chapter 14 capital structuret

44Chapt

er

Chapt

er Capital Structure

Khursheed Ahmad Bhat (Ass i s tant Professor)Head of Finance DepartmentBakhtar Univers i ty Kabul

Khursheed Ahmad Bhat, Controller of Finances Bakhtar University2

Chapter 4 – Capital Structure.

Chapter outlines

What is Capital Structure?


Chapter 4 – Meaning of Capital Structure.

• Capital structure refers to the kinds of securities and the proportionate amounts that make up capitalization.

• It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings.

• It also refers to the relationship between the various long-term source financing.

• Deciding the suitable capital structure is the important decision of the financial management because it is closely related to the value of the firm.

• Capital structure is the permanent financing of the company.


Chapter 4 – Definition of Capital Structure.

• The following definitions clearly initiate, the meaning and objective of the capital structures.

• According to Gerestenbeg, “Capital Structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources”.

• According to James C. Van Horne, “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity”.


Chapter 4 – Financial Structure.

• The term financial structure is different from the capital structure. Financial structure shows the pattern total financing. It measures the extent to which total funds are available to finance the total assets of the business.

• Financial Structure = Total liabilities

Or• Financial Structure = Capital Structure + Current liabilities.• The following points indicate the difference between the financial

structure and capital structure.


Chapter 4 – Example 1

• From the following information, calculate the capitalization, capital structure and financial structures.

Balance sheetLiabilitis Assets

share capital Preference share capital Debentures Retained earnings Creditors Cash and bankBills payable

50,000 5,000

6,000 4,000 3,000

10,0002,000

Fixed assets Good will Stock Bills receivable Debtors

25,00010,00015,0005,0005,000

70,000 70,000



• (i) Calculation of Capitalization

• (ii) Calculation of Capital Structures

S.No Source Amount

1 Equity share capital 50,000

2 Preference share capital 5000

3 Debenture 6000

Capitalization 61000

S.No Source Amount Proportion

1 Equity share capital 50,000 76.92 %

2 Preference share capital 5000 07.69%

3 Debenture 6000 09.23%

4 Retained earnings 4000 06.16%

65000 100%



• (iii) Calculation of Financial Structure

S.No Source Amount Proportion

1 Equity share capital 50,000 71.42 %

2 Preference share capital 5000 07.14%

3 Debenture 6000 08.58%

4 Retained earnings 4000 05.72%

5 Bills Payable 2000 02.85%

6 Creditors 3000 04.29%

70000 100%


OPTIMUM CAPITAL STRUCTURE

• Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum.

• Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm.


Objectives of Capital Structure

• Decision of capital structure aims at the following two important objectives:

• 1. Maximize the value of the firm.• 2. Minimize the overall cost of capital.


Forms of Capital Structure

• Capital structure pattern varies from company to company and the availability of finance.

• Normally the following forms of capital structure are popular in practice.

• Equity shares only.• Equity and preference shares only.• Equity and Debentures only.• Equity shares, preference shares and debentures.


Factors Determining Capital Structure

• The following factors are considered while deciding the capital structure of the firm.

Leverage• It is the basic and important factor, which affect the capital structure.

It uses the fixed cost financing such as debt, and preference share capital. It is closely related to the overall cost of capital.



Cost of Capital• Cost of capital constitutes the major part for deciding the capital

structure of a firm.• Normally long- term finance such as equity and debt consist of fixed

cost while mobilization.• When the cost of capital increases, value of the firm will also

decrease. Hence the firm must take careful steps to reduce the cost of capital.



a) Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital.

b) Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal sources. But if it is small size, they will go for external finance. It consists of high cost of capital.



c) Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some specific sources.

d) Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.

Government policy• Promoter contribution is fixed by the company Act. It restricts to

mobilize large, long term funds from external sources.


Capital Structure Theories

• Capital structure is the major part of the firm’s financial decision which affects the value of the firm and it leads to change EBIT and market value of the shares.

• There is a relationship among the capital structure, cost of capital and value of the firm.

• The aim of effective capital structure is to maximize the value of the firm and to reduce the cost of capital.

• There are two major theories explaining the relationship between capital structure, cost of capital and value of the firm.




Traditional ApproachModern Approach

Modigliani-Miller

Approach

Net Operating Income Approach

Net Income Approach


Traditional Approach

• It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also called as intermediate approach. According to the traditional approach, mix of debt and equity capital can increase the value of the firm by reducing overall cost of capital up to certain level of debt. Traditional approach states that the Ko decreases only within the responsible limit of financial leverage and when reaching the minimum level, it starts increasing with financial leverage.



