MBA 2nd Semester Financial Management Kavitha Menon

It

is the proportion of debt, preference and equity shares in a firms balance sheet

 It

is the capital structure at which the weighted average cost of capital is minimum and thereby maximizing the value of the firm.

There are only two sources of funds used by a firm, perpetual debt & equity shares There are no corporate taxes (this was removed later) The dividend payout ratio is 100 i.e. there are no retained earnings The total assets are given and do not change The total financing remains constant The EBIT are not expected to grow Business risk is constant over time & is independent of the capital structure & financial risk Investors have the same subjective probability distribution of expected operating profits of the firm Perpetual life of the firm no closures due to strikes, lockouts

 The

relationship between leverage, cost of capital & value of the firm has been analyzed & examined in different ways.

E = Total market value of the equity D = Total market value of the debt V = Total market value of the firm i.e. D + E I = total interest payment NOP = Net Operating profits i.e. EBIT NP = Net Profit or Profit after tax D0 = Dividend paid by the company at time 0 D1 = Expected dividend at the end of year 1 P0 = Current market price P1 = Expected market price of the share after year 1 kd = After tax cost of debt ke = Cost of equity k0 = Overall cost of Capital i.e. WACC

EBIT WACC ! V
Where

V = Total market value of the firm i.e. D + E EBIT = Earnings before Interest & Tax

or WACC kd * wd  ke * we

Interest paid kd ! Cost of debt ! Market value of debt

Pr ofits available to s / holders k e ! Cost of equity ! Market value of equity

k p ! Cost of preference capital ! Pr eference dividend Market value of preference capital

Net Income Approach Net Operating Income Approach Traditional Approach Modigliani Miller (MM) Hypothesis

 Suggested

by David Durand States there is a direct relationship between capital structure & value of the firm Hence, a firm can affect its value by increasing or decreasing the debt proportion in the overall financing mix. A change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. Thus, if debt is increased, WACC will decrease and the value of the firm as well as the market price of the ordinary shares will increase

 Total

capital requirement of the firm are given and remain constant kd < ke Both kd and ke remain constant, and increase in financial leverage i.e. use of more & more debt financing in the capital structure, does not affect the risk perception of the investors.

 Debt

is less costly than equity. Debt bears a tax advantage that lowers its effective cost

 Changing

the financing mix of the firm will lead to change in WACC of the firm resulting in change in the value of the firm. As kd < ke ,increasing the use of cheaper debt ( and simultaneous decrease in equity proportions) in the overall capital structure will result in the magnified returns available to the shareholders. The increased returns to the shareholders will increase the total value of the equity and thus increase the value of the firm The WACC will decrease & the value of the firm will increase.

ke
Cost of Capital %

ko kd

Degree of leverage

 The

expected EBIT of a firm is Rs. 200,000. It has issued equity share capital with ke @ 10% and 6% debt of Rs. 500,000. (I) Find the value of the firm and the overall cost of capital (II) If the firm had issued 6% debt of Rs. 700,000 instead of Rs. 500,000, find the value of the firm & WACC (III) If the firm had issued 6% debt of Rs. 200,000 instead of Rs. 500,000, find the value of the firm & WACC

EBIT (-) Interest Net profit ke kd Market value of equity, E = 170,000/0.10 Value of debt, D Total value of the firm, V WACC, ko = EBIT/V = 2,00,000/22,00,000

Rs. 200,000 30,000 170,000 10% 6% 17,00,000 500,000 22,00,000 0.09 9%

EBIT (-) Interest Net profit ke Market value of equity, E = 158,000/0.10 Value of debt, D Total value of the firm, V WACC, ko = EBIT/V = 2,00,000/22,80,000

Rs. 200,000 42,000 158,000 10% 15,80,000 700,000 22,80,000 0.087 8.7%

Rs. EBIT (-) Interest Net profit ke Market value of equity, E = 188,000/0.10 Value of debt, D Total value of the firm, V WACC, ko = EBIT/V = 2,00,000/20,80,000 200,000 12,000 188,000 10% 18,80,000 200,000 20,80,000 0.096 9.6%

 A firm

can increase its value and decrease its WACC by increasing the debt proportion in the capital structure

 Company

X and company Y are in the same risk class, and are identical in every respect except that Co. X uses debt, while Co. Y does not. The levered firm has 9 lakh debentures, carrying 10% rate of interest. Both the firms earn 20% operating profit on their total assets of Rs. 15 lakhs. Assume a tax rate of 35% and a capitalization rate of 15% Compute value and overall cost of capital of firm X & Y using net income approach.

 Assuming

no taxes & given the EBIT, Interest (I) at 10% and equity capitalization rate below, calculate the total market value of each firm:
Firm X Y Z W EBIT Rs. 200,000 300,000 500,000 600,000 I 20,000 60,000 200,000 240,000 ke(%) 12 16 15 18

Also

determine the WACC for each firm

 The

net income approach has no basis in reality. The optimum capital structure would be a capital structure having maximum debt.

 Also

suggested by Durand Opposite to NI approach The financing mix or the capital structure is irrelevant and does not affect the value of the firm. The market value of the firm depends upon the net operating profit or EBIT and the overall cost of capital, WACC. Any change in the leverage will not lead to any change in the total value of the firm and the market price of shares as well the WACC is independent of the degree of leverage.

