Chapter 14 capital structuret

Khursheed Ahmad Bhat, Controller of Finances Bakhtar University
2
Chapter 4 – Capital Structure.
 Chapter outlines
 What is Capital Structure?

3
Chapter 4 – Meaning of Capital Structure.
• Capital structure refers to the kinds of securities and the proportionate
amounts that make up capitalization.
• It is the mix of different sources of long-term sources such as equity
shares, preference shares, debentures, long-term loans and retained
earnings.
• It also refers to the relationship between the various long-term source
financing.
• Deciding the suitable capital structure is the important decision of the
financial management because it is closely related to the value of the
firm.
• Capital structure is the permanent financing of the company.

4
Chapter 4 – Definition of Capital Structure.
• The following definitions clearly initiate, the meaning and objective of
the capital structures.
• According to Gerestenbeg, “Capital Structure of a company refers to
the composition or make up of its capitalization and it includes all
long-term capital resources”.
• According to James C. Van Horne, “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common
stock equity”.

5
Chapter 4 – Financial Structure.
• The term financial structure is different from the capital structure.
Financial structure shows the pattern total financing. It measures the
extent to which total funds are available to finance the total assets of
the business.
• Financial Structure = Total liabilities
Or
• Financial Structure = Capital Structure + Current liabilities.
• The following points indicate the difference between the financial
structure and capital structure.

6
Chapter 4 – Example 1
• From the following information, calculate the capitalization, capital
structure and financial structures.
Balance sheet
Liabilitis Assets
share capital
Preference share capital
Debentures
Retained earnings
Creditors
Cash and bank
Bills payable
50,000
5,000
6,000
4,000
3,000
10,000
2,000
Fixed assets
Good will
Stock
Bills receivable
Debtors
25,000
10,000
15,000
5,000
5,000
70,000 70,000

7
• (i) Calculation of Capitalization
• (ii) Calculation of Capital Structures
S.No Source Amount
1 Equity share capital 50,000
2 Preference share capital 5000
3 Debenture 6000
Capitalization 61000
S.No Source Amount Proportion
1 Equity share capital 50,000 76.92 %
2 Preference share capital 5000 07.69%
3 Debenture 6000 09.23%
4 Retained earnings 4000 06.16%
65000 100%

8
• (iii) Calculation of Financial Structure
S.No Source Amount Proportion
1 Equity share capital 50,000 71.42 %
2 Preference share capital 5000 07.14%
3 Debenture 6000 08.58%
4 Retained earnings 4000 05.72%
5 Bills Payable 2000 02.85%
6 Creditors 3000 04.29%
70000 100%

9
OPTIMUM CAPITAL STRUCTURE
• Optimum capital structure is the capital structure at which the
weighted average cost of capital is minimum and thereby the value of
the firm is maximum.
• Optimum capital structure may be defined as the capital structure or
combination of debt and equity, that leads to the maximum value of
the firm.

10
Objectives of Capital Structure
• Decision of capital structure aims at the following two important
objectives:
• 1. Maximize the value of the firm.
• 2. Minimize the overall cost of capital.

11
Forms of Capital Structure
• Capital structure pattern varies from company to company and the
availability of finance.
• Normally the following forms of capital structure are popular in
practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.

12
Factors Determining Capital Structure
• The following factors are considered while deciding the capital
structure of the firm.
 Leverage
• It is the basic and important factor, which affect the capital structure.
It uses the fixed cost financing such as debt, and preference share
capital. It is closely related to the overall cost of capital.

13
 Cost of Capital
• Cost of capital constitutes the major part for deciding the capital
structure of a firm.
• Normally long- term finance such as equity and debt consist of fixed
cost while mobilization.
• When the cost of capital increases, value of the firm will also
decrease. Hence the firm must take careful steps to reduce the cost of
capital.

14
a) Nature of the business: Use of fixed interest/dividend bearing
finance depends upon the nature of the business. If the business
consists of long period of operation, it will apply for equity than debt,
and it will reduce the cost of capital.
b) Size of the company: It also affects the capital structure of a firm. If
the firm belongs to large scale, it can manage the financial
requirements with the help of internal sources. But if it is small size,
they will go for external finance. It consists of high cost of capital.