Assumptions

Capital structure theories are based on certain assumption to analysis in a single and convenient manner:

1. There are only two sources of funds used by a firm; debt and shares.

2. The firm pays 100% of its earning as dividend.

3. The total assets are given and do not change.

4. The total finance remains constant.

5. The operating profits (EBIT) are not expected to grow.

6. The business risk remains constant.

7. The firm has a perpetual life.

8. The investors behave rationally.


Exercise Question 1• ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new

factory expects to yield annual earnings before interest and tax (EBIT) of Rs.5,00,000. In choosing a financial plan, ABC Ltd., has an objective of maximizing earnings per share (EPS). The company proposes to issuing ordinary shares and raising debit of Rs. 3,00,000 and Rs. 10,00,000 of Rs. 15,00,000. The current market price per share is Rs. 250 and is expected to drop to Rs. 200 if the funds are borrowed in excess of Rs. 12,00,000. Funds can be raised at the following rates.

–up to Rs. 3,00,000 at 8%

–over Rs. 3,00,000 to Rs. 15,000,00 at 10%

–over Rs. 15,00,000 at 15%• Assuming a tax rate of 50% advise the company.


Exercise Question 1• Earnings Before Interest and Tax (BIT) less Interest Earnings Before

Tax less: Tax@50%.Alternatives

Particulars 1(Rs. 3,00,000 debt)

2(Rs. 1,000,000Debt)

3(Rs. 1,500,000 debt)

EBIT 500000 500000 500000

Less Interest 24000

EAIBT 476000

Less Tax 238000

EAIT 238000

Equity Share 27,00,000

Market Price Per share 250

Number of Shares 10800

Earning Per Share 238000/10800=22.037





2(Rs. 1,000,000Debt)

3(Rs. 1,500,000 debt)

EBIT 500000 500000 500000

Less Interest 24000 100000

EAIBT 476000 400000

Less Tax 238000 200000

EAIT 238000 200000

Equity Share 27,00,000 2,000,000

Market Price Per share 250 250

Number of Shares 10800 8000


200000/8000=25





2(Rs. 1,000,000Debt)

3(Rs. 1,500,000 debt)

EBIT 500000 500000 500000

Less Interest 24000 100000 225000

EAIBT 476000 400000 275000

Less Tax 238000 200000 137500

EAIT 238000 200000 137500

Equity Share 27,00,000 2,000,000 1,500,000

Market Price Per share 250 250 200

Number of Shares 10800 8000 7500


200000/8000=25

137500/7500=18.33


Exercise Question 2 Compute the market value of the firm, value of shares and the average

cost of capital from the following information.• Net operating income Rs. 1,00,000• Total investment Rs. 5,00,000• Equity capitalization Rate:

a) If the firm uses no debt 10%

b) If the firm uses Rs. 25,0000 debentures 11%

c) If the firm uses Rs. 4,00,000 debentures 13%• Assume that Rs. 5,00,000 debentures can be raised at 6% rate of

interest whereas Rs. 4,00,000 debentures can be raised at 7% rate of interest.


Solution 2 Computation of market value of firm value of shares and the average cost of capital.

Particulars (a)No Debt (b) Rs 250000 6% debentures

(c) Rs 4000007% Debentures

Net operating Income(–) Interest (i.e.)Cost of debtEarnings available toEquity shareholdersEquity Capitalization RateMarket value of shares

Market Value of firm

Average cost of capital=Earnings/Value of the firmEBIT/V

100000

-

10000010%

100,000 × 100/10=Rs. 10,00,000/-

1000000100000

100000/1000000×100=10%


Solution 2 Computation of market value of firm value of shares and the average cost of capital.






100000

-

10000010%

100,000 × 100/10=Rs. 10,00,000/-

1000000100000

100000/1000000×100=10%

100000

15000

8500011%

85000×100/11=Rs.772727/-

10,22,727100000

100000/1022727×100=9.78%


Solution 2

Computation of market value of firm value of shares and the average cost of capital.






100000

-

10000010%

100,000 × 100/10=Rs. 10,00,000/-

1000000100000

100000/1000000×100=10%

100000

15000

8500011%

85000×100/11=Rs.772727/-

10,22,727100000

100000/1022727×100=9.78%

100000

28000

7200013%

72000×100/13Rs.553846/-

953846100000

100000/953846×100=10.48%

The equity capitalization rate is determined by taking the net operating income of a property and dividing it by the sales price.


Net Income (NI) Approach 18.13

• According to this approach, a firm can minimise the weighted average cost of capital and increase the value of firm as well as the market price of equity share capital by using debt financing to the maximum possible extent.

• According to this approach, use of more debt finance reduce the overall cost of capital and increase the value of firm.


Net Income (NI) Approach

• Net income approach is based on the following three important assumptions:

• 1. There are no corporate taxes.• 2. The cost debt is less than the cost of equity.• 3. The use of debt does not change the risk perception of the investor.



