Capital Structure
Coverage –
• Capital Structure concept • Capital Structure theories –
• Capital Structure planning Net Income
• Concept of Value of a Firm Net Operating Income
• Terminologies in capital Modigliani-Miller
structure Traditional Approach
• Cost of Capital (WACC)
Form
Other
of Capital :
equity
sources
Capital Structure
Retain Preferen
earning ce
FINANCI
AL DEBENT
INSTITU URES
TIONS
Capital Structure
Capital structure can be defined as the mix of
owned capital (equity, reserves & surplus) and
borrowed capital (debentures, loans from
banks, financial institutions)
Maximization of shareholders’ wealth is prime
objective of a financial manager. The same may
be achieved if an optimal capital structure is
designed for the company.
Planning a capital structure is a highly
psychological, complex and qualitative process.
An
illustration of
Income
Statement
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t ru
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i ta f T )
p O er s
C a ity ld
O f b i l o
t fta re h
c
a ro ha
p
Im P ss(s
i n e
s
Bu
A company is considering 4 different plans to
finance its total project cost of Rs 5,00,000
Plan I Plan II Plan III Plan IV
Equity(Rs. 10 5,00,000 2,50,000 2,50,000 2,50,000
per share)
8% Preference - 2,50,000 - 1,00,000
Shares
Debt (8% - - 2,50,000 1,50,000
Debenture)
5,00,000 5,00,000 5,00,000 5,00,000
Plan I Plan II Plan III Plan IV
EBIT 1,00,000 1,00,000 1,00,000 1,00,000
Less: Interest NIL NIL 20,000 12,000
on Debentures
EBT 1,00,000 1,00,000 80,000 88,000
Less: Tax @50% 50,000 50,000 40,000 44,000
Earning after 50,000 50,000 40,000 44,000
Interest and
Tax
Less: NIL 20,000 NIL 8,000
Preference
Dividend
Earning available 50,000 30,000 40,000 36,000
for
[Link]
(A)
No. of Equity 50,000 25,000 25,000 25,000
Shares(B)
EPS(A/B) 50,000/50,000 30,000/25,000 40,000/25,000 36,000/25,000
= Rs.1per share =Rs.1.20per share =Rs.1.60per share =Rs.1.44per share
Planning the Capital Structure
Important Considerations –
Return: ability to generate maximum returns to
the shareholders, i.e. maximize EPS and market
price per share.
Cost: minimizes the cost of capital (WACC). Debt is
cheaper than equity due to tax shield on interest
& no benefit on dividends.
Risk: insolvency risk associated with high debt
component.
Control: avoid dilution of management control,
hence debt preferred to new equity shares.
Terminologies
Capitalization
Capital
Structure
Financial
Structure
Capitalization Balance Sheet
Total
amount of Current Liabilities Current Assets
Debt
(in )
issued by a Preference Shares
Fixed Assets
company
Equity Shares
Retained Earnings
Balance Sheet
Current Liabilities Current Assets
Debt
Capital Preference Shares
Structure Fixed Assets
( % mix) Equity Shares
Retained Earnings
Balance Sheet
Current Liabilities Current Assets
Debt
Financial
Structure Preference Shares
Fixed Assets
( % mix )
Equity Shares
Retained Earnings
What does it
Conclude !!
Capital Structure =
Financial Current
Structure
liabilities
Patterns / Forms /Kinds of Capital Structure
Equity Share Capital
Expansion
+ Retained Earnings
Debt + Preference
Share
Foundation
Debt
Horizontal Pyramid Inverte
Shaped d
Vertical
Pyrami
Cost of capital(Ko)
Debt capital Equity capital
1,50,000@12 2,50,000
% Ke
Kd
Preference capital
1,00,000@10%
Kp
Theories of Capital Structure
1. Net Income Approach
2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach
Theories of Capital Structure
PURPOSE OF STUDY
CAPITAL STRUCTURE
COST OF CAPITAL VALUE OF FIRM
Capital Structure
Theories
ASSUMPTIONS –
Firms use only two sources of
funds – equity & debt.
