Capital stucture copy

20th August 2017

Prepared by: Niruja Rajakulanajagam

Capital Structure

Learning Objectives:

After completing this lesson you should able to:

• define the meaning of capital structure

• identify forms of capital

• differentiate capital structure from financial structure

• identify the optimum capital structure

• understand the theories of capital structure

• calculate cost f capital

Capital StructureCoverage –

• Capital Structure concept

• Capital Structure Concept

of Value of a Firm

• Significance of Cost of

Capital (WACC)

• Capital Structure theories–

Net Income

Net Operating Income

Modigliani-Miller

Traditional Approach

Capital Structure

Capital Structure refers to the combination of mix of debt and equity

which a company uses to finance its long term operations.

Capital Structure

proportions or combinations ofequity share capital, preference sharecapital, debentures, long-term loans,retained earnings and other long-term sources of funds in the totalamount of capital which a firmshould raise to run its business

Capital Structure

“Capital structure refers to the mix oflong-term sources of funds, such as,debentures, long-term debts,preference share capital and equityshare capital including reserves andsurplus.”—I. M. Pandey.

Capital Structure vs. Financial Structure

• Capital structure is defined as the amount of, long-term debt and common equity used to finance a firm.

• Financial structure refers to the amount of total current liabilities, long-term debt, preferred stock, and common equity used to finance a firm.

Capital Structure =

Financial Current

Structure liabilities

Example of Capital StructureLong term debt is LKR. 30,000Equity Share Capital is LKR. 70,000Pref. Share Capital is LKR. 10,000Retained Earnings are LKR. 5000-------------------------------------Total Long term Fund = LKR. 115000============================


Example of Financial StructureLong term debt is LKR. 30,000short term debt is LKR. 20,000Equity Share Capital is LKR. 70,000Pref. Share Capital is LKR. 10,000Retained Earnings are LKR. 5000-------------------------------------Total Fund = LKR 135000============================


Assets Structure

Total asset = Current assets + Fixed assets

•Fixed claim•Tax deductible•High priority to financial trouble•Fixed maturity •No management control

•Residual claim•Not tax deductible•Lowest priority to financial trouble•Infinite•Management control

DebtBank debtCommercial papersCorporate bonds

EquityOwner’s equityVenture capitalCommon stockswarrants

Hybrid securitiesConvertible debtPreferred stockOption-linked bonds

The choice in financing

Capital structure and value of the firm

• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

V = B + S

• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S BS BS BS B

Value of the Firm

Importance of Capital Structure:

• Enables one to “optimize” the value of a firm or its WACC by finding the “best mix” for the amounts of debt and equity

• Provides a signal that the firm is following proper rules of corporate finance to “improve” its balance sheet. This signal is central to valuations provided by market investors and analysts

Optimal Capital Structure

Capital structure or combination of debt and equity that leads to maximum value

of firm.

Maximises value of company and wealth of owners.

Minimises the company’s cost of capital.

Capital Structure Terminology

• Optimal capital structure

– Minimizes a firm’s weighted average cost of capital

– Maximizes the value of the firm

• Target capital structure

– Capital structure at which the firm plans to operate

• Debt capacity

– Amount of debt contained in a firm’s optimal capital structure

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.

Flexible: altering capital structure without much costs & delays, to

raise funds whenever required.

Capacity: ability to generate profits to pay interest and principal.

Factors Affecting Capital Structure:

• Business Risk

• Tax structure: Debt’s tax deductibility

• Ability to raise capital under adverse terms

• Managerial decisions Business risk of the firm

• Extent of potential financial distress (e.g., bankruptcy)

• Agency costs

• Role played by capital structure policy in providing signals to the capital markets regarding the firm’s performance

• Government and other regulations

20

Factors determining capital structure

What are the risks associated with capital structure decisions?

• Meaning of risk : variability in income is called risk.

• Business risk = it is the situation, when the EBIT mayvary due to change in capital structure. It isinfluenced by the ratio of fixed cost in total cost. Ifthe ratio of fixed cost is higher, business risk is higher.

