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Capital Structure. Capital Structure concept Optimal capital structure. Capital Structure Coverage –. Capital Structure theories – Net Income Net Operating Income Modigliani-Miller Traditional Approach.
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Capital Structure concept Optimal capital structure Capital StructureCoverage – • Capital Structure theories – • Net Income • Net Operating Income • Modigliani-Miller • Traditional Approach
Capital structure is made up of debt and equity securities and refers to permanent financing of a firm. It is compose of long term debt, preference share capital and share holder’s fund. Capital structure is refers to composition or make up of its capitalization. Capital Structure
Capitalization refers to total amount of securities. Capital structure refers to kinds of securities and proportionate amounts that makes capitalization. Financial structure means the entire liabilities side of the balance sheet. Capital Structure, capitalization and financial structure
Compute capitalization, capital structure and financial structure liabilities Rupees 10,00,000 5,00,000 2,00,000 1,50,000 • Equity share capital • Preference share capital • Long term loan and debentures • Current liabilities
Capital structure can be defined as the mix of owned capital (equity, reserves & surplus) and borrowed capital (debentures, loans from banks, financial institutions) Maximization of shareholders’ wealth is prime objective of a financial manager. The same may be achieved if an optimal capital structure is designed for the company. Use of long term fixed interest bearing debt and share capital is called financial leverage or trading on equity. Capital Structure
ABC company has currently all equity capital structure consisting of 15,000 equity share of Rs.100 each. Management is planning to raise another 25,00,000 to finance expansion program, three alternative methods of financing are To issue 25,000 equity share of Rs.100 To issue 25,000, 8% deb. Of Rs.100 each To issue 25,000, 8% preference share of Rs.100 each expected EBIT =8,00,000 Tax rate 50%, determine EPS in each case. Illustration
EBIT less interest less tax = EAT EAT less dividend= earnings available to equity share holders. EPS=Earnings available to equity shareholders/No. of equity shares. Solution
Optimal Capital Structure • It means the capital structure or the combination of equity & debt that leads to the maximum value of the firm and minimizes the cost of capital.
Capital Structure Theories – A) Net Income Approach (NI) Net Income approach proposes that there is a definite relationship between capital structure and value of the firm. 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
Capital Structure Theories – A) Net Income Approach (NI) Assumption- 1.The cost of debt is less than the cost of equity 2.There are no taxes
Capital Structure Theories – A) Net Income Approach (NI) V=S+D V=Total market value of firm S=Market value of equity shares D=Market value of debt Overall cost of capital(ko)=EBIT/V
Capital Structure Theories – B) Net Operating Income (NOI) Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach. As per NOI approach, value of a firm is not dependent upon its capital structure. Assumptions – The market capitalizes the value of the firm as a whole The business risk is constant at every level of debt equity mix The cost of debt (Kd) is constant. Corporate income taxes do not exist.
Net Operating Income • V=EBIT/Ko • S=V-D • S= market value of equity shares • D= market value of debt • V=total market value of a firm • Ko=overall cost of capital
Capital Structure Theories – C) Modigliani – Miller Model (MM) Modigliani and Miller (1958) show that financing decisions don’t matter in perfect capital markets M&M Proposition 1: Firms cannot change the total value of their securities by splitting cash flows into two different stream. Capital structure is irrelevant MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm.
Assumptions – • Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible. • Investors can borrow without restrictions at par with the firms. • Investors are rational & informed of risk-return of all securities • No corporate income tax, and no transaction costs. • 100 % dividend payout ratio, i.e. no profits retention
Capital Structure Theories – C) Modigliani – Miller Model (MM) MM Model proposition – Value of a firm is independent of the capital structure. Firm’s total market value=EBIT/Ke Firm’s market value of equity(S)=V-D Firm’s leverage cost of equity=Cost of equity
Capital Structure Theories –D) Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm. Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches. Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum. As per this approach, a best possible mix of debt and equity will maximize the value of the firm.
