Theories Of Capital Structure
This document was uploaded by user and they confirmed that they have the permission to share it. If you are author or own the copyright of this book, please report to us by using this DMCA report form. Report DMCA
Overview
Download & View Theories Of Capital Structure as PDF for free.
More details
- Words: 1,724
- Pages: 28
Theories of capital structure
Net Income Approach Net Operating Income Approach The Traditional Approach Modiglianni and Miller Apprach
Net Income Approach
A firm can minimize the weighted average cost of capital and increase the value of the firm as well as 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 perception of investors in not changed by the use of debt.
Value of Firm (N I Approach)
Total Value of firm (V)= S + D S= Market Value of equity shares = Earning available to equity shareholders Equity Capitalisation rate D= Market Value of debt
And overall weighted avg cost of capital will be calculated as: K0= EBIT / V For example: (k) A company expects a net income of Rs 80,000. It has Rs 2,00,000, 8% debentures. The equity capitalisation rate of the company is 10%. Calculate the value of the firm and overall capitalisation rate according to the Net Income Approach (ignoring income tax) (l) If the company debt is increased to Rs 3,00,000, what will be the value of the firm and the overall capitalisation rate.
(a)
Net income Less: interest on 8% debentures of Rs 2,00,000 Earning available to equity shareholders Equity capitalisation rate
80,000 16,000 64,000 10%
Market value of equity (S)= 64,000 x (100/10) Market value of debentures (D) Value of firm (S+D) Overall cost of capital (EBIT/ V) = 80,000/8,40,000) x 100 = 9.52% (b) Net income Less: interest on 8% debentures of Rs 3,00,000 Earning available to equity shareholders Equity capitalisation rate
6,40,000 2,00,000 8,40,00 0
Market value of equity (S)= 56,000 x (100/10) Market value of debentures (D) Value of firm (S+D) Overall cost of capital (EBIT/ V) = 80,000/8,60,000) x 100 = 9.30%
5,60,000 3,00,000 8,60,00 0
80,000 24,000 56,000 10%
Net Operating Income Approach
Change in capital structure of a company does not effect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. 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 lenders is not affected. Thus, the advantage of using the cheaper source of funds, i.e. debt is exactly offset
Value of Firm (N O- I Approach) V=EBIT/K0 where, V=Value of firm & K0 is cost of capital The market value of equity, according to this approach is the residual value which is determined by deducting the market value of debentures from the total market value of the firm. S = V - D where, S is Market value of equity, V is Market value of firm and D is Market value of debt. For example; A company expects a net operating income of Rs 1,00,000. It has Rs 5,00,000, 6% Debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate (cost of equity). If debenture debt is increased to Rs 7,50,000, what will be the effect on the value of the firm and the equity capitalization
Net Operating income Overall cost of capital Market value of firm (V) = 1,00,000x(100/10) Less: Market value of debentures (D) Total Market value of Equity Equity capitalisation rate or Cost of equity (Ke) is: (EBIT - I / V - D) = (1,00,000 – 30,000/5,00,000)x100 = 14% If the debt is increased to Rs 7,50,000, the value of the firm shall remain unchanged at Rs 10,00,000, the equity capitalization rate will increase as follows: Equity capitalization rate (Ke) is as follows: (EBIT - I / V - D) = (1,00,000 – 45,000/2,50,000)x100 = 22%
1,00,00 0 10% 10,00,0 00 5,00,00 0 5,00,00 0
The Traditional Approach
This is an intermediate approach According to this theory, overall cost of capital decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter, and increases or rises beyond a certain point. Thus, the optimum capital structure can be reached by a proper debtequity mix.
Value of firm (Traditional Approach) (d) (e) (f)
Net operating income Rs 2,00,000 Total investment Rs 10,00,000 Equity capitalisation rate, if; The firm uses no debt 10% The firm uses Rs 4,00,000 debentures 11% The firm uses Rs 6,00,000 debentures 13% Assume that Rs 4 lacs debentures can be raised at 5% rate of interest whereas Rs 6 lacs debentures can be raised at 6% rate of inerest.
Net operating income Less: Interest Earning available to equity shareholders (a) Equity capitalisation rate Market Value of share (a x 100/capt rate) Market value of debt Market value of firm Average cost of capital (EBIT/V)
(a) no debt
2,00,000
2,00,000 10% 20,00,000 20,00,000 10%
(b)
(c)
2,00,000 20,000 1,80,000 11% 16,36,000 4,00,000 20,36,36 3 9.8%
2,00,000 36,000 1,64,00 0 13% 12,61,53 8 6,00,000 18,61,5 38 10.7%
Modigliani and Miller Approach
If taxes are ignored, it is identical with Net Operating approach. If taxes are assumed to exist, it is similar to the Net Income Approach.
