Presentation of capital budgeting

8/13/2019 Presentation of capital budgeting

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PROJECT PRESENTATION BY: MuhammadAhmedKhan

RoheelGhulamMuhammad

MuhammadIsmailUmar

WaqasHafeez

MuhammadBilalAsif


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What is Capital Structure?

Balance SheetCurrent CurrentAssets Liabilities

DebtFixed Preference

Ordinaryshares

FinancialStructure


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What is Capital Structure?

Balance Sheet Current CurrentAssets Liabilities

DebtFixed Preference sharesAssets

Ordinary sharesCapitalStructure


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Whatiscapitalstructure?

Combinationofcapitaliscalled

capitalstructure.Thefirmmayuse

onlyequity,oronlydebt,ora

combinationofequity+debt,oracombinationof

equity+debt+preferencesharesor

mayuseothersimilarcombinations.


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CONT The Capital structure of business can bemeasured by the ratio of various kinds ofpermanent loan and equity capital to totalcapital - Schwarty


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CapitalStructure

Capitalstructureincludesonlylong

termdebtandtotalstockholder

investment.

CapitalStructure=LongTermDebt+

PreferredStock+NetWorth

OR

CapitalStructure=TotalAssets

CurrentLiabilities.


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Howshouldyoudesigncapital

structure?1. Itshouldminimizecostofcapital

2. Itshouldreducerisks

3. Itshouldgiverequiredflexibility4. Itshouldproviderequiredcontrolto

theowners

5. Itshouldenablethecompanytohaveadequatefinance.


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capitalstructuredecisions?

Meaning of risk = variability in income iscalled risk. Business risk = it is the situation, when theEBIT may vary due to change in capital

structure. It is influenced by the ratio offixed cost in total cost. If the ratio of fixedcost is higher, business risk is higher. Financial risk = it is the variability in EPS

due to change in capital structure. It iscaused due to leverage. If leverage ismore, variability will be more and thusfinancial risk will be more.


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Basic Terms used in Capital Structure

Financial Risk Increasedfinancialriskthatcomeswith

increaseduseofdebt

Cost of Capital Interestrateonborrowingsaftertax

WACC Costofdebt,preferredstock,equityand

reservesandsurplus


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CONT EPS= Earnings Per ShareProfitaftertaxandpreferencedividend/numberofequityshares.

Diluted EPS Derivedafterredemptionofpreferenceshares.

Obtainedafterconvertedpreferenceshares,

convertibledebenturesandbonusissues


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FinancingDecision

Howshouldtheinvestmentprojectbefinanced?

Doesthewayinwhichtheinvestmentprojectsare financedmatter?

Howdoesfinancingaffecttheshareholdersrisk,

returnandvalue? Doesthereexistanoptimumfinancingmixin

termsofthemaximumvaluetothefirmsshareholders?

Cantheoptimumfinancingmixbedeterminedinpracticeforacompany?

Whatfactorsinpracticeshouldacompanyconsiderindesigningitsfinancingpolicy?


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DeterminantsofCapitalStructure

SeasonalVariations

TaxbenefitofDebt

Flexibility

Control

IndustryLeverageRatios

AgencyCosts

IndustryLifeCycle

DegreeofCompetition

CompanyCharacteristics

RequirementsofInvestors

TimingofPublicIssue

LegalRequirements


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CAPITALSTRUCTUREOF

MULTINATIONALFIRMS Capitalstructureforthemultinationalfirminvolvesachoicebetweendebtandequityfinancingacrossallits

subsidiaries.AMNCcanhavemoredebtinitscapitalstructureifitscashflowsaremorestableandithasalowcreditrisk.


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Optimal capital structure

Capitalstructureorcombinationof

debtandequitythatleadstothe

maximumvalueofthefirm

Maximizesthevalueofthecompany

Minimizethecompanyscostofcapital

O C S


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OptimalCapitalStructure

Itisthatcapitalstructureatthatlevelofdebtequityproportionwherethemarketvaluepershareismaximumandthecostofcapitalisminimum.

Features: Profitability

solvency

Flexibility

Conservation control


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These considerations should be kept in mind whilemaximizing the value of the firm IfROI>thefixedcostoffunds,thecompany

shouldprefertoraisethefundshavingafixedcost,suchas,debentures,LoansandPSC.Itwill

increaseEPSofthefirm.

