cap struc theoriesj

7/27/2019 cap struc theoriesj

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PRESENTED TO

DR ANIL MATKAR



PRATIK AHLUWALIA 2012002

RICHIKA CHANANA 2012026

JUHI CHAWLA 2012031



In finance, capital structure refers to the way

a corporation finances its assets.

It includes combination of equity, debt, or hybrid securities.

A firm's capital structure is then the composition or 'structure' of its

liabilities.

For example, a firm that sells $20 billion in equity and $80 billion

in debt is said to be 20% equity-financed and 80% debt-financed.

The firm's ratio of debt to total financing, 80% in this example, is

referred to as the firm's leverage



Capital restructuring

Adjusting leverage without changing the firm’s assets

Increase leverage

Issue debt and repurchase outstanding shares

Decrease leverage

Issue new shares and retire outstanding debt

Choose capital structure to max stockholder wealth

Maximizing firm value

Minimizing the WACC



Definition:

Traditional approach to capital structure advocates that there is a

right combination of equity and debt in the capital structure, at

which the market value of a firm is maximum.



The rate of interest on debt remains constant for acertain period and thereafter with increase in leverage, itincreases.

The expected rate by equity shareholders remainsconstant or increase gradually. After that the equityshareholders starts perceiving a financial risk and thenfrom the optimal point and the expected rate increasesspeedily.

As a result of activity of rate of interest and expectedrate of return, the WACC first decreases and thenincreases. The lowest point on the curve is optimalcapital structure.



This model was originally published in 1958 by two

scientist named Modigliani and Miller.

Restrictive Assumptions :-

1. No Income Tax

2. No Bankruptcy Cost

3. No Transaction Cost



Cost of Equity =Shareholders Expectation &Risk Element

Leverage = No Impact onCost Of Capital

Cost of Capital =Capitalization Rate ofCompany



PARTICULARS UNLEVEREDFIRM LEVERED FIRM

EBIT 1,000 1,000

Interest (5% on 1,000) - (50)

EBT 1,000 950

Tax - -

Net Income 1,000 950

Ro 10% 10%

Proposition 1 Vu = Vl =10,000(1,000/10%)

Ve=Vu-Vd=10,000-1,000=9,00



PARTICULARS UNLEVEREDFIRM

LEVEREDFIRM

Proposition 2

Rs=Ro + D/E (Ro-Rd) 10 + 0 = 10% 10 + 0.05/9= 10.56%



PARTICULARS UNLEVEREDFIRM LEVEREDFIRM

EBIT 1,000 1,000

Interest (5% on 1,000) - (50)

EBT 1,000 950Tax (30%) (300) (285)

Net Income 700 655

Ro 10% 10%

Proposition 1 Vu = Vl = 7,000(1,000 (1-0.3)/10%)

Ve=Vu-Vd(t)=7,000 -300=6,700

Vl = 7,700



PARTICULARS UNLEVEREDFIRM

LEVERED FIRM

Proposition 2

Rs=Ro + D[1-t]/E(Ro-Rd) 10 + 0 = 10% 10 + 300 *0.05/6700 =10.22%



The capital structure decision is relevant to the valuation of thefirm.

If the financial leverage increases, the weighted average cost ofcapital decreases, the value of the firm and the market price of

the equity shares increases.

If the financial leverage decreases, the weighted average costof capital increases and the value of the firm and the market

price of the equity shares decreases.



1.•There are no taxes

2.

•The cost of debt is less than the costof equity.

3.

•The use of debt does not changethe risk perception of the investors



This approach suggests that the change in debt of a firm or change inleverage fails top affect the total value of a firm. As per this approachthe weighted Average cost of capital and total value of a company areindependent of the capital structure decisions or degree of financial

leverage of a company

0

C a p i t a l C o s

t s ( % )

Kd (cost of debt)

ke (Required return on equity)

WACC



Example explaining Net Operating IncomeApproach to Capital Structure

Earnings before Interest Tax (EBIT)=1,00,000

Bonds (Debt part)= 3,00,000Cost of Bonds issued (Debt)=10%

WACC=12.5%



Calculating the value of the company:

(EBIT)=1,00,000

WACC=12.5%

Market value of the company= EBIT/WACC

= 1,00,000/12.5%= 8,00,000

Total Debt =3,00,000( given)

Total Equity = Total market value - Total debt

= 8,00,000-3,00,000

=5,00,000

Shareholders' earnings = EBIT-interest on debt=100,000 - 10% of 300,000

=70,000

Cost of equity = Shareholders earnings/ total equity

= 70,000/5,00,000

=14%



*Assume that proportion of debt increases from 3,00,000 to4,00,000 and everything else remains same

(EBIT)=1,00,000

WACC=12.5%Market value of the company = EBIT/WACC

=1,00,000/12.5%

= 8,00,000

Total Debt = 4,00,000 (Assumption)

Total Equity= Total market value - total debt

=8,00,000-400,000

=400,000

Shareholders' earnings = EBIT-interest on debt

=1,00,000 - 10% of 400,000= 60,000

so, Cost of equity = 60,000/4,00,000

=15%



Cost of equity increases with every increase in debt while theweighted average cost of capital (WACC) remains constant.

When the debt content in the capital structure increases, it increasesthe risk of the firm as well as its shareholders.

To compensate for the higher risk involved in investing in highlylevered company, equity holders naturally expect higher returnswhich in turn increases the cost of equity capital.

It is assumed under this method that overall cost of capital is

unaffected and hence it remains constant irrespective of the change inthe ratio of debts to equity capital

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