Capital Structure

Capital Structure
Capital structure can be defined as the mix of owned capital (equity,
reserves & surplus) and borrowed capital (debentures, loans from banks,
financial institutions)
Maximization of shareholders’ wealth is prime objective of a financial
manager. The same may be achieved if an optimal capital structure is
designed for the company.
Planning a capital structure is a highly psychological, complex and
qualitative process.
It involves balancing the shareholders’ expectations (risk & returns) and
capital requirements of the firm.
Planning the Capital Structure Important
Considerations –
 Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS
and market price per share.
 Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax
shield on interest & no benefit on dividends.
 Risk: insolvency risk associated with high debt component.
 Control: avoid dilution of management control, hence debt preferred to new equity
shares.
 Flexible: altering capital structure without much costs & delays, to raise funds
whenever required.
 Capacity: ability to generate profits to pay interest and principal.
 Particulars Rs.
Sales (A) 10,000

(-) Cost of goods sold (B) 4,000

Gross Profit (C = A - B) 6,000

(-) Operating expenses (D ) 2,500

Operating Profit (EBIT) (E = C - D ) 3,500

An illustration of
(-) Interest (F) 1,000
Income Statement
EBT (G = E - F) 2,500

(-) Tax @ 30% (H) 750

PAT (I = G - H) 1,750

(-) Preference Dividends (J) 750

Profit for Equity Shareholders (K = I - J) 1,000

N o. of Equity Shares (L) 200

Earning per Share (EPS) (K/ L) 5

Capital Structure Theories
ASSUMPTIONS –
 Firms use only two sources of funds – equity & debt.
 No change in investment decisions of the firm, i.e. no
change in total assets.
 100 % dividend payout ratio, i.e. no retained
earnings.
 Business risk of firm is not affected by the financing
mix.
 No corporate or personal taxation.
 Investors expect future profitability of the firm.
Capital Structure Theories –
A) Net Income Approach (NI)
As the proportion of debt
Cost
(Kd) in capital structure
increases, the WACC (Ko)
ke, ko ke
reduces.
ko
kd kd

Debt
Capital Structure Theories –
B) Net Operating Income (NOI)
 Cost of capital (Ko) is
Cost constant.
ke

 As the proportion of debt

ko
increases, (Ke) increases.
kd  No effect on total cost of
capital (WACC)
Debt
Capital Structure Theories –
C) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings (since Kd < Ke). As a
result, the WACC reduces gradually. This phenomenon is up to a certain
point.
2) At the end of this phenomenon, reduction in WACC ceases and it tends to
stabilize. Further increase in borrowings will not affect WACC and the value
of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’ risk (financial risk)
and hence Ke increases. Kd also rises due to higher debt, WACC increases &
value of firm decreases.
Capital Structure Theories –
C) Traditional Approach
 Cost of capital (Ko) is Cost

reduces initially. ke

 At a point, it settles ko

 But after this point, (Ko)

increases, due to increase in kd

the cost of equity. (Ke)

Debt
Capital Structure Theories –
D) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital structure (debt-equity
mix) has no effect on value of a firm.
 Further, the MM model adds a behavioural justification in favour of the NOI
approach (personal leverage)
 Assumptions –
o Capital markets are perfect and investors are free to buy, sell, & switch between securities.
Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
Capital Structure Theories –
D) Modigliani – Miller Model (MM)
MM Model proposition –
o As per MM, identical firms (except capital structure) will have the same level
of earnings.
o As per MM approach, if market values of identical firms are different,
‘arbitrage process’ will take place.
o In this process, investors will switch their securities between identical firms
(from levered firms to un-levered firms) and receive the same returns from
both firms.
WACC CALCULATION
WEIGHTED AVERAGE COST OF CAPITAL
COST OF CAPITAL CALCULATION
Cost of Debt:
Non Marketable: Interest (1-t)
Marketable: Interest (1-t) / Current Market Price

Cost of Equity:
Dividend Growth Model:
RE = D / P + g
But this model has drawbacks when considering that some firms concentrate on
growth and do not pay dividends at all, or only irregularly. Growth rates may also
be hard to estimate. Also this model doesn’t adjust for market risk.
Cost of Equity
CAPM Model

Re=Rf+ Beta*(RM-Rf)

Rf= Risk free rate of return

(RM-Rf)= Difference between the expected return on the market
portfolio and the riskless rate, this difference is called the expected
excess market return or market risk premium.
 Example
• Alpha Company trades on the NSE. The current yield on a 10-year
treasury bill is 4.5%. The average excess historical annual return
for Nifty stocks is 6.5% The beta of the stock is 1.25 (meaning its
average return is 1.25x as volatile as the Nifty)
• What is the expected return of the security using the CAPM
formula?
Expected return = Risk Free Rate + [Beta x Market Return Premium]
Expected return = 4.5% + [1.25 x 6.5%]
Expected return = 12.625%
 Example 2
• CBW trades on the Nasdaq. The average rate of return on
Nasdaq is 9 percent. The company's stock is slightly more
volatile than the market with a beta of 1.2. The risk-free rate
based on the three-month T-bill is 4.5 percent. Calculate Cost
of Equity.
Expected return = Risk Free Rate + [Beta x Market Return Premium]
Expected return = 4.5% + [1.2 x (9- 4.5)%]
Expected return = 9.9%
Weighted Average Cost of Capital (WACC)
• WACC weights the cost of equity and the cost of debt by the
percentage of each used in a firm’s capital structure
• WACC=(E/ V) x RE + (D/ V) x RD
• (E/V)= Equity % of total value
• (D/V)=Debt % of total value
• (1-Tc)=After-tax % or reciprocal of corp tax rate Tc. The after-tax rate must be
considered because interest on corporate debt is deductible
WACC Illustration
ABC Corp has 1.4 million shares common valued at $20 per share =$28 million.
Debt has face value of $5 million and trades at 93% of face ($4.65 million) in the
market. Total market value of both equity + debt thus =$32.65 million.
Equity % = .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABC’s β=.74
Return on equity per CAPM : RE = 4% + (7% x .74)=9.18% Tax rate is 40%
Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
Debt: $40 million; Equity- $60 million; Interest- 5%; Beta-1.41; Tax
Rate: 34%; Market risk premium- 9.5%; Tresury Bill Rate-1%.
Calculate WACC
Practice Questions
• The Lashgari Company is expected to pay a dividend of Rs.1 per share
at the end of the year, and that dividend is expected to grow at a
constant rate of 5% per year in the future. The company's beta is 1.2,
the market risk premium is 5%, and the risk-free rate is 3%. What is
the company's current stock price?
• McKenna Motors is expected to pay a Rs.1.00 per-share dividend at
the end of the year (D1 = Rs.1.00). The stock sells for Rs.20 per share
and its required rate of return is 11 percent. The dividend is expected
to grow at a constant rate, g, forever. What is the growth rate, g, for
this stock?
Practice Questions
Billick Brothers is estimating its WACC. The company has collected the following
information:
• Its capital structure consists of 40 percent debt and 60 percent common equity.
• The company has 20-year bonds outstanding with a 9 percent annual coupon that
are trading at par.
• The company’s tax rate is 40 percent.
• The risk-free rate is 5.5 percent.
• The market risk premium is 5 percent.
• The stock’s beta is 1.4.
What is the company’s WACC?