Ifdebtisusedasasourceoffinance,thefirmsavesaconsiderableamountinpaymentoftaxas

interestisallowedasadeductibleexpensein

computationoftax.

Itshouldalsoavoidunduefinancialriskattached

withtheuseofincreaseddebtfinancing

TheCapitalstructureshouldbeflexible.


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PATTERN OF CAPITAL STRUCTURE Completeequitysharecapital

Differentproportionsofequityandpreferencesharecapital

Differentproportionsofequityanddebenture(debt)capital

Differentproportionsofequity,preferenceanddebenture(debt)capital.


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APPROACHES TO DETERMINE APPROPRIATECAPITAL STRUCTURE

EBITEPSApproachThisapproachishelpfultoanalyzetheimpactofdebtonearningspershare.

ValuationApproachThisapproach

determinestheimpactofdebtuseontheshareholdersvalue.

CashFlowApproach-Thisapproach

analysesthefirmsdebtservicecapacity.

Th i f C i l S


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TheoriesofCapitalStructure

NetIncomeApproach

NetOperatingIncomeApproach

ModiglianiandMillerApproach TraditionalApproach.

N t I A h


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NetIncomeApproach

A change in the proportion in capital structure

will lead to a corresponding change in cost of

capital and Value of the firm.

Assumptions:(i) There are no taxes;

(ii) Cost of debt is less than the cost of equity;

(iii) Use of debt in capital structure does not change the

riskperception of investors.

(iv) Cost of debt and cost of equity remains constant;

A ti f NI Th


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AssumptionsofNITheory

Firsttherearenotaxes.

Secondthecostofdebtislessthan

thecostofequity.

Thirdtheuseofdebtdoesnot

changetheriskperceptionof

investor.

N t O ti I A h


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NetOperatingIncomeApproach

The essence of this approach is that the capital

structure decision of a firm is irrelevant.

Any change in leverage will not lead to any changein the total value of the firm and the market price of

shares as well as the overall cost of capital is

independent of the degree of leverage.Cost of debt

(Ki)remains constant. There are no corporate

taxes.

A ti f NOI Th


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AssumptionsofNOITheory

Thesplitoftotalcapitalizationbetweendebtandequityisnotessentialorrelevant.

Theequityshareholdersandotherinvestorsi.e.themarketcapitalizesthevalueofthefirmasawhole.

Thebusinessriskateachlevelofdebt-equitymixremainsconstant.Therefore,overallcostofcapitalalsoremainsconstant.

Thecorporateincometaxdoesnotexist


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Modigliani and Miller Approach Thisapproachwasdevelopedby

Prof.FrancoModiglianiandMertan

Miller.

Accordingtothisapproach,total

valueofthefirmisindependentofits

capitalstructure.


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CONT Modigliani and Miller Approach (MM)

Theydevelopedthecapital-structureirrelevanceproposition.

The basic M&M proposition is based on the following key

assumptions: The basic M&M proposition is based on the following key assumptions:

Notaxes

Notransactioncosts

Nobankruptcycosts

Equivalenceinborrowingcostsforbothcompaniesand

investors

Symmetryofmarketinformation,meaningcompaniesand

investorshavethesameinformation Noeffectofdebtonacompany'searningsbeforeinterestand

taxes


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MMApproachWithoutTax:PropositionI MMs Proposition I states that the firms value is independent of its capital

structure. With personal leverage, shareholders can receive exactly the same

return,withthesamerisk,fromaleveredfirmandanunleveredfirm.Thus,theywill

sellsharesoftheover-pricedfirmandbuysharesoftheunder-pricedfirmuntilthe

twovaluesequate.Thisiscalledarbitrage.


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MMsPropositionII Thecostofequity foraleveredfirmequals theconstantoverallcostofcapital

plusariskpremiumthatequalsthespreadbetweentheoverallcostofcapital

and the cost of debt multiplied by the firms debt-equity ratio. For financial

leverage to be irrelevant, the overall cost of capital must remain constant,

regardlessoftheamountofdebtemployed.Thisimpliesthatthecostofequitymustriseasfinancialriskincreases.


