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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