Financing

Decision
FM SESSION 13
What is Capital Structure?
 Capital Budgeting Decision

Need to raise Funds

Capital Structure Decision

Existing Capital Structure Desired Debt-Equity mix Payout policy

Effect on Return Effect on Risk

Effect on Cost of Capital

Optimal Capital structure

Value of Firm
 Financial Leverage
The use of the fixed charges sources of funds, such as debt and preference capital along with the
owner’s equity in the capital structure – financial leverage or gearing or trading on equity.

Give me a lever long enough and I could move the world.-Archimedes

• Science basically defines leverage as the use of a simple machine that makes doing work easier.
• So when looking for ways of gaining competitive advantages or efficiency, it helps to look at levers. The more
levers you can apply, either the easier work becomes, or the greater your output (impact, influence, etc) is with
the same amount of effort.
• Leverage acts as a “multiplier”
Financial Leverage
Debt multiplies our risk and reward.

The interest paid acts as a fulcrum used in

applying forces through leverage.
The lower the interest rate, the greater will be
the profit, and the less chance of loss.
The less the amount borrowed, the lower will
be the profit or loss.
The greater the borrowing, the greater the
risk of unprofitable leverage and a large gain.
 Financial Leverage
Measures:

1. Debt Ratio

2. Debt to Equity

3. Interest Coverage

The first two measures are also measure of capital gearing. They are static in nature and show the
borrowing position of the company at a point of time.

The third measure of financial leverage, indicates the capacity to meet fixed financial charges.

The reciprocal of interest coverage is a measure of the firm’s income gearing.- It is only a measure of
short-term liquidity rather than of leverage.
Financial Leverage
It depends on several factors:

Size, nature of product, capital intensity, technology, market conditions.

Assignment: Study the Financial leverage of top 20 Indian companies in terms of the 4 measures
discussed.

Why Financial Leverage?

Primary motive- magnify the shareholder’s return.

Assumption: The fixed charges funds can be obtained at a cost lower than the firm’s rate of return on
net assets RONA or ROI).
Financial Leverage
Suppose a new firm Brightways Ltd. is being formed. The management of the firm is expecting a
before tax rate of return of 24% on the estimated total investment of Rs. 500,000. This will imply that
EBIT= 0.24*500,000=120,000. The firm is considering two alternative financial plans:

A) raise the entire funds by issuing 50,000 ordinary shares at Rs. 10 per share.

B) raise Rs. 250,000 by issuing 25,000 ordinary shares at Rs. 10 per share and borrow Rs. 250,000 at
15% rate of interest.

The tax rate is 50%. What are the effects of the alternative plans for the shareholder’s earnings?
Financial Leverage
Debt-Equity All equity
EBIT 120,000 120,000
Less: Interest 37,500 0
PBT 82500 120,000
Less: Taxes 41,250 60,000
PAT 41,250 60,000
Total earnings of investors (PAT+INT) 78,750 60,000

Number of Ordinary shares 25,000 50,000

EPS 1.65 1.20

ROE (EBIT-INT)(1-Tax)/Equity 16.5% 12%
Financial Leverage
Suppose the management of the firm is considering a third alternative. They want to use 75% debt and
25% equity to finance the assets. What will be its effect?

Under this financial plan, for raising equity of Rs. 125000, the firm will sell 12,500 shares and pay Rs.
56,250 as interest on a debt of Rs, 375,000 at 15%.

Calculate the EPS and ROE for this scenario.

EPS= (EBIT-INT)(1-T)/N

120000-56250(0.5)/12500 = Rs. 2.55

ROE= 25.5%
Financial Leverage
Now, Let’s say that for some reason, the firm may not be able to earn 24% before tax return on its total
capital, rather it can earn only 12% return (12% of 500,000=60,000). What would be the impact on
EPS and ROE?
EPS and ROE decline as more debt is used because the firm’s rate of return on total funds or assets is
less than the cost of debt. The firm is paying 15% on debt and earning a return of 12% on funds
employed.

The financial leverage will have a favourable impact on EPS and ROE only when the firm’s ROI
exceeds the cost of debt.
Financial Leverage
Impact of Financial Leverage:

Favourable: ROI>I(cost of debt-interest rate)

Unfavourable: ROI<I

Neutral: ROI=I

ROE=[r+(r-i)D/E](1-T)

r- before tax return on assets=EBIT/V; V=(E+D); I –interest rate on debt

 Financial Leverage
Now let’s vary the EBIT Very poor Poor Normal Good
Probability 0.05 0.10 0.15 0.35 0.30 0.05
Suppose Brightways Ltd
Sales 510 660 710 800 880 1160
may face any of the four
possible economic Costs
conditions: very poor, poor, Variable 255 330 355 400 440 580
normal and good. Fixed 280 280 280 280 280 280
Following are the scenarios. Total costs 535 610 635 680 720 860
Assume 4 financial plans EBIT -25 50 75 120 160 300
ranging from 0% to 75% ROI -5% 10% 15% 24% 32% 60%
debt. Calculate the impact
on EPS and ROE.
 BUSINESS RISK OPER LEVERAGE FINANCIAL RISK OPT CAP STRUCT CAP STRUCT THEORY

Effect of Operating Leverage

More operating leverage leads to more business risk, for then a small sales decline
causes a big profit decline.

