CAPITAL STRUCTURE AND COST OF CAPITAL

MODULE 4

CAPITAL STRUCTURE

Capital structure refers to permanent financing of a firm and it is made up of debt and equity securities . It is composed of long term debt capital, preference share capital and equity share capital. It refers to the kinds of securities and the proportionate amounts that make up capitalization. Capitalization refers to the total amount of securities issued by the company. Financial structure refers to all the financial resources marshalled by the firm, short term as well as long term, and all forms of debt as well as equity. Gerestenbeg capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources viz: loans, reserves, shares and bonds.``

FORMS / PATTERN OF CAPITAL STRUCTURE

Equity shares only Equity shares and preference shares Equity shares and debentures Equity shares, preference shares and debentures

OPTIMAL CAPITAL STRUCTURE

It may be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm It maximises the value of the company and hence the wealth of its owners and minimises the companys cost of capital. The following points should be considered:

If the return on investment is higher than the fixed costs of funds, the company should prefer to raise funds having a fixed cost. It will increase EPS and the market value of the firm. A company should take advantage of tax leverage The firm should avoid undue financial risk attached with the use of increased debt financing. The capital structure should be flexible.

THEORIES OF CAPITAL STRUCTURE

Net income approach Net operating income approach Traditional approach Modigliani and Miller approach

NET INCOME APPROACH

According to this approach, a firm can minimise 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. The theory propounds that a company can increase its value and reduce the overall cost of capital by increasing the proportion of debt in its capital structure. Assumptions:

The cost of debt is less than the cost of equity. There are no taxes The risk perception of investors is not changed by the use of debt. (FIGURE)

NET INCOME APPROACH

Total value of the firm and overall cost of capital on the basis of NI approach: V= S+D V = total value of the firm S = market value of equity shares. = Earnings Available To Equity Shareholders Equity Capitalization Rate D = market value of debt Ko = overall/weighted average cost of capital Ko = EBIT V

NET OPERATING INCOME APPROACH (Durand)

It is diametrically opposite to the Net Income approach. According to this approach, change in the capital structure of the company does not affect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing. Assumptions:

The market capitalizes the value of the firm as a whole. There are no corporate taxes The business risk remains constant at every level of debt equity mix. (FIGURE)

NET OPERATING INCOME APPROACH

Total value of the firm on the basis of NOI approach: V = EBIT Ko The market value of the 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

TRADITIONAL APPROACH

It is also known as intermediate approach and it is a compromise between the extremes of Net Income approach and Net Operating Income approach. According to this approach, the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as debt is a cheaper source of funds than equity. Thus optimal capital structure can be reached proper debt equity mix.
Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. (FIGURE)

MODIGLIANI AND MILLER APPROACH

In the absence of taxes: (theory of irrelevance)

Identical to NOI approach: this theory proves that the cost of capital is not affected by changes in the capital structure or debt equity mix is irrelevant in the determination of the total value of a firm. Reason: Though debt is cheaper to equity with the increased use of debt the cost of equity increases. This increase in cost of equity offsets the advantage of the low cost of debt. Thus overall cost of capital remains same. Theory emphasis that a firm operating income is a determinant of its total value.

MODIGLIANI AND MILLER APPROACH

In the absence of taxes: (theory of irrelevance) Assumptions:

There are no taxes There is a prefect market Investors act rationally The expected earnings of all firms have identical risk characteristics The cut off point of investment in a firm is capitalization rate Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the actual value of the variables may turn out to be different from their best estimates. All earnings are distributed to the shareholders (FIGURE)

MODIGLIANI AND MILLER APPROACH

(b) When the corporate taxes are assumed to exist: (theory of relevance) Identical to NI approach:
According to this approach 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 charges for tax purpose. Thus, the optimum capital structure can be achieved by maximising the debt mix in the equity of a firm.

