Capital structure theories.pptx

capital structure theories with problems

1. Capital structure theories Mahesh k s DoS in Commerce Hemagangotri Hassan

2. Meaning of capital structure Capital structure refer to the proportion between the various long term source of finance in the total capital of firm. A financial manager choose that source of finance which include minimum risk as well as minimum cost of capital.

3. Sources of long term finance Proprietors fund Equity capital Preference capital Reserve and surplus B. Borrowed funds 1. Long term debts.

4. Importance of capital structure Capital structure determine the risk assumed by the firm. Capital structure determine the cost of capital of the firm. It affect the flexibility and solvency of the firm. It prevents over or under capitalization Tax planning tool

5. . Optimal Capital Structure Optimal capital structure is referred to as the perfect mix of debt and equity financing that helps in maximizing the value of a company in the market while at the same time minimizes its cost of capital.

6. Factors Determining Capital Structure Nature and size of the firm. Stability of Earnings. Cost of capital. Rate of corporate tax. Retaining control. Legal requirement. Trading on equity.

7. Capital structure Theories Relevance theories 1.Net income approach 2. Traditional approach B. Irrelevance theories Net operating income approach MM approach

8. Assumption of capital structure theories Firms use only two sources of funds- equity and debt. No change in investment decision of the firm 100% dividend payout ratio,i.e. no retained earnings. No corporate tax

9. NI- Approach ( Net income approach) This theory was propounded by David Durand. There is a relationship between value of firm and capital structure. According to this approach the value of the firm is increase and decrease overall cost of capital by increasing the proportion of debt financing in capital structure.

10. . It is due to the fact that debt is generally a cheaper source of finance because: Interest rate is lower than the dividend rate Benefit of tax : because interest is deductable expense. Under this approach optimum capital structure is 100% debt

11. Assumption of NI approach There is no tax The cost of debt is less than the cost of capital The uses of debt does not change the risk perception of the investors.

12. Formula Calculation of total value of firm V= S+D V= Total market value of the firm S= Market value of equity shares D= Value of debt S=NI/ ke

13. ‘ Calculation of over all cost of capital or WACC Ko = EBIT/V

14. Traditional Approach Proposed by E solomon , and weston etc…. As per the traditional approach, a firm should make judicious use of both the debt and the equity to achieve a capital structure which may be called the optimum capital structure. At this capital structure, the overall cost of capital, WACC of the firm will be minimum and the value of the firm maximum The traditional view point states that the value of the firm increases with increase in financial leverage but up to a certain limit only. Beyond this limit, the increase in financial leverage will increase its WACC and the value of the firm will decline.

15. . Suppose the cost of capital for totally equity financed company is 10%. Cost of equity and cost of capital will be same as company is totally financed with equity capital. If firm replaces 50% of its equity capital with interest bearing 7% debt capital, the cost of equity will increase slightly because of added financial risk of equity shareholders. New cost of equity increases to 11%. WACC = Cost of Equity × Weight of Equity + Cost of Debt × Weight of Debt WACC ( Ko ) = Ke × We + Kd × Wd = 0.11 × 0.50 + 0.07 × 0.50 = 0.09 or 9%

16. Assumption of traditional approach No taxes Earnings is constant All earnings are distributed as dividend Only two source of finance ie debt and equity There is existence of optimum capital structure Rate of debt and equity is constant certain period

17. First Stage: Increasing Value In the first stage, as a company starts moving from all equity to debt financing, the cost of equity ( Ke ) starts increasing by a very less amount. Thus, this slight increase in cost of equity is not able to set off the advantage of low cost of debt ( Kd ). The cost of debt also remains constant as the market perceives debt as a reasonable policy. Consequently, the overall cost of capital (WACC or Ko ) goes down and thus, the value of the firm increases.

18. Second Stage: Optimum Value As the company keeps increasing debt financing, there comes a point which gives optimum value of the firm. In this case, any further increase in debt causes the cost of equity to increase by such an amount which completely off sets the advantage of low cost debt. The result of this is that the WACC shows no change and therefore attains the minimum level. Such a point or range shows the maximum value of the firm due to lowest WACC. At this stage, firm achieves its optimum debt-equity ratio.