$ Rev. $ Rev.
TC }Profit
TC
FC
FC
QBE Sales QBE Sales

What happens if variable costs change?

14-15
Operating Leverage
Operating Leverage: Affects the firm’s operating profit (EBIT).

Degree of operating leverage: the percentage change in the EBIT relative to percentage change in
sales.

DOL: %change in EBIT/% change in Sales

= Contribution/EBIT= 1+F/EBIT

DFL: %change in EPS/% change in EBIT

=EBIT/PBT=1+INT/PBT
Degree of Combined Leverage
DCL= %change in EPS/%change in Sales

DCL= Contribution/Profit before taxes

=EBIT+Fixed costs/PBT

=1+(INT+F)/PBT
Operating Risk vs Financial Risk.

Operating Risk: variability of EBIT . Internal and external factors affecting

It is unavoidable risk. The EBIT variability has two components-

1. variability of sales

2. variability of expenses (composition of fixed and variable expenses)

Financial risk: The variability of EPS caused by the use of financial leverage.

It is an avoidable risk if the firm decides not to use any debt in its capital structure.
Problems
AB Ltd needs Rs. 10 lakh for expansion. The expansion is expected to yield an
annual EBIT of Rs. 160,000. In choosing a financial plan, AB Ltd has an
objective of maximizing EPS. It is considering the possibility of issuing equity
shares and raising debt of Rs. 100,000 or Rs. 400,000 or Rs. 600,000. The
current market price per share is Rs. 25 and is expected to drop to Rs. 20 if the
funds are borrowed in excess of Rs. 500,000. Funds can be borrowed at the rates
indicated below: a) upto Rs. 100,000 at 8%; b) over Rs. 100,000 upto Rs.
500,000 at 12%; c) over Rs. 500,000 at 18%. Assume a tax rate of 50%.
Determine the EPS for the three financing alternatives.
A company needs Rs. 500,000 for construction of a new plant. The following three financial plans are
feasible: i) The company may issue 50,000 ordinary shares of Rs.10 per share ii) The company may
issue 25000 ordinary shares at Rs. 10 per share and 2500 debentures of Rs. 100 denominations bearing
a 8% interest rate. Iii) The company may issue 25000 ordinary shares at Rs. 10 per share and 2500
preference shares at Rs. 100 per share bearing an 8% of dividend.

If the company’s EBIT are Rs. 10,000, Rs. 20,000, Rs. 40,000, Rs. 60,000 and Rs. 100,000, what are
the EPS under each of the three financial plans? Which alternative would you recommend and why?
Assume a corporate tax rate of 50%.
 BUSINESS RISK OPER LEVERAGE FINANCIAL RISK OPT CAP STRUCT CAP STRUCT THEORY

What effect does more debt have on a firm’s cost of

equity?

If the level of debt increases, the firm’s risk increases.

The increase in the cost of debt.

However, the risk of the firm’s equity also increases, resulting in a higher r s.

14-21
 BUSINESS RISK OPER LEVERAGE FINANCIAL RISK OPT CAP STRUCT CAP STRUCT THEORY

The Hamada Equation

Because the increased use of debt causes both the costs of debt and equity to
increase, we need to estimate the new cost of equity.
The Hamada equation attempts to quantify the increased cost of equity due to
financial leverage.
Uses the firm’s unlevered beta, which represents the firm’s business risk as if it had
no debt.

14-22
 BUSINESS RISK OPER LEVERAGE FINANCIAL RISK OPT CAP STRUCT CAP STRUCT THEORY

The Hamada Equation

bL = bU[1 + (1 – T)(D/E)]
Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is
1.0. We were previously told that invested capital was $2,000,000.

14-23
 BUSINESS RISK OPER LEVERAGE FINANCIAL RISK OPT CAP STRUCT CAP STRUCT THEORY

Calculating Levered Betas and Costs of Equity

If D = $250,

bL = 1.0[1 + (0.6)($250/$1,750)]

= 1.0857

rs = rRF + (rM – rRF)bL

= 6.0% + (6.0%)1.0857
= 12.51% 14-24
BUSINESS RISK OPER LEVERAGE FINANCIAL RISK OPT CAP STRUCT CAP STRUCT THEORY

Table for Calculating Levered Betas and Costs of

Equity

Amount D/Cap. D/E Levered

Borrowed Ratio Ratio Beta rs
$ 0 0% 0% 1.00 12.00%

250 12.50 14.29 1.09 12.51

500 25.00 33.33 1.20 13.20

750 37.50 60.00 1.36 14.16

1,000 50.00 100.00 1.60 15.60

14-25
Net Income Approach
According to this approach, the cost of debt, rD, and the cost of equity, rE, remain unchanged when D/E
varies.

Average cost of capital declines as D/E increases.

Net Income Approach
Under Net Income Approach

As debt is replaced for equity in the capital structure, being less expensive, it causes the WACC to
decrease, so that it ultimately approaches the cost of debt with 100 percent debt ratio.