• Financial risk = it is the variability in EPS due tochange in capital structure. It is caused due toleverage. If leverage is more, variability will be moreand thus financial risk will be more.

What is the optimal debt-equity ratio?

• Need to consider two kinds of risk:

– Business risk

– Financial risk

Theories of Capital Structure

1. Net Income Approach

2. Net Operating Income Approach

3. The Traditional Approach

4. Modigliani and Miller Approach

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 profitability of the firm.

Capital Structure Theories

-Assumptions

Where, V = value o f firmD = market value of debtE = market value of equity

V = D + E

Where, D = market value of debtI = Annual interest rate

kd = Cost of debt

D = I/kd

Where, E = market value of equityNI = earnings available to

- common stockholderske = Cost of equity

E = NI/ke

Where,ko= the firm’s overall cost of capital or

capitalization ratioEBIT = earnings before interest and tax

V = Value of the firm

ko = EBIT/V

Where,WACC= weighted average cost of

capital/ cost of capitalke= cost of equity

we = weight of equity(E/V)kd= cost of debt

wd = weight of debt(D/V)

WACC/ko=(ke*we)+(kd*wd)

ASSUMPTIONS:

1. COST OF DEBT < COST OF EQUITY

2. NO TAXES

3. RISK NOT INFLUENCED BY DEBT’S USAGE

Capital Structure Theories –1) 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.

As per NI approach, higher use of debt capital will result in

reduction of WACC. As a consequence, value of firm will be

increased.

Value of firm = Earnings

WACC

Earnings (EBIT) being constant and WACC is reduced, the

value of a firm will always increase.

Thus, as per NI approach, a firm will have maximum value

at a point where WACC is minimum, i.e. when the firm is

almost debt-financed.


ko = EBIT/V

IMPLICATIONS

Increase in FIRMS’ VALUE and MARKET PRICE of the

equity shares

WACC decreases

Proportion of DEBT

INCREASES

CONT…

decrease in FIRMS’VALUEandMARKET PRICE of the equity shares

Financial leverage is reduced

WACC increases

Proportion of DEBT FINANCING DECREASES

ke

kokd

Debt

Cost

kd

ke, ko

As the proportion of

debt (Kd) in capital

structure increases,

the WACC (Ko)

reduces.


Calculate the value of Firm and WACC for the following capital structures

EBIT of a firm Rs. 200,000Ke = 10%

Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000

Kd = 6%

Particulars case 1 case 2 case 3

EBIT 200,000 200,000 200,000

(-) Interest 30,000 42,000 12,000

EBT 170,000 158,000 188,000

Ke 10% 10% 10%

Value of Equity 1,700,000 1,580,000 1,880,000

(EBT / Ke)

Value of Debt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%

(EBIT / Value) * 100


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?


SolutionParticulars

Net income

Less interest on 8% debentures of

Rs .2,00,000/3,00,000

Earnings available to equity shareholders

Equity capitalization rate

Market value of equity(s)

Market value of debentures(D)

Value of the firm (S+D)

Overall cost of capital

Rs

80,000

(16000)

6400010%

6,40,000

2,00,000

8,40,000

(80,000/8,40,000)X100

=9.52%.

Rs

80,000

(24000)

56,00010%

5,60,000

3,00,000

8,60,000

(80,000/8,60,000)X100=9.30%

Capital Structure Theories –B) Net Operating Income (NOI)

Net Operating Income (NOI) approach is the exact

opposite of the Net Income (NI) approach.

As per NOI approach, value of a firm is not dependent

upon its capital structure.

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.

ASSUMPTIONS:

1. MARKET CAPITALISES VALUE OF FIRM AS A WHOLE

2. BUSINESS RISK REMAINS CONSTANT AT EVERY LEVEL OF DEBT EQUITY MIX

3. NO CORPORATE TAXES


NOI propositions (i.e. school of thought) –

– The use of higher debt component (borrowing) in the capital

structure increases the risk of shareholders.

