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Capital structure theories, Introduction to financial management, financing decisions, Leverages

Capital structure theories, Introduction to financial management, financing decisions, Leverages

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Financial management Financial management Presentation Transcript

  • FINANCIAL MANAGEMENT For: II Semester MBA, Pondicherry University Mohammed Umair| M.Com, PGDBA, NET Department of CommerceKristu Jayanti College Department of ManagementSt. Joseph‘s Evening College & FINANCE: AN INTRODUCTION UNIT 1
  • SYLLABUS UNIT I Financial Management – Financial goals - Profit vs. Wealth Maximization; Finance Functions – Investment, Financing and Dividend Decisions – Cost of Capital – Significance of Cost of Capital – Calculation of Cost of Debt – Cost of Preference Capital – Cost of Equity Capital (CAPM Model and Gordon‘s Model) and Cost of Retained Earnings – Combined Cost of Capital (weighted/Overall).
  • For a comprehensive understanding of the subject you can buy my book by clicking the link:↓ https://sapnaonline.com/shop/Author/mohammed-umair
  • FINANCE IS THE SCIENCE AND ART OF MANAGING MONEY AND OTHER ASSETS.  Public Finance: Public finance deals with role of the government in managing financial requirements of the economy.  Personal Finance: Personal finance deals with monetary decisions and activities of an individual or a family unit that includes routine income and expenses planning.  Corporate Finance: Corporate finance also called as financial management or Business finance focuses is concerned with planning, raising, investing and monitoring of finance in order to achieve the financial objectives of the company. What is finance? Thus the study of finance can be classified into following ways:-
  • Finance function refers to action performed by a finance department that involves acquiring and utilizing funds of a business.  Increasing Profitability: Profitability is necessary for every organization. The planning and control functions of finance aim at increasing profitability of the firm. What is finance Function?  Acquiring Sufficient and Suitable Funds: The primary aim of finance function is to assess the needs of the enterprise, properly, and procure funds, in time.  Proper Utilization of Funds: Raising funds is important, more than that is its proper utilization. If proper utilization of funds were not made, there would be no revenue generation.  Maximizing Firm’s Value: The ultimate aim of finance function is maximising the value of the firm, which is reflected in wealth maximisation of shareholders. AIMS OF FINANCE FUNCTION The following are the aims of finance function:
  • SCOPE OF FINANCIAL MANAGEMENT The scope of financial decisions revolves around four important decisions. In all the following financial areas of decision-making, the role of finance manager is vital. All organizations irrespective of type of business must raise funds to buy the assets necessary to support operations. Thus financing decisions involves addressing two questions:  How much capital should be raised to fund the firm's operations (both existing & proposed)  What is the best mix of financing these investment proposals? 1. Financing Decision: This decision in financial management is concerned with allocation of funds raised from various sources into acquisition assets or investment in a project. Further, Investment decision not only involves allocating capital to long term assets but also involves decisions of utilizing surplus funds in the business, any idle cash earns no further interest and therefore not productive. 2. Investment Decision:
  • SCOPE OF FINANCIAL MANAGEMENT The scope of financial decisions revolves around four important decisions. In all the following financial areas of decision-making, the role of finance manager is vital. Share holders are the owners and require returns, and how much money to be paid to them is a crucial decision. Thus payment of dividend is decision involves deciding whether profits earned by the business should be retained rather than distributed to shareholders in the form of dividends. 3. Dividend Decision: Working capital primarily deals with currents assets and current liabilities, in fact it is calculated as the current assets minus the current liabilities. One of the key objectives of working capital management is to ensure liquidity position of a firm to avoid insolvency. 4. Working Capital Decisions:
  • ORGANIZATION OF THE FINANCE FUNCTION In the context of financial management organisation structure of finance indicates established pattern of relationships among individuals and positions in a finance department of a business enterprise.
  • ORGANIZATION OF THE FINANCE FUNCTION  Forecasting and Planning:  Executing financing and investment decisions:  Coordination and control:  Management of financial resources:  Maximize profits & Minimise cost:  Dealing with financial markets: The board of directors is the top governing body, and the chairperson of the board is generally the highest-ranking individual. The CEO comes next, but note that the chairperson of the board often serves as the CEO as well. The CFO, who is generally a senior vice president and the third ranking officer, is in charge all the financial activities of the organisation. a The Finance Manager−Role, Functions and Duties
  • FINANCIAL PLANNING Types of Financial Plans  After the company starts, the finance manager does the financial planning. The types of financial plans are depicted and briefly explained below.  Short-term financial plan is prepared for maximum one year. This plan looks after the working capital needs of the company.  Medium-term financial plan is prepared for a period of one to five years. This plan looks after replacement and maintenance of assets, research and development, etc.  Long-term financial plan is prepared for a period of more than five years. It looks after the long-term financial objectives of the company, its capital structure, expansion activities, etc. Financial Planning is the process of ascertaining an organisation’s financial needs for the future and identifying how to achieve them.
