Capital Structure :Capital Structure Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.
Capital Structure :Capital Structure Presented By:-
Arshad Ali
PGDM
09929523710
Slide 3 :Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system of capital so that the maximum rate of return can be earned at a minimum cost.
This sort of system of capital is known as capital structure.
Total Required Capital :Total Required Capital From Shares
Equity Share capital
Preference Share Capital
From Debentures
Factors Influencing Capital Structure :Factors Influencing Capital Structure Internal Factors
External Factors
Internal Factors :Internal Factors Size of Business
Nature of Business
Regularity and Certainty of Income
Assets Structure
Age of the Firm
Desire to Retain Control
Future Plans
Operating Ratio
Trading on Equity
Period and Purpose of Financing
External Factors :External Factors Capital Market Conditions
Nature of Investors
Statutory Requirements
Taxation Policy
Policies of Financial Institutions
Cost of Financing
Seasonal Variations
Economic Fluctuations
Nature of Competition
Optimal Capital Structure :Optimal Capital Structure The optimal or the best capital structure implies the most economical and safe ratio between various types of securities.
It is that mix of debt and equity which maximizes the value of the company and minimizes the cost of capital.
Essentials of a Sound or Optimal Capital Structure :Essentials of a Sound or Optimal Capital Structure Minimum Cost of Capital
Minimum Risk
Maximum Return
Maximum Control
Safety
Simplicity
Flexibility
Attractive Rules
Commensurate to Legal Requirements
Basic Ratio :Basic Ratio Sound or Optimal Capital Structure requires (An Approximation):
Debt Equity Ratio: 1:1
Earning Interest Ratio: 2:1
During Depression: one and a half time of interest.
Total Debt Capital should not exceed 50 % of the depreciated value of assets.
Total Long Term Loans should not be more than net working capital during normal conditions.
Current Ratio 2:1 and Liquid Ratio 1:1 be maintained.
Point of Indifference(EBIT-EPS Analysis) :Point of Indifference(EBIT-EPS Analysis) It refers to that EBIT level at which EPS remains the same irrespective of different alternatives of debt equity mix.
At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as break-even level of EBIT for alternative financial plans.
Conclusion :Conclusion If the Expected EBIT is much more than the Point of Indifference Level - ?
If the Expected EBIT is lower than the Point of Indifference Level - ?
If the Expected EBIT is even less than the Fixed Cost - ?
Point of Indifference of EBIT - Ascertainment :Point of Indifference of EBIT - Ascertainment Point of Indifference :
(X-R1)(1-T)-PD = (X-R2)(1-T)-PD
N1 N2
Here,
X = EBIT at Indifference Point
R1 = Interest in Alternative 1
R2 = Interest in Alternative 2
T = Tax Rate
PD = Preference Dividend
N1 = No. of Equity Shares in Alternative 1
N2 = No. of Equity Shares in Alternative 2
Case :Case ABC Ltd. has a share capital of of Rs. 20 lacs divided into 40,000 equity shares of Rs.50 each. The company can raise additional funds of Rs.10 lacs for expansion either by issuing all equity shares or all 9% debentures. The company’s present EBIT is Rs. 2,80,000. Rate of income tax is 50%.
In this case: 1) What is the point of indifference?
2) Which alternative is beneficial to the company and Why?
Case :Case A new project under consideration by your company requires a capital investment of Rs.150 Lacs. Interest on Term Loan is 12% and tax rate is 50%. If the debt equity ratio insisted by the financing agencies is 2:1.
1) What is the point of indifference?
2) Which alternative is beneficial to the company and Why?
Theories of Capital Structure :Theories of Capital Structure Net Income (NI) Theory
Net Operating Income (NOI) Theory
Traditional Theory
Modigliani-Miller (M-M) Theory
Net Income (NI) Theory :Net Income (NI) Theory This theory was propounded by “David Durand” and is also known as “Fixed ‘Ke’ Theory”.