Point of Indifference
A project under consideration by your company requires a capital investment of Rs 60 Lakhs. Interest on term loan is 10% p.a. and tax rate is 50%. Calculate the point of indifference for the project, if the debt-equity ratio is insisted by financing agencies 2:1. Company has two options, 1) to raise entire amount through equity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs by way of equity. The point of indifference would be: {(X-I1) (1-t) – PD}/S1 = {(X-I2) (1-t) – PD}/S2 , where; X is point of indifference I1, I2 is interest under both alternatives, t is tax rate assume to be 50% PD is preference dividend and S1, S2 is amount of equity under different alternatives {(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20 .5X/60 = .5X – 2/20 10X = 30X-120 X=6 In case, the firm has EBIT level below Rs 6 lakhs then equity financing is preferable to debt financing; but if the EBIT is higher
Factors Determining the Capital Structure 1. 2. 3. 4. 5. 6. 7. 8.
Financial Leverage Growth and stability of sales Cost of Capital Cash Flow ability to service debt Nature and size of firm Control Flexibility Requirements of investors
1. 2. 3. 4. 5. 6.
Capital Market Conditions Assets Structure Purpose of financing Period of finance Costs of floatation Legal requirements
Cost of Capital
3. 4. 5. 6.
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. It is important in financial management, because; As an acceptance criterion in capital budgeting As a determinant of capital mix in capital structure decisions As a basis for evaluating financial performance As a basis for taking other financial decisions
Cost of debt Cost of preference capital Cost of equity capital Cost of retained earning And weighted average cost of capital is the average cost of the costs of above sources. It is also known as ‘overall cost of capital’.
EVALUATION OF INVESTMENT DECISIONS
Estimation of Cash Flows Determining the Rate of Discount or Cost of Capital Applying the technique of Capital Budgeting to determine the viability of Investment Proposal
Types Of Cash Flows
Initial Investment or Cash Outlay Operating Cash Flows or Net Annual Cash Flows Terminal Cash Flows
Capital Budgeting Techniques
Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involve the comparison of the expected future streams of earnings from a project, with the immediate and subsequent streams of expenditures for it.
Capital Budgeting Techniques (2) (3) (4) (6) (7) (8) (9)
Non Discounted Method Pay Back Method Rate of return or Accounting method Urgency Method Discounted Method Discounted pay back method Net Present Value Method Internal Rate of Return Method Profitability Index
Risk Analysis in Capital Budgeting
Risk Adjusted Discount Rate Certainity Equivalent Method Sensitivity Analysis Probability Analysis Standard Deviation method Decision Tree Analysis
Working Capital Management
Working Capital is the amount of funds necessary to cover the cost of operating the enterprise. Gross Vs Net Working Capital Gross is total of Current Assets Net Working Capital = C.A. – C.L. Permanent Vs Temporary Working Capital
Factors affecting Working Capital Requirement
Nature of Business Size of Business Production Policy Manufacturing Process Seasonal Variations Operating cycle Rate of Stock Turnover Credit policy Business Cycles Rate of growth of Business Earning capacity and Dividend Policy Price never changes
Financing of Working Capital
(d) (e) (f)
Permanent Vs Temporary Working Capital Requirement Long Term Vs Short Term Sources Approaches for determining W.C. financing mix Conservative approach Aggressive approach Hedging or Matching approach
Motives for Holding Cash
Transaction motive Precautionary motive Speculative motive Compensatory motive
Managing Cash flows (2) (3) (4) (5) (7) (8)
Accelerating Cash Inflows Prompt payment by customers Quick conversion of payment into cash Decentralized collections Lock box systems Delaying Cash Outflows Paying on last date Centralization of payments
Investment of Surplus Funds
Treasury bills Certificate of deposits Inter-corporate deposits Commercial papers Money market mutual funds
Receivables Management
(iii) (iv) (v)
Receivables represent amounts owed to the firm as a result of sale of goods or service on credit in the ordinary course of business. Cost of maintaining receivables Cost of financing receivables Cost of collection Bad debts
Factor Affecting the Size of Receivables
Size of credit sales Credit policy Terms of trade Expansion plans Relation with profits Credit collection efforts Habits of cutomers
Dimension of Receivables Management
Forming a Credit Policy Executing a Credit Policy Formulating and Executing Collection policy
Net Income Approach Net Operating Income Approach The Traditional Approach Modiglianni and Miller Apprach
Net Income Approach
A firm can minimize the weighted average cost of capital and increase the value of the firm as well as 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 perception of investors in not changed by the use of debt.