15
c) Legal requirements: Legal requirements are also one of the
considerations while dividing the capital structure of a firm. For
example, banking companies are restricted to raise funds from some
specific sources.
d) Requirement of investors: In order to collect funds from different
type of investors, it will be appropriate for the companies to issue
different sources of securities.
 Government policy
• Promoter contribution is fixed by the company Act. It restricts to
mobilize large, long term funds from external sources.

16
Capital Structure Theories
• Capital structure is the major part of the firm’s financial decision
which affects the value of the firm and it leads to change EBIT and
market value of the shares.
• There is a relationship among the capital structure, cost of capital and
value of the firm.
• The aim of effective capital structure is to maximize the value of the
firm and to reduce the cost of capital.
• There are two major theories explaining the relationship between
capital structure, cost of capital and value of the firm.

17
Traditional ApproachModern Approach
Modigliani-Miller
Approach
Net Operating Income
Approach
Net Income Approach

18
Traditional Approach
• It is the mix of Net Income approach and Net Operating Income
approach. Hence, it is also called as intermediate approach. According
to the traditional approach, mix of debt and equity capital can increase
the value of the firm by reducing overall cost of capital up to certain
level of debt. Traditional approach states that the Ko decreases only
within the responsible limit of financial leverage and when reaching
the minimum level, it starts increasing with financial leverage.

19
 Assumptions
Capital structure theories are based on certain assumption to analysis in a
single and convenient manner:
1. There are only two sources of funds used by a firm; debt and shares.
2. The firm pays 100% of its earning as dividend.
3. The total assets are given and do not change.
4. The total finance remains constant.
5. The operating profits (EBIT) are not expected to grow.
6. The business risk remains constant.
7. The firm has a perpetual life.
8. The investors behave rationally.

20

21
Exercise
Question 1
• ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The
new factory expects to yield annual earnings before interest and tax (EBIT)
of Rs.5,00,000. In choosing a financial plan, ABC Ltd., has an objective of
maximizing earnings per share (EPS). The company proposes to issuing
ordinary shares and raising debit of Rs. 3,00,000 and Rs. 10,00,000 of Rs.
15,00,000. The current market price per share is Rs. 250 and is expected to
drop to Rs. 200 if the funds are borrowed in excess of Rs. 12,00,000. Funds
can be raised at the following rates.
–up to Rs. 3,00,000 at 8%
–over Rs. 3,00,000 to Rs. 15,000,00 at 10%
–over Rs. 15,00,000 at 15%
• Assuming a tax rate of 50% advise the company.

22
Exercise Question 1
• Earnings Before Interest and Tax (BIT) less Interest Earnings Before
Tax less: Tax@50%.
Alternatives
Particulars 1
(Rs. 3,00,000 debt)
2
(Rs. 1,000,000Debt)
3
(Rs. 1,500,000 debt)
EBIT 500000 500000 500000
Less Interest 24000
EAIBT 476000
Less Tax 238000
EAIT 238000
Equity Share 27,00,000
Market Price Per share 250
Number of Shares 10800
Earning Per Share 238000/10800
=22.037

23
Exercise Question 1
Tax less: Tax@50%.
Alternatives
Particulars 1
(Rs. 3,00,000 debt)
2
(Rs. 1,000,000Debt)
3
(Rs. 1,500,000 debt)
EBIT 500000 500000 500000
Less Interest 24000 100000
EAIBT 476000 400000
Less Tax 238000 200000
EAIT 238000 200000
Equity Share 27,00,000 2,000,000
Market Price Per share 250 250
Number of Shares 10800 8000
=22.037
200000/8000
=25

24
Exercise Question 1
Tax less: Tax@50%.
Alternatives
Particulars 1
(Rs. 3,00,000 debt)
2
(Rs. 1,000,000Debt)
3
(Rs. 1,500,000 debt)
EBIT 500000 500000 500000
Less Interest 24000 100000 225000
EAIBT 476000 400000 275000
Less Tax 238000 200000 137500
EAIT 238000 200000 137500
Equity Share 27,00,000 2,000,000 1,500,000
Market Price Per share 250 250 200
Number of Shares 10800 8000 7500
=22.037
200000/8000
=25
137500/7500
=18.33

25
Exercise Question 2
 Compute the market value of the firm, value of shares and the average
cost of capital from the following information.
• Net operating income Rs. 1,00,000
• Total investment Rs. 5,00,000
• Equity capitalization Rate:
a) If the firm uses no debt 10%
b) If the firm uses Rs. 25,0000 debentures 11%
c) If the firm uses Rs. 4,00,000 debentures 13%
• Assume that Rs. 5,00,000 debentures can be raised at 6% rate of
interest whereas Rs. 4,00,000 debentures can be raised at 7% rate of
interest.

