Capital Structure

PRESENTATIONPRESENTATIONON ON CAPITAL STRUCTURE OF A CAPITAL STRUCTURE OF A COMPANYCOMPANY

SUBMITTED TO:MRS. RASHMI CHOUDHARY

SUBMITTED BY: TANUPRIYA

H-2008-MBA-41

DEFINITION :

“Capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources viz: loans, reserves, shares and bonds.”

The capital structure is made up of debt and equity securities and refers to permanent financing of a firm . It is composed of long-term debt, preference share capital and shareholder’s fund.

CAPITALIZATION, CAPITAL STRUCTURE

AND FINANCIAL STRUCTURE

1)Capitalization refers to the total amount of securities issued by a company. Its is computed as follows

Equity Share CapitalPreference Share CapitalLong-term Loans and Debentures

Capitalization

Rs 10,00,000 5,00,000 2,00,000

17,00,000

2) Capital structure refers to the proportionate amount that makes up capitalisation, is computed as below:

Equity Share CapitalPreference Share CapitalLong-term Loans and Debentures

Rs

10,00,000 5,00,000 2,00,000

Proportion/Mix58.82%29.41%11.77%

17,00,000

100%

3)Financial structure refers to all the financial resources , short as well as long-term and is calculated as:

Equity Share CapitalPreference Share CapitalLong-term Loans and DebenturesRetained EarningsCapital surplusCurrent Liabilities

Rs10,00,000 5,00,000 2,00,000 6,00,000 50,000 1,50,000

Proportion/Mix 40% 20% 8% 24% 2% 6%

25,00,000 100%

FORMS/PATTERNS OF CAPITAL STRUCTURE

The capital structure of a new company may consist of the following forms:

a) Equity Shares onlyb) Equity and Preference Sharesc) Equity Shares and Debenturesd) Equity Shares, Preference Shares and Debentures.

THEORIES OF CAPITAL STRUCTURE The important theories of capital

structure are:1) Net Income Approach2) Net Operational Income Approach3) The Traditional Approach4) Modigliani and Miller Approach

1) NET INCOME APPROACH The theory propounds that a company can increase its value

and reduce the overall cost of capital by increasing the proportion of debt in its capital structure. A firm can minimise the weighted average cost of capital & increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent. This approach is based on the following assumptions:

i. The cost of debt is less than the cost of equity.ii. There are no taxes.iii. The risk perception of investors is not changed by the use of

debt.The total market value of a firm on the basis of Net Income

Approach can be ascertained as: V= S + D Where, V= Total market value of a firm S= Market value of equity shares = Earnings Available to Equity Shareholders (NI)/Equity

Capitalisation Rate D= Market value of debt.And, Overall Cost of Capital or Weighted Average Capital can be

calculated as: K = EBIT/ V

Illustration A company expects a net income of Rs. 80,000. it has Rs. 2,00,000, 8%

debentures. The equity capitalisation rate of the company is 10%. Calculate the value of the firm and overall capitalisation rate according to the net income approach.

Overall Cost of Capital(k)= Earnings/ Value of the Firm

(EBIT/V) = 80,000/8,40,000 * 100 = 9.52%

Calculation of the value of the Firm

Net IncomeLess: Interest on 8% Debentures of Rs. 2,00,000Earnings available to equity shareholdersEquity Capitalisation Rate

Market Value of equity(S)= 64,000*100/10Market Value of Debentures(D)

Value of the Firm (S+D)

Rs80,00016,000

64,000 10%

6,40,0002,00,000

8,40,000

2) Net Operating Income Approach. This approach says that 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 irrespective of the method of financing. It implies that the overall cost of capital remains the same whether the debt-equity mix is 50:50 or 20:80.

This theory presumes that:i. The market capitalises the value of the firm as a whole;ii. The business risk remains constant at every level of debt equity mix;iii. There are no corporate taxes.The reason propounds for such assumptions are that 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 the constant with the increasing proportion of debt as the financial risk of the lenders is not effected.

The value of the firm on the basis of Net Operating Income Approach can be determined as:

V= EBIT/K Where , V= Value of a firm EBIT= Net Operating Income or Earning before interest and

tax Ko= Overall cost of Capital The market value of Equity is S=V-D Where, S= Market value of equity V= total market value of a firm D= market value of debt

IllustrationA co. expects a net operating income of Rs. 1,00,000. it has Rs. 5,00,000 , 6%

Debentures. The overall capitalisation rate is 10%. Calculate the value of the firm and the equity capitalisation rate according to Net Income Operating Approach.