  • STEPS IN FINANCIAL PLANNING OR FINANCIAL PLANNING PROCESS 1. Assessing business environment 2. Developing financial goals 3. Framing financial policies & procedures 4. Esuring adaptibility & flexibility 5. Review of financial plan Need, Benefits, Significance and Objectives of financial planning What is the need of financial planning? Increase financial efficiency Reduce finance-related risks Coordination with other departments Gives right direction Helps to achieve objectives of financial management Keeps good control of financial activities What are the benefits of financial planning? What is significance of financial planning? What are the objectives of financial planning? Principles and Characteristics of Sound Financial Planning Principles Description Simplicity financial plan should be easily understandable to all the stake holders Objectivity provide clarity and direction for strategic planning Flexibility easily changed or modified, adjusted when there is a change Liquidity an asset can be converted to cash, financial plan should ensure availability Economy cost of borrowing funds should always be kept in mind Provision for contingencies Provision of funds should be made for meeting the contingencies Optimum use efficiently, effective use of funds
  • NEED AND IMPORTANCE OF FINANCIAL MANAGEMENT 1. ESTIMATING THE CAPITAL REQUIREMENTS OF THE CONCERN 2. DETERMINING THE CAPITAL STRUCTURE OF THE ENTERPRISE 3. FINALIZING THE CHOICE AS TO THE SOURCES OF FINANCE 4. DECIDING THE PATTERN OF INVESTMENT OF FUNDS 5. DISTRIBUTION OF SURPLUS JUDICIOUSLY 6. EFFICIENT MANAGEMENT OF CASH
  • OBJECTIVES OF FINANCIAL MANAGEMENT  Profit maximization is the process of identifying the most efficient manner of obtaining the highest rate of return from its production model.  The following arguments are advanced in favor of profit maximization as the objective of business: A. PROFIT MAXIMIZATION B. WEALTH MAXIMIZATION  Barometer of Performance: Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise.  Survival in different business conditions: Economic and business conditions do not remain same at all times. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under unfavorable situation, only if it has some past earnings to rely upon.  Expansion and Diversification: Profits are the main sources of finance for the growth and expansion of a business. So, a business should aim at maximization of profits for enabling its growth and development.  Attract Investors: Profits are the main sources returned to investors or shareholders as a percentage of their capital contribution.  Maximize stakeholders return: Growth and development of a business has a number of requirements and not only the money.  To fulfill social desire: Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximization also maximizes socio-economic welfare by means undertaking various social welfare initiatives.
  • OBJECTIVES OF FINANCIAL MANAGEMENT  However, profit maximization objective has been criticized on many grounds. They are: A. PROFIT MAXIMIZATION B. WEALTH MAXIMIZATION  Not a clear term: The term ‗profit‘ is vague and it cannot be precisely defined. It means different things for different people. Should we consider short-term profits or long-term profits? Does it mean total profits or earnings per share?  Does not Considers Risk: It does not take into consideration the risk of the prospective earnings stream. Some projects are more risky than other.  Leads to corrupt practices: A firm pursuing the objective of profit maximization starts exploiting workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices.  Attracts competition: Supernormal profit attracts entry of new firms because knowledge is everywhere and also the main aim of any producers is to make profit.  Induces Government intervention: Firms may fear that the existence of supernormal profits would attract government intervention into the market and thereby restrict the firm‘s activities.  Leads to employee unrest: The concept of larger profit making would result in employers and business owners not only focusing their attention on making a financial profit at all cost which inevitably leads to workforce exploitation
  • OBJECTIVES OF FINANCIAL MANAGEMENT  Wealth maximization emphasis on stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual utility.  The following arguments are advanced in favor of Wealth maximization as the objective of business: A. PROFIT MAXIMIZATION B. WEALTH MAXIMIZATION  There is a rationale in applying wealth maximizing policy as an operating financial management policy. It serves the interests of suppliers of loaned capital, employees, management and society. Besides shareholders, there are short-term and long-term suppliers of funds who have financial interests in the concern. Short-term lenders are primarily interested in liquidity position so that they get their payments in time. The long-term lenders get a fixed rate of interest from the earnings and also have a priority over shareholders in return of their funds.  Wealth maximization objective not only serves shareholder‘s interests by increasing the value of holdings but ensures security to lenders also. The economic interest of society is served if various resources are put to economical and efficient use.
  • OBJECTIVES OF FINANCIAL MANAGEMENT  Cons or Demerits: The wealth maximization objective has also been criticized by certain financial theorists mainly on following accounts; A. PROFIT MAXIMIZATION B. WEALTH MAXIMIZATION  It is a prescriptive idea. The objective is not descriptive of what the firms actually do.  The objective of wealth maximization is not necessarily socially desirable.  There is some controversy as to whether the objective is to maximize the stockholders wealth or the wealth of the firm which includes other financial claimholders such as debenture holders, preferred stockholders, etc.,  The objective of wealth maximization may also face difficulties when ownership and management are separated as is the case in most of the large corporate form of organizations.
