Advanced Financial Management
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Advanced financial management
Corporate finance Capital structure: capital structure refers to the make-up of its capitalization and it includes all long term capital resources like shares,loans,reserves and bonds
Capitalization includes capital stock and debt. Capitalization is the total accounting value of the stock, surprises in whatever form it may appear and long term debt
Essentials of an optimum capital structure
Flexibility Economy Solvency Efficiency Simplicity Safety control
Determinants of capital structure
Nature of business Stability of earning Growth rate Nature of investors ROI Trends in capital market Government regulations
Capital structure decision
In capital structure decision such alternative should be selected which will give the highest EPS/MPS as the case may be.
Theories of capital structure
Net income approach Net operating income approach The traditional approach MM approach
Net income approach: It states that a firm can minimize the WACC and increase the value of the firm as well the market price of equity shares by using debt financing to the maximum possible extent
Assumptions: The cost of debt is less than the cost of equity there are no taxes The risk perceptions of the investors is not changed by the use of debt.
The increase in the debt financing in the capital structure decreases the proportion of equity capital and this results in decrease in the WACC resulting in an increase in the value of the firm.
The cost of debt is less that the cost of equity because of two reasons : Debt involves less risk than equity Interest being a tax deductible expenses
Net operating income approach
Net operating income approach is propounded by Durand.This theory is diametrically opposite to the net income approach theory.
According to this theory changes in the capital structure of a company does not affect the market value of the and the overall cost of capital remains constant irrespective of the method of financing. The Debt-equity mix has no influence on the overall cost of capital of the firm
Assumptions The market capitalizes the value of the firm as a whole The business risk remains constant at every level of debt-equity mix.
According to this theory with the increased use of debt in the capital structure it increases the financial risk of the equity shareholders and hence the cost of capital increases
Traditional approach
According to this approach the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. There are two types of risks
Business risk Financial risk
Assumption The capital structure of a firm consists of only two kinds of capital debt and equity shares The business risk of the company remains constant overtime and is assumed to be independent of its capital structure and financial risk The firm has a perpetual life Corporate income tax does not exist
Transaction costs are assumed to be nil The operating income of the company is assumed not to grow over time
The traditional theory states that the financing pattern should include moderate proportion of debt which would result in safety to the creditors claims as well as least cost accounting
Modigliani-Miller approach
This approach states that the average cost of capital of any firm is independent of its capital structure and equal to the capitalization rate of pure equity streams of its class. The value of the firm and cost of capital is the same for all the firms irrespective of the proportion of debt included in a firms capital structure.
Assumptions All the firms in a class can be termed as homogenous and placed in an equvalent risk class. Capital markets are perfect and investors are rational There does not exist ant transactions cost The dividend payout ratio is 100 percent
Criticisms Personal leverage is not equivalent to corporate leverage Due to the capital market imperfections the cost of borrowing may be higher than for the individual than for the corporate In the actual practice there are transaction cost in the form of brokerage,underwritting ,commission etc.
Corporate finance Capital structure: capital structure refers to the make-up of its capitalization and it includes all long term capital resources like shares,loans,reserves and bonds
Capitalization includes capital stock and debt. Capitalization is the total accounting value of the stock, surprises in whatever form it may appear and long term debt
Essentials of an optimum capital structure
Flexibility Economy Solvency Efficiency Simplicity Safety control
Determinants of capital structure
Nature of business Stability of earning Growth rate Nature of investors ROI Trends in capital market Government regulations
Capital structure decision
In capital structure decision such alternative should be selected which will give the highest EPS/MPS as the case may be.
Theories of capital structure
Net income approach Net operating income approach The traditional approach MM approach
Net income approach: It states that a firm can minimize the WACC and increase the value of the firm as well the market price of equity shares by using debt financing to the maximum possible extent
Assumptions: The cost of debt is less than the cost of equity there are no taxes The risk perceptions of the investors is not changed by the use of debt.
The increase in the debt financing in the capital structure decreases the proportion of equity capital and this results in decrease in the WACC resulting in an increase in the value of the firm.
The cost of debt is less that the cost of equity because of two reasons : Debt involves less risk than equity Interest being a tax deductible expenses
Net operating income approach
Net operating income approach is propounded by Durand.This theory is diametrically opposite to the net income approach theory.
According to this theory changes in the capital structure of a company does not affect the market value of the and the overall cost of capital remains constant irrespective of the method of financing. The Debt-equity mix has no influence on the overall cost of capital of the firm
Assumptions The market capitalizes the value of the firm as a whole The business risk remains constant at every level of debt-equity mix.
According to this theory with the increased use of debt in the capital structure it increases the financial risk of the equity shareholders and hence the cost of capital increases
Traditional approach
According to this approach the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. There are two types of risks
Business risk Financial risk
Assumption The capital structure of a firm consists of only two kinds of capital debt and equity shares The business risk of the company remains constant overtime and is assumed to be independent of its capital structure and financial risk The firm has a perpetual life Corporate income tax does not exist
Transaction costs are assumed to be nil The operating income of the company is assumed not to grow over time
The traditional theory states that the financing pattern should include moderate proportion of debt which would result in safety to the creditors claims as well as least cost accounting
Modigliani-Miller approach
This approach states that the average cost of capital of any firm is independent of its capital structure and equal to the capitalization rate of pure equity streams of its class. The value of the firm and cost of capital is the same for all the firms irrespective of the proportion of debt included in a firms capital structure.
Assumptions All the firms in a class can be termed as homogenous and placed in an equvalent risk class. Capital markets are perfect and investors are rational There does not exist ant transactions cost The dividend payout ratio is 100 percent
Criticisms Personal leverage is not equivalent to corporate leverage Due to the capital market imperfections the cost of borrowing may be higher than for the individual than for the corporate In the actual practice there are transaction cost in the form of brokerage,underwritting ,commission etc.
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