19. Third Stage: Decreasing Value After reaching the optimum level, any increase in debt results into very large increase in the cost of equity as required by the shareholders for the increased financial risk. Such a large increase in cost of equity is not able to set off the advantage of low cost debt. Moreover, the cost of debt also increases, as a result of which the WACC increases and thus, value of the firm goes down.

20. Criticism of Traditional Approach Its assumption of financial risk premium is not justifiable. Existence of corporate tax. It assumes existence of optimum capital structure. Existence of transaction cost

21. NOI Approach The Net Operating Income Approach is opposite to the Net Income Approach. According to Net Operating Income Approach, the market value of the firm depends upon the net operating profit or EBIT The financing mix or the capital structure is irrelevant and does not affect the value of the firm

22. •The investor sees the firm as a whole and thus capitalizes the total earnings of the firm to find the value of the firm as a whole. •The overall cost of capital, Ko , of the firm is constant and depends upon the business risk, which also is assumed to be unchanged. •The cost of debt, Kd , is also taken as constant. •The use of more and more debt in the capital structure increases the risk of shareholder and thus results in the increase in the cost of equity capital, Ke . The increase in Ke is such as to completely off set the benefits of employing cheaper debt. •There is no tax.

23. Formula Value of the Firm = Net Operating Profit WACC OR = EBIT Ko ( Ke ) = Net Income Value of Equity

24. MM Hypothesis with No Taxes: Irrelevance of Capital Structure Modigliani and Millar hypothesize that capital structure is irrelevant for firm valuation. That is by changing the proportion of debt and equity, a firm cannot change its value. Firm’s value depends on earnings and risk of its assets rather than leverage (debt-equity ratio).

25. Assumptions of MM hypothesis Perfect Capital Markets: Homogeneous Risk: No Taxes Full Payout: All investors have the same expectation. Investors are rational Only two source of finance

26. . Against NI and traditional approach According to this approach leverage will not affect value of the firm and cost of capital remain unaffected No optimal capital structure or optimal debt equity mix.

27. Proposition 1: Capital structure is irrelevant for firm’s valuation. First proposition of MM hypothesis states that capital structure does not affect the value of a firm. Value of levered firm is equal to value of unlevered firm

28. Arbitrage and home made leverage Its is operational justification by Modigliani and Miller The arbitrage refers to an act of buying a security in one market at a lower price and selling it to another market at a higher price with a view to earn profit.

29. MM Proposition 2: Capital structure affects investors’ returns MM proposition 1 states that capital structure does not affect the value of a firm. But second proposition of MM says that it affects returns of investors (shareholders) i.e. return on equity (ROE) and earnings per share (EPS). It says that as the leverage increases, variability of dividends to shareholders also increases. Thus, the risk for shareholders increases. Now, to compensate for this increasing risk, they expect higher return. Thus, it can be said that with increasing leverage, the risk and return of shareholders increase.

30. rE  = Cost of levered equity ra = Cost of unlevered equity rD  = Cost of debt D/E = Debt-to-equity ratio

31. MM approach with Tax

32. . Problems on NI approach The expected Earnings before interest and taxes (EBIT) of a firm is Rs 2,00,000. It has issued equity share capital and the cost of equity is 10%. It has also issued 6% debt of Rs 5,00,000. Find out the value of company and overall cost of capital (WACC).

33. given that EBIT = Rs. 200,000. Ke = 10%, Kd = 6% and Value of Debt = Rs. 500,000

34. . EBIT 2,00,000 Less: Interest (6% of Rs 5,00,000) 30,000 Net Profit available to eq holders 1,70,000 Cost of Equity ( Ke ) 10% Value of Equity (1,70,000/0.10) 17,00,000 Value of Debt 5,00,000 Total Value of Firm 22,00,000 Weighted Average Cost of Capital (WACC) = Ko = 2,00,000/2200000 = 0.09 or 9% WACC can also be calculated as follows: WACC = Cost of Equity×Weight of Equity + Cost of Debt×Weight of