The optimal capital structure occurs at the point of minimum WACC.

Traditional View
Does not assume cost of equity to be constant with financial leverage and continuously declining
WACC.

A judicious mix of debt and equity capital can increase the value of the firm by reducing the WACC
upto a certain level of debt. This implies that WACC decreases only within the reasonable limit of
financial leverage and after reaching the minimum level, it starts increasing with financial leverage.
Traditional View
Suppose a firm is expecting a perpetual net operating income of Rs. 150 crore on
assets of Rs. 1500 crore, which are entirely financed by equity. The firm’s equity
capitalization rate (cost of equity) is 10%. It is considering substituting equity
capital by issuing perpetual debentures of Rs. 300 crore at 6% interest rate. The
cost of equity is expected to increase to 10.56 percent. The firm is also
considering the alternative of raising perpetual debentures of Rs. 600 crore and
replace equity. The debt holders will charge interest of 7%, and the cost of equity
will rise to 12.5% to compensate shareholders for higher financial risk. We
assume that the expected net income is distributed entirely to shareholders.
Traditional View
Irrelevance –MM Hypothesis
Modigliani and Miller

Perfect capital markets without taxes and transaction costs, a firm’s market value and the cost of
capital remain invariant to the capital structure changes.

Value of levered firm= value of unlevered firm

Proposition I

Two firms with identical assets, irrespective of how these assets have been financed, cannot command
different market values.

If not true, arbitrage results- engage in personal or homemade leverage as against the corporate
leverage to restore the equilibrium.
Irrelevance –MM Hypothesis
Value of the firm= Net Operating income/ Firm’s opportunity cost of capital

Suppose two firms Firm U –unlevered firm and Firm L, a levered firm have identical assets and
expected net operating income = Rs. 10,000. The value of Firm U is Rs. 1,00,000 assuming the cost of
equity of 10%. Firm L employs 6% Rs. 50,000 debt. Suppose cost of equity under traditional view is
11.7%. Thus, the value of Firm L’ equity shares is Rs. 60,000 and its total value of firm is Rs. 110,000
(50,000+60,000).
Irrelevance –MM Hypothesis
Assume that you hold 10% share of the
levered firm L. What is your return
from your investment in the shares of
L?
Irrelevance –MM Hypothesis
Key assumptions:

Homogenous risk class

Full payout

No taxes

Perfect capital markets

Proposition II
Suppose Information Technology Limited is an all equity financed company. It has 10,000 shares outstanding. The market
value of these shares is Rs. 1,20,000. The expected operating income of the company is Rs. 18,000. The expected EPS of
the company is Rs. 18,000/10,000= Rs. 1.8. Since ITL is an unlevered company, its opportunity cost of capital will be
equal to its cost of equity i.e. ke= 15%. Let us assume that ITL is considering borrowing Rs. 60,000 at 6% rate of interest
and buying back 5,000 shares at the market value of Rs. 60,000. Now ITL has Rs. 60,000 equity and Rs. 60,000 debt in its
capital structure. The change in the company’s capital structure does not affect its assets and expected net operating
income. However, EPS will change.

EPS= Net income /Number of shares =(18000-3600)/5000= Rs 2.88

ITL’s expected EPS increases by 60% due to financial leverage. Since operating risk does not change, its opportunity cost
of capital will still remain 15%. The cost of equity will increase to compensate for the financial risk:

ke= ka+(ka-kd)D/E= 0.15+(0.15-0.06)60,000/60,000

24%
Proposition II
Trade off Theory
Why don’t firms in practice borrow 100%?

Financial Distress:

Arises when a firm is not able to meet its obligations to debt holders.

For a given level of operating risk, financial distress exacerbates with higher debt.

The probability of financial distress becomes much greater due to higher business risk and higher debt.

Financial distress may ultimately force a firm to insolvency. Direct costs of financial distress include
cost of insolvency.

Indirect costs of financial distress relate to actions of employees, managers, customers and suppliers.
Trade off Theory
Financial distress reduces the value
of the firm.

Value of levered firm = Value of

unlevered firm +PV of tax shield-
PV of financial distress.

The optimum point is reached when

the marginal present values of the
tax benefit and financial distress
cost are equal.
Dividend Decision
Relationship between dividend
policy and value
WALTER’S Model

Assumptions:

Internal Financing: The firm finances all investment through retained earnings, that is no debt or new
equity is issued.

Constant return and cost of capital: The firm’s rate of return r and it cost of capital are constant.

100% payout or retention: All earnings are distributed or reinvested internally immediately.

Constant EPS and DIV: Any given value of EPS and DIV are assumed to remain constant forever.

Infinite time: The firm has a long or infinite time.

Walter’s Model
In Walter model, the dividend policy of the firm depends on the availability of investment
opportunities and the relationship between the firm’s internal rate of return, r and its cost of capital, k.
Thus, the decision criteria:

1) Retain all earnings when r>k

2) Distribute all earnings when r<k

3) Dividend has no impact when r=k.

Gordon’s Model
P0 = Div 1/(k-g)