Value of Firm (N I Approach)
Total Value of firm (V)= S + D S= Market Value of equity shares = Earning available to equity shareholders Equity Capitalisation rate D= Market Value of debt
And overall weighted avg cost of capital will be calculated as: K0= EBIT / V For example: (k) A company expects a net income of Rs 80,000. It has Rs 2,00,000, 8% debentures. The equity capitalisation rate of the company is 10%. Calculate the value of the firm and overall capitalisation rate according to the Net Income Approach (ignoring income tax) (l) If the company debt is increased to Rs 3,00,000, what will be the value of the firm and the overall capitalisation rate.
(a)
Net income Less: interest on 8% debentures of Rs 2,00,000 Earning available to equity shareholders Equity capitalisation rate
80,000 16,000 64,000 10%
Market value of equity (S)= 64,000 x (100/10) Market value of debentures (D) Value of firm (S+D) Overall cost of capital (EBIT/ V) = 80,000/8,40,000) x 100 = 9.52% (b) Net income Less: interest on 8% debentures of Rs 3,00,000 Earning available to equity shareholders Equity capitalisation rate
6,40,000 2,00,000 8,40,00 0
Market value of equity (S)= 56,000 x (100/10) Market value of debentures (D) Value of firm (S+D) Overall cost of capital (EBIT/ V) = 80,000/8,60,000) x 100 = 9.30%
5,60,000 3,00,000 8,60,00 0
80,000 24,000 56,000 10%
Net Operating Income Approach
Change in capital structure of a company does not effect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. 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 lenders is not affected. Thus, the advantage of using the cheaper source of funds, i.e. debt is exactly offset
Value of Firm (N O- I Approach) V=EBIT/K0 where, V=Value of firm & K0 is cost of capital The market value of equity, according to this approach is the residual value which is determined by deducting the market value of debentures from the total market value of the firm. S = V - D where, S is Market value of equity, V is Market value of firm and D is Market value of debt. For example; A company expects a net operating income of Rs 1,00,000. It has Rs 5,00,000, 6% Debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate (cost of equity). If debenture debt is increased to Rs 7,50,000, what will be the effect on the value of the firm and the equity capitalization
Net Operating income Overall cost of capital Market value of firm (V) = 1,00,000x(100/10) Less: Market value of debentures (D) Total Market value of Equity Equity capitalisation rate or Cost of equity (Ke) is: (EBIT - I / V - D) = (1,00,000 – 30,000/5,00,000)x100 = 14% If the debt is increased to Rs 7,50,000, the value of the firm shall remain unchanged at Rs 10,00,000, the equity capitalization rate will increase as follows: Equity capitalization rate (Ke) is as follows: (EBIT - I / V - D) = (1,00,000 – 45,000/2,50,000)x100 = 22%
1,00,00 0 10% 10,00,0 00 5,00,00 0 5,00,00 0
The Traditional Approach
This is an intermediate approach According to this theory, overall cost of capital decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter, and increases or rises beyond a certain point. Thus, the optimum capital structure can be reached by a proper debtequity mix.
Value of firm (Traditional Approach) (d) (e) (f)
Net operating income Rs 2,00,000 Total investment Rs 10,00,000 Equity capitalisation rate, if; The firm uses no debt 10% The firm uses Rs 4,00,000 debentures 11% The firm uses Rs 6,00,000 debentures 13% Assume that Rs 4 lacs debentures can be raised at 5% rate of interest whereas Rs 6 lacs debentures can be raised at 6% rate of inerest.
Net operating income Less: Interest Earning available to equity shareholders (a) Equity capitalisation rate Market Value of share (a x 100/capt rate) Market value of debt Market value of firm Average cost of capital (EBIT/V)
(a) no debt
2,00,000
2,00,000 10% 20,00,000 20,00,000 10%
(b)
(c)
2,00,000 20,000 1,80,000 11% 16,36,000 4,00,000 20,36,36 3 9.8%
2,00,000 36,000 1,64,00 0 13% 12,61,53 8 6,00,000 18,61,5 38 10.7%
Modigliani and Miller Approach
If taxes are ignored, it is identical with Net Operating approach. If taxes are assumed to exist, it is similar to the Net Income Approach.
