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# Capital structure

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### Capital structure

1. 1. Form of Capital: Capital Structure
2. 2. Capitalization Capital Structure Financial Structure Terminologies
3. 3. Total amount of (in ) issued by a company Current Liabilities Current Assets Debt Preference Shares Fixed Assets Equity Shares Retained Earnings Balance Sheet
4. 4. Balance Sheet Current Liabilities Current Assets Debt Preference Shares Fixed Assets Equity Shares Retained Earnings
5. 5. Balance Sheet Current Liabilities Current Assets Debt Preference Shares Fixed Assets Equity Shares Retained Earnings
6. 6. What does it Conclude !!
7. 7. Capital Structure = Financial Current Structure liabilities
8. 8. Equity Share Capital + Retained Earnings Debt + Preference Share Debt FoundationExpansion Horizontal Vertical Pyramid Shaped Inverted Pyramid Shaped
9. 9. Importance of Capital Structure:
10. 10.  Level of EBIT which is just equal to pay the total financial charges.  At this point EPS = 0.  Critical point in planning capital structure of firm.  If EBIT < financial break even point, then debt and preference share capital should be reduced in capitalization.  If EBIT> financial break even point more of fixed cost may be inducted in capital structure. Financial Break-Even Point
11. 11. • Financial Break Even Point = Fixed Interest Charges When capital structure consists of debt and equity share capital and no preference share capital • Financial break even point= I+ Dp • (1-t) • here, I = fixed interest charges • Dp = preference dividend • t = tax rate When capital structure consists of equity share capital, preference share capital and debt
12. 12. Point of Indifference/ Range of Earnings  It is EBIT level at which EPS remains the same ; irrespective of different alternatives of debt-equity mix.  At this level of EBIT, rate of return on capital employed = cost of debt.
13. 13.  Calculation of Point of Indifference (algebraically): (X-I1) (1-T) – PD = (X-I2) (1-T)- PD S1 S2 WHERE, X = point of indifference, I1 = interest under alternative financial plan 1, I2 = interest under alternative financial plan 2, T= tax rate, S1 = no of equity shares under financial plan1, S2 = no of equity shared under financial plan 2, PD= preference dividend.
14. 14. A project under consideration by your company requires a capital investment of 60 lakhs. Interest on loan 10 % p.a and tax rate 50%. Calculate point of indifference for the project, if debt equity ratio is 2:1.
15. 15. As debt equity ratio is 2:1. So, Company has two alternatives : (i) Raising entire amount by issue of share capital and no debt. (ii) Raising 40 lakh by way of debt and 20 lakh by issue of equity share capital. Calculation of point of indifference: (X-I1) (1-T) – PD = (X-I2) (1-T)- PD S 1 S2 I1 = 0 , I2 = 40* 10% = 4 , tax rate = 50 % or .5 , S1= 60, S2 = 20 now substitute the values, (X-0) (1-0.5) – 0 = (X-4) (1-0.5) – 0 60 20 20 (.5X) = 60 (.5X-2) 10X = 30X-120 X=6 Thus, EBIT at point of indifference is 6 lakhs.
16. 16. Graphically : 0 0.2 0.4 0.6 0.8 1 1.2 1 2 3 4 5 6 7 8 9 10 Plan 1 Plan 2 EPS(Rs.) EBIT (Rs. In lakhs) Indifference point
17. 17. Point of indifference and uncommitted earnings per share Equivalency point for uncommitted EPS can be calculated as below: (X-I1) (1-T) –PD-SF = (X-I2) (1-T)- PD- SF S1 S2 where, X = Equivalency point or point of indifference I1 = interest under alternative financial plan 1, I2 = interest under alternative financial plan 2, T= tax rate, S1 = no of equity shares under financial plan1, S2 = no of equity shared under financial plan 2, PD= preference dividend. SF= sinking fund obligations
18. 18. Optimal Capital Structure
19. 19. Considerations to be kept in mind while maximising value of firm:
21. 21. Capital mix involves two types of risks: 1. Financial Risk 2. Non-Employment of Debt Capital Risk (NEDC)
22. 22. Financial Risk • Debt causes financial risk ! • The use of debt financing is referred to as financial leverage. • Financial leverage measures Financial risk. Sales Operating (–) Variable costs Leverage Contribution (–) Fixed costs EBIT / Profit (–) Interest expense Financial EBT Leverage (–) Taxes EAT (-) Preference dividend Earnings available for equity Shareholders
23. 23. Non-Employment of Debt Capital (NEDC) Risk  No advantage of Financial leverage.  Loss of control by issue of more and more Equity.  Higher Floatation Cost.