26
Solution 2
 Computation of market value of firm value of shares and the average cost of capital.
Particulars (a)No Debt (b) Rs 250000
6% debentures
(c) Rs 400000
7% Debentures
Net operating Income
(–) Interest (i.e.)
Cost of debt
Earnings available to
Equity shareholders
Equity Capitalization Rate
Market value of shares
Market Value of firm
Average cost of capital=
Earnings/Value of the firm
EBIT/V
100000
-
100000
10%
100,000 × 100/10
=Rs. 10,00,000/-
1000000
100000
100000/1000000×100
=10%

27
Solution 2
6% debentures
(c) Rs 400000
7% Debentures
Cost of debt
Equity shareholders
EBIT/V
100000
-
100000
10%
100,000 × 100/10
=Rs. 10,00,000/-
1000000
100000
100000/1000000×100
=10%
100000
15000
85000
11%
85000×100/11
=Rs.772727/-
10,22,727
100000
100000/1022727×100
=9.78%

28
Solution 2
6% debentures
(c) Rs 400000
7% Debentures
Cost of debt
Equity shareholders
EBIT/V
100000
-
100000
10%
100,000 × 100/10
=Rs. 10,00,000/-
1000000
100000
100000/1000000×100
=10%
100000
15000
85000
11%
85000×100/11
=Rs.772727/-
10,22,727
100000
100000/1022727×100
=9.78%
100000
28000
72000
13%
72000×100/13
Rs.553846/-
953846
100000
100000/953846×100
=10.48%
The equity capitalization rate is determined by taking the net
operating income of a property and dividing it by the sales price.

29
Net Income (NI) Approach 18.13
• According to this approach, a firm can minimise the weighted average
cost of capital and increase the value of firm as well as the market
price of equity share capital by using debt financing to the maximum
possible extent.
• According to this approach, use of more debt finance reduce the
overall cost of capital and increase the value of firm.

30
Net Income (NI) Approach
• Net income approach is based on the following three important
assumptions:
• 1. There are no corporate taxes.
• 2. The cost debt is less than the cost of equity.
• 3. The use of debt does not change the risk perception of the investor.

31
• The line of argument in favour of this approach is that as the
proportion of debt financing in capital structure increases, the
proportion of a less expensive source of fund increases.
• It results in the decrease in overall cost of capital leading to n increase
in the value of firm.
• Reasons are that the interest rates are usually less than rate of dividend
due to risk element and tax benefit as the interest is deductible
expense.
• The Net income approach showing the effect of leverage on overall
cost of capital has been presented in the figure that follows:
KE (COST OF EQUITY)
KD (COST OF DEBT)
--------- DEGREE OF LEVERAGE-----------
---------COSTOFCAPITAL%-----------

32
• The total market value of the firm on the basis of NIA can be ascertained as below
• V = S+D
• where
• V = Value of firm
• S = Market value of equity
• D = Market value of debt
• Market value of the equity can be ascertained by the following formula:
• S =NI/Ke
• where
• NI = Earnings available to equity shareholder
• Ke = Cost of equity/equity capitalization rate
Format for calculating value of the firm on the basis
of NI approach

33
• Question:
• X Ltd is expecting an annual EBIT of 1 lakh AF’s. the company has 4 lakh in 10%
debentures. The cost of wquity or capitlisation rate is 12.5%. You are required to calculate the
total value of the firm accor.ding to NI Approach
Solution AF’s
Calculation of the value of the Firm
Net income (EBIT) 100000
Less: Interest on 10% Debenture of 400000 40000
Earnings available to equity share holders 60000
Market capitalization rate 12.5%
Market value of the share(S)=60000x100/12.5 480000
Market value of the debenture (D) 400000
Value of the Firm (S+D) 880000

