Post on 07-Apr-2018
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Capital Structure
Financial Management
Author: I M Pandey
Capital Structure
What is capital structure?
A term used to represent the proportionate relationship
between debt and equityWhat are the components of
equity?
Equity includes:
paid-up share capital
Share premium
Reserves and retained earnings
Capital Structure
Is the knowledge about capital structure important?
Yes
Because it influences shareholders return and risks
Which in turn may influence the market value of the share of the
company
The structure of capital is therefore a managerial/
investment decision
Financial leverage
What is meant by financial leverage?
The use of fixed-charges source of funds (debt and
preference shares) along with owners equity (ordinary
shares) in the capital structure
Financial leverage is also known as gearing or
trading on equity
Replacement
Modernisation
Expansion
Diversification
Internal Funds
Debt
Equity
Payout Policy
Effect on
Return
Effect on
Risk
capital budgeting decision
Need to raise funds
Capital structure decision
Desired Debt-Equity Mix
Effect on Cost of Capital
Value of the Firm
Optimum
Capital
Structure
Existing capitalStructure
Capital structure and value of firm
Since capital structure decisions affect the value of a
firm, the firm would like to have a capital structure
which would maximise market value
Note: the value of a firm is the sum of the values of all its
securities
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Capital structure and value of firm
There exists conflicting theories on the relationshipbetween capital structure and the value of a firm
Traditional approach: Capital structure affects the value of firm
Modligiani and Miller under perfect capital market with notaxes
Capital structure decision is irrelevant
Modligiani and Miller with corporate taxes Capital structure decision is relevant
Tax savings resulting from interest paid on debts creates value forthe firm
Traditional Approach: Net Income Approach
Suppose firm L is a levered firm I.e. financed asset with both equity and debt
It has an expected EBIT or NOI of Rs1,000
Interest payment is equal to Rs 300
The firms cost of equity, ke, is 9.33% Cost of equity is also known as equity capitalisation rate
The firms cost of debt, kd, is 6%
What is the firms value?
The value of a firm
What is the firms value?
Recall: The value of a firm is the sum of the values
of all its securities Securities include both equity and debt
Therefore:
calculate the value of equity,
then calculate the value of debt and
then add them together
Value of Firms Equity
The value of firms equity, E, is the discounted
value of shareholders earnings
Shareholders earnings is also called net incomenet income (NI)
Net income = net operating income (NOI) interest I.e. 1000 300 = 700
Recall: cost of equity is 9.33%
Hence, the value of Ls equity is Rs 7,500
500,7.0933.0
700Rs
K
NIE
e
===
Value of Firms Debt
The value of a firms debt is the discounted value of
debt-holders interest income
Recall: cost of debt debt is 6%
The value of firms L debt is Rs. 5,000
5000.06.0
300Rs
K
IntD
d
===
Value of firm
Value of firm = value of equity + value of debt
Calculate the firms overall expected rate of return
(I.e. cost of capital)
500,12000,5500,7 RsDEV =+=+=
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Calculate the firms overall expected rate of return(I.e. cost of capital)
The firm overall cost of capital is also known as theweighted average cost of capital (WACC)
There is an alternative way to calculate WACC (k0)
%8500,12
000,1
cos'
0 ===
=
V
NOIk
mValueofFir
ngIncomeNetOperatitofcapitalsfirm
WACC
WACC = cost of Equity * Equity Weight + Cost of
Debt * debt Weight
%8
%4006.0%600933.0
500,12
000,506.0
12500
75000933.0
0
0
0
0
=
+=
+=
+=
k
k
k
V
Dk
V
Ekk
de
Recall: cost of equity is 9.33% and cost of debt is
6%.
I.e. cost of debt is less than cost of equity. Therefore, it pays to have a capital structure with more debts
than equity
I.e. as the ratio of debt to total capital increases, the overall cost of
capital (WACC) falls
Try the following:
Suppose in the above example NOI is 1000 and interest is 853;cost of debt and cost of equity are same as before
Ke = 0.0933; kd = 0.06
E = 147/0.0933 = 1575.6
D = 853/0.06 = 14216.7
V = E + D = 1575.6 + 14216.7 = 15792.3
V
Dk
V
Ekk de +=0
%33.6
%9006.0%100933.0
3.15792
7.1421606.0
3.15792
6.15750933.0
0
=
+=
+=k
Comparing results:
When value of Debt to total value of firm increased
from 40% to 90%: the overall cost of capital fell from 8% to 6.33%
The value of firm increased from 12500 to 15792
I.e. firms value increases with more debt
2nd part of the Capital Structure Chapter