Capital Structure

Capital Structure
Capital Structure -- The mix (or proportion) of
a firm’s permanent long-term financing
Capital Structure represented by debt, preferred stock, and
common stock equity.
Theory Concerned with the effect of capital
market decisions on security prices.

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A Conceptual Look -- A Conceptual Look --

Relevant Rates of Return Relevant Rates of Return
Kd = the yield on the company’s debt Ke = the expected return on the company’s equity
I Annual interest on debt Earnings available to
Kd = = E
E common shareholders
D Market value of debt Ke = S =
S Market value of common
stock outstanding
Assumptions:
• Interest paid each and every year Assumptions:
• Bond life is infinite • Earnings are not expected to grow
• Results in the valuation of a perpetual bond • 100% dividend payout
• No taxes (Note: allows us to focus on just • Results in the valuation of a perpetuity
capital structure issues.) • Appropriate in this case for illustrating the theory
of the firm
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A Conceptual Look --
Relevant Rates of Return Capitalization Rate
ko = An overall capitalization rate for the firm Capitalization Rate, Ko -- The discount rate
used to determine the present value of a
O Net operating income stream of expected cash flows.
ko = V =
Total market value of the firm

Assumptions: D E
Ko = Kd + Ke
• V = D + S = Total market value of the firm
D+E D+E
• O = I + E = Net operating income = Interest
Paid plus earnings available to common What happens to Kd, Ke, and Ko
shareholders when leverage, D/E, increases?
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 Capital Structure

Capital Structure Theories Net Operating Income Approach

ASSUMPTIONS : Net Operating Income Approach -- A theory of
•Firms use only two sources of funds equity & debt. capital structure in which the weighted average
•No change in investment decisions of the firm, i.e. no cost of capital and the total value of the firm
change in total assets. remain constant as financial leverage is changed.
• 100 % dividend payout ratio, i.e. no retained
earnings. Assume:
• Business risk of firm is not affected by the financing Net operating income equals R.1,00,000
mix. Market value of debt is Rs. 5,00,000 at 6 %
• No corporate or personal taxation. interest
Overall capitalization rate is 10%

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Net Operating Income Approach Required Rate of Return on Equity

According to this approach the overall capitalisation rate (Ko) and the cost of
debt (Kd) remain constant for all degrees of leverage. Hence
NOI (EBIT) 100000 Ke = Ko + (Ko – Kd) (D/E)
-INT 30000
NI (EBT) 70000 .25

Ko 10.00%
Capital Costs (%)

.20
ke (Required return on equity)
TOTAL MKT 1000000 .15
ko (Capitalization rate)
MKT. DEBT 500000 .10
kd (Yield on debt)
MKT. EQU 500000 .05

0
Ke 14.00% 0 .25 .50 .75 1.0 1.25 1.50 1.75 2.0
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Total Value Principle: Arbitrage and Total

Modigliani and Miller (M&M) Market Value of the Firm
Provide behavioral justification for a constant Two firms that are alike in every respect
Ko over the entire range of financial leverage EXCEPT capital structure, MUST have
possibilities. the same market value.
Total risk for all security holders of the firm is
not altered by the capital structure. Otherwise, arbitrage is possible.
Therefore, the total value of the firm is not
altered by the firm’s financing mix. Arbitrage -- Finding two assets that are
essentially the same and buying the
cheaper and selling the more expensive.
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 Capital Structure