35. Now if the company had issued 6% debt of Rs 7,00,000 instead of Rs 5,00,000 the position have been as follows: EBIT 2,00,000 Less: Interest (6% of Rs 7,00,000) 42,000 Net Profit (EBT) 1,58,000 Cost of Equity ( Ke ) 10% Value of Equity (158,000/0.10) 15,80,000 Value of Debt 7,00,000 Total Value of Firm 22,80,000 Weighted Average Cost of Capital (WACC) = 2,00,000 /2280000= 0.087 or 8.7% So, if 6% debt is increased from Rs 5,00,000 to Rs 7,00,000 the value of firm increases from Rs 22,00,000 to Rs 22,80,000 and WACC decreases from 9% to 8.7%

36. Now suppose that the company has issued 6% debt of Rs 2,00,000 only instead of Rs 5,00,000. The position would be as follows: EBIT 2,00,000 Less: Interest (6% of Rs 2,00,000) 12,000 Net Profit provided to equity shareholders (EBT) 1,88,000 Cost of Equity ( Ke ) 10% Value of Equity (188,000/0.10) 18,80,000 Value of Debt 2,00,000 Total Value of Firm 20,80,000 Weighted Average Cost of Capital (WACC) = 2,00,000 = 0.096 or 9.6% 20,80,000 So, when the proportion of 6% debt is reduced to Rs 2,00,000 the value of firm reduces to Rs 20,80,000 and WACC increases from 9% to 9.6%.

37. . Calculate the value of firm and WACC from the following information under Net Income approach EBIT of a firm Rs 200000 Ke = 10% Kd = 6% Case 1 – debt capital Rs 500000 Case 2 – Debt capital Rs 800000 Case 3 – Debt capital Rs 200000

38. . Particulars Case 1 (Debt 500000) Case 2 (Debt 800000) Case 3 (Debt 200000) EBIT 200000 200000 200000 Less interest on debt @6% 30000 480000 12000 Net income available to Eq share holders 170000 152000 188000 Value of Eq share NI/ Ke 170000 1520000 1880000 Add value of Debt 500000 800000 200000 Total value of firm 2200000 2320000 2080000 WAAC 0.0909 0.0862 0.0962 Under NI approach when firm is using maximum debt its WACC is minimum and total value of the firm is maximum

39. Problem 2 An organization expects a net income of Rs 100000 and it has Rs 150000, 10% debentures. The equity capitalization rate of the company is 12%. Calculate the value of the firm and overall capitalization rate according to the Net income approach( ignore income tax). If the debenture increased to Rs 200000 what shall be the value be the firm and the overall capitalization rate?

40. Problem no 3 Sterling co. Furnishes the following details Expected net operating income Rs 400000 P.A The cost of equity capital 18% The co. has 14%debenture of Rs 1000000 The co. wishes to borrow additional Rs 1000000 debenture to finance its operation Find out the values of the firm the overall cost of capital and the effects of new borrowings on the value of the firms as per durands net income approach

41. . Calculation of total value of firm and WACC under NI approach for existing capital structure Particulars Existing capital structure EBIT 400000 Less int on debenture (1000000*14/100) 140000 Net income 260000 Equity capitalization rate 18% Value of equity 260000/.18 1444444 Add value of debt 1000000 Total value of firm 2444444 WACC 400000/2444444*100 16.36%

42. Calculation of value of firm and WACC under NI approach for proposed capital structure Particulars When additional debt barrowed EBIT 400000 Less interest 2000000*14/100 280000 Net income 120000 Equity capitalization rate 18% Value of equity 120000/.18 666667 Add value of debt 2000000 Total value of firm 2666667 WACC 400000/2666667*100 15%

43. Problem no 4 Spring ltd issues 12% debenture of Rs 3000000 Summer ltd issues only equity capital of Rs 3000000 . Both co. earn 20% before interest and taxes on their total assets of 6000000 assume tax rate at 40% and capitalization rate of 15% for the all equity co. calculate the value of both the companies using NI approach

