Theories of capital structure

 Net Income Approach

 Net Operating Income Approach
 The Traditional Approach
 Modiglianni and Miller Apprach
 Net Income Approach
 A firm can ASSUMPTIONS
minimize the  The cost of debt is
weighted average less than the cost
cost of capital and of equity
increase the value  There are no taxes
of the firm as well
as market price of
 The risk perception
equity shares by of investors in not
using debt changed by the
financing to the use of debt.
maximum possible
extent.
 Value of Firm (N I Approach)
 Total Value of firm (V)= S + D
 S= Market Value of equity shares
= Earning available to equity shareholders
Equity Capitalisation rate
D= Market Value of debt

And overall weighted avg cost of capital will be calculated as:

K0= EBIT / V

For example:
(k) A company expects a net income of Rs 80,000. It has Rs
2,00,000, 8% debentures. The equity capitalisation rate of the
company is 10%. Calculate the value of the firm and overall
capitalisation rate according to the Net Income Approach
(ignoring income tax)
(l) If the company debt is increased to Rs 3,00,000, what will be
the value of the firm and the overall capitalisation rate.
(a) Net income 80,000
Less: interest on 8% debentures of Rs 2,00,000 16,000
Earning available to equity shareholders 64,000
Equity capitalisation rate 10%

Market value of equity (S)= 64,000 x (100/10) 6,40,000

Market value of debentures (D) 2,00,000
Value of firm (S+D) 8,40,00
Overall cost of capital (EBIT/ V) = 80,000/8,40,000) x 100 0
= 9.52%
(b) Net income 80,000
Less: interest on 8% debentures of Rs 3,00,000 24,000
Earning available to equity shareholders 56,000
Equity capitalisation rate 10%

Market value of equity (S)= 56,000 x (100/10) 5,60,000

Market value of debentures (D) 3,00,000
Value of firm (S+D) 8,60,00
Overall cost of capital (EBIT/ V) = 80,000/8,60,000) x 100 0
= 9.30%
 Net Operating Income Approach
 Change in capital structure of a company
does not effect the market value of the
firm and the overall cost of capital remains
constant irrespective of the method of
financing.
 Increased use of debt increases the
financial risk of the equity shareholders
and hence the cost of equity increases.
 On the other hand, the cost of debt
remains constant with the increasing
proportion of debt as the financial risk of
lenders is not affected.
 Thus, the advantage of using the cheaper
source of funds, i.e. debt is exactly offset
 Value of Firm (N O- I Approach)

V=EBIT/K0 where, V=Value of firm & K0 is cost of capital

The market value of equity, according to this approach is

the residual value which is determined by deducting the
market value of debentures from the total market value of
the firm.
S = V - D where, S is Market value of equity, V is Market value
of firm and D is Market value of debt.

For example; A company expects a net operating income of Rs

1,00,000. It has Rs 5,00,000, 6% Debentures. The overall
capitalization rate is 10%. Calculate the value of the firm
and the equity capitalization rate (cost of equity).
If debenture debt is increased to Rs 7,50,000, what will be the
effect on the value of the firm and the equity capitalization
Net Operating income 1,00,00
Overall cost of capital 0
Market value of firm (V) = 1,00,000x(100/10) 10%
Less: Market value of debentures (D) 10,00,0
Total Market value of Equity 00
Equity capitalisation rate or Cost of equity (Ke) is: 5,00,00
(EBIT - I / V - D) = (1,00,000 – 30,000/5,00,000)x100 0
= 14% 5,00,00
0
If the debt is increased to Rs 7,50,000, the value of
the firm shall remain unchanged at Rs
10,00,000, the equity capitalization rate will
increase as follows:

Equity capitalization rate (Ke) is as follows:

(EBIT - I / V - D) = (1,00,000 – 45,000/2,50,000)x100
= 22%
 The Traditional Approach

 This is an intermediate approach

 According to this theory, overall cost
of capital decreases up to a certain
point, remains more or less
unchanged for moderate increase in
debt thereafter, and increases or
rises beyond a certain point.
 Thus, the optimum capital structure
can be reached by a proper debt-
equity mix.
 Value of firm (Traditional Approach)
 Net operating income Rs 2,00,000
 Total investment Rs 10,00,000
 Equity capitalisation rate, if;
(d) The firm uses no debt 10%
(e) The firm uses Rs 4,00,000 debentures 11%
(f) The firm uses Rs 6,00,000 debentures 13%
Assume that Rs 4 lacs debentures can be raised at 5% rate of
interest whereas Rs 6 lacs debentures can be raised at 6% rate
of inerest.
(a) no (b) (c)
debt
Net operating income 2,00,000 2,00,000 2,00,000
Less: Interest 20,000 36,000
Earning available to equity shareholders 2,00,000 1,80,000 1,64,00
(a) 10% 11% 0
Equity capitalisation rate 20,00,000 16,36,000 13%
Market Value of share (a x 100/capt 4,00,000 12,61,53
rate) 8
20,00,000 20,36,36
Market value of debt 3 6,00,000
10%
Market value of firm 9.8% 18,61,5
Average cost of capital (EBIT/V) 38
10.7%
 Modigliani and Miller Approach

