Capital Structure Final Ppt

1

Capital Structure

Presented By

Pooja

Topics

• What is capital structure?

• Why is it important?

• What does capital structure consist of ?

• What is business risk and financial risk?

• What are the theories of capital structure?

• What is an optimum capital structure?

• Summary

2

What is “Capital Structure”?

3

•FinancialStructure

Balance Sheet

Current Current Assets Liabilities

Debt Fixed Preference

Assets shares

Ordinary shares

4

•CapitalStructure

Balance Sheet

Current Current Assets Liabilities

Debt Fixed Preference

Assets shares

Ordinary shares

What is “Capital Structure”?

5

Definition

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

- Gerstenberg

Format of Capital Structure

66

PLANS

Option 1 Option 2 Option 3Particulars

EBIT=-------x funds employedLess: Interest on DebenturesNet Profit Before TaxLess: Tax @ ______%Net Profit After TaxNumber of Equity shareEPS=NPAT/Number of Equity share

PE RatioMarket Price=EPS x PE Ratio

xxxxxx

xxxxxx

xxxx

xxxxxxxx

xxxxxx

xxxx

xxxxxx

xxxxxx

xxxxxx

xxxx

xxxx

xxxx

xxxx

xxxx

Why is it important?

7

8

Capital Structure consists of:

1. Owned Funds: • It belongs to the proprietors• It includes share capital, free reserves and surplus.

2. Borrowed Funds: • It consists of long-term borrowings from outside

sources.• It consists of debentures, bonds and long-term loans provided by banks and term lending institutions.

9

Equity share capital• ‘Risk bearing’ capital of the company

• Shares which do not enjoy special rights in respect of payment of dividend and repayment of capital.

• Rate of dividend fluctuates depending upon the availability of profits

10

Advantages

1. It represents a permanent source of finance

2. It does not carry any fixed burden

3. It enhances the creditworthiness of the firm

Disadvantages1. Its cost is very high

2. Issue of equity to outsiders causes dilution of control

11

Preference Shares

• Shares which enjoy priorities in the payment of dividend as well as in the repayment of capital

• Preference shareholders are entitled to receive a fixed rate of dividend

• Preference shareholder

is paid back the capital

before any payment is

made to the equity

shareholders.

Types of preference shares

12

•Surplus profit•Fixed Dividend

•Returnable•Non-Returnable

•Dividend gets carried over next year

•Dividend lapses

•Can be converted into equity share

•Cannot be converted into ordinary share

13

Advantages• Preferential rights

• Arrears of Unpaid dividend payable

• Gives flexibility to the company - Redeemable and Convertible Shares

Disadvantages• Fixed dividend

• No control

14

Debentures• Money received by the issue of debentures is a loan• Debenture is a security issued by a company against

the debt.• Debenture holders are the creditors of the company• Interest on debentures has to be paid even if the

company makes losses• Debenture holders have no voting rights • No dilution of control• Less risky for shareholders

15

Advantages• Regular fixed income

• Safety and security of investment

• Liquidity- easy sale in stock exchange

• Conversion into shares

Disadvantages• No control

• Fixed returns

16

Term Loans

• 3 categories based on Pay back period: Short term Loans Medium term Loans Long term Loans

17

Advantages

• Cost lower than share capital• No dilution of control• Backed by security

Disadvantages

• No voting rights• Repayment is obligatory

Risk and the Income Statement

Sales

Operating – Variable costs

Leverage – Fixed costs

EBIT

– Interest expense

Financial Earnings before taxes

Leverage – Taxes

Net Income

EPS =Net Income

No. of Shares 18

Business Risk

• The basic risk inherent in the operations of a firm is called business risk

• Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)

19

Financial risk

• Debt causes financial risk because it imposes a fixed cost in the form of interest payments.

• The use of debt financing is referred to as financial leverage.

• Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.

20

Financial Risk Vs Business Risk

• There is a trade-off between financial risk and business risk.

• A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even.

• A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).

21

Weighted Average Cost of Capital

• USED IN CAPITAL BUDGETING DECISIONS TO CALCULATE NPV

• EXPECTED RETURN ON PORTFOLIO OF ALL COMPANY’S SECURITIES

rA = (D/D+E)rD + (E/D+E)rE

• EXAMPLE: FIRM HAS £2 MILLION DEBT

– CURRENT BORROWING RATE, rD= 8%

– 100,000 SHARES PRICED AT £30 PER SHARE

– EXPECTED RATE OF RETURN ON SHARES, rE = 15%

• D=£2M, E=100,000 x £30= £3M, V = D+E=2+3 = £5M

• WACC = (D/D+E)rD + (E/D+E)rE

= (2/5).08 + (3/5).15

=.122 OR 12.2%

22

What are the theories of capital structure?

• Net Income Theory of Capital Structure Financial leverage is beneficial

• Net Operating Income Theory of Capital Structure Financial leverage is irrelevant

• Traditional Theory of Capital StructureThere exists an optimal capital structure

• Modigliani and Miller

23

2424

•Financial Leverage

•rD

•rA

•Stock•Price

•Financial Leverage

•Po

•rE•Capital•Cost

Net Income Theory

Net Income Theory of Capital Structure

• No matter how modest or excessive the firm’s use of debt financing, both its cost of debt capital, rD, and cost of equity capital, rE, remain CONSTANT

• The weighted average cost of capital, rA, and the firm’s share price, Po, ARE affected by the firm’s use of financial leverage

• Since the cost of debt is lower than the cost of equity, greater use of debt reduces the weighted average cost of capital, ie the firm’s stock value increases with increase in financial leverage

25

Net Operating Income Theory

•Financial Leverage

•Capital•Costs

•rE

•rD

•rA

•Stock•Price

•Financial Leverage

•Po

Net Operating Income (NOI) Theory

•The firm’s market value is unaffected by it’s capital structure

•As financial leverage increases cheaper debt, rD, is substituted for more expensive equity

•However, the firm’s cost of equity, rE, will gradually rise in line with the increasing use of debt

•The value of the firm’s equity is therefore unaffected by the increase in financial leverage

•Suggests that capital structure is irrelevant

27

28

•Financial Leverage

•Capital •Costs

•rE

•rA

•rD

Traditional Theory

Traditional Theory

• Intermediate Position

• At moderate levels of financial leverage investors don’t notice the risk of borrowing

• This results in a decrease in the weighted average cost of capital, rA

• The probability that the firm will not be able to meet its financial obligations increases as more and more debt is employed

• Thus investors “wake up” when debt is excessive and eventually at some point the expected cost of default outweighs the advantage of debt

29

Modigliani & Miller’s theory

• Modigliani was awarded the 1985 Nobel price in Economics for this and other contributions.

• This approach says that there is not any relationship between capital structure and cost of capital

• Value of firm and cost of capital is fully affected from investor's expectations.

30

What is an optimum capital structure?

31

• An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value

• Essentials of optimum capital structure FlexibilitySolvencyEfficiencySimplicityControl

Summary• A firm’s capital structure is the proportion of a firm’s

long-term funding provided by long-term debt and equity.

• Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk.

• Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

32

33

Thank you