Capital Structure

What is capital structure?

A term used to represent the proportionate relationship between debt and equity

Capital Structure
Financial Management Author: I M Pandey
Equity includes:

What are the components of equity?

paid-up share capital Share premium Reserves and retained earnings

Capital Structure
Is the knowledge about capital structure important?
Yes
Because it influences shareholders return and risks
Which in turn may influence the market value of the share of the company

Financial leverage
What is meant by financial leverage?
The use of fixed-charges source of funds (debt and preference shares) along with owners equity (ordinary shares) in the capital structure

The structure of capital is therefore a managerial/ investment decision

Financial leverage is also known as gearing or trading on equity

capital budgeting decision

Replacement Modernisation Expansion Diversification

Capital structure and value of firm

Need to raise funds

Internal Funds Debt Equity

Capital structure decision

Existing capital Structure

Desired Debt-Equity Mix

Payout Policy

Since capital structure decisions affect the value of a firm, the firm would like to have a capital structure which would maximise market value

Effect on Return

Effect on Risk

Effect on Cost of Capital Optimum Capital Structure Value of the Firm

Note: the value of a firm is the sum of the values of all its securities

Capital structure and value of firm

There exists conflicting theories on the relationship between capital structure and the value of a firm
Traditional approach:
Capital structure affects the value of firm

Traditional Approach: Net Income Approach

Suppose firm L is a levered firm
I.e. financed asset with both equity and debt

It has an expected EBIT or NOI of Rs1,000 Interest payment is equal to Rs 300

Modligiani and Miller under perfect capital market with no taxes

Capital structure decision is irrelevant

The firms cost of equity, ke, is 9.33%

Cost of equity is also known as equity capitalisation rate

Modligiani and Miller with corporate taxes

Capital structure decision is relevant Tax savings resulting from interest paid on debts creates value for the firm

The firms cost of debt, kd, is 6% What is the firms value?

The value of a firm

What is the firms value? Recall: The value of a firm is the sum of the values of all its securities
Securities include both equity and debt

Value of Firms Equity

The value of firms equity, E, is the discounted value of shareholders earnings
Shareholders earnings is also called net income (NI)

Net income = net operating income (NOI) interest

I.e. 1000 300 = 700

Therefore:
calculate the value of equity, then calculate the value of debt and then add them together

Recall: cost of equity is 9.33% Hence, the value of Ls equity is Rs 7,500

E = NI 700 = = Rs . 7 , 500 Ke 0 . 0933

Value of Firms Debt

The value of a firms debt is the discounted value of debt-holders interest income
Recall: cost of debt debt is 6% The value of firms L debt is Rs. 5,000
D = Int 300 = = Rs . 5000 Kd 0 . 06

Value of firm
Value of firm = value of equity + value of debt

V = E + D = 7,500 + 5,000 = Rs12,500

Calculate the firms overall expected rate of return (I.e. cost of capital)

WACC
Calculate the firms overall expected rate of return (I.e. cost of capital)
NetOperati ngIncome ValueofFir m

WACC = cost of Equity * Equity Weight + Cost of Debt * debt Weight

firm ' s cos tofcapital = k0 =

NOI 1,000 = = 8% V 12,500

The firm overall cost of capital is also known as the weighted average cost of capital (WACC)
There is an alternative way to calculate WACC (k0)

E D + kd V V 7500 5,000 k0 = 0.0933 + 0.06 12500 12,500 k0 = 0.0933 60% + 0.06 40% k0 = ke k0 = 8%

k0 = ke
Recall: cost of equity is 9.33% and cost of debt is 6%. I.e. cost of debt is less than cost of equity.
Therefore, it pays to have a capital structure with more debts than equity
I.e. as the ratio of debt to total capital increases, the overall cost of capital (WACC) falls

E D + kd V V

Ke = 0.0933; kd = 0.06 E = 147/0.0933 = 1575.6 D = 853/0.06 = 14216.7 V = E + D = 1575.6 + 14216.7 = 15792.3

Try the following:

Suppose in the above example NOI is 1000 and interest is 853; cost of debt and cost of equity are same as before

1575.6 14216.7 + 0.06 15792.3 15792.3 = 0.0933 10% + 0.06 90% = 6.33% k 0 = 0.0933

Comparing results: When value of Debt to total value of firm increased from 40% to 90%:
the overall cost of capital fell from 8% to 6.33% The value of firm increased from 12500 to 15792
I.e. firms value increases with more debt

2nd part of the Capital Structure Chapter