44. . Calculation of value of firm and WACC under NI approach Particular Springs ltd Summer ltd EBIT 6000000*20% 1200000 1200000 Less interest 3000000*12/100 360000 ------------ EAIBT 840000 1200000 Less tax @ 40% 336000 480000 Net income available to Eq share holders 504000 720000 Equity capitalization rate 15% 15% Value of equity 3360000 4800000 Add value of debt 3000000 ----------- Total value of firm 6360000 4800000

45. Problems on NOI approach Value of the Firm = Net Operating Profit WACC OR = EBIT Ko ( Ke ) = Net Income Value of Equity Value of equity = V - D

46. Problem no 1 Company A has annual Net operating income (EBIT) of Rs 360000. And the company has Rs 1400000 12% debt. The over all cost of capital of the company is 14% What would be the value of the company and also calculate equity capitalization rate under NOI approach .

47. ‘ Calculation of value of firm under NOI approach Value of the Firm = Net Operating Profit WACC = 360000 .14 Calculation of equity capitalization rate ( Ke ) = Net Income Value of Equity

48. . Value of equity = V – D = 2571428 – 1400000 = 1171428 Net income = EBIT – interest = 360000 – 168000 = 192000 ( Ke ) = Net Income Value of Equity = 192000 1171428 = 0.1639 or 16.39%

49. Ke = EBIT- Interest V – D = 360000 – 168000 2571428 – 1400000 = 192000 1171428 = 0.1639 0r 16.39%

50. Problem no 2 ABC co ltd has annual NOI of Rs 90000. the company has Rs 300000, 10% debenture. The over all cost of capital is 12%. Find out value of the firm and equity capitalization rate under NOI approach.

51. Problem no 3 A company ltd has furnish the following information calculate firm value and equity capitalization rate under NOI approach Particulars Existing capital structure Proposed capital structure EBIT 120000 120000 Debt @10% 100000 400000 Equity capitalization rate ? ? Over all cost of capital 12% 12%

52. ‘ Calculation of value of firm and equity capitalization rate under NOI approach Particular Existing capital structure Proposed capital structure EBIT 120000 120000 Less interest 10000 40000 Net income 110000 80000 Value of firm 12000/0.12 1000000 1000000 Equity capitalization rate (NI/E)*100 12.22% 13.33%

53. Problem no 4 A firm has an EBIT of Rs 2,00,000 and belongs to a risk class of 10%. What is the value of equity capital if it employees 6% debt to the extent of 30%, 40% or 50% of the capital fund of Rs 10,00,000 under NOI approach.

54. . Calculation of value of firm under NOI approach Particular 30% Debt (300000) 40% Debt (400000) 50% Debt (500000) EBIT 200000 200000 200000 Less interest 18000 24000 30000 Net income 182000 176000 170000 Total Value of the firm (200000/.10) 2000000 2000000 2000000 Less value of debt 300000 400000 500000 Value of equity 1700000 1600000 150000 Equity capitalization rate 10.7% 11% 11.33%

55. ‘ The cost of equity capital ( Ke ) of 10.7%, 11% and 11.33% can be verified for different proportion of debt by calculating WACC as follows: For 30% Debt: 𝐾𝑂 = 0.107 ∗ 17,00,000 /20,00,000 + 0.06 ∗ 3,00,000/ 20,00,000 = 0.10 𝑜𝑟 10% For 40% Debt : 𝐾𝑂 = 0.11 ∗ 16,00,000/ 20,00,000 + 0.06 ∗ 4,00,000 /20,00,000 = 0.10 𝑜𝑟 10% For 50% Debt: 𝐾𝑂 = 0.1133 ∗ 15,00,000/ 20,00,000 + 0.06 ∗ 5,00,000 /20,00,000 = 0.10 𝑜𝑟 10%

56. Problems of Traditional approach Indra ltd has EBIT of Rs 100000, the company make use of debt and equity capital. The firm has 10% debenture of Rs 500000 and firm equity capitalization rate is 15% You are require to compute Firm value Over all cost of capital

57. Firm value = 833333 WACC= 12%

58. . Determine the optimal capital structure of a company from the following information Options Cost of debt (%) Cost of equity (%) Percentage of debt on total value 1 11 13 2 11 13 10 3 11.6 14 20 4 12 15 30 5 13 16 40 6 15 18 50 7 18 20 60