 If taxes are ignored, it is identical

with Net Operating approach.
 If taxes are assumed to exist, it is
similar to the Net Income Approach.
 Point of Indifference
 A project under consideration by your company requires a capital
investment of Rs 60 Lakhs. Interest on term loan is 10% p.a. and
tax rate is 50%. Calculate the point of indifference for the project,
if the debt-equity ratio is insisted by financing agencies 2:1.
 Company has two options, 1) to raise entire amount through
equity, 2) raising Rs 40 lakhs by way of debt and Rs 20 lakhs by
way of equity. The point of indifference would be:

{(X-I1) (1-t) – PD}/S1 = {(X-I2) (1-t) – PD}/S2 , where; X is point of

indifference
I1, I2 is interest under both alternatives, t is tax rate assume to be
50%
PD is preference dividend and S1, S2 is amount of equity under
different alternatives
{(X- 0) (1-.5) – 0}/60 = {(X-4) (1-.5) – 0}/20
.5X/60 = .5X – 2/20
10X = 30X-120
X=6
In case, the firm has EBIT level below Rs 6 lakhs then equity
financing is preferable to debt financing; but if the EBIT is higher
 Factors Determining the Capital Structure

1. Financial Leverage 1. Capital Market

2. Growth and stability Conditions
of sales 2. Assets Structure
3. Cost of Capital 3. Purpose of financing
4. Cash Flow ability to 4. Period of finance
service debt 5. Costs of floatation
5. Nature and size of 6. Legal requirements
firm
6. Control
7. Flexibility
8. Requirements of
investors
 Cost of Capital
 It is the minimum rate of return which a
firm, must and, is expected to earn on its
investments so as to maintain the market
value of its shares.
 It is important in financial management,
because;
3. As an acceptance criterion in capital
budgeting
4. As a determinant of capital mix in capital
structure decisions
5. As a basis for evaluating financial
performance
6. As a basis for taking other financial
decisions
 Cost of debt
 Cost of preference capital
 Cost of equity capital
 Cost of retained earning

And weighted average cost of capital

is the average cost of the costs of
above sources. It is also known as
‘overall cost of capital’.
 EVALUATION OF
INVESTMENT DECISIONS
 Estimation of Cash Flows
 Determining the Rate of Discount or
Cost of Capital
 Applying the technique of Capital
Budgeting to determine the viability
of Investment Proposal
 Types Of Cash Flows
 Initial Investment or Cash Outlay
 Operating Cash Flows or Net Annual
Cash Flows
 Terminal Cash Flows
 Capital Budgeting
Techniques
 Capital budgeting is concerned with
the allocation of the firm’s scarce
financial resources among the
available market opportunities. The
consideration of investment
opportunities involve the comparison
of the expected future streams of
earnings from a project, with the
immediate and subsequent streams
of expenditures for it.
 Capital Budgeting
Techniques
 Non Discounted Method
(2) Pay Back Method
(3) Rate of return or Accounting method
(4) Urgency Method
 Discounted Method
(6) Discounted pay back method
(7) Net Present Value Method
(8) Internal Rate of Return Method
(9) Profitability Index
Risk Analysis in Capital Budgeting

 Risk Adjusted Discount Rate

 Certainity Equivalent Method
 Sensitivity Analysis
 Probability Analysis
 Standard Deviation method
 Decision Tree Analysis
 Working Capital Management

Working Capital is the amount of

funds necessary to cover the cost of
operating the enterprise.
 Gross Vs Net Working Capital
 Gross is total of Current Assets
 Net Working Capital = C.A. – C.L.
 Permanent Vs Temporary Working
Capital
 Factors affecting Working
Capital Requirement
 Nature of Business
 Size of Business
 Production Policy
 Manufacturing Process
 Seasonal Variations
 Operating cycle
 Rate of Stock Turnover
 Credit policy
 Business Cycles
 Rate of growth of Business
 Earning capacity and Dividend Policy
 Price never changes
 Financing of Working
Capital
 Permanent Vs Temporary Working
Capital Requirement
 Long Term Vs Short Term Sources
 Approaches for determining W.C.
financing mix
(d) Conservative approach
(e) Aggressive approach
(f) Hedging or Matching approach
Motives for Holding Cash
 Transaction motive
 Precautionary motive
 Speculative motive
 Compensatory motive
 Managing Cash flows
 Accelerating Cash Inflows
(2) Prompt payment by customers
(3) Quick conversion of payment into
cash
(4) Decentralized collections
(5) Lock box systems
 Delaying Cash Outflows
(7) Paying on last date
(8) Centralization of payments
 Investment of Surplus
Funds
 Treasury bills
 Certificate of deposits
 Inter-corporate deposits
 Commercial papers
 Money market mutual funds
 Receivables
Management
 Receivables represent amounts
owed to the firm as a result of sale
of goods or service on credit in the
ordinary course of business.
 Cost of maintaining receivables
(iii) Cost of financing receivables
(iv) Cost of collection
(v) Bad debts
 Factor Affecting the Size of
Receivables
 Size of credit sales
 Credit policy
 Terms of trade
 Expansion plans
 Relation with profits
 Credit collection efforts
 Habits of cutomers
 Dimension of Receivables
Management
 Forming a Credit Policy
 Executing a Credit Policy
 Formulating and Executing Collection
policy