  • CONCEPT OF FINANCING DECISIONS  Enterprises often need to raise capital for commencing new business, expanding business and sustaining business. Business in most of the cases is an outcome of ideas of people and the moment idea is conceived the need of funds arises.  As the business grows there is inevitably the requirement of funds to finance the expansion, further day to day running of the business also needs funds.  A solid financial base is essential for starting up a new business. The right financing package will carry the business enterprise through any temporary difficulties yet still allow business to make the most of growth opportunities when they arise. The financial needs of a business will vary according to the type and size of the business. The financing decisions are concerned with deciding capital structure and procuring funds. Estimating fund requirements Identifying Sources of Funds Evaluating various sources Deciding capital structure Procuring funds Scope or process of Financing Decisions
  • SOURCES OF FUNDS SourcesofFunds Internal Sources Retained Earnings Sales of assets External Sources Long-term: Share Capital Loan Capital Short term: Overdraft Trade Credit *Short term loans are discussed in Last unit-Working capital
  • FINANCIAL MANAGEMENT -INTERNAL SOURCES OF FUNDS  The after-tax profit earned and retained by a business which is an important and inexpensive source of finance, for example, the retained earnings of the business. A large part of finance is funded from profit. Retained Earnings © PhotoDisc  When a business can not raise finance from banks or other sources, it may be forced to sell some assets, such as company cars, land property; or even subsidiary or associated company to solve its urgent financial problems (this activity is called divestment). Sales of Assets
  • -EXTERNAL LONG-TERM SOURCES OF FUNDS  Types of shares are: 1. Ordinary shares: The most common types of shares, and the most riskiest shares since no guaranteed dividend. Dividend depends on how much profit is made by the firm. But all ordinary shareholders have voting rights. 2. Preference shares: The share owners receive a fixed rate of return. They carry less risk because shareholders are entitled to the dividend before the ordinary shares. But they are not strictly owners of the company.  Share capital: The most important source of funds for a limited company. It is often considered as permanent capital as it is not repaid by the business, but the shareholder can have a share in the profit, called dividend.
  • EXTERNAL LONG-TERM SOURCES OF FUNDS  There are four major types of loan capital: Debentures, Mortgage, Loan specialists’ funds, Government assistance. Any money which is borrowed for a long period of time by a business is called loan capital  Loan capital  Types of loan capital: 1. Debentures: The holder of a debenture is a creditor of the company, not an owner. Holders are paid with an agreed fixed rate of return, but having no voting rights. The amount of money borrowed must be repaid by the expiry date. 2. Mortgage: These are long-term bank loans (usually over one year period) from banks or other financial institutions. The borrower‘s land or property must be used as a security on such as a loan. 3. Loan specialists’ funds: These are venture capitalists or specialists who provide funds for small businesses, especially for high tech investment projects in their start-up stage. There are also individuals who invest in such businesses, which are often called ‗business angels‘. 4. Government assistance: To encourage small businesses and high employment, governments may be involved in providing finance for businesses. In the USA, there is an organization which is called the Small Business Administration (SBA). SBA provides guarantees for small businesses‘ loans and they even offer some loans themselves.
  •  Debt and Equity Capital: Two Basic Sources of Funds
  •  Comparison of Debt and Equity Capital
  • CONCEPT OF CAPITALIZATION, CAPITAL STRUCTURE AND FINANCIAL STRUCTURE Point of Difference Capitalization Capital Structure Financial Structure Meaning It is the sum of a corporation's long term financing included in the capital. Capital structure of a company refers to types of long term financing included in the capital. Financial structure refers to the balance between all of the company's liabilities and its equities. Financial structure thus concerns the entire "Liability‖ side of the balance sheet. Components Debt, common stock, preferred stock Debt, common stock, preferred stock, retained earnings and reserves. Financial structure on the other hands also includes short term debt and accounts payable. Perspective Quantitative aspect: as it represents quantum of funds used Qualitative aspects: as it represents source of funding It represents financial obligations a company owes to outside parties Equation CS=FS-CL Capital Structure = Financial Structure - FS=Total of Liabilities
  • The capital structure of a company is a particular combination of debt, equity and other sources of finance that it uses to fund its long- term asset. Determinants of Capital Structure or Factors influencing capital requirements Factors affecting capital structure Internal Factors External Factors  Nature of Business  Corporate taxes  Size of a Firm  Degree of competition  Stability in Earnings  Economic condition  Growth stage  Cost of capital  Asset structure  Government policies  Control factor  Floatation cost  Risk apatite of management  Cost of capital
  • Planning of capital structure involves deciding the way in which assets of the company are to be financed. The common sources of capital structure constitutes mix of long-term sources of funds, such as debentures, long-term debt, preference share capital and equity share capital including reserves and surpluses. Due considerations in capital structure planning should be given to formulate appropriate capital structure, the following are key approaches for selecting appropriate capital structure  1. Cost and Risk Approach: In this approach of capital structure planning a firm primarily considers cost and risk as a basis of planning capital structure. For business cost is the amount payable for the capital it obtains from various sources.  2. EBIT—EPS Approach: In simple words, EBIT—EPS Approach emphasis on maximizing the earning of equity share holders. In order to maximize earning of equity share holders a firm must use debt capital in such as way that that it results increased earnings per share. Capital Structure Planning or Approaches to select capital Structure Establishing Capital structure Cost & Risk approach EBIT-EPS approach
  • Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return. When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm. Capital Structure Planning Cost and Risk Approach  Meaning of Cost of Capital Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders. According to the definition of John J. Hampton ―Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place‖. According to the definition of Solomon Ezra, ―Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure‖.
  • COMPUTATION OF COST OF CAPITAL Measurement of Cost of Capital It refers to the cost of each specific sources of finance like: • Cost of equity • Cost of debt • Cost of preference share • Cost of retained earnings Capital Structure Planning Cost and Risk Approach Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
  • The cost of equity is the return a firm theoretically pays to its equity investors.  Cost of equity can be calculated from the following approach (Dividend Growth Model) In other words: Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Measurement of Cost of Capital Cost of equity Where, Ke = Cost of equity capital D = Dividend per equity share g = Growth in expected dividend Np = Net proceeds of an equity share According to this method, the return required by the investor is equal to the current dividend yield on the common stock plus an expected growth rate for dividend payments. It is also known as Gordon model.