Solution: Net operating income = Rs.1,00,000

Overall cost of capital =10%

Market value of the firm(V)=net operating income/ overall cost of capital [EBIT/k]

=1,00,000 * 100/10 = Rs. 10,00,000

Market value of firm =Rs 10,00,000

Less: market value of debentures =Rs. 5,00,000

Total market value of equity = Rs. 5,00,000

Equity Capitalisation rate or Cost of Equity

= earnings available to equity shareholders/total market value of equity shares or (EBIT – I/V-D)

= 1,00,000-30,000/10,00,000-5,00,000 * 100

= 70,000/5,00,000* 100

= 14%

3) The Traditional approach

It is the compromise between two extremes of net income approach and the net income operating approach. According to this theory, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity. Thus optimum capital structure can be reached by a proper debt-equity mix. Overall cost of capital according to this theory decreases upto certain point, remains more or less unchanged for moderate increase in debt thereafter ; and increases or rises beyond a certain point.

IllustrationCompute the market value of the firm, value of shares and the average cost

of capital from the following:

Assume that Rs. 4,00,000 deb. Can be raised @ 5% ROI where as Rs. 6,00,000 deb. Can be raised @ 6% ROI

Net operating IncomeTotal investmentEquity capitalisation rate:a)If the firm uses no debtb)If the firm uses Rs.4,00,000 debenturesc)If the firm uses Rs.6,00,000 debentures

Rs. 2,00,000 10,00,000

10% 11% 13%

Computation of Market value of firm, value of shares & the average cost of capital

Net operating incomeLess: Interest i.e., cost of equityEarning available to equity shareholdersEquity capitalisation rate

Market value of shares

Market value of debt(deb.)Market value firm

Average cost of capitalEarnings/value of firm orEBIT/V

(a) No Debt (b)Rs.6,00,000 5% debentures

(c) Rs.6,00,000 6% debentures

Rs.2,00,000 Rs.2,00,000 2,00,000

Rs.2,00,000 36000

Rs.2,00,000

10%

2,00,000*100/ 10=Rs.20,00,000 -

Rs.1,80,000

11%

1,80,000*100/ 11=Rs.16,36,363 4,00,000

Rs.1,64,000

13%

1,64,000*100/ 13=Rs.12,61,538 6,00,000

20,00,000 20,36,363 18,61,538

2,00,000/20,00,0000*100= 10%

2,00,000/20,36,363*100=9.8%

2,00,000/18,61,538*100=10.7%

4) Modigliani and Miller Approach M&M hypothesis is identical with the net operating income

approach if taxes are ignored. However, when corporate taxes are assumed to exist, their hypothesis similar to the net income approach.

a) In the absence of taxes

Illustration:

A co. has retained earnings before interest and taxes of Rs.1,00,000. it expects a return on its investment @ 12.5%. Find out total value of the firm.

Solution:

Total value of the firm= earnings before interest and tax/overall cost of capital

or V= EBIT/Ko

=1,00,000/12.5 / 100

=1,00,000*100/12.5

= Rs.8,00,000.

b) When the corporate taxes are assumed to exist

Value of unlevered firm(Vu) = Earnings before interest &taxes/Overall cost of capital

i.e. EBIT/Ko (1-t)

And, value of levered firm is:

Vl= Vu+tD

Where Vu is unlevered firm and tD is discounted present value of the taxes savings resulting from tax deductibility of the interest charges, t is the rate of tax and D the quantum of debt used in mix.

Illustration: there are 2 firms X & Y which are exactly identical except that X does not use any debt in its financing, while Y has Rs.1,00,000 5% deb. In its financing. Both the firms have earning before interest and tax of Rs.25,000 and the equity capitalization rate is 10%. Assuming the corporation tax of 50% calculate the value of firm.

Solution: The market value of firm X which does not use any debt

Vu = EBIT/Ko(1-t)

= 25,000/0.10*0.5 = Rs. 1,25,000

The market value of firm Y which uses debt financing of Rs. !,00,000

Vl = Vu+ tD

=Rs.1,25,000+0.5*1,00,000

=Rs.1,25,000+50,000

=Rs.1,75,000

ESSENTIAL FEATURES OF A SOUND CAPITAL STRUCTURE

A sound or an appropriate capital structure should have the following essential features:

a) Maximum possible use of leverage.

b) The capital structure should be flexible.

c) To avoid undue financial/business risk with the increase of debt.

d) The use of debt should be with in the capacity of a firm. The firm should be in a position to meet its obligation in paying the loan interest charges as and when due.

e) It should involve minimum possible risk of loss of control.

f) It must avoid undue restrictions in agreement of debt.

FACTORS DETERMINIG THE CAPITAL STRUCTURE

The factors determining the capital structure are: Growth and stability of sales Cost of capital Nature and size of a firm Control Flexibility Requirements of investors Capital market condition Assets structure Purpose of financing. etc