No change in investment
decisions of the firm, i.e. no
change in total assets.
100 % dividend payout ratio,
i.e. no retained earnings.
Business risk of firm is not
affected by the financing mix.
No corporate or personal
taxation.
Investors expect future
Capital Structure Theories –
A) Net Income Approach (NI)
Net Income approach proposes that there is a
definite relationship between capital structure
and value of the firm.
The capital structure of a firm influences its
cost of capital (WACC), and thus directly
affects the value of the firm.
NI approach assumptions –
o NI approach assumes that a continuous
increase in debt does not affect the risk
perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke)
Net Income (NI) Approach
According to NI approach both the cost
Cost
of debt and the cost of equity are
independent of the capital structure;
they remain constant regardless of how
ke, ko ke
much debt the firm uses. As a result,
the overall cost of capital declines and
ko
the firm value increases with debt. kd kd
This approach has no basis in reality;
the optimum capital structure would be
Debt
100 per cent debt financing under NI
approach.
IMPLICATIONS
INCREASE IN FIRMS’ VALUE
PROPORTION OF CHEAP SOURCE OF FUNDS INCREASE
PROPORTION OF DEBT
INCREASES
CONT…
DECREASE IN FIRMS’VALUE
FINANCIAL LEVERAGE IS REDUCED
PROPORTION OF DEBT FINANCING DECREASES
Calculation of THE TOTAL MARKET VALUE OF A FIRM
V=S+D
Where, V= Total market value of a firm
S= Market value of equity shares
S Earnings available to equity shareholders (NI)
Equity Capitalization Rate
D = market value of debt
And, Overall Cost of Capital (Weighted Average Cost of Capital)
K0 = EBIT
V
A company expects a net income of Rs. 80,000. It has
Rs. 2,00,000, 8% debentures. The equity
capitalization rate of the company is 10%.
Calculate:
(a) the value of the firm & overall capitalization rate.
(b) If the debenture debt is increased to Rs 3,00,000,
what shall be the value of the firm & overall
capitalization rate?
Solution
Particulars Rs Rs
80,000 80,000
Net income
(16000) (24000)
Less interest on 8% debentures of
64000 56,000
Rs .2,00,000/3,00,000 10% 10%
6,40,000 5,60,000
Earnings available to equity shareholders
Equity capitalization rate 2,00,000 3,00,000
8,40,000 8,60,000
Market value of equity(s) (80,000/8,40,000) (80,000/8,60,000)
X100 X100
=9.52%. =9.30%
Market value of debentures(D)
Value of the firm (S+D)
2. NET OPERATING INCOME
APPROACH
Cost of capital
Cost (Ko) is constant.
ke
As the
proportion of
ko
kd
debt increases,
(Ke) increases.
Debt No effect on
total cost of
capital (WACC)
• This is just the opposite to the Net Income
approach.
• According to this approach, Capital Structure
decision is irrelevant to the valuation of the firm.
• The market value of the firm is not at all affected
by the capital structure changes.
• According to this approach, the change in capital
structure will not lead to any change in the total
value of the firm and market price of shares as
well as the overall cost of capital.
2. NET OPERATING INCOME APPROACH
Assumptions –
o WACC is always constant, and it
depends on the business risk.
o Value of the firm is calculated using
the overall cost of capital i.e. the
WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.
IMPLICATIONS ADVANTAGE OF
USING CHEAP
INCREASED USE
SOURCE OF
OF DEBT OVERALL COST
FUND i.e., DEBT
INCREASES COST OF EQUITY OF CAPITAL
IS EXACTLY
FINANCIAL RISK INCREASES. REMAINS THE
OFFSET BY
OF THE EQUITY SAME.
INCREASED
SHAREHOLDERS.
COST OF
EQUITY.