  • Illustration 1: calculation of cost of equity Given:  D = Dividend per equity share Rs. 15  g = 7%  Np = Net proceeds of an equity share Market Price Rs. 125 a share  Ke = Cost of equity capital ? A Ltd intends to issue new equity shares. It‘s present equity shares are being sold in the market at Rs. 125 a share. The company‘s past record show its dividend growing at 7%. The company pays a dividend of Rs, 15 per share. You are required to calculate Cost of funds raised by issue of equity shares. Solution :
  • Illustration 2: calculation of cost of equity Given:  D = Dividend per equity share Rs. 12  g = 4%  Np = Net proceeds of an equity share (Issue price of Share Flotation Cost = (100-4= Rs. 96)  Ke = Cost of equity capital ? A company plans to issue 10000 new shares of Rs. 100 each at a par. The floatation costs are expected to be 4% of the share price. The company pays a dividend of Rs. 12 per share initially and growth in dividends is expected to be 5%. (a) Compute the cost of new issue of equity shares. (b) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity share capital Solution : mpute the cost of new issue of equity shares. Given:  D = Dividend per equity share Rs. 12  g = 4%  Np = Net proceeds of an equity share Market Price Rs. 120 a share  Ke = Cost of equity capital ? (B) If the current market price of an equity share is Rs. 120. Calculate the cost of existing equity share capital Solution : *Flotation cost is the cost of issuing new shares in the market.
  • Illustration 3: calculation of cost of equity Given:  D = Dividend per equity share Rs. 4.50  g = 7%  Np = Net proceeds of an equity share Market Price Rs. 95 a share  Ke = Cost of equity capital ? The current market price of the shares of Apple Ltd. is Rs. 95. The floatation costs are Rs. 5 per share, dividend paid amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to calculate the cost of equity share capital. Solution : *Flotation cost applicable only when new shares are issued to the public. Here floatation cost to be neglected as the company is not issuing new shares.
  • The capital asset pricing model (CAPM) is used to calculate the required rate of return for any risky asset.  Cost of equity can be calculated from the following equation using CAPM approach 1. This approach is based on the principle that risk and return of an investment are positively correlated—more risky the investment, higher is the desired returns. 2. This model emphasizes not only the risk differential between equity share and government bond but also risk differential among various common stocks. Measurement of Cost of Capital Cost of equity (CAPM approach) Ke = Rf + b (Rm—Rf) Where, Ke = Cost of equity capital Rf = the rate of return for a risk-free security b = beta of the stock Rm = the Stock market's expected rate of return
  • The Hypothetical Limited wishes to calculate its cost capital using the CAPM approach. The following information is supplied to you. The risk-free rate of return is 10%. The firms beta is 1.50 and the return on market is equals to 12.5%. Compute Cost of equity capital.  Solution Measurement of Cost of Capital Cost of equity (CAPM approach) Ke = Rf + b (Rm—Rf) Given, Ke = Cost of equity capital - ? Rf = the rate of return for a risk-free security -10% b = beta of the stock – 1.50 Rm = the Stock market's expected rate of return – 12.5% The CAPM says that the expected return of a share is equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. Ke = 10 + 1.5 (12.5—10) Ke = 10 + 3.75 Ke = 13.75%
  • Cost of debt generally refers to the effective paid by a company on its debts.  Cost of debt can be calculated from the following equation The cost of debt can be calculated in either before or after tax returns. However, the interest expense being deductible, the after tax cost is considered very often. Moreover, the cost of debt is one part of capital structure of the company and also includes the cost of equity. Measurement of Cost of Capital Cost of Debt Where, Kd = Cost of debt capital I = Annual interest payable Np = Net proceeds of debenture t = Tax rate
  • Illustration 1: calculation of cost of Debt Given:  Kd = ?  I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a  Np = Net proceeds of debenture (a) Par Rs. 1,00,000  t = 35% Kingfisher Limited has debt capital of Rs. 1,00,000 on which 15% interest is payable. Tax applicable is 35%. Your are required to calculate cost of capital assuming debt is issued at (a) Par value (b) 10% discount and (c) At a premium of 10%. Solution : Given:  Kd = ?  I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a  Np = Net proceeds of debenture (b) Rs. 1,00,000- 10% Discount =Rs. 90,000.  t = 35% Solution : Given:  Kd = ?  I = On Rs. 1,00,000 at 15% Rs. 15,000 p.a  Np = Net proceeds of debenture (b) Rs. 1,00,000+10% Discount =Rs. 1,10,000.  t = 35% (a) Par value (b) Discount (C) Premium
  • Illustration 2: calculation of cost of Debt 1. A Ltd. issues Rs. 10,00,000, 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital. 2. B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital. 3. C Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute the cost of debt capital. 4. D Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt- capital. From flowing information four different companies calculate cost of debt of each company.
