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    Capital Structure

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    mobinsai
    The document discusses various theories of capital structure including the Net Income Approach, Net Operating Income Approach, Traditional Approach, and Miller and Modigliani Approach. The Net Income Approach proposes that the overall cost of capital decreases as debt increases in the capital structure. The Net Operating Income Approach suggests the overall cost of capital remains constant as debt changes. The Traditional Approach shows the cost of capital decreases with debt up to an optimal point, then increases thereafter. The Miller and Modigliani Approach argues that the value of the firm and overall cost of capital are independent of the capital structure when certain assumptions hold, such as perfect markets and no taxes. It proposes an arbitrage process by which investors can maintain returns

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    © All Rights Reserved
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    Capital Structure

    Uploaded by

    mobinsai
    428 views41 pages
    The document discusses various theories of capital structure including the Net Income Approach, Net Operating Income Approach, Traditional Approach, and Miller and Modigliani Approach. The Net Income Approach proposes that the overall cost of capital decreases as debt increases in the capital structure. The Net Operating Income Approach suggests the overall cost of capital remains constant as debt changes. The Traditional Approach shows the cost of capital decreases with debt up to an optimal point, then increases thereafter. The Miller and Modigliani Approach argues that the value of the firm and overall cost of capital are independent of the capital structure when certain assumptions hold, such as perfect markets and no taxes. It proposes an arbitrage process by which investors can maintain returns

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    The document discusses various theories of capital structure including the Net Income Approach, Net Operating Income Approach, Traditional Approach, and Miller and Modigliani Approach. The Net Income Approach proposes that the overall cost of capital decreases as debt increases in the capital structure. The Net Operating Income Approach suggests the overall cost of capital remains constant as debt changes. The Traditional Approach shows the cost of capital decreases with debt up to an optimal point, then increases thereafter. The Miller and Modigliani Approach argues that the value of the firm and overall cost of capital are independent of the capital structure when certain assumptions hold, such as perfect markets and no taxes. It proposes an arbitrage process by which investors can maintain returns

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    428 views41 pages

    Capital Structure

    Uploaded by

    mobinsai
    The document discusses various theories of capital structure including the Net Income Approach, Net Operating Income Approach, Traditional Approach, and Miller and Modigliani Approach. The Net Income Approach proposes that the overall cost of capital decreases as debt increases in the capital structure. The Net Operating Income Approach suggests the overall cost of capital remains constant as debt changes. The Traditional Approach shows the cost of capital decreases with debt up to an optimal point, then increases thereafter. The Miller and Modigliani Approach argues that the value of the firm and overall cost of capital are independent of the capital structure when certain assumptions hold, such as perfect markets and no taxes. It proposes an arbitrage process by which investors can maintain returns

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    Capital structure

    expansion

    Capital Budgeting Decision

    Replacement

    Modernization

    Need to Raises Fund


    Capital Structure Decision

    Existing cap
    structure

    Payout
    Policy

    Desired
    Debt-Equity mix

    Cont.

    Effect on
    RISK

    Effect
    On Return

    Effect on
    Cost OF Capital

    Optimum
    Capital structure

    Value of
    Firm

    Components of Capital
    Debt
    Debentures
    Term Loans
    Equity
    Equity shares
    Preference Shares
    Retained Earnings

    Capital Structure
    The capital structure of a company
    refers to the mix of the long-term
    finances used in the organization.
    As the proportion of Debt increases in
    the capital structure of an
    organization , the risk of shareholders
    increases.

    Capital structure
    Mix of long-term finance used by the firm.
    Authorized Capital of Rs. 10 each
    Issued, subscribed and paid up
    capital
    Present issue
    Equity at par
    16% secured loan
    Term loan from bank
    Buyers credit

    90,00,00,000
    8,25,00,000
    19,34,00,000
    56,50,00,000
    50,60,00,000
    13,50,00,000
    1,48,20,00,000

    Factors Affecting the capital structure

    Cost of capital
    Cash flow projections of the company
    Size of the company
    Dilution of control
    Floatation costs

    Optimal capital structure

    Profitability
    Flexibility
    Control
    solvency

    Theories of capital structure

    Net income approach (NI)


