capital structure.ppt

Capital structure

Capital structure

Capital Budgeting Decision Capital Budgeting Decision expansion

expansion

Replacement

Replacement ModernizationModernization

Need to Raises Fund Need to Raises Fund Capital Structure Decision Capital Structure Decision

Existing cap Existing cap

structure

structure DesiredDesired

Debt-Equity mix Debt-Equity mix ayout ayout olicy olicy

E##ect E##ect $n Return $n Return E##ect on E##ect on R%S& R%S& E##ect on E##ect on Cost $F Capital Cost $F Capital 'alue o#  'alue o#  Firm Firm $ptimum $ptimum Capital structure Capital structure

Components of Capital

Components of Capital

Teerm rm LoanLoanss •• EquityEquity Equity shares Equity shares Preference Shares Preference Shares Retained Earnings Retained Earnings

Capital Structure

• The capital structure of a company refers to the mix of the long-term finances used in the organization

• !s the proportion of Debt increases in the capital structure of an

organization " the ris# of shareholders increases.

Capital structure

• Mix of long-term finance used by the firm .  Authorized Capital of Rs. 1 each

!ssued" subscribed and paid up capital

#resent issue

• $%uity at par  

• 1&' secured loan (erm loan from ban) *uyers credit   +"""   ,"""   1+"/0""   &"""   "&""   1/""" 1"0,"""

actors Affecting the capital structure

• Cost of capital

• Cash flo2 pro3ections of the company • Size of the company

• 4ilution of control • loatation costs

5ptimal capital structure

• lexibility • Control • sol6ency

(heories of capital structure

• $et (perating &ncome approach %$(&' • Traditional !pproach

!n the theories 2e 2ill study

*hat is the impact of 

change in capital Structure

- (n the +alue of the firm

.d/012 .e/E1S .o/3.d421%25S'65 3.e4S1%25S'6 or (1+ +/25S 0 K 

K _oo = Total cost of capital= Total cost of capital K 

K dd = Cost of debt= Cost of debt

K 

K ee = Cost of equity = Cost of equity 

 V = Value of the Firm  V = Value of the Firm

B = Market value of debt B = Market value of debt

S = market value of equity  S = market value of equity 

(!Kd"t

B=

S=

#

7! Approach

*hile increasing the le,erage in the firm"

the ost of apital %.o' of the firm is decrease

)eans the in,erse relationship bet7een .o and

le,erage

7$( !7C5M$ A##R5AC8

or decrease debt in the mix of capital structure

- the cost of equity and cost of debt remain same

- (,erall cost of capital decrease 7ith increase in Debt

- So +alue of the firm increases 7ith use of debt

!ssumptions

• $o tax

• Sources of finance equity and debt • $o changes in ris# of in,estors

• Retained earning is rein,esting in the firm •  899: di,idend pay-out ratio

• $o changes in assets

• $et operating income is not expected to gro7 or decline o,er time

hanges in le,erage / changes

in .

• increase in le,erage / decrease

in .

 and increase ,alue of firm

• Decrease in le,erage / increase

in .

and decrease ,alue of the

firm

#_e #_o ._d  ( S t Proportion of Debt

75! Approach

*hile increasing or decrease in the le,erage of the firm"

.o remain constant

)eans the undefined relationship bet7een .o

and le,erage

7$( 5#$RA(!79 !7C5M$

 A##R5AC8

!ccording to this theory " if 7e

increase or decrease debt in the mix

of capital structure

- the cost of equity increases and

cost of debt remain same

- (,erall cost of capital remain same

- So +alue of the firm remain same

hanges in le,erage / $o

changes in .

• increase in le,erage / .

remain same and increase .

• Decrease in le,erage / .

.e .d .o .o le,erage  ( S T :

(raditional approach

certain le,el .o decrease !fter that"

le,erage increase continuously the .o

increase

)eans the us relationship bet7een .o

and le,erage is in,erse at certain le,el then after co-relationship.

TR!D&T&($!L !PPR(!;

• !ccording to this theory " if 7e increase or decrease debt in the mix of capital

structure

- the cost of equity and cost of debt

remain same up to a degree of le,erage" then they rises sharply

- (,erall cost of capital remain same up to a degree of le,erage" then rises

sharply

- So +alue of the firm remain same up to a degree of le,erage then decrease

Traditional !pproach

#_e #_o ._d  ( S t Proportion of Debt

! company has $(& Rs <"99"999 Total

in,estment is Rs 89"99"999

(ptions

%!'&f company issues only equity shares

then .e is 8=:

%2'&f company issues 89: debentures

Rs >"99"999 then .e become 8?:

