Cost of Capital and Capital Structure Planning
Cost of Capital and Capital Structure Planning
Cost of Capital and Capital Structure Planning
Structure Planning
Neetu Singhania
CA,MBA,Mcom
Cost of Capital
Meaning
The cost of capital is the minimum required rate
of earnings or the cut-off rate of capital
expenditure.
It refers to the cost that is incurred in retaining
the funds obtained from various sources and
employed in business.
Dividend Approach
Dividends can grow at a uniform rate perpetually,
this is called a perpetuity of dividends .
Ke=D1 +g
P0
D1=Dividend per share
P0=Current market price or net proceeds
per share
g=growth in constant dividends
Meaning
A mix of debt, preferred stock, and common stock with
which the firm plans to finance its investments.
Objective is to have such a mix of debt, preferred stock,
and common equity which will maximize shareholder
wealth or maximize market price per share.
WACC depends on the mix of different securities in the
capital structure. A change in the mix of different
securities in the capital structure will cause a change in
the WACC. Thus, there will be a mix of different
securities in the capital structure at which WACC will be
the least.
An optimal capital structure means a mix of different
securities which will maximize the stock price share or
minimize WACC.
Flexibility
Economy
Solvency
Efficiency
Simplicity
Safety
Control
Indifference Point
The indifference between the two alternative methods is calculated
using the formulae:
EPS Plan 1
= EPS Plan 2
(EBIT-I1)(1- t)-Pd1
= (EBIT-I2)(1-t)-PD2
E1
E2
Where ,
EBIT=Earning before interest & tax
I1=Interest charges in plan 1
I2=Interest charges in plan 2
t=Rate of tax
Pd1=Preference dividend in Plan 1
Pd2=Preference Dividend in Plan 2
E1=Number of equity shares in Plan 1
E2=Number of equity shares in Plan 2
Debt
Equity
Indifference
point
EBIT (Rs)
o NI
Traditional Approach
Traditional Approach
Modigliani-Miller Approach
It states that there is no correlation between cost
of capital and debt equity ratio.
The average cost of any firm is independent of its
capital structure and equal to capitalization rate
of pure equity stream of its class.
Assumptions:
Perfect Capital Markets
Given the assumption of perfect information and
rationality ,all investors have the same expectation
of firms net operating income (EBIT) with which to
evaluate the value of a firm.
There does not exist any transaction costs .
The dividend payout ratio is 100%
There are no taxes.
Business risk is equal among all firms within similar
operating environment.
MM Model proposition
o Value
o Value
o Value
Value of Debt
= Expected EBIT
Expected WACC
MM
Model
proposition
o As per
MM, identical
firms (except capital
structure) will have the same level of earnings.
o As
o In