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Capital Structure Planning

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Group members Kiran Bhoir 42003 Ravi Khetia 42006 Swati Singh 42013 Shiva Nadar 42008

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Agenda Definition Capital Structure Consists Of Owned Funds Borrowed Funds Factors Influencing Capital Structure Internal Factors External Factors Point Of Indifference Assumptions Theories of Capital Structure Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory Modigliani-Miller (M-M) Theory Format Of Evaluation Of Alternative Capital Plans

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Definition “Capital structure of a company refers to the make-up of its capitalisation and it includes all long term capital resources, viz :- shares, loans, reserves and bonds”  Gerstenberg

Capital Structure Consist Of :-:

Capital Structure Consist Of :- 1) Owned funds:  It belongs to the proprietors.  It includes share capital, free reserve & surplus. 2) Borrowed funds:  It consist of long-term borrowing from outside sources.  It consists of debentures,bonds & long term loans provided by banks and term lending institutions.

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

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

Assumptions:

Assumptions There are only two source of funds. There are no corporate taxes. The dividend-payout ratio is 100. The total assets remain constant. Firms total financing remain constant. Risk perception of the investor remains constant. The operating profit (EBIT) are not expected to grow. Perpetual life of the firm. Return on Investment remains constant. Investor’s profits remains constant.

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 . It is due to the fact that debt is, generally a cheaper source of funds because: Interest rates are lower than dividend rates due to element of risk. 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 .

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.

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.

Assumptions of Traditional Theory:

Assumptions of Traditional Theory Firm has a perpetual life. Corporate income tax does not exist. Company follows a 100 % dividend pay out policy. Operating income of company not to grow over time.

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.

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 recognized 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).

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.

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Format of Evaluation of Alternative Capital Plans