Ascertainment of value of firm
V= EBIT/KO
V= Value of the firm
EBIT= Net operating income or earnings
before interest & tax
KO= Overall cost of capital
S= V-D
S= Market value of equity shares
V= total market value of a firm
D= market value of debt
A company expects a net operating income of
Rs.1,00,000. It has Rs 5,00,000 6% debentures. The
overall capitalization rate is 10%. Calculate the value
of the firm & cost of equity according to net
operating income approach. If the debenture debt is
increased to Rs 7,50,000. What will be the effect on
the value of the firm % the equity capitalization
rate?
Solution
PARTICULARS RS RS
Net operating income 1,00,000 1,00,000
10% 10%
Overall cost of capital (Ko)
10,00,000 10,00,000
Market value of the firm=
EBIT/Ko (100000x100/10)
10,00,000 10,00,000
(5,00,000) (7,50,000)
Market value of the firm(v) 5,00,000 2,50,000
Less market value of (1,00,000-30,000) x 100 (1,00,000-45000) x 100
debentures (D) 10,00,000-5,00,000 10,00,000-7,50,000
Total market value of equity =14%. =22%
Cost of equity=
(EBIT-I) x 100
(V-D)
[Link] approach
• According to the traditional approach, mix of
debt and equity capital can increase the value
of the firm by reducing overall cost of capital
up to certain level of debt.
• Traditional approach states that the Ko
decreases only within the responsible limit of
financial leverage and when reaching the
minimum level, it starts increasing with
financial leverage.
Traditional
USE OF DEBT
VALUE OF approach
FINANCIAL
COST OF
RISK OF COST OF CAPITALOVERALL COST
INCREASED FIRMEQUITY DECREASES
USEINITIALLY
EQUITY OF CAPIAL
OF DEBT SHAREHOLDER INCREASES INCREASES
INCREASES
Implications:
S INCREASE
BUT..
Compute:
Market value of Firm, Value of shares, and Average cost of Capital
Particulars Rs.
Net operating income 2,00,000
Total investment 10,00,000
Equity capitalization rate
a. If the firm uses no debt 10%
b. If the firm uses Rs 4,00,000 debentures 11%
c. If the firm uses Rs 6,00,000 debentures 13%
Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest
whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.
Solution
(a) No debt (b) Rs 4,00,000 5% (c) Rs. 6,00,000
debentures 6% debentures
Net operating income
2,00,000 2,00,000 2,00,000
Less int.
- (20,000) (36,000)
Earnings available to
2,00,000 1,80,000 1,64,000
eq. [Link]
Eq. Capitalization rate
10% 11% 13%
Market value of shares
20,00,000 16,36,363 12,61,538
- 4,00,000 6,00,000
Market value of debt
(IN THE ABSENCE OF TAXES)
4. Modigliani & Miller Approach
ASSUMPTIONS:
THERE ARE NO CORPORATE TAXES
THERE IS A PERFECT MARKET
INVESTORS ACT RATIONALLY
THE EXPECTED EARNINGS OF ALL THE FIRMS HAVE IDENTICAL
RISK CHARACTERSTICS
ALL EARNINGS ARE DISTIBUTED TO THE SHAREHOLDERS
Implications
Cost of capital not influenced by changes in
capital structure
Debt-equity mix is irrelevant in
determination of market value of frm
(B) WHEN TAXES ARE ASSUMED TO EXIST
ACHIEVEMENT
COST OF
OF OPTIMAL
USE OF DEBT CAPITAL
CAPITAL
DECREASE
STRUCTURE
Implication:
The mix of debt, preferred stock, and
common stock the frm plans to use over the
long-run to fnance its operations.
Features of a Optimal
Capital Mix
• Optimum capital structure is also referred as “
appropriate capital structure” and “sound capital
structure”
• Capacity of a FIRM
• Possible use of LEVERAGE
• FLEXIBLE
• Avoid Business RISK
• MINIMISE the cost of Financing and MAXIMISE
earning per share
Factors determining capital
structure
COST
PRINCIPLES OF CAPITAL
PRINCIPLE
STRUCTURE
CONTROL RISK
PRINCIPLE PRINCIPLE
FLEXIBILITY TIMING
PRINCIPLE PRINCIPLE
BY Manisha
Joshi