34
• Question: 2
a) A company expects a net income of Rs. 80000. it has 200000 8% Debentures. The equity
capitalization rate of the company is 10%. Calculate the value of the firm and overall
capitalization rate according to NI approach. (Ignor income tax)
b) If the debenture is increased to Rs. 300000 what shall be the value of the firm and overall
capitalization rate?
Solution AF’s
(a) Calculation of the value of the Firm Alternative
(a)
200000 Debt
Alternative
(b)
300000 Debt
Net income (EBIT) 80000 80000
Less: Interest on 10% Debenture of 200000 16000 24000
Earnings available to equity share holders 64000 56000
Market capitalization rate 10% 10%
Market value of the share [a] (S)=64000x100/10=640000
[b] (S)=56000x100/10=560000
640000 560000
Market value of the debenture (D) 200000 300000
Value of the Firm (S+D) 840000 860000
Calculation of overall capitalization rate
Overall cost of capital (ko) =EBIT/ Value of the firm
(a) (ko) =80000/840000x100= 9.52%
[b] (ko) =80000/860000x100= 9.30%

35
Net Operating Income (NOI) Approach
• This theory as suggested by David Durand is another extreme of the
effect of leverage on the value of firm.
• It is dramatically opposite to the net income approach.
• According to this approach, change in the capital structure of a company
does not affect the market value of the firm and the overall cost of capital
remains constant irresective of the method of financing.
• Thus there is nothing as an optimal capital structure and every capital
structure is the optimum capital structure.
• The theory presumes that:
i. The market capitalises the value of firm as a whole.
ii. The business risk remains constant at every level of D/E mix
iii. There are no corporate taxes.
KE (COST OF EQUITY)
KD (COST OF DEBT)
KO (OVERALL
COST OF CAPITAL)
--------- DEGREE OF LEVERAGE-----------
---------COSTOFCAPITAL%-----------
It implies that the overall cost
of capital remains the same
whether the debt-equity mix is
50:50 or 80:20 or 0:100.

36
Net Operating Income (NOI) Approach
• The reasons propounded for such assumptions are:
• The increased use of debt increases the financial risk of the equity shareholders and
hence the cost of equity increases.
• On the other hand, the cost of debt remains constant with the increasing proportion
of debt as the financial risk of the lender is not affected. Thus the advantage of using
the cheaper source of fund i.e., debt is exactly offset by the increased cost of equity.
• The value of the firm on the basis of NOI approach can be determined as below:
• V=EBIT/Ko
• Where V= Value of the firm
• EBIT= Earnings before interest and tax
• Ko= Overall Cost of Capital
• The cost of equity or Equity capitalization rate can be calculated as below
• Ke=
Earnings after interest before Tax
Market value of Firm- Market Value of Debt EBIT-I
V-D

Khursheed Ahmad Bhat, Controller of Finances Bakhtar University 37
Question:
a. A company expects a net operating income of 100000. it has 500,000 6% Debentures. The
overall capitalization rate is 10%. Calculate the value of the firm and the equity capitlization
rate (Cost of equity) according to the Net Operating Income Approach.
b. If the debenture debt is increased to 700000 what will be the effect on the value of the firm?

Question:
a. A company expects a net operating income of 100000. it has 500,000 6% Debentures. The
overall capitalization rate is 10%. Calculate the value of the firm and the equity capitlization
rate (Cost of equity) according to the Net Operating Income Approach.
b. If the debenture debt is increased to 700000 what will be the effect on the value of the firm?
Solution AF’s
Calculation of the value of the Firm (a)
Net operating income (EBIT)
Overall cost of capital
Market Value of the Firm (V)=
100000
10%
Less: Market Value of the Debentures =500000
Market value of the Equity =500000
Equity Capitalization Rate=
Calculation of the value of the Firm (b)
(Net operating Income) EBIT
Overall Cost of Capital K
=100000x100 =1,000,000
10
Earnings after interest before Tax
Market value of Firm- Market Value of Debt
EBIT-I
V-D
100000-30000
1000000- 500000
X100=
70000
500000
X100=14%
100000-45000
1000000- 750000
X100=
55000
250000
X100=22%
(Net operating Income) EBIT
Overall Cost of Capital K
=100000x100 =1,000,000
10

Modigliani and Miller Approach:
 MM hypothesis is identical with Net Operating Income approach in
the absence of taxes. However, when corporate taxes are assumed to
exist there hypothesis is similar to NI Approach.
A. In the absence of taxes (Theory of Irrelevance): The theory proves
that the cost of capital is not affected by the change of debt-equity
mix and is irrelevant in determining the value of the firm.
• Reason: Though debt is cheaper to equity, increased use of debt
increases the cost of equity. The increased cost of equity offsets the
advantage of debt. Financial leverage effects the cost of equity, the
overall cost of capital remains constant.
• The theory emphasises the fact that the firms operating income
determines its total value.

