and Miller Approach
Modigliani and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. Modigliani and Miller make the following propositions: 1. The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalising the expected stream or operating earnings at a discount rate considered appropriate for its risk class. 2. The cost of equity (Ke) is equal to capitalisation rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to offset exactly the use of less expensive source of funds. 3. The cut off rate for investment purposes is completely independent of the way in which the investment is financed. Assumptions: A. The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities. They are well informed about the risk-return on all type of securities. There are no transaction costs. The investors behave rationally. They can borrow without restrictions on the same terms as the firms do. B. The firms can be classified into µhomogenous risk class¶. They belong to this class if their expected earnings is having identical risk characteristics. C. All investors have the same expectations from a firm¶s net operating income (EBIT) which are necessary to evaluate the value of a firm. D. The dividend payment ratio is 100%. In other words, there are no retained earnings. E. There are no corporate taxes. However, this assumption has been removed later.

Modigliani and Miller Approach
Illustration The following is the data regarding two Companies µX¶ and µY¶ belonging to the same equivalent risk class: Company X Company Y Number of Ordinary Shares 90,000 1,50,000 Market Price Per Share Rs.1.20 Rs. 1.00 6% Debentures 60,000 -Profits before interest Rs.18,000 Rs.18,000 All profit after debentures interest are distributed as dividends. Required: Explain how under Modigliani & Miller approach, an investor holding 10% of shares in Company µX¶ will be better off in switching his holding to Company µY¶. Solution Modigliani and Miller supported the NOI (Net Operating Income) approach. According to NOI approach the overall capitalization rate and the cost of debt remains for all degree of financial leverage. Modigliani and Miller argued that ³two firms identical in all aspects except for their capital structure which cannot command two different values´. They are brought in the process of arbitrage to support the same.

Modigliani and Miller Approach
In the problem given, the arbitrage process will work out as follows: Step ± 1: Investor will dispose of in the market 10% of shares in Company µX¶ and all realize Rs.10,800 [9,000 shares at Rs.1.20 each] Step ± 2: He will borrow a sum of Rs.6,000 [10% of debt] at 6% interest Step ± 3: With the total amount of Rs.16,800, the investor will buy 16,800 shares (11.2% shares) in Company µY¶ at Re.1 each. This action will result in the following income: Present Income in µX¶ Ltd. PBIT ± Interest 9,000 -------- x (Rs.18,000 ± Rs.3,600) 90,000 Proposed Income in µY¶ Ltd. 16,800 ------------- x Rs.18,000 1,50,000 Less: Interest (6,000 x 6/100 ) = = Rs.2,016 Rs. 360 Rs.1,656 = Rs.1,440

Modigliani and Miller Approach The net income Rs.1,656 is higher than the net income of Rs.1,440 forgone by selling 10% equity of Company X. This shows that the investor will be better off in switching his holding to Company Y. It may be noted that when the investor sells equity in Company X and buys equity in company Y with personal leverage, the market value of equity of Company X tends to decline and the market value of equity of Company Y tends to rise. This process will only end when the market values of both the companies are the same.

TAXATION AND CAPITAL STRUCTURE
Corporate Taxes: When taxes are applicable to corporate income, debt financing is advantageous. This is because dividends and retained earnings are not deductible for tax purposes, interest on debt is a tax-deductible expense. Illustration: Consider two firms which have an expected net operating income of Rs.20 lakhs and which are similar in all respects, expect in the degree of leverage employed by them. Firm A employs no debt capital whereas firm B has Rs.80 lakhs in debt capital on which it pays 12 per cent interest. The corporate tax rate applicable to both the firm is 50 per cent. The income to stockholders and debt holders of these two firms is as follows: Corporate Taxes and Income of Debt-Holders and Stock-Holders A B Net Corporate Income 20,00,000 20,00,000 Interest and Debt 0 9,60,000 Profit Before Tax 20,00,000 10,40,000 Taxes 10,00,000 5,20,000 Profit after tax (Income available to stock holders) 10,00,000 5,20,000 Combined Income of DebtHolders & Stock-Holders 10,00,000 14,80,000

TAXATION AND CAPITAL STRUCTURE
It is apparent from above that combined income of debt holder and stock holders of the leveraged firm (Firm B) is higher than that of unleveraged firm (Firm A). The reason for this is that the interest payment of Rs.4,80,000 made by the leveraged firm brings a tax shield of Rs.4,80,000 (Rs.9,60,000 x Tax Rate) If the debt employed by a leveraed firm is permanent in nature the present value of the tax shield associated with interest payment can be obtained by applying the formula for perpetuity. Tax rate x Interest T x Kd x D Present Value of Tax Shield = -------------------------- = --------------Cost of Debt Kd Where, T D = Corporate Tax Rate = Market Value of Debt

Kd = Interest Rate on Debt

TAXATION AND CAPITAL STRUCTURE Thus the present value of the interest tax shields is independent of the cost of debt. It is simply the corporate tax rate times the amount of permanent debt. For Firm B the present value of tax shield works out to : 0.5(Rs.80,00,000) = Rs.40,00,000. This represents the increase in its market value arising from Financial Leverage. The value of unleveraged firm is : EBIT (l ± t) Vu = ---------------Ko And the value of leveraged firm: Vl = Vu + Debt (t) From the above it is evident that greater the leverage, greater the value of the firm, other things being equal. This implies that the optimal strategy of a firm should be to maximize the degree of leverage in its capital structure.

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