Capital Structure F

8/2/2019 Capital Structure F

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Capital Structure

Capital Structure refers to thecombination or mix of debt andequity which a company uses to

finance its long term operations.


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Raising of capital from different sources

and their use in different assets by a

company is made on the basis of certainprinciples that provide a system of capital

so that the maximum rate of return can be

earned at a minimum cost.

This sort of system of capital is known as

capital structure.


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Total Required Capital

From Shares

Equity Share capital

Preference Share Capital

From Debentures


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Factors Influencing Capital

Structure

Internal Factors

External Factors The firms business risk

The firms tax position

Financial flexibility Managerial attitude


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Internal Factors

Size of Business

Nature of Business

Regularity and Certainty of Income

Assets Structure Age of the Firm

Desire to Retain Control

Future Plans

Operating Ratio Trading on Equity

Period and Purpose of Financing


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External Factors

Capital Market Conditions

Nature of Investors

Statutory Requirements

Taxation Policy

Policies of Financial Institutions

Cost of Financing

Seasonal Variations Economic Fluctuations

Nature of Competition


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Optimal Capital Structure

The optimal or the best capital structure

implies the most economical and safe ratio

between various types of securities. It is that mix of debt and equity which

maximizes the value of the company and

minimizes the cost of capital.


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Essentials of a Sound or Optimal

Capital Structure Minimum Cost of Capital Minimum Risk

Maximum Return

Maximum Control

Safety

Simplicity

Flexibility Attractive Rules

Commensurate to Legal Requirements


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Basic Ratio

Sound or Optimal Capital Structure requires (AnApproximation):

Debt Equity Ratio: 1:1

Earning Interest Ratio: 2:1

During Depression: One and a half time of interest. Total Debt Capital should not exceed 50 % of the

depreciated value of assets.

Total Long Term Loans should not be more than networking capital during normal conditions.

Current Ratio 2:1 and Liquid Ratio 1:1 be maintained.


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Point of Indifference

(EBIT-EPS Analysis) It refers to that EBIT level at which EPS

remains the same irrespective of different

alternatives of debt equity mix.

At this level of EBIT, the rate of return on

capital employed is equal to the cost of

debt and this is also known as break-even

level of EBIT for alternative financial plans.


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Conclusion

If the Expected EBIT is much more than

the Point of Indifference Level - ?

If the Expected EBIT is lower than thePoint of Indifference Level - ?

If the Expected EBIT is even less than the

Fixed Cost - ?


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Point of Indifference of EBIT -

Ascertainment Point of Indifference :

(X-R1)(1-T)-PD = (X-R2)(1-T)-PD

N1 N2

Here,

X = EBIT at Indifference Point

R1 = Interest in Alternative 1

R2 = Interest in Alternative 2

T = Tax Rate

PD = Preference DividendN1 = No. of Equity Shares in Alternative 1

N2 = No. of Equity Shares in Alternative 2


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Case

ABC Ltd. has a share capital of ofRs. 20 lacsdivided into 40,000 equity shares ofRs.50 each.The company can raise additional funds ofRs.10 lacs for expansion either by issuing all

equity shares or all 9% debentures. Thecompanys present EBIT is Rs. 2,80,000. Rate ofincome tax is 50%.

In this case: 1) What is the point of indifference?2) Which alternative is beneficial to

the company and Why?


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Case

A new project under consideration by yourcompany requires a capital investment ofRs.150 Lacs. Interest on Term Loan is

12% and tax rate is 50%. If the debt equityratio insisted by the financing agencies is2:1.

1) What is the point of indifference?2) Which alternative is beneficial to thecompany and Why?


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Theories of Capital Structure

Net Income (NI) Theory

Net Operating Income (NOI) Theory

Traditional Theory Modigliani-Miller (M-M) Theory


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Net Income (NI) Theory

This theory was propounded by David

Durandand is also known as Fixed Ke

Theory.

According to this theory a firm can

increase the value of the firm and reduce

the overall cost of capital by increasing the

proportion of debt in its capital structure tothe maximum possible extent.


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It is due to the fact that debt is, generally a

cheaper source of funds because:

(i) Interest rates are lower than dividend ratesdue to element of risk,

(ii) The benefit of tax as the interest is

deductible expense for income tax purpose.


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Assumptions of NI Theory

The Kd is cheaper than the Ke.

Income tax has been ignored.

The Kd and Ke remain constant.


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Computation of the Total Value of

the FirmTotal Value of the Firm (V) = S + D

Where,

S = Market value of Shares = EBIT-I = E

Ke Ke

D = Market value of Debt = Face Value

E = Earnings available for equity shareholders

Ke = Cost of Equity capital or Equity capitalization

rate.


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Computation of the Overall Cost of

Capital or Capitalization Rate

Ko = EBIT

V

Where,

Ko = Overall Cost of Capital or CapitalizationRate

V = Value of the firm


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Case

K.M.C. Ltd. Expects annual net income (EBIT) ofRs.2,00,000 and equity capitalization rate of10%. Thecompany has Rs.6,00,000; 8% Debentures. There is nocorporate income tax.

(A) Calculate the value of the firm and overall (weightedaverage) cost of capital according to the NI Theory.

(B) What will be the effect on the value of the firm andoverall cost of capital, if: (i) the firm decides to raise the amount of debentures by

Rs.4,00,000 and uses the proceeds to repurchase equity shares.

(ii) the firm decides to redeem the debentures ofRs. 4,00,000 byissue of equity shares.