– Increase in shareholders’ risk causes the equity capitalization

rate to increase, i.e. higher cost of equity (Ke)

– A higher cost of equity (Ke) nullifies the advantages gained due

to cheaper cost of debt (Kd )

– In other words, the finance mix is irrelevant and does not affect

the value of the firm.


INCREASED USE OF DEBT INCREASES

FINANCIAL RISK OF THE EQUITY

SHAREHOLDERS.

COST OF EQUITY INCREASES.

ADVANTAGE OF USING CHEAP

SOURCE OF FUND i.e., DEBT IS EXACTLY

OFFSET BY INCREASED COST OF

EQUITY.

OVERALL COST OF CAPITAL REMAINS

THE SAME.


Cost of capital (Ko)

is constant.

As the proportion

of debt increases,

(Ke) increases.

No effect on total

cost of capital (WACC)

ke

ko

kd

Debt

Cost


Calculate the value of firm and cost of equity for the following capital structure -

EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%

Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)

Particulars Option I Option II Option III

EBIT 200,000 200,000 200,000

WACC (Ko) 10% 10% 10%

Value of the firm 2,000,000 2,000,000 2,000,000

Value of Debt @ 6 % 300,000 400,000 500,000

Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000

Interest @ 6 % 18,000 24,000 30,000

EBT (EBIT - interest) 182,000 176,000 170,000

Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%


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?


SolutionPARTICULARS

Net operating income

Overall cost of capital (Ko)

Market value of the firm= EBIT/Ko (100000x100/10)

Market value of the firm(v)Less market value of debentures (D)Total market value of equity

Cost of equity=(EBIT-I) x 100

(V-D)

RS

1,00,000

10%

10,00,000

10,00,000(5,00,000)

5,00,000

(1,00,000-30,000) x 10010,00,000-5,00,000

=14%.

RS

1,00,000

10%

10,00,000

10,00,000(7,50,000)

2,50,000

(1,00,000-45000) x 10010,00,000-7,50,000

=22%

Capital Structure Theories –C) Traditional Approach

The NI approach and NOI approach hold extreme views on

the relationship between capital structure, cost of capital

and the value of a firm.

Traditional approach (‘intermediate approach’) is a

compromise between these two extreme approaches.

Traditional approach confirms the existence of an optimal

capital structure; where WACC is minimum and value is the

firm is maximum.

As per this approach, a best possible mix of debt and

equity will maximize the value of the firm.

The approach works in 3 stages –

1) Value of the firm increases with an increase in borrowings

(since Kd < Ke). As a result, the WACC reduces gradually. This

phenomenon is up to a certain point.

2) At the end of this phenomenon, reduction in WACC ceases

and it tends to stabilize. Further increase in borrowings will

not affect WACC and the value of firm will also stagnate.

3) Increase in debt beyond this point increases shareholders’ risk

(financial risk) and hence Ke increases. Kd also rises due to

higher debt, WACC increases & value of firm decreases.


D)Traditional approach

USE OF DEBT INITIALLY

VALUE OF FIRM INCREASES

COST OF CAPITAL DECREASES

BUT..

INCREASED USE OF DEBT

FINANCIAL RISK OF EQUITY

SHAREHOLDERS INCREASE

COST OF EQUITY

INCREASES

OVERALL COST OF CAPIAL INCREASES

Implications:

Cost of capital (Ko)

is reduces initially.

At a point, it settles

But after this point,

(Ko) increases, due

to increase in the

cost of equity. (Ke)


O

Ko

Ke

Kd

Degree of Leverage

Co

st o

f C

apit

al (

pe

r ce

nt)

.

Stage II

Stage I

Stage III

• Stage I Increasing Value : Ke either remains constant Ke does notincrease fast enough to offset the advantage of low-cost debt. Duringthis stage Kd remains constant. Ko decreases with increasingleverage and value of firm V also increases.

• Stage II Optimum Value : Beyond stage I any subsequent increase inleverage have a negligible effect on Ko and hence value of the firm.Increase in Ke due to the added financial risk just offsets theadvantage of low cost debt. Within this range, at a specific point Kowill be minimum and the value of the firm will be maximum.