• The line of argument in favour of this approach is that as the proportion of debt financing in capital structure increases, the proportion of a less expensive source of fund increases.

• It results in the decrease in overall cost of capital leading to n increase in the value of firm.

• Reasons are that the interest rates are usually less than rate of dividend due to risk element and tax benefit as the interest is deductible expense.

• The Net income approach showing the effect of leverage on overall cost of capital has been presented in the figure that follows:

KE (COST OF EQUITY)

KD (COST OF DEBT)

KO (OVERALL COST OF CAPITAL)

--------- DEGREE OF LEVERAGE---------------

----

- C

OS

T O

F C

AP

ITA

L %

---

----

----



• The total market value of the firm on the basis of NIA can be ascertained as below• V = S+D• where• V = Value of firm• S = Market value of equity• D = Market value of debt• Market value of the equity can be ascertained by the following formula:• S =NI/Ke• where• NI = Earnings available to equity shareholder• Ke = Cost of equity/equity capitalization rate

Format for calculating value of the firm on the basis of NI approach



• Question:• X Ltd is expecting an annual EBIT of 1 lakh AF’s. the company has 4 lakh in 10%

debentures. The cost of wquity or capitlisation rate is 12.5%. You are required to calculate the total value of the firm accor.ding to NI Approach

Solution AF’s

Calculation of the value of the Firm

Net income (EBIT) 100000

Less: Interest on 10% Debenture of 400000 40000

Earnings available to equity share holders 60000

Market capitalization rate 12.5%

Market value of the share(S)=60000x100/12.5 480000

Market value of the debenture (D) 400000

Value of the Firm (S+D) 880000



• Question: 2

a) A company expects a net income of Rs. 80000. it has 200000 8% Debentures. The equity capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization rate according to NI approach. (Ignor income tax)

b) If the debenture is increased to Rs. 300000 what shall be the value of the firm and overall capitalization rate?

Solution AF’s

(a) Calculation of the value of the Firm Alternative(a)

200000 Debt

Alternative(b)

300000 Debt

Net income (EBIT) 80000 80000

Less: Interest on 10% Debenture of 200000 16000 24000

Earnings available to equity share holders 64000 56000

Market capitalization rate 10% 10%

Market value of the share [a] (S)=64000x100/10=640000 [b] (S)=56000x100/10=560000

640000 560000

Market value of the debenture (D) 200000 300000

Value of the Firm (S+D) 840000 860000

Calculation of overall capitalization rate

Overall cost of capital (ko) =EBIT/ Value of the firm (a) (ko) =80000/840000x100= 9.52% [b] (ko) =80000/860000x100= 9.30%


Net Operating Income (NOI) Approach

• This theory as suggested by David Durand is another extreme of the effect of leverage on the value of firm.

• It is dramatically opposite to the net income approach.• According to this approach, change in the capital structure of a company

does not affect the market value of the firm and the overall cost of capital remains constant irresective of the method of financing.

• Thus there is nothing as an optimal capital structure and every capital structure is the optimum capital structure.

• The theory presumes that:

i. The market capitalises the value of firm as a whole.

ii. The business risk remains constant at every level of D/E mix

iii. There are no corporate taxes.

KE (COST OF EQUITY)

KD (COST OF DEBT)

KO (OVERALL

COST OF CAPITAL)

--------- DEGREE OF LEVERAGE---------------

----

- C

OS

T O

F C

AP

ITA

L %

---

----

----

It implies that the overall cost of capital remains the same whether the debt-equity mix is 50:50 or 80:20 or 0:100.


Net Operating Income (NOI) Approach

• The reasons propounded for such assumptions are: • The increased use of debt increases the financial risk of the equity shareholders and

hence the cost of equity increases. • On the other hand, the cost of debt remains constant with the increasing proportion

of debt as the financial risk of the lender is not affected. Thus the advantage of using the cheaper source of fund i.e., debt is exactly offset by the increased cost of equity.

• The value of the firm on the basis of NOI approach can be determined as below:

• V=EBIT/Ko• Where V= Value of the firm• EBIT= Earnings before interest and tax• Ko= Overall Cost of Capital• The cost of equity or Equity capitalization rate can be calculated as below• Ke=

Earnings after interest before Tax

Market value of Firm- Market Value of Debt EBIT-I

V-D

Khursheed Ahmad Bhat, Controller of Finances Bakhtar University 37

Question:

a. A company expects a net operating income of 100000. it has 500,000 6% Debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitlization rate (Cost of equity) according to the Net Operating Income Approach.

b. If the debenture debt is increased to 700000 what will be the effect on the value of the firm?


Question:

a. A company expects a net operating income of 100000. it has 500,000 6% Debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitlization rate (Cost of equity) according to the Net Operating Income Approach.

b. If the debenture debt is increased to 700000 what will be the effect on the value of the firm?