MODIGLIANI AND MILLER APPROACH

(b) When the corporate taxes are assumed to exist: (theory of relevance) Identical to NI approach:
Value

of unlevered firm (Vu) = EBIT (1- t) Ko + Value of levered firm (VL) = Vu + tD (FIGURE)

FACTORS DETERMINING THE CAPITAL STRUCTURE

Financial leverage/ trading on equity Growth and stability of sales Cost of capital Cash flow ability to service debt Nature and size of a firm Control Flexibility Requirements of investors Capital market conditions

FACTORS DETERMINING THE CAPITAL STRUCTURE( CDTN)

Assets structure Purpose of financing Period of finance Costs of floatation Personal considerations Corporate tax rate Legal requirements

COST OF CAPITAL
SECOND PART

COST OF CAPITAL
The cost of capital of a firm is the minimum required rate of return expected by the investors. It may be defined as the cost of obtaining funds, i.e. the average rate of return that the investors in a firm would expect for supplying funds to the firm. Solomon Ezra cost of capital is the minimum required rate of earnings or the cut off rate of the capital expenditures.

K = ro + b +f

SIGNIFICANCE OF COST OF CAPITAL

As an acceptance criterion in capital budgeting As a determinant of capital mix in capital structure decisions As a basis for evaluating the financial performance As a basis for taking other financial decisions.

PROBLEMS IN DETERMINATION OF COST OF CAPITAL Conceptual controversies regarding the relationship between the cost of capital and capital structure. Historic cost and future cost Problems in computation of cost of equity Problems in computation of cost of retained earnings. Problems in assigning weights

COMPUTATION OF COST OF CAPITAL

Computation of cost of specific sources of finance

Cost

of debt Cost of preference share capital Cost of equity share capital Cost of retained earnings

Computation of weighted average cost of capital

Cost of debt
The cost of debt is the rate of interest payable on debt. Kdb = I P I = Interest P = principal Kdb = before tax cost of debt

Incase debt is raised at a premium or discount consider p as net proceeds (NP). Thus Kdb= I/ NP

Cost of debt ( after tax)

Kda

I P Kda

I * (1- t) P = Interest = principal = after tax cost of debt

=

Incase debt is raised at a premium or discount consider p as net proceeds (NP). Thus Kda= I/ NP (1- t)

Cost of debt (redeemable debt)

Kdb = I + (RV-NP)/n RV+NP/2 Kda = I +(1-t) (RV-NP)/n RV+NP/2 RV = Redeemable value NP = Net proceeds I = Interest n = No: of years or maturity year.

Cost of preference share capital

It is a function of dividend expected by its investors i.e. its fixed dividend. Kp = D NP Cost of redeemable preference shares: Kp = D+ (MV-NP)/n MV+NP/2 MV = Maturity value D = dividend

Cost of equity capital

The return that stockholders require or expect from a company.

Ke = D + G NP A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.( see note )

Cost of retained earnings

It may be considered as the rate of return which the existing shareholders can be obtain by investing the after tax dividends in alternative opportunity of equal qualities. It is the opportunity cost of dividends foregone by the shareholders. Kr = D + G * (1- t) * (1-b) NP Kr = Ke (1- t) ( 1- b) Kr = Cost of retained earnings b = Cost of purchasing new securities or brokerage costs. t = tax rate. The shareholders are required to pay tax on their dividend income.

WEIGHTED AVERAGE COST OF CAPITAL

It is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. Kw = zigma XW zigma W The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: WACC = E/V x Ke + D/V x Kd WACC = E/V x Ke + D/V x Kd x (1-tax rate)

WEIGHTED AVERAGE COST OF CAPITAL

WACC = E/V x Ke + D/V x Kd WACC = E/V x Ke + D/V x Kd x (1-tax rate)

Ke = cost of equity Kd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V =E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt

CAPM CAPITAL ASSET PRICING METHOD

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. Ke = risk free rate of interest + premium for risk Premium for risk is the difference between the market return from a diversified portfolio and the risk free rate of return indicated in terms of beta co-efficient. Risk premium = market retrun on diversified portfolio -- risk free dividend * B i Ke = Rf + Bi (Rm- Rf)

Ke = Rf + Bi (Rm- Rf)
Ke

= Cost of equity capital Rf = risk free rate of return Bi = beta co- efficient of firms portfolio Rm = market return of diversified portfolio

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