Point of Indifference
A project under consideration by your company requires a capital investment of Rs 60 Lakhs. Interest on term loan is 10% p.a. and tax rate is 50%. Calculate the point of indifference for the project, if the debt-equity ratio is insisted by financing agencies 2:1. Company has two options, 1) to raise entire amount through equity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs by way of equity. The point of indifference would be: {(X-I1) (1-t) – PD}/S1 = {(X-I2) (1-t) – PD}/S2 , where; X is point of indifference I1, I2 is interest under both alternatives, t is tax rate assume to be 50% PD is preference dividend and S1, S2 is amount of equity under different alternatives {(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20 .5X/60 = .5X – 2/20 10X = 30X-120 X=6 In case, the firm has EBIT level below Rs 6 lakhs then equity financing is preferable to debt financing; but if the EBIT is higher
Factors Determining the Capital Structure 1. 2. 3. 4. 5. 6. 7. 8.
Financial Leverage Growth and stability of sales Cost of Capital Cash Flow ability to service debt Nature and size of firm Control Flexibility Requirements of investors
1. 2. 3. 4. 5. 6.
Capital Market Conditions Assets Structure Purpose of financing Period of finance Costs of floatation Legal requirements
Cost of Capital
3. 4. 5. 6.
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. It is important in financial management, because; As an acceptance criterion in capital budgeting As a determinant of capital mix in capital structure decisions As a basis for evaluating financial performance As a basis for taking other financial decisions
Cost of debt Cost of preference capital Cost of equity capital Cost of retained earning And weighted average cost of capital is the average cost of the costs of above sources. It is also known as ‘overall cost of capital’.
EVALUATION OF INVESTMENT DECISIONS
Estimation of Cash Flows Determining the Rate of Discount or Cost of Capital Applying the technique of Capital Budgeting to determine the viability of Investment Proposal
Types Of Cash Flows
Initial Investment or Cash Outlay Operating Cash Flows or Net Annual Cash Flows Terminal Cash Flows
Capital Budgeting Techniques
Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involve the comparison of the expected future streams of earnings from a project, with the immediate and subsequent streams of expenditures for it.
Capital Budgeting Techniques (2) (3) (4) (6) (7) (8) (9)
Non Discounted Method Pay Back Method Rate of return or Accounting method Urgency Method Discounted Method Discounted pay back method Net Present Value Method Internal Rate of Return Method Profitability Index
Risk Analysis in Capital Budgeting
Risk Adjusted Discount Rate Certainity Equivalent Method Sensitivity Analysis Probability Analysis Standard Deviation method Decision Tree Analysis
Working Capital Management
Working Capital is the amount of funds necessary to cover the cost of operating the enterprise. Gross Vs Net Working Capital Gross is total of Current Assets Net Working Capital = C.A. – C.L. Permanent Vs Temporary Working Capital
Factors affecting Working Capital Requirement
Nature of Business Size of Business Production Policy Manufacturing Process Seasonal Variations Operating cycle Rate of Stock Turnover Credit policy Business Cycles Rate of growth of Business Earning capacity and Dividend Policy Price never changes
Financing of Working Capital
(d) (e) (f)
Permanent Vs Temporary Working Capital Requirement Long Term Vs Short Term Sources Approaches for determining W.C. financing mix Conservative approach Aggressive approach Hedging or Matching approach
Motives for Holding Cash
Transaction motive Precautionary motive Speculative motive Compensatory motive
Managing Cash flows (2) (3) (4) (5) (7) (8)
Accelerating Cash Inflows Prompt payment by customers Quick conversion of payment into cash Decentralized collections Lock box systems Delaying Cash Outflows Paying on last date Centralization of payments
Investment of Surplus Funds
Treasury bills Certificate of deposits Inter-corporate deposits Commercial papers Money market mutual funds
Receivables Management
(iii) (iv) (v)
Receivables represent amounts owed to the firm as a result of sale of goods or service on credit in the ordinary course of business. Cost of maintaining receivables Cost of financing receivables Cost of collection Bad debts
Factor Affecting the Size of Receivables
Size of credit sales Credit policy Terms of trade Expansion plans Relation with profits Credit collection efforts Habits of cutomers
Dimension of Receivables Management
Forming a Credit Policy Executing a Credit Policy Formulating and Executing Collection policy
Related Documents
Theories Of Capital Structure
May 2020 30
Capital Structure
May 2020 30
Capital Structure
May 2020 30
Capital Structure
June 2020 25
Capital Structure
May 2020 35
Capital Structure
April 2020 29More Documents from ""
Theories Of Capital Structure
May 2020 30
Financial Management
May 2020 28
Accounting For Managers
May 2020 20
Tqm Final
May 2020 14
20816205
April 2020 54