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MODULE III: FINANCING DECISIONS <ul><li>CAPITAL STRUCTURE AND COST OF CAPITAL, MARGINAL COST OF CAPITAL </li></ul>
INTRODUCTION <ul><li>Financing decision is raising the necessary funds to meet our investment expenditures.  </li></ul><ul...
<ul><li>In financing decision company has to decide its capital structure. In this the debt & equity ratio is decided. It ...
<ul><li>That is how these two decisions are correlated.  </li></ul><ul><li>In financing decision, we not only have to look...
<ul><li>In financing decision company has to decide its capital structure. In this the debt & equity ratio is decided. It ...
<ul><li>Simplicity </li></ul><ul><li>Flexibility </li></ul><ul><li>Minimum Cost of Capital </li></ul><ul><li>Adequate Liqu...
<ul><li>Simplicity </li></ul><ul><li>Flexibility </li></ul><ul><li>Minimum Cost of Capital </li></ul><ul><li>Adequate Liqu...
<ul><li>Floatation Cost </li></ul><ul><li>Control </li></ul><ul><li>Cost of Capital </li></ul><ul><li>Flexibility </li></u...
Theories of Capital Structure <ul><li>Net income Approach: </li></ul><ul><li>According to this approach, a firm can minimi...
Assumptions of NI Approach <ul><li>The cost of debt is less than the cost of equity. </li></ul><ul><li>No Taxes.  </li></u...
<ul><li>V=S+D </li></ul><ul><li>Where V=Total market value of a firm </li></ul><ul><li>S= Market value of equity shares </...
Practical Problem <ul><li>A Company expects a net income of Rs.50,000.  It has Rs.2,00,000, 8% Debentures. The Equity capi...
Net Operating Income Approach <ul><li>Suggested by Durand </li></ul><ul><li>Opposite to NI Approach </li></ul><ul><li>Acco...
Assumptions of NOI Approach <ul><li>The market capitalizes the value of the firm as a whole; </li></ul><ul><li>The busines...
<ul><li>V=EBIT/K o </li></ul><ul><li>V= Value of a firm </li></ul><ul><li>EBIT=Net operating Income or Earnings before int...
Practical Problem A company expects a net operating income of Rs 100000. It has Rs 500000, 6% Debentures. The overall capi...
The Traditional Approach <ul><li>Intermediate Approach </li></ul><ul><li>According to this: the value of firm can be incre...
<ul><li>The advantage of cheaper debt at this point is offset by increased cost of equity. </li></ul><ul><li>After this th...
Modigliani and Miller Approach <ul><li>Assumptions </li></ul><ul><li>The capital markets are perfect and complete informat...
<ul><li>All the investors have the same probability  distribution about the expected future earnings. </li></ul><ul><li>Th...
<ul><li>Suppose two firms  A Ltd (levered) and B Ltd (unlevered) are identical in all respect except that A ltd has 10 % d...
<ul><li>Arbitrage Process </li></ul><ul><li>Reverse Arbitrage Process. </li></ul>
Cost of Capital
Meaning <ul><li>Cost of Capital means cost of obtaining funds i.e. average rate of return that the investors in a firm wou...
Significance of Cost of capital <ul><li>Helpful in capital Budgeting </li></ul><ul><li>Helpful in capital structure decisi...
Classification of Cost of capital <ul><li>Historical cost and Future cost </li></ul><ul><li>Specific cost and composite co...
Computation of Cost <ul><li>Cost of Specific Source of finance </li></ul><ul><li>Composite Cost of Capital </li></ul>
Cost of Debt <ul><li>In case of Irredeemable debt </li></ul><ul><li>Kdb  =  I/P </li></ul><ul><li>Kdb  = Before tax cost o...
<ul><li>Redeemable debt </li></ul><ul><li>Kdb  = I + 1/n (P-NP)/ ½ (P+NP) </li></ul><ul><li>Kda = Kdb (1-t) </li></ul><ul>...
Cost of Preference Capital <ul><li>Kp  = D/P </li></ul><ul><li>Where D = Annual Preference dividend </li></ul><ul><li>P  =...
Cost of Equity Share Capital <ul><li>Dividend yield Method </li></ul><ul><li>Ke  = D/NP or  D/MP </li></ul><ul><li>Where D...