LEVEL OF LEVERAGE LEVEL OF LEVERAGE

PARTICULARS PARTICULARS
Rate LEVERED Rate UNLEVERED Rate LEVERED Rate UNLEVERED

DEBENTURES 10.00% 500000 0 DEBENTURES 10.00% 500000 0

EBIT 100000 100000 EBIT 100000 100000
Ke 16.00% 12.50% Ke 16.00% 12.50%
MR. X HOLDINGS 10.00% MR. X HOLDINGS 10.00%

LEVEL OF LEVERAGE ARBITAGE PROCESS LEVEL OF LEVERAGE ARBITAGE PROCESS

PARTICULARS LEVERED UNLEVERED PARTICULARS ROI AMOUNT PARTICULARS LEVERED UNLEVERED PARTICULARS ROI AMOUNT
EBIT (NOI) 100000 100000 EQ. HOLDINGS 31250 EBIT (NOI) 100000 100000 EQ. HOLDINGS 31250
- INTEREST 50000 0 BORRWINGS 10.00% 50000 - INTEREST 50000 0 BORRWINGS 10.00% 50000
TOTAL INVT. IN TOTAL INVT. IN
NI 50000 100000 UNLEVER 81250 NI 50000 100000 UNLEVER 81250
Ke 16.00% 12.50% INTEREST 10.00% 5000 Ke 16.00% 12.50% INTEREST 10.00% 5000
MKT VALUE OF EQUITY 312500 800000 MKT VALUE OF EQUITY 312500 800000
MKT VALUE OF INCOME IN MKT VALUE OF INCOME IN
DEBENTURE 500000 0 UNLEVER 12.50% 10156 DEBENTURE 500000 0 UNLEVER 12.50% 10156
TOTAL MKT VALUE 812500 800000 INTEREST 5000 TOTAL MKT VALUE 812500 800000 INTEREST 5000
Ko 12.31% 12.50% NET INVT. 31250 Ko 12.31% 12.50% NET INVT. 31250
DEBT-EQUITY RATIO 1.60 0 NET RETURN 5156 DEBT-EQUITY RATIO 1.60 0 NET RETURN 5156

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Leverage and Trading on Equity

Capital Structure

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EBIT-EPS Analysis EBIT-EPS Analysis

Consider Two Alternative Investments
1. Existing Capital Structure: 10,00,000 Equity Shares of Particulars Equity Financing Debt Financing
Rs. 10 Each EBIT 2,000,000 4,000,000 2,000,000 4,000,000
2. Tax Rate: 50 Per Cent 0 0 1,000,000 1,000,000
Interest
The company Plans to raise additional Capital of Rs. EBT 2,000,000 4,000,000 1,000,000 3,000,000
1,00,00,000 for financing an expansion Project. In this Tax 1,000,000 2,000,000 500,000 1,500,000
context, it is evaluating two alternative financing plans:
1. Issue of Equity Shares (10,00,000 equity shares at PAT 1,000,000 2,000,000 500,000 1,500,000
Rs. 10 per share) No. of Eq. Shares 2,000,000 2,000,000 1,000,000 1,000,000
2. Issue of debentures carrying 10 Per Cent Interest
EPS 0.5 1 0.5 1.5
What will be the EPS Under the two alternative financing
plans for two levels of EBIT, Say Rs. 20,00,000 and Rs.
40,00,000.
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 Capital Structure

Degree of Operating
Operating Leverage Leverage (DOL)
Operating Leverage -- The use of Degree of Operating Leverage -- The
fixed operating costs by the firm. percentage change in a firm’s operating
profit (EBIT) resulting from a 1 percent
One potential “effect” caused by the change in output (sales).
presence of operating leverage is
that a change in the volume of sales DOL at Q Percentage change in
results in a “more than proportional” units of operating profit (EBIT)
output =
change in operating profit (or loss). Percentage change in
(or sales) output (or sales)
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Operating Leverage (OL) Financial Leverage

Financial Leverage -- The use of

CONTRIBUTION fixed financing costs by the firm.
OL = ------------------ The British expression is gearing.
EBIT Financial leverage is acquired by
choice.
Used as a means of increasing the
return to common shareholders.
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Measures of Financial Degree of Financial

Leverage Leverage (DFL)
Degree of Financial Leverage -- The
Debt Ratio = D/(D+E) = D/V percentage change in a firm’s earnings
per share (EPS) resulting from a 1
Debt Equity Ratio = D/E
percent change in operating profit.
Interest Coverage = EBIT/Interest
Percentage change in
earnings per share (EPS)
DFL =
Percentage change in
operating profit (EBIT)
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 Capital Structure

Degree of Total
Computing the FL Leverage (DTL)
Calculating the FL Degree of Total Leverage -- The
percentage change in a firm’s earnings
EBIT per share (EPS) resulting from a 1
FL =
EBIT - I percent change in output (sales).

