PRESENTED TO DR ANIL MATKAR

PRATIK AHLUWALIA 2012002 RICHIKA CHANANA 2012026 JUHI CHAWLA 2012031

In finance, capital structure refers to the way a corporation finances its assets. It includes combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities.

For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed.
The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage

Capital restructuring

Adjusting leverage without changing the firms assets Increase leverage

Issue debt and repurchase outstanding shares

Decrease leverage
Issue new shares and retire outstanding debt

Choose capital structure to max stockholder wealth Maximizing firm value Minimizing the WACC

Definition:
Traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum.

The rate of interest on debt remains constant for a certain period and thereafter with increase in leverage, it increases. The expected rate by equity shareholders remains constant or increase gradually. After that the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily. As a result of activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.

This model was originally published in 1958 by two scientist named Modigliani and Miller. Restrictive Assumptions :-

1.
2. 3.

No Income Tax No Bankruptcy Cost No Transaction Cost

Cost of Equity = Shareholders Expectation & Risk Element

Leverage = No Impact on Cost Of Capital

Cost of Capital = Capitalization Rate of Company

PARTICULARS EBIT Interest (5% on 1,000)

UNLEVERED LEVERE FIRM D FIRM 1,000 1,000 (50)

EBT Tax Net Income Ro Proposition 1

1,000 1,000 10% Vu = Vl = 10,000 (1,000/10%)

950 950 10% Ve=VuVd =10,0001,000=9,00

PARTICULARS Proposition 2 Rs=Ro + D/E (Ro-Rd)

UNLEVERED FIRM 10 + 0 = 10%

LEVERED FIRM 10 + 0.05/9 = 10.56%

PARTICULARS EBIT Interest (5% on 1,000) EBT

UNLEVERED FIRM 1,000 1,000

LEVERED FIRM 1,000 (50) 950

Tax (30%) Net Income Ro Proposition 1

(300) 700 10% Vu = Vl = 7,000 (1,000 (10.3)/10%)

(285) 655 10% Ve=VuVd(t) =7,000 300=6,700 Vl = 7,700

PARTICULARS Proposition 2 Rs=Ro + D[1-t]/E (Ro-Rd)

UNLEVERED FIRM 10 + 0 = 10%

LEVERED FIRM

10 + 300 * 0.05/6700 = 10.22%

The

capital structure decision is relevant to the valuation of the firm.

If

the financial leverage increases, the weighted average cost of capital decreases, the value of the firm and the market price of the equity shares increases.
If

the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases.

1. 2. 3.

There are no taxes The cost of debt is less than the cost of equity. The use of debt does not change the risk perception of the investors

Capital Costs (%)

ke (Required return on equity) WACC Kd (cost of debt)

This approach suggests that the change in debt of a firm or change in leverage fails top affect the total value of a firm. As per this approach the weighted Average cost of capital and total value of a company are independent of the capital structure decisions or degree of financial leverage of a company

Example explaining Net Operating Income Approach to Capital Structure Earnings before Interest Tax (EBIT)=1,00,000 Bonds (Debt part)= 3,00,000 Cost of Bonds issued (Debt)=10% WACC=12.5%

Calculating the value of the company:

(EBIT)=1,00,000 WACC=12.5% Market value of the company= EBIT/WACC = 1,00,000/12.5%= 8,00,000 Total Debt =3,00,000( given) Total Equity = Total market value - Total debt = 8,00,000-3,00,000 =5,00,000 Shareholders' earnings = EBIT-interest on debt =100,000 - 10% of 300,000 =70,000 Cost of equity = Shareholders earnings/ total equity = 70,000/5,00,000 =14%

*Assume that proportion of debt increases from 3,00,000 to

4,00,000 and everything else remains same

(EBIT)=1,00,000 WACC=12.5% Market value of the company = EBIT/WACC =1,00,000/12.5% = 8,00,000 Total Debt = 4,00,000 (Assumption) Total Equity= Total market value - total debt =8,00,000-400,000 =400,000 Shareholders' earnings = EBIT-interest on debt =1,00,000 - 10% of 400,000 = 60,000 so, Cost of equity = 60,000/4,00,000 =15%

Cost

of equity increases with every increase in debt while the weighted average cost of capital (WACC) remains constant.
When

the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders.
To

compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.
It

is assumed under this method that overall cost of capital is unaffected and hence it remains constant irrespective of the change in the ratio of debts to equity capital