<ul><li>Earning Yield Method </li></ul><ul><li>Ke = Earnings per share / Net Proceeds </li></ul><ul><li>Or  </li></ul><ul>...
Cost of Retained Earnings <ul><li>Kr  = D  /NP  + G </li></ul><ul><li>Where Kr  = Cost of retained earnings </li></ul><ul>...
Weighted Average cost of Capital <ul><li>Weighted Av. Cost of capital is the average cost of the costs of various sources ...
Marginal Cost of Capital <ul><li>Cost of Capital of the additional funds is called the Marginal Cost of Capital. </li></ul...
Calculation of WMCC <ul><li>1. The WMCC is calculated on the basis of market value weights because the new funds are to be...
<ul><li>Cases </li></ul><ul><li>No external financing for new proposals </li></ul><ul><li>External Financing with same cos...
 
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4a304 capital structure

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4a304 capital structure

  1. 1. MODULE III: FINANCING DECISIONS <ul><li>CAPITAL STRUCTURE AND COST OF CAPITAL, MARGINAL COST OF CAPITAL </li></ul>
  2. 2. INTRODUCTION <ul><li>Financing decision is raising the necessary funds to meet our investment expenditures. </li></ul><ul><li>Most of the investment is done through borrowed funds. </li></ul><ul><li>So, while making an investment decision it is necessary to see whether adequate funds are available or not. </li></ul><ul><li>Because without a financing decision investment decision is not possible and without investment decision financing decision has no purpose </li></ul>
  3. 3. <ul><li>In financing decision company has to decide its capital structure. In this the debt & equity ratio is decided. It also termed as debt equity mix. </li></ul><ul><li>The capital structure or financing decision indicates the left side (Liabilities) of the balance sheet whereas investment decision shows right side (Assets) of the balance sheet. The capital structure shows the proportionate relationship between debt & equity. </li></ul>
  4. 4. <ul><li>That is how these two decisions are correlated. </li></ul><ul><li>In financing decision, we not only have to look at availability of funds but also at its cost. </li></ul><ul><li>We have to pay in future, that is why the cost of capital is very significant decision. </li></ul><ul><li>It (cost of capital) has two dimensional impacts like it affects both the investment and financing decision </li></ul>
  5. 5. <ul><li>In financing decision company has to decide its capital structure. In this the debt & equity ratio is decided. It also termed as debt equity mix. </li></ul><ul><li>The capital structure or financing decision indicates the left side (Liabilities) of the balance sheet whereas investment decision shows right side (Assets) of the balance sheet. The capital structure shows the proportionate relationship between debt & equity. </li></ul>
  6. 6. <ul><li>Simplicity </li></ul><ul><li>Flexibility </li></ul><ul><li>Minimum Cost of Capital </li></ul><ul><li>Adequate Liquidity </li></ul><ul><li>Minimum Risk </li></ul><ul><li>Legal Requirements </li></ul><ul><li>Maximum Returns </li></ul><ul><li>Control </li></ul>Qualities of Optimum Capital Structure
  7. 7. <ul><li>Simplicity </li></ul><ul><li>Flexibility </li></ul><ul><li>Minimum Cost of Capital </li></ul><ul><li>Adequate Liquidity </li></ul><ul><li>Minimum Risk </li></ul><ul><li>Legal Requirements </li></ul><ul><li>Maximum Returns </li></ul><ul><li>Control </li></ul>Factors Affecting Capital Structure
  8. 8. <ul><li>Floatation Cost </li></ul><ul><li>Control </li></ul><ul><li>Cost of Capital </li></ul><ul><li>Flexibility </li></ul><ul><li>Interest Coverage Ratio </li></ul>
  9. 9. Theories of Capital Structure <ul><li>Net income Approach: </li></ul><ul><li>According to this approach, a firm can minimize the weighted average cost of capital and increase the value of firm as well as market price of equity of shares by using debt financing to the maximum possible extent. </li></ul>