Solution AF’s

Calculation of the value of the Firm (a)

Net operating income (EBIT)Overall cost of capital Market Value of the Firm (V)=

10000010%

Less: Market Value of the Debentures =500000

Market value of the Equity =500000

Equity Capitalization Rate=

Calculation of the value of the Firm (b)

(Net operating Income) EBIT

Overall Cost of Capital K

=100000x100 =1,000,000 10

Earnings after interest before Tax

Market value of Firm- Market Value of Debt

EBIT-I

V-D 100000-30000

1000000- 500000X100=

70000

500000X100=14%

100000-45000

1000000- 750000X100=

55000

250000X100=22%

(Net operating Income) EBIT

Overall Cost of Capital K

=100000x100 =1,000,000 10


Modigliani and Miller Approach:

MM hypothesis is identical with Net Operating Income approach in the absence of taxes. However, when corporate taxes are assumed to exist there hypothesis is similar to NI Approach.

A. In the absence of taxes (Theory of Irrelevance): The theory proves that the cost of capital is not affected by the change of debt-equity mix and is irrelevant in determining the value of the firm.

• Reason: Though debt is cheaper to equity, increased use of debt increases the cost of equity. The increased cost of equity offsets the advantage of debt. Financial leverage effects the cost of equity, the overall cost of capital remains constant.

• The theory emphasises the fact that the firms operating income determines its total value.


Modigliani and Miller Approach:

• The theory further propounds that beyond certain limit of debt, the cost of debt increases due to increased financial risk and the cost of equity falls thereby again balancing two costs.

• In the opinion of Modigliani & Miller two identical firms except their capital structure cannot have different market value due to Arbitrage Process.

• In case of such identical firms (Except their capital structure) if the firms have different market value, arbitrage will take place, investors will buy equity of the firm having more value as against the corporate leverage and this will render two firms to have same market value.


Assumptions underlying MM Approach:

i. There are no corporate taxes.

ii. There is a perfect market.

iii. Investors act rationally.

iv. The expected earnings of all firms have identical risk characteristics.

v. The cut-off point of investment in a firm is capitalization rate.

vi. Risk to investor depends upon the random fluctuations of expected earnings and the possibility that the variables my turn out to be different from their best estimates

vii. All earnings are distributed to the shareholders.


Graphical presentation of MM Approach:


Question: The following information is available regarding Mid Air Enterprises:

i. Mid Air has no debt, it is all equity company;

ii. Estimated EBIT=24 lakh. EBIT is expected to remain constant.

iii. There are no taxes therefore, T=0 %

iv. Dividend pay-out ratio is 100%

v. If Mid Air rises debt, rate of interest will be 8% constant for all degrees of leverages. Any money raised by selling debt would be used to retire common stock, so the assets of firm will be constant..

vi. Expected rate of return on equity is 12%, if no debt is used. Using MM model without corporate taxes & assuming 1crore debt, you are

required to:

a. Determine the firm’s total market value.

b. Determine the firm’s value of euity

c. Determine the firms leverage cost of equity.


Question: The following information is available regarding Mid Air Enterprises:

i. Mid Air has no debt, it is all equity company;

ii. Estimated EBIT=24 lakh. EBIT is expected to remain constant.

iii. There are no taxes therefore, T=0 %

iv. Dividend pay-out ratio is 100%

v. If Mid Air rises debt, rate of interest will be 8% constant for all degrees of leverages. Any money raised by selling debt would be used to retire common stock, so the assets of firm will be constant..

vi. Expected rate of return on equity is 12%, if no debt is used. Using MM model without corporate taxes & assuming 1crore debt, you are

required to:

a. Determine the firm’s total market value.

b. Determine the firm’s value of euity

c. Determine the firms leverage cost of equity.

a. Firm’s total Market Value:

V=

V= =Rs. 20,000,000

b. Firm’s Market value of Equity

S=V-D

S=2-1= 1crore

c. Firm’s Leverage Cost of Equity;

=cost of equity+(Cost of equity-cost of debt)

=12%+(12%-8%) = 16%

EBITKe

24000000.12


Question: When corporate taxes are assumes to Exist (Theory of Relevance): • Modigliani and Miller in their article of 1963 have recognised that the value of the

firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charged for tax purpose.

• Thus the optimum capital structure can be achieved by maximising the debt mix in the equity of firm.

VL (Value of Levered Firm)

VL (Value of Unlevered Firm)

Value of interest tax shield

Degree of Leverage

Val

ue

MM Approach: Value of Levered and Unlevered Firm)


Question: According to the MM approach, the value of Livered and unlevered firm can be

calculated as: Value of Unlevered firm(Vu) = (1-i)

And the value of Levered Firm is : VL=Vu+tD

EBIT

KO

Thank You


chapter 14 capital structuret

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