Modigliani and Miller Approach:
• The theory further propounds that beyond certain limit of debt, the
cost of debt increases due to increased financial risk and the cost of
equity falls thereby again balancing two costs.
• In the opinion of Modigliani & Miller two identical firms except their
capital structure cannot have different market value due to Arbitrage
Process.
• In case of such identical firms (Except their capital structure) if the
firms have different market value, arbitrage will take place, investors
will buy equity of the firm having more value as against the corporate
leverage and this will render two firms to have same market value.

Assumptions underlying MM Approach:
i. There are no corporate taxes.
ii. There is a perfect market.
iii. Investors act rationally.
iv. The expected earnings of all firms have identical risk characteristics.
v. The cut-off point of investment in a firm is capitalization rate.
vi. Risk to investor depends upon the random fluctuations of expected
earnings and the possibility that the variables my turn out to be
different from their best estimates
vii. All earnings are distributed to the shareholders.

Graphical presentation of MM Approach:

Question:
 The following information is available regarding Mid Air Enterprises:
i. Mid Air has no debt, it is all equity company;
ii. Estimated EBIT=24 lakh. EBIT is expected to remain constant.
iii. There are no taxes therefore, T=0 %
iv. Dividend pay-out ratio is 100%
v. If Mid Air rises debt, rate of interest will be 8% constant for all degrees of
leverages. Any money raised by selling debt would be used to retire common
stock, so the assets of firm will be constant..
vi. Expected rate of return on equity is 12%, if no debt is used.
 Using MM model without corporate taxes & assuming 1crore debt, you are required
to:
a. Determine the firm’s total market value.
b. Determine the firm’s value of euity
c. Determine the firms leverage cost of equity.

Question:
 The following information is available regarding Mid Air Enterprises:
i. Mid Air has no debt, it is all equity company;
ii. Estimated EBIT=24 lakh. EBIT is expected to remain constant.
iii. There are no taxes therefore, T=0 %
iv. Dividend pay-out ratio is 100%
v. If Mid Air rises debt, rate of interest will be 8% constant for all degrees of
leverages. Any money raised by selling debt would be used to retire common
stock, so the assets of firm will be constant..
vi. Expected rate of return on equity is 12%, if no debt is used.
 Using MM model without corporate taxes & assuming 1crore debt, you are required
to:
a. Determine the firm’s total market value.
b. Determine the firm’s value of euity
c. Determine the firms leverage cost of equity.
a. Firm’s total Market Value:
V=
V= =Rs. 20,000,000
b. Firm’s Market value of Equity
S=V-D
S=2-1= 1crore
c. Firm’s Leverage Cost of Equity;
=cost of equity+(Cost of equity-cost of debt)
=12%+(12%-8%) = 16%
EBIT
Ke
2400000
0.12

Question:
 When corporate taxes are assumes to Exist (Theory of Relevance):
• Modigliani and Miller in their article of 1963 have recognised that the value of the
firm will increase or the cost of capital will decrease with the use of debt on account
of deductibility of interest charged for tax purpose.
• Thus the optimum capital structure can be achieved by maximising the debt mix in
the equity of firm.
VL (Value of Levered
Firm)
VL (Value of Unlevered
Firm)
Value of interest tax shield
Degree of Leverage
Value
MM Approach: Value of Levered and Unlevered Firm)

Question:
 According to the MM approach, the value of Livered and unlevered firm can be
calculated as:
 Value of Unlevered firm(Vu) = (1-i)
 And the value of Levered Firm is : VL=Vu+tD
EBIT
KO

47

Chapter 14 capital structuret

More Related Content

What's hot

Viewers also liked

Similar to Chapter 14 capital structuret

More from CMA Khursheed Ahmad Bhat

Chapter 14 capital structuret