  10. 10. Assumptions of NI Approach <ul><li>The cost of debt is less than the cost of equity. </li></ul><ul><li>No Taxes. </li></ul><ul><li>The risk perception of investors is not changed by the use of debt. </li></ul>
  11. 11. <ul><li>V=S+D </li></ul><ul><li>Where V=Total market value of a firm </li></ul><ul><li>S= Market value of equity shares </li></ul><ul><li>S=Earnings Available to Equity Share holders (NI)/Equity capitalization rate </li></ul><ul><li>D= Market value of Debt </li></ul><ul><li>K o = EBIT/ V </li></ul>
  12. 12. Practical Problem <ul><li>A Company expects a net income of Rs.50,000. It has Rs.2,00,000, 8% Debentures. The Equity capitalization rate of the company is 10%. Calculate (a) the value of the firm and overall capitalization rate according to NI approach ( ignore taxes) </li></ul><ul><li>(b) If Debt Increases to Rs. 300000, show effect on value & cost. </li></ul>
  13. 13. Net Operating Income Approach <ul><li>Suggested by Durand </li></ul><ul><li>Opposite to NI Approach </li></ul><ul><li>According to this: Change in capital structure of a company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. </li></ul><ul><li>NO OPTIMUM CAPITAL STRUCTURE, EVERY STRUCTURE IS OPTIMUM </li></ul>
  14. 14. Assumptions of NOI Approach <ul><li>The market capitalizes the value of the firm as a whole; </li></ul><ul><li>The business risk remains constant at every level of debt equity mix </li></ul><ul><li>There are no corporate taxes. </li></ul><ul><li>Kd is constant </li></ul><ul><li>The use of more and more debt increases the risk of shareholders & thus results in increase in Ke. The increase in Ke is such as to offset the benefits of employing cheaper debt. </li></ul>
  15. 15. <ul><li>V=EBIT/K o </li></ul><ul><li>V= Value of a firm </li></ul><ul><li>EBIT=Net operating Income or Earnings before interest and taxes </li></ul><ul><li>K o= Overall cost of capital </li></ul><ul><li>S= V-D </li></ul><ul><li>Ke = EBIT-I/V-D </li></ul>
  16. 16. Practical Problem A company expects a net operating income of Rs 100000. It has Rs 500000, 6% Debentures. The overall capitalization rate is 10%. Calculate (a) the value of firm and the equity capitalization rate according to the NOI Approach. (b) If the debenture is increased to Rs. 750000. What will be the effect on the value of the firm and equity capitalization rate?
  17. 17. The Traditional Approach <ul><li>Intermediate Approach </li></ul><ul><li>According to this: the value of firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. </li></ul>
  18. 18. <ul><li>The advantage of cheaper debt at this point is offset by increased cost of equity. </li></ul><ul><li>After this there comes a stage, when the increased cost of equity cannot by offset by the advantage of low cost debt. Thus overall cost of capital, decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter; and increases beyond a certain point. </li></ul>
  19. 19. Modigliani and Miller Approach <ul><li>Assumptions </li></ul><ul><li>The capital markets are perfect and complete information is available to all the investors free of cost. </li></ul><ul><li>The securities are infinitely divisible. </li></ul><ul><li>Investors are rational and well informed about the risk return of all the securities. </li></ul>
  20. 20. <ul><li>All the investors have the same probability distribution about the expected future earnings. </li></ul><ul><li>There is no corporate taxes. </li></ul><ul><li>The personal leverage and the corporate leverage are perfect substitute. </li></ul>
  21. 21. <ul><li>Suppose two firms A Ltd (levered) and B Ltd (unlevered) are identical in all respect except that A ltd has 10 % debt of Rs. 30 Lakhs in its capital structure. B Ltd has raised funds only by issue of equity share capital. Both these firms have an EBIT of Rs. 10 Lakh & Ke of 20%. Show Total Value and WACC of both the firms. </li></ul>
  22. 22. <ul><li>Arbitrage Process </li></ul><ul><li>Reverse Arbitrage Process. </li></ul>
  23. 23. Cost of Capital