  • Illustration 2: calculation of cost of Debt A Ltd. issues Rs. 1,00,000, 8% debentures at par. The tax rate applicable to the company is 50%. Compute the cost of debt capital. Given:  Kd = ?  I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a  Np = Net proceeds of debenture (a) Par Rs. 1,00,000  t = 50% Solution : Company (a) Par value
  • Illustration 2: calculation of cost of Debt B Ltd. issues Rs. 1,00,000, 8% debentures at a premium of 10%. The tax rate applicable to the company is 60%. Compute the cost of debt capital. Given:  Kd = ?  I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a  Np = Np = Face Value + Premium = 1,00,000+10,000=1,10,000  t = 60% Solution : Company (b) premium
  • Illustration 2: calculation of cost of Debt C Ltd. issues Rs. 1,00,000, 8% debentures at a discount of 5%. The tax rate is 60%, compute the cost of debt capital. Given:  Kd = ?  I = On Rs. 1,00,000 at 8% Rs. 8,000 p.a  Np = Np = Face Value - Discount= 1,00,000 - 5,000= Rs. 95,000  t = 60% Solution : Company (C) Discount
  • Illustration 2: calculation of cost of Debt D Ltd. issues Rs. 10,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The tax rate applicable is 50%. Compute the cost of debt- capital. Given:  Kd = ?  I= 9% on Rs. 10,00,000 = 90,000  Np = On Rs. Rs. (10,00,000 + 1,00,000) 2% = 11,00,000 – 22,000 = Rs. 10,78,000  t = 50% Solution : Company (D) premium
  • The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.  A company has different sources of finance, namely common stock, retained earnings, preferred stock and debt. Weighted average cost of capital (WACC) is the average after tax cost of all the sources. 'WEIGHTED AVERAGE COST OF CAPITAL - WACC' The computation of the overall cost of capital (Kw) involves the following steps.  (a) Assigning weights to specific costs.  (b) Multiplying the cost of each of the sources by the appropriate weights.  (c) Dividing the total weighted cost by the total weights. The overall cost of capital can be calculated with the help of the following formula; Kw= Kd Wd + Kp Wp + Ke We + Kr Wr Where, Ko = Overall cost of capital Kd = Cost of debt Kp = Cost of preference share Ke = Cost of equity Kr = Cost of retained earnings Wd= Percentage of debt of total capital Wp = Percentage of preference share to total capital We = Percentage of equity to total capital Wr = Percentage of retained earnings Weighted average cost of capital is calculated in the following formula also: Where, Kw = Weighted average cost of capital X = Cost of specific sources of finance W = Weight, proportion of specific sources of finance.
  • Illustration 1: calculation of WACC A firm has the following capital structure and after-tax costs for the different sources of funds used :Source of Funds Amount Proportion (%) After-tax cost (%) Debt 12,000 20 4 Preference Shares 15,000 25 8 Equity Shares 18,000 30 15 Retained Earnings 15,000 25 11 Total 60,000 100 Computation of Weighted Average Cost of Capital Source of Funds Proportio n % (w) After-tax cost % (x) (WX) A C D E = (c) x (d) Debt 20 4 80 Preference Shares 25 8 200 Equity Shares 30 15 450 Retained Earnings 25 11 275 Solution :
  • Illustration 11: calculation of WACC ABC Ltd. has the following capital structure. Particulars Amount Equity (expected dividend 12%) 10,00,000 10% Preference Shares 5,00,000 4% loan 15,00,000 Total 30,00,000 Computation of Weighted Average Cost of Capital Source of Funds Proportion % (w) After-tax cost % (x) (WX) A C D E = (c) x (d) Equity 33.33 12 399.96 Preference Shares 16.67 10 166.7 loan 50.00 4 200 Total You are required to calculate the weighted average cost of capital. Solution :
  • Retained earnings is one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital.  Cost of Retained Earnings Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share.  Cost of Preference Share Where, Kp = Cost of preference share Dp = Fixed preference dividend Np = Net proceeds of an equity share
  • EBIT-EPS: APPROACH  In simple words, EBIT—EPS Approach emphasis on maximizing the earning of equity share holders. In order to maximize earning of equity share holders a firm must use debt capital in such as way that that it results increased earnings per share. Capital Structure Planning or Approaches to select capital Structure Establishing Capital structure Cost & Risk approach EBIT-EPS approach
  • FORMAT FOR COMPUTING EBIT & EPS Particulars Amount Sales revenue -------- Less : Variable Cost -------- Contribution [C] -------- Less: Fixed Cost -------- Operating Profit or EBIT -------- Less: Interest of Debt capital -------- Earnings Before Tax [EBT] -------- Less: Tax -------- Earnings After Tax [EAT] -------- Less: Dividend on preference shares -------- Earnings Available to Equity Share Holders [EAESH] -------- Earnings Per Share= EAESH ÷ No. of Equity Shares ---
  • HDFD bank has an existing capital of Rs. 10,00,000 comprising of 1,00,000 equity shares of Rs. 10 each. The management is planning to raise another Rs. 10,00,000 to finance its growth programme. There are four possible financing plans which are given below:  All 10,00,000 through issue of 1,00,000 equity shares of Rs. 10 each  Rs. 5,00,000 in equity and the balance in debentures carrying 10% interest  Entire 10,00,000 through debentures carrying 8% interest  Rs. 5,00,000 in equity and Rs. 5,00,000 through preference shares carrying 10% dividend The anticipated operating profits after expansion programmes amounts to Rs. 2,40,000, the company is subject to 50% tax bracket. You are required to advice the management in choosing appropriate capital structure plan on the basis on EPS. Illustration 1: Calculation of EPS I II III IV Entire 10 Lakhs Equity 5 Lakhs in Equity & 5 Lakhs Debentures @ 10% Interest Entire 10 Lakhs through debentures @ 8% Interest 5 Lakhs in Equity & 5 Lakhs preference @ 10% dividend
  • I II III IV Entire 10 Lakhs Equity 5 Lakhs in Equity & 5 Lakhs Debentures @ 10% Interest Entire 10 Lakhs through debentures @ 8% Interest 5 Lakhs in Equity & 5 Lakhs preference @ 10% dividend Illustration 1: Calculation of EPS Particulars Existing capital: Rs. 10 Lakhs Financial Plans Fresh capital required: 10 Lakhs I II III IV Expected operating Profit [EBIT] 2,40,000 2,40,000 2,40,000 2,40,000 Less: Interest on Debt capital Plan II: 10% interest on debentures of Rs. 5 Lakhs Plan III: 8% interest on debentures of 10 Lakhs No Debt 50,000 80,000 No debt Earnings Before Tax [EBT] 2,40,000 1,90,000 1,60,000 2,40,000 Less: Tax at 50% on EBT 1,20,000 95,000 80,000 1,20,000 Earnings After Tax [EAT] 1,20,000 95,000 80,000 1,20,000 Less: Preference dividend Plan IV: 10% dividend on Rs. 5 Lakhs No Pref. shares No Pref. shares No Pref. shares 50,000 Earnings Available to Equity Share Holders 1,20,000 95,000 80,000 70,000 No. of equity Shares  Existing (Rs. 10,00,000 ÷ Rs. 10 each)  New (Plan- I, II and III) Total equity shares (Existing + New) 1,00,000 1,00,000 2,00,000 1,00,000 50,000 1,50,000 1,00,000 No new shares 1,00,000 1,00,000 50,000 1,50,000 EPS = EAESH ÷ Total equity shares Rs. 0.60 Rs. 0.633 Rs. 0.80 Rs. 0.47 Comments: Since the EPS in plan III is highest, therefore plan III should be
  • Illustration 1I: Calculation of EPS Brave Limited is capitalised with 50,000 equity shares of Rs. 10 each. Company wants another Rs. 5,00,000 for expansion programme. The following are the different Plans 1. All equity shares 2. Rs. 2,50,000 in equity and the balance in preference shares carrying 10 dividend 3. Rs. 2,50,000 in debentures and the balance in debentures at 10 interest 4. All debentures at 8% interest Tax rate is 50% and the existing EBIT is Rs. 60,000 p.a, Calculate EPS for four plans Particulars Existing capital: Rs. 5 Lakhs Financial Plans Fresh capital required: 5 Lakhs I II III IV Expected operating Profit [EBIT] 60,000 60,000 60,000 60,000 Less: Interest on Debt capital Plan III: 10% interest on Loan of Rs. 2.5 Lakhs Plan IV: 8% interest on debentures of 5 Lakhs No Debt No Debt 25,000 40,000 Earnings Before Tax [EBT] 60,000 60,000 35,000 20,000 Less: Tax at 50% on EBT 30,000 30,000 17,500 10,000 Earnings After Tax [EAT] 30,000 30,000 17,500 10,000 Less: Preference dividend Plan II: 10% dividend on Rs. 2.5 Lakhs No Pref. shares 25,000 No Pref. shares No Pref. shares Earnings Available to Equity Share Holders 30,000 5,000 17,500 10,000 No. of equity Shares  Existing (Rs. 5,00,000 ÷ Rs. 10 each)  New (In all plans except IV) Total equity shares (Existing + New) 50,000 50,000 1,00,000 50,000 25,000 75,000 50,000 25,000 75,000 50,000 No new shares 50,000
  • Assessment of Capital Structure Capital structure should be constituted in such a way that it minimises cost of capital and maximize the value of organization. In order to assess the quality of capital structure financial management provides two important tools, they are as follows: Capital Gearing Leverages 1. Capital gearing focuses on the capital structure by establishing relationship between equity shares to other fixed income bearing securities. Interpretation:  Highly geared—Less equity capital and more fixed cost bearing capital  Low geared—More equity capital and less fixed cost bearing capital