According to this theory a firm can increase the value of the firm and reduce the overall cost of capital by increasing the proportion of debt in its capital structure to the maximum possible extent.
Slide 18 :It is due to the fact that debt is, generally a cheaper source of funds because:
(i) Interest rates are lower than dividend rates due to element of risk,
(ii) The benefit of tax as the interest is deductible expense for income tax purpose.
Assumptions of NI Theory :Assumptions of NI Theory The ‘Kd’ is cheaper than the ‘Ke’.
Income tax has been ignored.
The ‘Kd’ and ‘Ke’ remain constant.
Computation of the Total Value of the Firm :Computation of the Total Value of the Firm Total Value of the Firm (V) = S + D
Where,
S = Market value of Shares = EBIT-I = E
Ke Ke
D = Market value of Debt = Face Value
E = Earnings available for equity shareholders
Ke = Cost of Equity capital or Equity capitalization rate.
Computation of the Overall Cost of Capital or Capitalization Rate :Computation of the Overall Cost of Capital or Capitalization Rate Ko = EBIT
V
Where,
Ko = Overall Cost of Capital or Capitalization Rate
V = Value of the firm
Case :Case K.M.C. Ltd. Expects annual net income (EBIT) of Rs.2,00,000 and equity capitalization rate of 10%. The company has Rs.6,00,000; 8% Debentures. There is no corporate income tax.
(A) Calculate the value of the firm and overall (weighted average) cost of capital according to the NI Theory.
(B) What will be the effect on the value of the firm and overall cost of capital, if:
(i) the firm decides to raise the amount of debentures by Rs.4,00,000 and uses the proceeds to repurchase equity shares.
(ii) the firm decides to redeem the debentures of Rs. 4,00,000 by issue of equity shares.
Net Operating Income Theory :Net Operating Income Theory This theory was propounded by “David Durand” and is also known as “Irrelevant Theory”.
According to this theory, the total market value of the firm (V) is not affected by the change in the capital structure and the overall cost of capital (Ko) remains fixed irrespective of the debt-equity mix.
Assumptions of NOI Theory :Assumptions of NOI Theory The split of total capitalization between debt and equity is not essential or relevant.
The equity shareholders and other investors i.e. the market capitalizes the value of the firm as a whole.
The business risk at each level of debt-equity mix remains constant. Therefore, overall cost of capital also remains constant.
The corporate income tax does not exist.
Computation of the Total Value of the Firm :Computation of the Total Value of the Firm V = EBIT
Ko
Where,
Ko = Overall cost of capital
Market Value of Equity Capital :Market Value of Equity Capital S = V – D
Where,
S = Market Value of Equity Capital
V = Value of the Firm
D = Market value of the Debt
Cost of Equity Capital :Cost of Equity Capital Ke = EBIT – I X 100
S
Where,
Ke = Equity capitalization Rate or Cost of Equity
I = Interest on Debt
S = Market Value of Equity Capital
Case :Case ABC Ltd. Expects annual net operating income of Rs.4,00,000. It has Rs.10,00,000 outstanding debts, cost of debt is 10%. If the overall capitalization rate is 12.5%,
(1) What would be the total value of the firm and the equity capitalization rate according to NOI Theory.
(2) What will be the effect of the following on the total value of the firm and equity capitalization rate, if
The firm increases the amount of debt from Rs.10,00,000 to Rs.15,00,000 and uses the proceeds of the debt to repurchase equity shares.
The firm returns debt of Rs.5,00,000 by issuing fresh equity shares of the same amount.
Traditional Theory :Traditional Theory This theory was propounded by Ezra Solomon.
According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital.
Effects of Changes in Capital Structure on ‘Ko’ and ‘V’ :Effects of Changes in Capital Structure on ‘Ko’ and ‘V’ As per Ezra Solomon:
First Stage: The use of debt in capital structure increases the ‘V’ and decreases the ‘Ko’.
Because ‘Ke’ remains constant or rises slightly with debt, but it does not rise fast enough to offset the advantages of low cost debt.
‘Kd’ remains constant or rises very negligibly.
Effects of Changes in Capital Structure on ‘Ko’ and ‘V’ :Effects of Changes in Capital Structure on ‘Ko’ and ‘V’ Second Stage: During this Stage, there is a range in which the ‘V’ will be maximum and the ‘Ko’ will be minimum.
Because the increase in the ‘Ke’, due to increase in financial risk, offset the advantage of using low cost of debt.
Effects of Changes in Capital Structure on ‘Ko’ and ‘V’ :Effects of Changes in Capital Structure on ‘Ko’ and ‘V’ Third Stage: The ‘V’ will decrease and the ‘Ko’ will increase.
Because further increase of debt in the capital structure, beyond the acceptable limit increases the financial risk.
Computation of Market Value of Shares & Value of the Firm :Computation of Market Value of Shares & Value of the Firm S = EBIT – I
Ke
V = S + D
Ko = EBIT
V
Case :Case Compute the total value of the firm, value of equity shares and the overall cost of capital from the following information and also give conclusion?
Net Operating Income: Rs.2,00,000
Total Investment: Rs.10,00,000
Equity Capitalization Rate:
If the firm uses no debt: 10%
If the firm uses Rs.4,00,000, 5% debentures: 11%
If the firm uses Rs.6,00,000, 6% debentures: 13%
Modigliani-Miller Theory :Modigliani-Miller Theory This theory was propounded by Franco Modigliani and Merton Miller.
They have given two approaches
In the Absence of Corporate Taxes
When Corporate Taxes Exist
In the Absence of Corporate Taxes :In the Absence of Corporate Taxes According to this approach the ‘V’ and its ‘Ko’ are independent of its capital structure.
The debt-equity mix of the firm is irrelevant in determining the total value of the firm.
Because with increased use of debt as a source of finance, ‘Ke’ increases and the advantage of low cost debt is offset equally by the increased ‘Ke’.
In the opinion of them, two identical firms in all respect, except their capital structure, cannot have different market value or cost of capital due to Arbitrage Process.
Assumptions of M-M Approach :Assumptions of M-M Approach Perfect Capital Market
No Transaction Cost
Homogeneous Risk Class: Expected EBIT of all the firms have identical risk characteristics.
Risk in terms of expected EBIT should also be identical for determination of market value of the shares
Cent-Percent Distribution of earnings to the shareholders
No Corporate Taxes: But later on in 1969 they removed this assumption.
When Corporate Taxes Exist :When Corporate Taxes Exist M-M’s original argument that the ‘V’ and ‘Ko’ remain constant with the increase of debt in capital structure, does not hold good when corporate taxes are assumed to exist.
They recognised that the ‘V’ will increase and ‘Ko’ will decrease with the increase of debt in capital structure.
They accepted that the value of levered (VL) firm will be greater than the value of unlevered firm (Vu).
Computation :Computation Value of Unlevered Firm
Vu = EBIT(1 – T)
Ke
Value of Levered Firm
VL = Vu + Dt
Where,
Vu : Value of Unlevered Firm
VL :Value of Levered Firm
D : Amount of Debt
t : tax rate
Case :Case XYZ Ltd. is planning an expansion programme which will require Rs.30 crores and can be funded through out of the following three options:
Issue further equity shares of Rs.100 each at par.
Raise loans at 15% interest.
Issue Preference shares at 12%.
Present paid up capital is Rs.60 Crores and average annual EBIT is Rs.12 crores. Assume income tax rate at 50%. After the expansion, EBIT is expected to be Rs.15 crores p.a.
Calculate EPS under the three financing options indicating the alternative giving the highest return to the equity shareholders.
Determine the point of indifference between equity share capital and debt i.e option (a) and (b) above.