%'&f company issues 8<: debentures

particular ! 2  $(& -&nterest $& .e Equity capitalization 5debenture

+alue of the firm

.o/$(&1+ <"99"999 9 <"99"999 8=: 8A"AA"AAA 9 8A"AA"AAA 8=: <"99"999 >9"999 8"?9"999 8?: 89"99"999 >"99"999 8>"99"999 8><B: <"99"999 C<"999 8"<@"999 8@: C"88"888 ?"99"999 8A"88"888 8=<=:

)) !PPR(!;

• !ccording to this theory " if 7e increase or decrease debt in the mix of capital

structure"

- the cost of equity and cost of debt remain same

- (,erall cost of capital 7ill remain same

- So +alue of the firm remain same • &n support of it they ga,e arbitrage

)) !pproach

Relationship bet7een .o and

le,erage is undefined

&ts ust equal to $(& approach but

presentation is quiet different

) ) theory is centered on beha,ior

of in,estor

!ssumption

• $o tax

• Loan on securities is a,ailable • Same business ris#

• 899:di,idend pay-out

• $o transferring cost of securities • ompetent capital mar#et

 Assumptions of MM

• Capital Mar)et are #erfect • !n6estors are rational

• 7o corporate or personal income (ax • !ndi6idual can borro2 at same rate as

borro2ed by corporate • 7o transaction Cost

• 7o agency Cost

#roposal of M M theory

8 +alue of firm %+' and total cost %.o' ha,e no relationship 7ith capital structure

%Equity and debt '

8 .e / .e5 ris# premium

< Sources of finance is not depended on cost of rate of return

%rbitra&e process

,urchase security at lo- price a'd

hi&h price a'd &ai' pro.t)

!rbitrage Process

• !ccording to )) " if ,alue of the le,eraged firm increases " the in,estors of le,eraged firm sells his in,estment in the firm and

create home le,erage in the same proportion • &n this 7ay he can earn same money 7ith

lesser &n,estment

• !nd the ,alue of the le,eraged firm comes do7n and become equal to unle,eraged firm • So capital structure is irrele,ant in deciding

!R2&TR!E PR(ESS

• Suppose there are t7o firm ! and 2 ha,ing follo7ing capital structure ha,ing equal

income of <"99"999 each 0irm ! Equity- 8?"99"999 0irm 2 Equity- 89"99"999 Debt %89:'- ?"99"999

0irm !

&ncome <"99"999 Less &nterest $&L

  ---Earning !,ailable to

shareholder <"99"999

0irm 2

• 0&R) !

;alue of 4ebt 7!<

;alue of $%uity 1&""

---;alue of the firm 1&"" • 0&R) 2

;alue of 4ebt 1"" ;alue of $%uity &""

• Suppose an &n,estor is holding 89 :

shares in 0irm 2" his earning 7ill be Rs 89"999

• ;e 7ill sell all his share for Rs ?<"=99 • ;e 7ill Ta#e Loan of Rs 8"99"999 at the

same interest rate of 89 : and Fse his Rs ?9"999 %Total Rs 8"?9"999' to

purchase 89 : share in ! firm

• ;is Earning 7ill be Rs <9"999 out of

7hich he 7ill pay Rs 89"999 &nterest to Loan" his remaining earning 7ill be Rs 89"999 " 7hich is equal to the pre,ious earning

• &n this 7ay he can get the same earning by sparing Rs <=99 %?<"=99- ?9"999'

• So e,ery in,estor li#e this 7ill start selling his in,estment in 0irm

2% Le,eraged firm' and start purchasing shares in 0irm ! %Fnre,ealed 0irm' " So ,alue of 0irm 7ill come do7n and

become equal to 0irm !

• &n this 7ay ,alue of the firm remain same irrespecti,e of the capital structure

K _e K _d K _o levera&e C * S T 0 K _e K _e$

 % a'd B has same busi'ess risk) %

 % a'd B has same busi'ess risk) %

compa'y1s cap) Structure based

compa'y1s cap) Structure based

o' o'ly equity a'd B compa'y

o' o'ly equity a'd B compa'y

has 20 3ebe'ture 4s)

has 20 3ebe'ture 4s)

$5225222)

$5225222)

6*7 is 4s)+5225222) Ke is +0 i' %

6*7 is 4s)+5225222) Ke is +0 i' %

compa'y a'd 80 i' B compa'y)

compa'y a'd 80 i' B compa'y)

)

) 9hat is value of the .rm:

 9hat is value of the .rm:

$)

$)Ko

Ko

+)

+)Mr) %;it has <20 equity share i'

Mr) %;it has <20 equity share i'

B Compa'y5 o- he reduce his

B Compa'y5 o- he reduce his

i'vestme't -ithout a'y reduci'&

i'vestme't -ithout a'y reduci'&

of his i'come:

of his i'come: