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What is “Capital Structure”? <ul><li>Balance Sheet </li></ul><ul><li>Current Current </li></ul><ul><li>Assets Liabilities </li></ul><ul><li> Debt </li></ul><ul><li>Fixed P reference </li></ul><ul><li> </li></ul><ul><li> Ordinary </li></ul><ul><li>shares </li></ul>Financial Structure
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What is “Capital Structure”? <ul><li>Balance Sheet </li></ul>Current Current Assets Liabilities Debt Fixed P reference shares Assets Ordinary shares Capital Structure
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Definition <ul><li>The term capital structure is used to represent the proportionate relationship between debt, preference and equity shares on a firm’s balance sheet. </li></ul><ul><li>OPTIMUM CAPITAL STRUCTURE: </li></ul><ul><li>Optimum capital structure is the capital structure at which the market value per share is maximum and the cost of capital is minimum. </li></ul>
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Why is it important? <ul><ul><li>Enables one to “optimize” the value of a firm or its WACC by finding the “best mix” for the amounts of debt and equity on the balance sheet </li></ul></ul><ul><ul><li>Provides a signal that the firm is following proper rules of corporate finance to “improve” its balance sheet. This signal is central to valuations provided by market investors and analysts </li></ul></ul>
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Factors affecting capital structure <ul><li>INTERNAL </li></ul><ul><li>Financial leverage </li></ul><ul><li>Risk </li></ul><ul><li>Growth and stability </li></ul><ul><li>Retaining control </li></ul><ul><li>Cost of capital </li></ul><ul><li>Cash flows </li></ul><ul><li>Flexibility </li></ul><ul><li>Purpose of finance </li></ul><ul><li>Asset structure </li></ul><ul><li>EXTERNAL </li></ul><ul><li>Size of the company </li></ul><ul><li>Nature of the industry </li></ul><ul><li>Investors </li></ul><ul><li>Cost of inflation </li></ul><ul><li>Legal requirements </li></ul><ul><li>Period of finance </li></ul><ul><li>Level of interest rate </li></ul><ul><li>Level of business activity </li></ul><ul><li>Availability of funds </li></ul><ul><li>Taxation policy </li></ul><ul><li>Level of stock prices </li></ul><ul><li>Conditions of the capital market </li></ul>
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Assumptions Of Capital Structure <ul><li>There are only two sources of funds i.e.: debt and equity. </li></ul><ul><li>The total assets of the company are given and do not change. Investment decisions will be constant. </li></ul><ul><li>The total financing remains constant. The firm can change the degree of leverage either by selling the shares and retiring debt or by issuing debt and redeeming equity. </li></ul><ul><li>Operating profits (EBIT) are not expected to grow. </li></ul><ul><li>All the investors are assumed to have the same expectation about the future profits. </li></ul><ul><li>Business risk is constant over time and assumed to be independent of its capital structure and financial risk. </li></ul><ul><li>Corporate tax does not exit. (removed Later) </li></ul><ul><li>The company has infinite life. </li></ul><ul><li>Dividend payout ratio = 100%.(No Retained Earnings) </li></ul>
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Theories <ul><li>Net Income (NI) Approach </li></ul><ul><li>Net Operating Income (NOI) Approach </li></ul><ul><li>MM Approach Without Tax: Proposition I,II,III </li></ul>
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Net Income (NI) Approach <ul><li>This theory was propounded by “ David Durand” and is also known as “Fixed ‘Ke’ Theory”. </li></ul><ul><li>According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. </li></ul><ul><li>This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach </li></ul>
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Assumptions of NI Theory <ul><li>The ‘Kd’ is cheaper than the ‘Ke’. </li></ul><ul><li>Income tax has been ignored. </li></ul><ul><li>The ‘Kd’ and ‘Ke’ remain constant </li></ul>
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Net Operating Income (NOI) Approach <ul><li>This theory was propounded by “David Durand” and is also known as “Irrelevant Theory ”. </li></ul><ul><li>According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. Overall cost of capital is independent of degree of leverage. </li></ul><ul><li>In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same. </li></ul>
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Assumptions of NOI Theory <ul><li>The split of total capitalization between debt and equity is not essential or relevant. </li></ul><ul><li>The equity shareholders and other investors i.e. the market capitalizes the value of the firm as a whole. </li></ul><ul><li>The business risk at each level of debt-equity mix remains constant. Therefore, overall cost of capital also remains constant. </li></ul><ul><li>The corporate income tax does not exist </li></ul>
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MM Approach Without Tax: Proposition I <ul><li>MM’s Proposition I, states that the firm’s value is independent of its capital structure .The Total value of firm must be constant irrespective of the Degree of leverage(debt equity Ratio). With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm. This will continue till the market prices of identical firms become identical. This is called arbitrage. </li></ul>
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MM Approach Without Tax: Proposition II <ul><li>The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firm’s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases. </li></ul>
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MM Hypothesis With Corporate Tax <ul><ul><li>Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). </li></ul></ul><ul><ul><li>It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs. </li></ul></ul>
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Assumptions of M-M Approach <ul><li>Perfect Capital Market </li></ul><ul><li>No Transaction Cost </li></ul><ul><li>Homogeneous Risk Class: Expected EBIT of all the firms have identical risk characteristics. </li></ul><ul><li>Risk in terms of expected EBIT should also be identical for determination of market value of the shares </li></ul><ul><li>Cent-Percent Distribution of earnings to the shareholders </li></ul><ul><li>No Corporate Taxes: But later on in 1969 they removed this assumption. </li></ul>
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Traditional Theory <ul><li>This theory was propounded by Ezra Solomon. </li></ul><ul><li>It’s a Midway Between Two Extreme (NI & NOI Approach) </li></ul><ul><li>According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital. </li></ul>
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Features of an Appropriate Capital Structure <ul><li>Profitability </li></ul><ul><li>Solvency </li></ul><ul><li>Return </li></ul><ul><li>Risk </li></ul><ul><li>Flexibility </li></ul><ul><li>Capacity </li></ul><ul><li>Control </li></ul><ul><li>Conservatism </li></ul>
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