  • High Gear or Low Gear Sources of Funds Mar '12 Mar '11 Mar '10 Mar '09 Mar '08 Equity Share Capital 577.65 497.78 265.91 265.91 135.8 Share Application Money 0 2.95 7.48 8.11 10.09 Preference Share Capital 553.1 553.1 97 97 0 Reserves -6,213.15 -4,005.02 -4,268.84 -2,496.36 52.99 Revaluation Reserves 0 0 0 0 0 Net worth -5,082.40 -2,951.19 -3,898.45 -2,125.34 198.88 Secured Loans 5,368.76 5,184.53 4,842.43 2,622.52 592.38 Unsecured Loans 2,661.24 1,872.55 3,080.17 3,043.04 342 Data extracted from Balance Sheet of Kingfisher Airlines Sources of Funds Mar '13 Mar '12 Mar '11 Mar '10 Mar '09 Total Share Capital 287 287 287 287 286 Equity Share Capital 287 287 287 287 286 Share Application Money 0 0 0 0 0 Preference Share Capital 0 0 0 0 0 Reserves 35,772.00 29,470.00 24,214.00 21,749.00 17,523.00 Revaluation Reserves 0 0 0 0 0 Networth 36,059.00 29,757.00 24,501.00 22,036.00 17,809.00 Secured Loans 0 0 0 0 0 Unsecured Loans 0 0 0 0 0 Total Debt 0 0 0 0 0 Total Liabilities 36,059.00 29,757.00 24,501.00 22,036.00 17,809.00 Data extracted from Balance Sheet of Infosys
  • FINANCIAL MANAGEMENT CAPITAL STRUCTURE THEORIES UNIT II1 Operating and Financial Leverage – Measurement of Leverages – Effects of Operating and Financial Leverage on Profit – Analyzing Alternate Financial Plans - Combined Financial and Operating Leverage – Capital Structure Theories - Traditional approach - M.M. Hypotheses – without Taxes and with Taxes – Net Income Approach (NI) – Net Operating Income Approach (NOI) - Determining capital structure in practice. SYLLABUS UNIT III
  • LEVERAGES The concept of leverages revolves around two aspects,  First—the effects that fixed interest cost capital (Debentures and bonds or long term loans) have on the returns that shareholders earn.  Second, impact of fixed cost on the earnings of company and shareholder  finance manager determine degree of leverage by assessing three types of leverages Financial Leverage Operating Leverage Combined Leverage
  • [A] OPERATING LEVERAGE:  Operating leverage is a measure to establish relation between a firm's fixed cost and variable cost and its impact of profits.  EBIT: Earnings Before Interest and Tax  Contribution = Sales — Variable cost Interpretation: Criteria Outcome Impact on Profitability (EBIT) When, C>FC Favourable Positive EBIT When, C<FC Unfavourable Negative EBIT
  • [B] FINANCIAL LEVERAGE  It determines the impact of using debt financing (debentures and bonds or long term loans) on the earnings of shareholders.  EBIT: Earnings Before Interest and Tax  EBT: Earnings Before Tax [EBIT – Interest(i)]  EPS: Earnings Per Share Interpretation: Criteria Outcome Impact on Profitability (EBT) When, EBIT > Interest payable Favourable Positive EBT When, EBIT < Interest payable Unfavourable Negative EBT
  • [C] COMBINED LEVERAGE  As the name suggests, Combined leverage represents the total effect of the operating and financial leverages on the earning per share[EPS]. In other words, combined leverage shows the total risks associated with the firm. It is the product of both the leverages. Interpretation: The combined leverage can work in either direction. It would be favourable if sales increase and unfavourable in the reverse scenario.
  • STEPS IN CALCULATION OF LEVERAGES AND EPS: GENERAL INCOME STATEMENT FORMAT Particulars Amount Sales revenue -------- Less : Variable Cost -------- Contribution [C] -------- Less: Fixed Cost -------- Operating Profit or EBIT -------- Less: Interest of Debt capital -------- Earnings Before Tax [EBT] --------
  • A company has sales of Rs. 60,00,000, variable cost of Rs. 40,00,000, fixed cost of Rs. 5,00,000 and debt of Rs. 30,00,000 at 10% rate of interest. Calculate operating, financial, operating and combined leverages. Particulars Amount Sales 60,00,00 0 Less: Variable cost 40,00,00 0 Contribution [C] 20,00,00 0 Less: Fixed Cost 5,00,000 Operating Profit or EBIT 15,00,00 0 Less: Interest on Debt Capital (10% on Rs. 30,00,000 ) 3,00,000 Earnings Before Tax [EBT] 12,00,00 0 1.25 1.33 1.6625 Illustration 1: Calculation of Leverages Comments:  Since, EBIT is > Interest payable, this means firm has sufficient operating profits to pay interest on debt capital and therefore it has favourable financial.  Since, Contribution is > Fixed cost, this means firm has sufficient sales revenue to meet its fixed cost and therefore it has favourable operating leverage and positive operating profit.  Combined leverage is also favourable.
  • Capital Structure Theories Different kinds of theories have been propounded by different authors to explain the relationship: Capital Structure—Cost of Capital—Value of the firm The important theories are as follows: 1. Net Income approach 2. Net Operating Income approach 3. The traditional approach 4. Modigliani and Miller approach
  • NET INCOME APPROACH This approach is based upon the following assumptions:  The cost of debt (Kd)is less than the cost of equity (Ke)  There are no taxes  The risk perception of investors is not changes by the use of debt. According to this approach, a firm can minimize the weighted average cost of capital (WACC) and increase the value of the firm as well as the market price of the equity shares by using debt financing to maximum possible extent. Net Income Approach was presented by Durand.