  24. 24. Meaning <ul><li>Cost of Capital means cost of obtaining funds i.e. average rate of return that the investors in a firm would expect for supplying funds to the firm. </li></ul><ul><li>OR </li></ul><ul><li>It is the minimum rate of return which a firm, must and is expected to earn on its investments so as to maintain the market value of its shares </li></ul>
  25. 25. Significance of Cost of capital <ul><li>Helpful in capital Budgeting </li></ul><ul><li>Helpful in capital structure decisions </li></ul><ul><li>Helpful in evaluating the financial performance </li></ul><ul><li>Basis for other financial decisions like dividend policy, working capital decisions etc. </li></ul>
  26. 26. Classification of Cost of capital <ul><li>Historical cost and Future cost </li></ul><ul><li>Specific cost and composite cost </li></ul><ul><li>Explicit cost and Implicit cost </li></ul><ul><li>Average cost and Marginal cost </li></ul>
  27. 27. Computation of Cost <ul><li>Cost of Specific Source of finance </li></ul><ul><li>Composite Cost of Capital </li></ul>
  28. 28. Cost of Debt <ul><li>In case of Irredeemable debt </li></ul><ul><li>Kdb = I/P </li></ul><ul><li>Kdb = Before tax cost of debt </li></ul><ul><li>I = Interest </li></ul><ul><li>P = Principal </li></ul><ul><li>Kdb = I/NP </li></ul><ul><li>Where NP= Net proceeds </li></ul><ul><li>Kda = Kdb(1-t) </li></ul><ul><li>t= tax rate </li></ul>
  29. 29. <ul><li>Redeemable debt </li></ul><ul><li>Kdb = I + 1/n (P-NP)/ ½ (P+NP) </li></ul><ul><li>Kda = Kdb (1-t) </li></ul><ul><li>At Premium </li></ul><ul><li>= I + 1/n (RV-NP)/ ½ (RV+NP) </li></ul>
  30. 30. Cost of Preference Capital <ul><li>Kp = D/P </li></ul><ul><li>Where D = Annual Preference dividend </li></ul><ul><li>P = preference Share Capital (Proceeds) </li></ul><ul><li>Kp = D/NP </li></ul><ul><li>Redeemable Preference Shares </li></ul><ul><li>Kpr = D+ MV-NP/1/2 (MV+NP) </li></ul><ul><li>Where MV = Maturity value of Preference shares </li></ul>
  31. 31. Cost of Equity Share Capital <ul><li>Dividend yield Method </li></ul><ul><li>Ke = D/NP or D/MP </li></ul><ul><li>Where D = Expected dividend per share </li></ul><ul><li>NP =Net Proceeds per share </li></ul><ul><li> MP = Market Price per share </li></ul><ul><li>Dividend yield plus growth in dividend method </li></ul><ul><li>Ke = D1 /NP + G </li></ul><ul><li>Or D0 (1+g) / NP + G </li></ul>
  32. 32. <ul><li>Earning Yield Method </li></ul><ul><li>Ke = Earnings per share / Net Proceeds </li></ul><ul><li>Or </li></ul><ul><li>= Earnings per share / Market Price per share </li></ul><ul><li>Realised Yield Method </li></ul>
  33. 33. Cost of Retained Earnings <ul><li>Kr = D /NP + G </li></ul><ul><li>Where Kr = Cost of retained earnings </li></ul><ul><li> D = expected dividend </li></ul><ul><li> NP = Net Proceeds of share issue </li></ul><ul><li> G = Rate of Growth </li></ul><ul><li>Kr = ( D/NP + G ) * (1-t ) * (1-b ) </li></ul>
  34. 34. Weighted Average cost of Capital <ul><li>Weighted Av. Cost of capital is the average cost of the costs of various sources of financing. Also known as Composite cost of capital </li></ul><ul><li>Weights are assigned either on Book value basis or Market Value basis. </li></ul>
  35. 35. Marginal Cost of Capital <ul><li>Cost of Capital of the additional funds is called the Marginal Cost of Capital. </li></ul><ul><li>If the additional financing uses more than one source, say a combination of debt and equity, then the WACC of new financing is called the Weighted Marginal Cost of Capital ( WMCC) </li></ul>
  36. 36. Calculation of WMCC <ul><li>1. The WMCC is calculated on the basis of market value weights because the new funds are to be raised at the market values. </li></ul><ul><li>2. The specific cost of capital can be accurately calculated. </li></ul>
  37. 37. <ul><li>Cases </li></ul><ul><li>No external financing for new proposals </li></ul><ul><li>External Financing with same cost and with different cost </li></ul>

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