This document discusses cost of capital and capital structure. It defines different types of capital like equity, debt, and preference shares. It explains how to calculate the overall cost of capital by determining the costs of each capital type and weighting them. The document also summarizes different approaches to determining an optimal capital structure, including EBIT/EPS analysis, valuation approaches, and cash flow analysis. It reviews relevant, irrelevant, and neutral capital structure theories, as well as Modigliani-Miller theory which argues capital structure does not affect firm value under certain assumptions.

1. Cost of Capital
&
Capital Structure
BY
Abhilash Nissankararao

2. Contents
 Types of cost of capital.
 Significance of Ko .
 Computation of overall ko.
 Approaches capital Structure.

3. Types of Cost of capital
 Equity capital
 Preference capital
 Debt capital
 Reserves & surplus
The main objective of capital structure is to
minimize the Ko

4. Significance of Ko
 Designing optimal capital structure
 Investment evaluation (or) Capital budgeting
 Financial preference appraisal

5. Computation of overall ko
1. Determination of types of funds.
2. Computation of cost of each type of funds
3. Assign weights to specific cost.
4. Multiplying the cost of each of the source by
the assigned weights.
5. Dividing the total weighted cost by the total
weights to get overall cost of capital

6. Determination of types of funds
1. Cost of retained earnings
2. Cost of equity
3. Cost of preference shares
4. Cost of debt

7. Cost of Retained earnings
 Undistributed profits to share holders
Kre =Ke
1−𝑇𝑖
1−𝑇𝑏
Ke=
𝐷
𝑁𝑝 𝑜𝑟 𝐶𝑀𝑃

8. Cost of Equity
 Dividend capitalization approach
Ke=
𝐷
𝑁𝑃
x 100
 Earnings capitalization approach
Ke=
𝐸
𝑁𝑃
x100
 Dividend capitalization plus growth rate approach
ke=
𝐷
𝑁𝑃
+ 𝑔
 Bond yield plus risk premium approach
ke= Bond yield+ risk premium
 Capital asset pricing model approach
ke= Rf(Rmf- Rf)xb

9. Cost of preference shares
 Cost of irredeemable preference shares
kp(with out tax) =
𝐷
𝐶𝑀𝑃 𝑜𝑟 𝑁𝑝
Kp (with tax) =
𝐷(1+𝑡𝑎𝑥)
𝐶𝑀𝑃 𝑜𝑟 𝑁𝑃
 Cost of redeemable preference shares
Kp= 𝑡=1
𝑛 𝐷𝑡
1+𝑘𝑝
+…..+ 𝐷𝑛
1+𝑘𝑝 𝑛
+ 𝑃𝑛
1+𝑘𝑝 𝑛

10. Cost of Debt
 Costofirredemabledebt
a. Pre tax costkd=
𝐼
𝑃 𝑂𝑅 𝑁𝑃
b. Post tax cost Kd=
𝐼(1−𝑡)
𝑃 𝑜𝑟 𝑁𝑃
 Cost of redeemable debt
Kd=
𝐼 1−𝑡 +(𝑓+𝑑+Pr −𝑃𝑖)/𝑁𝑀
𝑅𝑉+𝑁𝑃
2

11. Meaning of capital structure
 Meaning:
Capital structure include long term debt
and total stockholders investment.
Optimum Capital structure the level of
debt equity proportion or level of capital mix
where market value of share is maximum and ko
is minimum.

12. Sources of long term finance
Sources of
finance
Proprietor's
funds
Equity
capital
Preference
capital
Reserves
&surplus
Borrowed
funds
Long term
debt

13. Determinants of capital structure
 Tax benefit of debt
 Flexibility
 Control
 Industry leverage ratio
 Agency cost
 Legal requirements
 Cost of capital

14. Approaches to determine capital
structure
 EBIT and EPS approach
 Valuation approach
 Cash flow approach

15. EBIT and EPS analysis
 Explains the sensitivity of EPS to the
changes in EBIT under different financial
plans.

16. Capital Structure and Firm
Valuation
 Relevant Theory
 Irrelevant Theory
 Neutral Theory

17. Relevant Theory
 They argued that other things being equal,
increase in financial leverage increases the
value of the firm

18. Irrelevant Theory
 They argued that there is no relationship
between capital structure and value of the
firm.

19. Neutral theory
 They argued that use of debt in capital
structure has a positive effect on the value of
the firm up to certain level and have negative
effect these after.

20. Capital structure theories
 Net income theory
 Net operating income theory
 MM Theory
 Traditional theory

21. Net income approach
 The capital structure of a firm influence its
cost of capital and thus directly affects the
value of the firm.
 NI approach assumes that a continuous
increase in debt does not effect the risk
perception of investors
 Cost of debt is less than cost of equity.

22.  Value of the firm (v)=
𝐸𝐵𝐼𝑇
𝐾𝑜
As per the proportion of debt (Kd) in
capital structure increases, the WACC (Ko)
reduces.

23. Diagrammatic representation
Ke
Ko
Kd
Debt
Cost

24. Net operating income approach
 Value of the firm is not dependent upon its
capital structure.
Assumptions
 WACC is always constant.
 Value of the firm calculated only on WACC .
 Kd is constant.
 No taxes.

25.  Cost of capital is constant as the proportion of
debt increases (Ko) increases.
 No effect on total cost of capital(WACC).
Ke
Ko
Kd
Debt
Cost

26. Modigliani & Miller Theory
 Capital structure has no effect on value of a
firm
 A adds a behavioral justification in favor of
NOI approach (Personal leverage).

27. Assumptions
 Capital markets are “Perfect”.
 Investors can borrow without restrictions at
par with the firms.
 Investors are rational & informed of risk return
of all securities.
 No taxes and costs.
 100% dividend payout ratio.

28. MM propositions
 Value of a firm is independent of the capital
structure.
 Value of a firm is equal to the capitalized
value of operating by the appropriate.
 Value of firm= Mrk value of equity+Mrk value
of debt.
=
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝐵𝐼𝑇
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑊𝐴𝐶𝐶

29. Arbitrage process
Buying an Asset in one
market at lower price and
selling it in another market
at higher price.

30. Steps in Arbitrage process
 Current position of investor.
 Calculate savings in investment – moving
from levered firm to unlevered firm.
 Calculation of increased income.

31. Traditional Approach
 Compromise between two extreme approach.
 WACC is minimum and value of the firm is
maximum.
 Best possible mix of debt and equity will
maximize the value of the firm.

32. Stages in traditional approach
 Cost of capital reduces initially, at a point it
settles .
 After the point (Ko) increases, due to increase
in the cost of equity(Ke).

33. Kd
Ko
Ke
Debt
Cost