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Net Operating Income Theory

This theory was propounded by David

Durandand is also known as Irrelevant

Theory.

According to this theory, the total market

value of the firm (V) is not affected by the

change in the capital structure and the

overall cost of capital (Ko) remains fixedirrespective of the debt-equity mix.


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Assumptions of NOI Theory

The split of total capitalization between debt and

equity is not essential or relevant.

The equity shareholders and other investors i.e.

the market capitalizes the value of the firm as awhole.

The business risk at each level of debt-equity

mix remains constant. Therefore, overall cost of

capital also remains constant.

The corporate income tax does not exist.


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Computation of the Total Value of

the Firm

V = EBIT

Ko

Where,

Ko = Overall cost of capital


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Market Value of Equity Capital

S = V D

Where,S = Market Value of Equity Capital

V = Value of the Firm

D = Market value of the Debt


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Cost of Equity Capital

Ke = EBIT I X 100

S

Where,Ke = Equity capitalization Rate or Cost of

Equity

I = Interest on DebtS = Market Value of Equity Capital


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Case

ABC Ltd. Expects annual net operating income ofRs.4,00,000. It has Rs.10,00,000 outstanding debts, costof debt is 10%. If the overall capitalization rate is 12.5%,

(1) What would be the total value of the firm and the

equity capitalization rate according to NOI Theory. (2) What will be the effect of the following on the total

value of the firm and equity capitalization rate, if The firm increases the amount of debt from Rs.10,00,000 to

Rs.15,00,000 and uses the proceeds of the debt to repurchase

equity shares. The firm returns debt ofRs.5,00,000 by issuing fresh equity

shares of the same amount.


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Traditional Theory

This theory was propounded by EzraSolomon.

According to this theory, a firm can reducethe overall cost of capital or increase thetotal value of the firm by increasing thedebt proportion in its capital structure to acertain limit. Because debt is a cheapsource of raising funds as compared toequity capital.


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Effects of Changes in Capital

Structure on Koand V

As per Ezra Solomon:

First Stage: The use of debt in capital

structure increases the Vand decreasesthe Ko.

Because Ke remains constant or rises

slightly with debt, but it does not rise fast

enough to offset the advantages of low costdebt.

Kdremains constant or rises very negligibly.


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Second Stage: During this Stage, there is

a range in which the Vwill be maximum

and the Kowill be minimum.

Because the increase in the Ke,due to

increase in financial risk, offset the advantage

of using low cost of debt.


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Third Stage: The V will decrease and the

Ko will increase.

Because further increase of debt in the capital

structure, beyond the acceptable limit

increases the financial risk.


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Computation of Market Value of

Shares & Value of the Firm

S = EBIT I

Ke

V = S + D

Ko= EBITV


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Case

Compute the total value of the firm, value of equityshares and the overall cost of capital from thefollowing information and also give conclusion?

Net Operating Income: Rs.2,00,000

Total Investment: Rs.10,00,000

Equity Capitalization Rate:

(a) If the firm uses no debt: 10%

(b) If the firm uses Rs.4,00,000, 5% debentures:11%

(c) If the firm uses Rs.6,00,000, 6% debentures:13%


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Modigliani-Miller Theory

This theory was propounded by Franco

Modigliani and Merton Miller.

They have given two approaches In the Absence of Corporate Taxes

When Corporate Taxes Exist


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In the Absence of Corporate Taxes

According to this approach the Vand its Koare independent of its capital structure.

The debt-equity mix of the firm is irrelevant indetermining the total value of the firm.

Because with increased use of debt as a sourceof finance, Ke increases and the advantage oflow cost debt is offset equally by the increasedKe.

In the opinion of them, two identical firms in allrespect, except their capital structure, cannothave different market value or cost of capital dueto Arbitrage Process.


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Assumptions of M-M Approach

Perfect Capital Market

No Transaction Cost

Homogeneous Risk Class: Expected EBIT of all

the firms have identical risk characteristics. Risk in terms of expected EBIT should also be

identical for determination of market value of theshares

Cent-Percent Distribution of earnings to theshareholders

No Corporate Taxes: But later on in 1969 theyremoved this assumption.


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When Corporate Taxes Exist

M-Ms original argument that the V and Koremain constant with the increase of debt incapital structure, does not hold good when

corporate taxes are assumed to exist.They recognised that the V will increase andKo will decrease with the increase of debt incapital structure.

They accepted that the value of levered (VL) firmwill be greater than the value of unlevered firm

(Vu).


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Computation

Value ofUnlevered Firm

Vu = EBIT(1 T)

Ke

Value ofLevered Firm

VL = Vu + Dt

Where,

Vu : Value ofUnlevered FirmVL :Value ofLevered Firm

D : Amount of Debt

t : tax rate


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Case

XYZ Ltd. is planning an expansion programme which will require Rs.30crores and can be funded through out of the following threeoptions:

(a) Issue further equity shares ofRs.100 each at par.

(b) Raise loans at 15% interest.

(c) Issue Preference shares at 12%.

Present paid up capital is Rs.60 Crores and average annual EBIT isRs.12 crores. Assume income tax rate at 50%. After theexpansion, EBIT is expected to be Rs.15 crores p.a.

(i) Calculate EPS under the three financing options indicating the

alternative giving the highest return to the equity shareholders.(ii) Determine the point of indifference between equity share capital

and debt i.e option (a) and (b) above.

Capital Structure F

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