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MMHypothesisWithCorporateTax Under current laws in most countries, debt has an important advantage over

equity: interest payments on debt are tax deductible, whereas dividend

paymentsand retainedearningsarenot. Investorsina levered firm receive in

the aggregate the unlevered cash flow plus an amount equal to the tax

deduction on interest.Capitalising the first component of cash flowat the all-equityrateandthesecondatthecostofdebtshowsthatthevalueofthelevered

firmisequaltothevalueoftheunleveredfirmplustheinteresttaxshieldwhich

istaxratetimesthedebt(iftheshieldisfullyusable).

Itisassumedthatthefirmwillborrowthesameamountofdebtinperpetuityand

willalwaysbeabletousethetaxshield.Also,itignoresbankruptcyandagency

costs.


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ArbitragePROCESS

TheMM approach illustrates the arbitrage processwith reference to valuation in terms of two firms

which are exactly similar in all respects except

leveragesothatoneofthemhasdebtinitscapital

structurewhiletheotherdoesnot.

Tounderstandtheprocessletushaveanexample

Modigliani miller approach


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Modigliani-millerapproach

Feature

1. Capitalmarketsareperfect

2. Homogeneousriskclassesoffirm

3. Expectationsaboutthenetoperatingincome

4. Dividendpayoutratio100%

5. Nocorporatetaxes


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Limitations of MM Approach Investors cannot borrow on the same

terms and conditions of a firm

Personal leverage is not substitute for

corporate leverage Existence of transaction cost

Institutional restriction on personal

leverage Asymmetric information

Existence of corporate tax

Assumptions


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Assumptions

a. Information is available at free of costb. The same information is available for all

investors

c. Securities are infinitely divisible

d. Investors are free to buy or sell securitiese. There is no transaction cost

f. There are no bankruptcy costs

g. Investors can borrow without restrictions as the

same terms on which a firm can borrowh. Dividend payout ratio is 100 percent

i. EBIT is not affected by the use of debt

Traditional Approach


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TraditionalApproach

Thisapproachwasgivenby

Soloman.

Thisapproachisthemidwaybetween

NIApproachandNOIApproach.

Traditional approach says judicious use

of debt helps increase value of firm and

reduce cost of capital


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CONT Traditional Approach (TA) TheorythatwhentheWeightedAverageCostofCapital(WACC)isminimized.

The Traditional Theory of Capital Structure says that afirm's value increases to a certain level of debt capital,after which it tends to remain constant and eventuallybegins to decrease.


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Factors affecting capital structure INTERNAL Financialleverage

Risk

Growthandstability

Retainingcontrol

Costofcapital Cashflows

Flexibility

Purposeoffinance

Assetstructure

EXTERNAL Sizeofthecompany

Natureoftheindustry

Investors

Costofinflation

Legalrequirements Periodoffinance

Levelofinterestrate

Levelofbusinessactivity

Availabilityoffunds Taxationpolicy

Levelofstockprices

Conditionsofthecapitalmarket


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Alternative Approach to Capital Structure Analysis Using theBetaIncorporating Hamadas quation

Capital structure in the real world


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Capitalstructureintherealworld

Trade-off theory Pecking order theory Agency Costs


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Trade-off theory Trade-offtheoryallows

thebankruptcycosttoexist.Itstatesthatthereisanadvantageto

financingwithdebt(namely,thetax

benefitsofdebt)andthatthereisacostoffinancingwithdebt(the

bankruptcycostsandthefinancial

distresscostsofdebt).
http://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Bankruptcy


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Pecking order theory Itstatesthatcompaniesprioritizetheir

sourcesoffinancing(frominternal

financingtoequity)accordingtothelawof

leasteffort,orofleastresistance,preferringtoraiseequityasafinancing

meansoflastresort.Hence:internal

financingisusedfirst;whenthatis

depleted,thendebtisissued;andwhenitisnolongersensibletoissueanymore

debt,equityisissued


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Capital structure in a perfect


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Capitalstructureinaperfect

market

ModiglianiandMillermadetwo

findings

1-Thevalueofacompanyis

independentofitscapitalstructure

2-Thecostofequityforaleveraged

firmisequaltothecostofequityfor

anunleveragedfirm,plusanaddedpremiumforfinancialrisk

FeaturesofAnAppropriateCapitalStructure


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pp p p

capitalstructureisthatcapitalstructureatthatlevelofdebtequity

proportionwherethemarketvaluepershareismaximumandthecostof

capitalisminimum.

Appropriatecapitalstructureshouldhavethefollowingfeatures

Profitability/Return

Solvency/Risk

Flexibility

Conservation/Capacity

Control


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