• Stage III Declining Value : Beyond the acceptable level of leverage,the value of the firm decreases with leverage as Ko increases withleverage. Investors perceive a high degree of financial risk anddemand a higher equity capitalization rate which exceeds theadvantage of low-cost debt.

EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to

the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.

For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC

Particulars Presently case I case II

Debt component - 300,000 500,000

Rate of interest 0% 10% 12%

EBIT 150,000 150,000 150,000

(-) Interest - 30,000 60,000

EBT 150,000 120,000 90,000

Cost of equity (Ke) 16% 17% 20%

Value of Equity (EBT / Ke) 937,500 705,882 450,000

Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000

WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%


Compute:Market value of Firm, Value of shares, and Average cost

of CapitalParticulars


Total investment

Equity capitalization rate

a. If the firm uses no debt

b. If the firm uses Rs 4,00,000

debentures

c. If the firm uses Rs 6,00,000

debentures

Rs.

2,00,000

10,00,000

10%

11%

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


Less int.

Earnings available to

eq. Sh.Holders

Eq. Capitalization rate

Market value of shares

Market value of debt

Market value of firm

Average cost of

Capital =EBIT/v

(a) No debt

2,00,000

-

2,00,000

10%

20,00,000

-

20,00,000

2,00,000/20,00,000X100

=10%

(b) Rs 4,00,000 5%

debentures

2,00,000

(20,000)

1,80,000

11%

16,36,363

4,00,000

20,36,363

2,00,000/20,36,363X100

=9.8%

(c) Rs. 6,00,000 6%

debentures

2,00,000

(36,000)

1,64,000

13%

12,61,538

6,00,000

18,61,538

2,00,000/18,61,538X

100

=10.7%

Capital Structure Theories –D) Modigliani – Miller Model (MM)

MM approach supports the NOI approach, i.e. the capital

structure (debt-equity mix) has no effect on value of a firm.

Further, the MM model adds a behavioural justification in

favour of the NOI approach (personal leverage)

Assumptions –

o Capital markets are perfect and investors are free to buy, sell, & switch

between securities. Securities are infinitely divisible.

o Investors can borrow without restrictions at par with the firms.

o Investors are rational & informed of risk-return of all securities

o No corporate income tax, and no transaction costs.

o 100 % dividend payout ratio, i.e. no profits retention

(IN THE ABSENCE OF TAXES)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

Capital Structure Theories –D. Modigliani & Miller Approach

Implications

Cost of capital not influenced by changes in

capital structure

Debt-equity mix is irrelevant in

determination of market value of firm

Co

st o

f C

apit

al (

%)

Ko

MM Model proposition –

1.Value of a firm is independent of the capital structure.

2.Value of firm is equal to the capitalized value of

operating income (i.e. EBIT) by the appropriate rate (i.e.

WACC).

3.Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt

= Expected EBIT

Expected WACC

Capital Structure Theories –D) Modigliani – Miller Model (MM)

(B) WHEN TAXES ARE ASSUMED TO EXIST (Proposition I & II)

USE OF DEBTCOST OF CAPITAL

DECREASE

ACHIEVEMENT OF OPTIMAL

CAPITAL STRUCTURE

Implication:

• Overall cost of capital (ko) and the Value of the firm (V) remains constant.

• Independent of the capital structure.

• The total value can be obtained by capitalizing the operating earnings stream

• Size of the corporate pie = PV of cash flows

• V=EBIT/ko

Proposition I

Proposition II

• The cost of capital (ke) equals thecapitalization rate of a pure equity stream anda premium for financial risk.

• Ke=ko+Risk premium• The premium for financial risk is equal to the

difference between the pure equitycapitalization rate and kd times the debt-equity ratio.

• Ke=ko+(ko-kd)(D/E)

Limitations of MM approach

• Investors cannot borrow on the same terms and conditions of a firm

• Perfect Capital Markets

• Existence of transaction cost

• Floatation costs

• Asymmetric information

• Existence of corporate tax

• Uncertainty

Date post:	23-Jan-2018
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