EBIT = Earnings before interest and taxes Percentage change in

I = Interest earnings per share (EPS)
DTL =
Percentage change in
output (or sales)
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Computing the TL
Calculating the TL

Contribution
TL =
EBT

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EBIT-EPS Break-Even, EBIT-EPS Break-Even,

or Indifference, Analysis or Indifference, Analysis
EBIT-EPS Indifference Analysis -- Analysis EBIT-EPS Indifference Analysis -- Analysis
of the effect of financing alternatives on of the effect of financing alternatives on
earnings per share. The Indifference point earnings per share. The Indifference point
is the EBIT level where EPS is the same for is the EBIT level where EPS is the same for
two (or more) alternatives. two (or more) alternatives.

Calculate EPS for a given level of EBIT at a

(EBIT - I1) (1 - t) - Pref. Div. (EBIT – I2) (1 - t) - Pref. Div.
given financing structure. EPS = =
n1 n2
(EBIT - I) (1 - t) - Pref. Div.
EPS =
Number of Common Shares
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 Capital Structure

Skyline Software Ltd has appointed you as its finance

ABC Limited’s present capital structure consists of 20 million
manager. Company’s existing capital structure includes Rs. 50
equity shares of Rs.10 each. It requires Rs.60 million of external
lakhs share capital and 11% Rs. 10 lakhs preference share. The
financing. It is considering two alternatives:
company wants to implement a project for which Rs. 30 lakhs
Alternative 1 : Issue of 3 million equity shares of Rs.10 par at
are required to be raised from the market as a means of
Rs.15 each and 1.5 million preference shares of Rs.10 par, financing the project. The following financing plans and
carrying a dividend rate of 10 percent. options are at hand:
Particulars Financing Plans
Plan A (Rs.) Plan B (Rs.)
Alternative 2 : Issue of 2 million equity shares of Rs.10 par at Option 1: Equity 30,00,000 30,00,000
Rs.15 each and debentures for Rs.30 million carrying an interest V/s
rate of 11 percent. Option 2:
Equity Shares 15,00,000 20,00,000
12% Preference Shares Nil 10,00,000
The company’s tax rate is 35 percent. 10% Debentures 15,00,000 Nil
Assuming corporate tax to be 30 per cent and the face value of
Calculate the EPS-PBIT indifference point and interpret the all the shares and debentures to be Rs. 100 each, calculate the
same. indifference points and earnings per share (EPS) for each of
the financing plans. Which plan should be accepted by the
company?
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The dividend policy of a firm determines what

DIVIDEND POLICY proportion of earnings is paid to shareholders.
If a firm's capital budgeting decision is

AND FIRM VALUE independent of its dividend policy, a higher

dividend payment will entail a greater
dependence on external financing.
On the other hand, if a firm's capital budgeting
decision is dependent on its dividend decision, a
higher payment will cause shrinkage of its capital
budget and vice versa.

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Kinds of divided policy

Regular Dividend Policy: Payment of dividend at the
usual rate is termed as regular dividend.
Stable Dividend Policy: The term 'stability of dividends'
means consistency in the stream of dividend payments.
In more precise terms, it means payment of certain
minimum amount of dividend regularly.
Irregular Dividend Policy: Some companies follow
irregular dividend payments on account of the
Thank You
following: (i) Uncertainty of earnings(ii) Unsuccessful
business operations(iii) Lack of liquid resources
No Dividend Policy: A company can follow a policy of
paying no dividends presently because of its
unfavorable working capital position or on account of
requirements of funds for future expansion and growth.
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