    Net Operating Income approach (NOI)
    Traditional Approach
    Miller and Modigliani approach (M M)

    In the theories we will study


    What is the impact of
    change in capital Structure
    - On the Value of the firm
    - On the Overall cost of Capital

    Kd=F/B

    Ke=E/S
    Ko=[Kd*B/(B+S)]+
    [Ke*S/(B+S)] or O/V
    V=B+S

    B= (1+Kd)t
    E
    S=
    (1+Ke)t

    Ko = Total cost of capital


    Kd = Cost of debt
    Ke = Cost of equity
    V = Value of the Firm
    B = Market value of debt
    S = market value of equity

    NI Approach
    While increasing the leverage in the firm,
    the Cost of Capital (Ko) of the firm is decrease.
    Means the inverse relationship between Ko and
    leverage
    Mr. Devid Durrande invented this approach

    NET INCOME APPROACH


    According to this theory , if we increase
    or decrease debt in the mix of capital
    structure
    - the cost of equity and cost of debt
    remain same
    - Overall cost of capital decrease with
    increase in Debt
    - So Value of the firm increases with
    use of debt

    Assumptions

    No tax
    Sources of finance equity and debt
    No changes in risk of investors
    Retained earning is reinvesting in the firm
    100% dividend pay-out ratio
    No changes in assets
    Net operating income is not expected to
    grow or decline over time
    Business risk remain same

    Changes in leverage = changes


    in Ko
    increase in leverage = decrease
    in Ko and increase value of firm
    Decrease in leverage = increase
    in Ko and decrease value of the
    firm

    ke

    C
    O
    S
    t

    ko
    Kd

    Proportion of Debt

    NOI Approach
    While increasing or decrease in the leverage of
    the firm,

    Ko remain constant.
    Means the undefined relationship between Ko
    and leverage
    Mr. Devid Durrande invented this approach

    NET OPERATING INCOME


    APPROACH
    According to this theory , if we
    increase or decrease debt in the mix
    of capital structure
    - the cost of equity increases and
    cost of debt remain same
    - Overall cost of capital remain same
    - So Value of the firm remain same

    Changes in leverage = No
    changes in Ko
    increase in leverage = Ko
    remain same and increase Ke
    Decrease in leverage = Ko
    remain same and decrease Ke

    Ke
    C
    O
    S
    T
    %

    Ko

    Kd

    leverage

    Traditional approach
    When leverage increase, then at the
    certain level Ko decrease. After that,
    leverage increase continuously the K o
    increase.
    Means the us relationship between K o
    and leverage is inverse at certain level
    then after co-relationship.
    Ezra Solomon invented this approach

    TRADITIONAL APPROACH

    According to this theory , if we 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 leverage,
    then they rises sharply
    - Overall cost of capital remain same up
    to a degree of leverage, then rises
    sharply
    - So Value of the firm remain same up to
    a degree of leverage then decrease
    sharply

    Traditional Approach

    At 1 stage company
    trading on equity
    Ke
    C
    O
    S
    T
    %

    Ko

    leverage

    Kd

    At 2 stage no gai
    Leverage. Optim
    cap. st

    At 3 stage risk is inc


    So Ke increase.

    ke
    ko
    Kd

    C
    O
    S
    t

    Proportion of Debt

    A company has NOI Rs 2,00,000. Total


    investment is Rs 10,00,000.
    Options
    (A)If company issues only equity shares
    then Ke is 15%
    (B)If company issues 10% debentures
    Rs. 4,00,000 then Ke become 16%
    (C)If company issues 12% debentures
    Rs. 6,00,000 then Ke become 18%

    particular

    NOI
    -Interest
    NI
    Ke
    Equity
    capitalization
    +debenture
    Value of the firm

    2,00,000
    0
    2,00,000
    15%
    13,33,333

    2,00,000
    40,000
    1,60,000
    16%
    10,00,000

    2,00,000
    72,000
    1,28,000
    18%
    7,11,111

    Ko=NOI/V

    15%

    0
    4,00,000 6,00,000
    13,33,333 14,00,000 13,11,111
    14.29%

    15.25%

    MM APPROACH
    According to this theory , if we increase
    or decrease debt in the mix of capital
    structure,
    - the cost of equity and cost of debt
    remain same
    - Overall cost of capital will remain
    same
    - So Value of the firm remain same
    In support of it they gave arbitrage
    process

    M.M Approach
    Relationship between Ko and
    leverage is undefined.
    Its just equal to NOI approach but
    presentation is quiet different.
    M M theory is centered on behavior
    of investor.