  • TEST OF NET INCOME APPROACH THEORY  Consider a fictitious company with below figures. All figures in Rs. According to this approach, a firm can minimize the weighted average cost of capital (WACC) and increase the value of the firm as well as the market price of the equity shares by using debt financing to maximum possible extent. Earnings before Interest Tax (EBIT) = 1,00,000 Debentures(Debt part) = 3,00,000 Cost of Debentures (Debt) = 10% Cost of Equity = 14% EBIT = 1,00,000 Less: Interest cost (10% of 300,000) = 30,000 Earnings after Interest Tax (since tax is assumed to be absent) = 70,000 Earning available to equity share holders = 70,000 Market value of Equity Shares (70,000 14%) = 5,00,000 Market value of Debt = 3,00,000 Total Market value = (S + D) = 8,00,000 Overall cost of capital = EBIT (Total value of firm) = 100,000 800,000 = 12.5% Calculating the value of a company = Total Market Value of Shares (S) + Debentures (D) 1. Value of a company (V) = Total Market Value of Shares (S) + Debentures (D) 2. Market value of Equity shares (S) = Earning available to equity share holders Cost of Equity 3. Over all cost of capital or WACC = EBIT V)
  • TEST OF NET INCOME APPROACH THEORY  Consider a fictitious company with below figures. All figures in Rs. According to this approach, a firm can minimize the weighted average cost of capital (WACC) and increase the value of the firm as well as the market price of the equity shares by using debt financing to maximum possible extent. Earnings before Interest Tax (EBIT) = 1,00,000 Debentures(Debt part) = 3,00,000 Cost of Debentures (Debt) = 10% Cost of Equity = 14% Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains s 1. Value of a company (V) = Total Market Value of Shares (S) + Debentures (D) 2. Market value of Equity shares (S) = Earning available to equity share holders Cost of Equity (EBIT) = 100,000 Less: Interest cost (10% of 300,000) = 40,000 Earnings after Interest Tax (since tax is assumed to be absent) = 60,000 Shareholders' Earnings = 60,000 Market value of Equity (60,000/14%) = 428,570 (approx) Market value of Debt = 400,000 Total Market value = 828,570 Overall cost of capital = EBIT/(Total value of firm) = 100,000/828,570 = 12% (approx.)
  • CONCLUSIVE SUMMARY (NI APPROACH)  According to this approach, the capital structure decision is relevant to the valuation of the firm.  This means that a change in the financial leverage (use of more debt capital) will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm.  According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases.  Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases. As observed, in case of Net Income Approach, with increase in debt proportion, the total market value of the company increases and cost of capital decreases.
  • NET OPERATING INCOME APPROACH This approach is based upon the following assumptions or features:  The overall capitalization rate remains constant irrespective of the degree of leverage. (This means WACC (Weightage Average Cost of Capital) remains constant with the increase in debt, the cost of equity increases.)  The business risk remains constant at entry level of debt equity mix. (Increase in debt in the capital structure results in increased risk for shareholders. As a compensation of investing in highly leveraged company, the shareholders expect higher return resulting in higher cost of equity capital.)  There are no corporate taxes According to this approach, change in capital structure of a company does not affect the market value of the firm and overall cost of capital remains constant irrespective of the method of financing. This approach was put forth by Durand and totally differs from the Net Income Approach.
  • NET OPERATING INCOME APPROACH According to this approach, change in capital structure of a company does not affect the market value of the firm and overall cost of capital remains constant irrespective of the method of financing. Consider a fictitious company with below figures. All figures in Rs. Earnings before Interest Tax (EBIT) = 100,000 Bonds (Debt part) = 300,000 Cost of Bonds issued (Debt) = 10% WACC = 12.5% Calculating the value of the company: (EBIT) = 100,000 WACC = 12.5% Market value of the company = EBIT/WACC = 100,000/12.5% = 800,000 Total Debt = 300,000 Total Equity = Total market value-total debt = 800,000-300,000 = 500,000 Shareholders' earnings = EBIT-interest on debt = 100,000-10% of 300,000 = 70,000 Cost of equity = 70,000/500,000 = 14% Market value of the company = EBIT WACC
  • NET OPERATING INCOME APPROACH According to this approach, change in capital structure of a company does not affect the market value of the firm and overall cost of capital remains constant irrespective of the method of financing. Consider a fictitious company with below figures. All figures in Rs. Earnings before Interest Tax (EBIT) = 100,000 Bonds (Debt part) = 300,000 Cost of Bonds issued (Debt) = 10% WACC = 12.5% Now, assume that the proportion of debt increases from 300,000 to 400,000 and everything else remains same. EBIT) = 100,000 WACC = 12.5% Market value of the company = EBIT/WACC = 100,000/12.5% = 800,000 Total Debt = 400,000 Total Equity = Total market value-total debt = 800,000-400,000 = 400,000 Shareholders' earnings = EBIT-interest on debt = 100,000-10% of 400,000 = 60,000 Cost of equity = 60,000/400,000 = 15% As observed, in case of Net Operating Income approach, with the increase in debt proportion, the total market value of the company remains unchanged, but the cost of equity increases.
  • TRADITIONAL APPROACH Traditional approach to capital structure suggests that there exist an optimal debt to equity ratio where the overall cost of capital is the minimum and market value of the firm is the maximum. Traditional approach, advocated by Ezta Solomon and Fred Weston is a midway approach also known as ―intermediate approach‖. Assumptions/Features of Modigliani and Miller Approach 1. As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in reduction in value of the firm. 2. The rate of interest on debt remains constant for a certain period and thereafter with increase in leverage, it increases. 3. The expected rate by equity shareholders remains constant or increase gradually. After that the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily. 4. As a result of activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.
  • MODIGLIANI AND MILLER (MM) APPROACH This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component, it has no bearing on its market value. Rather, the market value of a firm is dependent on the operating profits of the company. Modigliani and Miller approach to capital theory, devised in 1950s advocates capital structure irrelevancy theory. Assumptions/Features of Modigliani and Miller Approach 1. There are no taxes. 2. Transaction cost for buying and selling securities as well as bankruptcy cost is Nil. 3. There is symmetry of information. This means that an investor will have access to same information that a corporate would and investors would behave rationally. 4. The cost of borrowing is the same for investors as well as companies. 5. Debt financing does not affect companies EBIT