59. . Alpha ltd and beta ltd are identical except for capital structure. Alpha ltd has 50% debt and 50% equity where as beta ltd has 20% debt and 80% equity(all % are in market value terms). The borrowing rate for both companies is 8% in a no tax world and capital markets are assumed to be perfect. A) 1)If you own 2% of the shares of Alpha ltd, determine your return if the company has net operating income of Rs 360000 and the overall capitalization rate of the company Ko is 18%? 2) calculate the implied required rate of return on equity B) Beta ltd has the same net operating income as Alpha ltd 1) determine the implied required equity return of beta ltd 2) analyze why does it differ from that of alpha ltd?

60. . Particulars Alpha ltd Debt(50%) Beta ltd Debt(20%) EBIT 360000 360000 Less interest @8% Net income Total value of firm 360000/0.18 2000000 2000000 Less value of debt Value of equity Calculation of equity capitalization rate

61. MM approach:1958 without tax 1) Value of firm V= NOI Ko 2) A firm having debt in capital structure has higher cost of equity than an unlevered firm. The cost of equity in a levered firm is determined as under Ke = Ko +( Ko-Kd )Debt/equity 3) The structure of the capital does not affect the overall cost of capital. The cost of capital is only affected by the business risk.

62. Shortcoming of this approach Arbitrage process fails to work because Capital market is not perfect Existence of transaction cost Existence of tax Non homogeneous risk class

63. MM approach 1963 with tax In 1963 MM model was amended by incorporating tax they recognized that the value of the firm will increase or cost of capital will decrease where corporate taxes exist. As a result, there will be some difference in the earning of equity and debt holders in levered and unlevered firm and value of levered firm will be greater than the value of unlevered firm by an amount equal to amount of debt multiplied by corporate tax rate

64. MM has developed the formulae for computation of cost of capital, cost of equity for the levered firm. 1) Value of levered firm= value of unlevered firm+ tax benefits V= Vu + TB 2) Cost of equity in a levered firm is Ke = Keu+(Keu- Kd )Debt/equity + debt

65. WACC in levered firm K OL = K OU (1-TL) KOL= overall cost of capital in levered firm KOU= overall cost of capital in unlevered firm T= tax L = leverage ( debt/ debt+equity )

66. . There are two company N ltd and M ltd having EBIT is 20000. M ltd is a levered company having a debt of 100000 @ 7%rate of interest. The cost of equity of N ltd is 10% and M ltd is 11.50% Compute how arbitrage process will be carried on Given Particulars M ltd N ltd EBIT 20000 20000 debt 100000 ---------------- Ke 11.5% 10% Kd 7% ----------------

67. . M ltd N ltd EBIT 20000 20000 Less interest @ 7% 7000 -------- Net income 13000 20000 Value of equity (Net income/ ke ) 113043 200000 Add debt 100000 ----- Total value of firm 213043 200000

68. Step 1 if you have 10% shares in M ltd Your total investment=(113043*10/100)= 11304 Your return is 10% on net income (13000*10/100)= 1300 Step 2 sell the shares of M ltd and barrow 10% debt(100000*10/100) sales amount = 11304 + barrowed amount = 10000 you have total source = 21304

69. Step 3 invest 10% in N ltd( unlevered ) Your total source = 21304 10% of N ltd (200000*10/100) = 20000 your surplus will be = 1304 Step 4 your return in unlevered firm 10% of net income in N ltd (20000*10/100) = 2000 less intest for debt 10000*7/100 = 700 your final return will be = 1300

70. . i.e. your return is same i.e. 1300 which are getting from N ltd. Before investing in M ltd. But still you have Rs 1304 excess money available with you. Hence, you are better off by doing arbitrage.

71. . A and B firms are identical in all aspect except capital structure B firm is levered firm with total 6% debt of Rs 500000. EBIT of both the firm is Rs 90000 Cost of equity of A ltd is 10% and B ltd is 15% Compute how arbitrage process will be carried on ?