    Assumption

    No tax
    Loan on securities is available
    Same business risk
    100%dividend pay-out.
    No transferring cost of securities
    Competent capital market

    Assumptions of MM

    Capital Market are Perfect


    Investors are rational
    No corporate or personal income Tax
    Individual can borrow at same rate as
    borrowed by corporate
    No transaction Cost
    No agency Cost
    No bankruptcy cost

    Proposal of M M theory
    1.

    1.
    2.

    Value of firm (V) and total cost (Ko) have no


    relationship with capital structure.
    (Equity and debt )
    Ke = Ke+ risk premium
    Sources of finance is not depended on cost of rate
    of return.

    Arbitrage process
    Purchase security at low price and s
    high price and gain profit.
    This price difference call arbitrage.

    Arbitrage Process
    According to MM , if value of the leveraged
    firm increases , the investors of leveraged
    firm sells his investment in the firm and
    create home leverage in the same proportion
    In this way he can earn same money with
    lesser Investment
    And the value of the leveraged firm comes
    down and become equal to unleveraged firm
    So capital structure is irrelevant in deciding
    the value of the firm

    ARBITRAGE PROCESS
    Suppose there are two firm A and B having
    following capital structure having equal
    income of 2,00,000 each
    Firm A
    Equity- 16,00,000
    Firm B
    Equity- 10,00,000
    Debt (10%)6,00,000

    Firm A
    Income
    Less Interest

    2,00,000
    NIL
    ------Earning Available to
    shareholder
    2,00,000
    Ke
    12.5%

    Firm B
    Income
    Less Interest
    Earning Available to
    shareholder
    Ke

    2,00,000
    1,00,000
    ---------------1,00,000
    16%

    FIRM A
    Value of Debt
    Value of Equity
    --------------------Value of the firm
    FIRM B
    Value of Debt
    Value of Equity
    --------------------Value of the firm

    NIL
    16,00,000
    16,00,000
    10,00,000
    6,25,000
    16,25,000

    Suppose an Investor is holding 10 %


    shares in Firm B, his earning will be Rs.
    10,000
    He will sell all his share for Rs. 62,500
    He will Take Loan of Rs. 1,00,000 at the
    same interest rate of 10 % and Use his
    Rs. 60,000 (Total Rs. 1,60,000) to
    purchase 10 % share in A firm
    His Earning will be Rs. 20,000 out of
    which he will pay Rs. 10,000 Interest to
    Loan, his remaining earning will be Rs.
    10,000 , which is equal to the previous
    earning

    In this way he can get the same earning


    by sparing Rs. 2500 (62,500- 60,000)
    So every investor like this will start
    selling his investment in Firm
    B( Leveraged firm) and start purchasing
    shares in Firm A (Unrevealed Firm) , So
    value of Firm will come down and
    become equal to Firm A
    In this way value of the firm remain same
    irrespective of the capital structure

    Ke2
    C
    O
    S
    T
    %

    Ke
    Ke1
    Ko
    Kd

    leverage

    A and B has same business risk. A


    companys cap. Structure based
    on only equity and B company
    has 10% Debenture Rs.
    12,00,000.
    NOI is Rs.3,00,000. Ke is 13% in A
    company and 15% in B company.
    1.What is value of the firm?
    2.Ko
    3.Mr. Ajit has 90% equity share in
    B Company, How he reduce his
    investment without any reducing
    of his income?

    particular

    NOI
    -Interest
    NI
    Ke
    Equity capitalization
    +debenture
    Value of the firm
    Ko=NOI/V

    3,00,000
    0
    3,00,000
    13%
    23,07,692
    0
    23,07,692
    13%

    3,00,000
    1,20,000
    1,80,000
    15%
    12,00,000
    12,00,000
    24,00,000
    12.5%

    When Arbitrage process completed?

    Value of the firm V


    Total cost Ko

    A company B company
    23,07,692 24,00,000
    13%
    12.5%

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