24. 24. Strike a balance (trade off) between the financial risk and Risk of non-employment of debt capital to increase Firm’s Market Value.
25. 25. Theories of Capital Structure 1. Net Income Approach 2. Net Operating Income Approach 3. The Traditional Approach 4. Modigliani and Miller Approach
26. 26. PURPOSE OF STUDY CAPITAL STRUCTURE VALUE OF FIRM COST OF CAPITAL
27. 27. 1. NET INCOME APPROACH ASSUMPTIONS: 1. COST OF DEBT < COST OF EQUITY 2. NO TAXES 3. RISK NOT INFLUENCED BY DEBT’S USAGE
28. 28. IMPLICATIONS INCREASE IN FIRMS’ VALUE PROPORTION OF CHEAP SOURCE OF FUNDS INCREASE PROPORTION OF DEBT INCREASES
29. 29. CONT… DECREASE IN FIRMS’VALUE FINANCIAL LEVERAGE IS REDUCED PROPORTION OF DEBT FINANCING DECREASES
30. 30. Calculation of THE TOTAL MARKET VALUE OF A FIRM V = S + D Where, V= Total market value of a firm S= Market value of equity shares Earnings available to equity shareholders (NI) Equity Capitalization Rate D = market value of debt And, Overall Cost of Capital (Weighted Average Cost of Capital) K0 = EBIT V
31. 31. A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8% debentures. The equity capitalization rate of the company is 10%. Calculate: (a) the value of the firm & overall capitalization rate. (b) If the debenture debt is increased to Rs 3,00,000, what shall be the value of the firm & overall capitalization rate?
32. 32. Solution Particulars Net income Less interest on 8% debentures of Rs .2,00,000/3,00,000 Earnings available to equity shareholders Equity capitalization rate Market value of equity(s) Market value of debentures(D) Value of the firm (S+D) Overall cost of capital Rs 80,000 (16000) 64000 10% 6,40,000 2,00,000 8,40,000 (80,000/8,40,000) X100 =9.52%. Rs 80,000 (24000) 56,000 10% 5,60,000 3,00,000 8,60,000 (80,000/8,60,000) X100 =9.30%
33. 33. 2. NET OPERATING INCOME APPROACH ASSUMPTIONS: 1. MARKET CAPITALISES VALUE OF FIRM AS A WHOLE 2. BUSINESS RISK REMAINS CONSTANT AT EVERY LEVEL OF DEBT EQUITY MIX 3. NO CORPORATE TAXES
34. 34. IMPLICATIONS INCREASED USE OF DEBT INCREASES FINANCIAL RISK OF THE EQUITY SHAREHOLDERS. COST OF EQUITY INCREASES. ADVANTAGE OF USING CHEAP SOURCE OF FUND i.e., DEBT IS EXACTLY OFFSET BY INCREASED COST OF EQUITY. OVERALL COST OF CAPITAL REMAINS THE SAME.
35. 35. Ascertainment of value of firm  V= EBIT/KO  V= Value of the firm  EBIT= Net operating income or earnings before interest & tax  KO= Overall cost of capital  S= V-D  S= Market value of equity shares  V= total market value of a firm  D= market value of debt
36. 36. A company expects a net operating income of Rs.1,00,000. It has Rs 5,00,000 6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm & cost of equity according to net operating income approach. If the debenture debt is increased to Rs 7,50,000. What will be the effect on the value of the firm % the equity capitalization rate?
37. 37. Solution PARTICULARS Net operating income Overall cost of capital (Ko) Market value of the firm= EBIT/Ko (100000x100/10) Market value of the firm(v) Less market value of debentures (D) Total market value of equity Cost of equity= (EBIT-I) x 100 (V-D) RS 1,00,000 10% 10,00,000 10,00,000 (5,00,000) 5,00,000 (1,00,000-30,000) x 100 10,00,000-5,00,000 =14%. RS 1,00,000 10% 10,00,000 10,00,000 (7,50,000) 2,50,000 (1,00,000-45000) x 100 10,00,000-7,50,000 =22%
38. 38. 3. Traditional approach USE OF DEBT INITIALLY VALUE OF FIRM INCREASES COST OF CAPITAL DECREASES BUT.. INCREASED USE OF DEBT FINANCIAL RISK OF EQUITY SHAREHOLDER S INCREASE COST OF EQUITY INCREASES OVERALL COST OF CAPIAL INCREASES Implications:
39. 39. Compute: Market value of Firm, Value of shares, and Average cost of Capital Particulars Net operating income Total investment Equity capitalization rate a. If the firm uses no debt b. If the firm uses Rs 4,00,000 debentures c. If the firm uses Rs 6,00,000 debentures Rs. 2,00,000 10,00,000 10% 11% 13% Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.
40. 40. Solution Net operating income Less int. Earnings available to eq. Sh.Holders Eq. Capitalization rate Market value of shares Market value of debt Market value of firm Average cost of Capital =EBIT/v (a) No debt 2,00,000 - 2,00,000 10% 20,00,000 - 20,00,000 2,00,000/20,00,000X 100 =10% (b) Rs 4,00,000 5% debentures 2,00,000 (20,000) 1,80,000 11% 16,36,363 4,00,000 20,36,363 2,00,000/20,36,363X1 00 =9.8% (c) Rs. 6,00,000 6% debentures 2,00,000 (36,000) 1,64,000 13% 12,61,538 6,00,000 18,61,538 2,00,000/18,61,5 38X100 =10.7%
41. 41. 4. Modigliani & Miller Approach (IN THE ABSENCE OF TAXES) ASSUMPTIONS: THERE ARE NO CORPORATE TAXES THERE IS A PERFECT MARKET INVESTORS ACT RATIONALLY THE EXPECTED EARNINGS OF ALL THE FIRMS HAVE IDENTICAL RISK CHARACTERSTICS ALL EARNINGS ARE DISTIBUTED TO THE SHAREHOLDERS
42. 42. Implications  Cost of capital not influenced by changes in capital structure  Debt-equity mix is irrelevant in determination of market value of firm
43. 43. (B) WHEN TAXES ARE ASSUMED TO EXIST USE OF DEBT COST OF CAPITAL DECREASE ACHIEVEMENT OF OPTIMAL CAPITAL STRUCTURE Implication:
44. 44. The mix of debt, preferred stock, and common stock the firm plans to use over the long-run to finance its operations.
45. 45. Features of a Optimal Capital Mix • Optimum capital structure is also referred as “ appropriate capital structure” and “sound capital structure” • Capacity of a FIRM • Possible use of LEVERAGE • FLEXIBLE • Avoid Business RISK • MINIMISE the cost of Financing and MAXIMISE earning per share
46. 46. Factors determining capital structure
47. 47. A company is considering 4 different plans to finance its total project cost of Rs 5,00,000 Plan I Plan II Plan III Plan IV Equity(Rs. 10 per share) 8% Preference Shares Debt (8% Debenture) 5,00,000 - - 5,00,000 2,50,000 2,50,000 - 5,00,000 2,50,000 - 2,50,000 5,00,000 2,50,000 1,00,000 1,50,000 5,00,000
48. 48. Plan I Plan II Plan III Plan IV EBIT 1,00,000 1,00,000 1,00,000 1,00,000 Less: Interest on Debentures EBT - 1,00,000 - 1,00,000 20,000 80,000 12,000 88,000 Less: Tax @50% Earning after Interest and Tax Less: Preference Dividend 50,000 50,000 NIL 50,000 50,000 20,000 40,000 40,000 NIL 44,000 44,000 8,000 Earning available for eq.Shareholders (A) 50,000 30,000 40,000 36,000 No. of Equity Shares(B) 50,000 25,000 25,000 25,000 EPS(A/B) 50,000/50,000 = Rs.1per share 30,000/25,000 =Rs.1.20per share 40,000/25,000 =Rs.1.60per share 36,000/25,000 =Rs.1.44per share
49. 49. PRINCIPLES OF CAPITAL STRUCTURE COST PRINCIPLE RISK PRINCIPLE TIMING PRINCIPLE FLEXIBILITY PRINCIPLE CONTROL PRINCIPLE
50. 50. CAPITAL GEARING • The term "capital gearing" or "leverage" normally refers to the proportion of relationship between equity share capital including reserves and surpluses to preference share capital and other fixed interest bearing funds or loans. • It is the proportion between the fixed interest or dividend bearing funds and non fixed interest or dividend bearing funds. • Equity share capital includes equity share capital and all reserves and surpluses items that belong to shareholders. Fixed interest bearing funds includes debentures, preference share capital and other long-term loans.
51. 51. HOW TO CALCULATE Formula of capital gearing ratio:- [Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds]
52. 52. EXAMPLE 1992 1993 EQUITY SHARE CAPITAL 5,00,000 4,00,000 RESERVES AND SURPLUSES 3,00,OOO 2,00,000 LONG TERM LOANS 2,50,000 3,00,000 6% DEBENTURES 2,50,000 4,00,000
53. 53. CALCULATI ON  Capital Gearing Ratio  1992 = (500,000 + 300,000) / (250,000 + 250,000) = 8 : 5 (Low Gear) 1993 = (400,000 + 200,000) / (300,000 +400,000) =6 : 7 (High Gear)  It may be noted that gearing is an inverse ratio to the equity share capital.  Highly Geared------------Low Equity Share Capital  Low Geared---------------High Equity Share Capital
54. 54. SIGNIFICANCE Capital gearing ratio is important to the company and the prospective investors. It must be carefully planned as it affects the company's capacity to maintain a uniform dividend policy during difficult trading periods. It reveals the suitability of company's capitalization.
55. 55. REASONS FOR CHANGE IN CAPITAL STRUCTURE :- To restore balance in financial plan To simplify the capital structure To suit investors needs To fund current liabilities To write-off the debts
56. 56. To capitalise retained earnings To clear default on fixed cost structures To fund accumulated dividends To facilitate merger and expansion To meet legal requirements
57. 57. 1.) A company can adjust its capital structure as according to needs. So as to maintain a balance in financial plan and ease out the tension and strain Restoring balance in financial plan
58. 58. 2.) Simplify the capital structure
59. 59. 3.)To suit the need of investors To make the investment more attractive especially when the shares are limited due to wide fluctuations in market the company may change capitalisation to suit the needs of investors.
60. 60. 4.)To fund current liabilities There may be need of converting short term obligations into long term obligations Or vice versa When the market conditions are favorable
61. 61. 5.)To write off deficit A company may need to re-organize its capital by reducing book value of its liabilities and assets to its real values As when the book value of assets are over- valued Or when there are accumulated losses So as to make company legally payable for dividends to its shareholders
62. 62. 6.)To capitalise retained earnings To avoid over- capitalisation Maintain a balance between preference shares and equity shares and equity shares and debentures Company may capitalise retained earnings by issuing bonus shares out of it
63. 63. 7.)To clear defaults on fixed cost securities:- When the company is not in a position to pay interest on debentures or to repay them on maturity It may offer them certain securities(equity shares, preference shares or new debentures) to clear default
64. 64. 8.)To fund accumulated dividend When its time to pay fixed dividends to its preference shareholders Or when the preference shares are due for redemption And the company do not have sufficient funds The company may prefer to issue new shares in lieu
65. 65. 9.)To facilitate merger and expansion To facilitate merger and expansion Companies may be required to re adjust its capital structure
66. 66. 10.)To meet legal requirements To meet the legal requirements It is necessitated to meet the changes in various legal requirements As and when took place
67. 67. Financial Distress and Capital Structure • Financial risk increases when firm uses more debt; it may not be able to pat fixed interest and runs into bankruptcy. • Firms using more equity don't face this problem. • Use of debt provides tax benefit but bankruptcy costs work against the advantage. • When firm raises debt, suppliers put restrictions in agreement resulting to less freedom of decision making by management called agency cost.
68. 68. • This theory was suggested by DONALDSON in 1961. • It was modified by MYERS in 1984. According to Donaldson, o Firm has well defined order of preference for raising finance. o When firm need funds it will rely on internally generated funds. o This order of preference is so defined because internally generated funds have no issue costs.
69. 69. Theory presumptions Cost of internally generated funds is lowest. Raising of debt is cheaper source of finance. Raising of debt through term loan is cheaper than issuing bonds. Issue of new equity capital involves heavy issue cost. Servicing of debt capital is relatively less as compared to equity
70. 70. Proposes of pecking order theory Dividend policy is stickily There is preference for internally generated funds to external financing If external financing is needed, debt is preferred to equity Issue of new equity for raising additional funds is considered as a last resort
71. 71. According to modified pecking order theory, o Order of preference for raising funds arises because of asymmetric information between market and firm. o Firm may prefer internal funds and then raising of debt as compared to issue of new equity share capital.
72. 72. BY Manisha Joshi