 The

investors see the firm as a whole and thus capitalize the earnings of the firm to find the value of the firm as a whole. WACC is constant and depends upon the business risk which remains unchanged The cost of debt is constant. The use of more & more debt in the capital structure increases the risk of the shareholders and thus results in increase in the cost of equity There are no taxes

ke ko kd

Cost of Capital %

Degree of leverage

All equity point at which ke = ko. As the debt proportion increases, ke will increase but ko remain constant.

 For

all degrees of leverage, overall cost of capital of the firm remains constant. Therefore, value of the firm will be -

EBIT V! ko

 The

total market value of equity capital is -

E V D

 A firm

has an EBIT of Rs. 5,00,000 and belongs to a risk class of 10%. What is the cost of Equity if it employs 6% debt to the extent of 30%, 40% or 50% of the total capital fund of Rs. 20,00,000?

Debt (Rs.) Equity (Rs. ) EBIT (Rs.) ko Value of the Firm (V) (Rs.) (EBIT/ko) Value of Equity (E) (Rs.) (VD) Interest @ 6% (Rs.) Net Profit (EBITInt.) (Rs.) ke (NP/E)

30% debt 6,00,000 14,00,000 5,00,000 10% 50,00,000 44,00,000 36,000 4,64,000 10.545%

40% debt 8,00,000 12,00,000 5,00,000 10% 50,00,000 42,00,000 48,000 4,52,000 10.76%

50% debt 10,00,000 10,00,000 5,00,000 10% 50,00,000 40,00,000 60,000 4,40,000 11%

 The

total value of the firm is unaffected by its capital structure. The market price of shares will not change with the change in the debt-equity ratio. There is nothing like optimum capital structure. Any capital structure is optimum, according to NOI approach.

 Calculate market

value of equity and cost of equity under the net operating income approach. Norton Co. has Rs. 400,000 in outstanding debt at 7% interest. Nortons cost of capital is 12% and expected EBIT is Rs. 120,000

NI and NOI seem to be unrealistic in practical situations It takes a mid-way between the NI approach and the NOI approach. As per this approach, a firm should make judicious use of debt & equity to achieve an optimum capital structure. At this capital structure, the overall cost of capital should be minimum and the value of the firm will be maximum. It states that the value of the firm increases with increase in financial leverage but upto a certain limit only. Beyond this limit, the increase in financial leverage will increase its WACC also, and the value of the firm will decline.

 The

value of the firm increases with the increase in financial leverage, upto a certain limit only. kd is assumed to be less than ke.

PQR Ltd. is having an EBIT of Rs. 150,000. it is contemplating to redeem a part of the capital by introducing debt financing. Presently, it is a 100% equity firm with equity capitalization rate of 16%. The firm is to redeem the capital by introducing debt financing upto Rs. 300,000 i.e. 30% of the total funds or upto Rs. 500,000 i.e. 50% of the total funds. It is expected that for the debt financing upto 30%, the rate of interest will be 10% and ke will increase to 17%. However, if the firm opts for 50% debt financing, then interest will be payable @12% and the ke will be 20%. Find the value of the firm and its WACC under different levels of debt financing?

1. 2. 3.

Jumbo Ltd. has EBIT of Rs. 4 lakhs. The firm currently has an outstanding debt of Rs. 15 lakhs at an average cost of Rs. 10%. Its cost of equity is estimated to be 16%. Determine the current value of the firm using Traditional Valuation approach Determine the overall capitalization rate. The firm is considering to issue capital of Rs. 500,000 in order to redeem Rs. 5 lakhs debt. The cost of debt is expected to be unaffected. However, the firms cost of capital is to be reduced to 14% as a result of decrease in leverage. would you recommend the proposed action?

There is one optimal capital structure where ko is at its lowest point. This is also the point where the firms total value will be the largest

 The

Modigliani Miller hypothesis is identical with the net operating Income approach. Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not affected by the changes in capital structure. In other words, capital structure decisions are irrelevant and value of the firm is independent of debt equity mix.

1.

2.

The overall cost of capital (ko) and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. The financial risk increases with more debt content in the capital structure. As a result cost of equity (ke) increases in a manner to offset exactly the low cost advantage of debt. Hence, overall cost of capital remains the same.

Market value of debt ($35M) Market value of equity ($65M) Total firm market value ($100M)

Market value of debt ($65M) Market value of equity ($35M) Total firm market value ($100M)

Total

market value is not altered by the capital structure

1. Perfect

capital market i.e.

i) investors are free to buy and sell securities, ii) they can borrow funds without restriction at the same terms as the firms do, iii) they behave rationally, iv) they are well informed, and v) there are no transaction costs.
2. Firms

can be classified into homogeneous risk classes. All the firms in the same risk class will have the same degree of financial risk. 3. All investors have the same expectation of a firms net operating income (EBIT). 4. The dividend payout ratio is 100%, which means there are no retained earnings. 5. There are no corporate taxes. This assumption has been removed later.

Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value. Otherwise, arbitrage is possible.

 Switching of

investment from one firm to

another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price.

 Arbitrage Support

Net Op Income Interest on debt (12% pa) nil Net earnings 10,000 Equity req return .15 Market Value of equity 66,667 Market value of debt nil Total value of the firm 66,667

Co A 10,000

Co B 10,000 3,600 6, 00 .16 0,000 30,000 70,000

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 M&M

would argue that it would not be possible for one company to remain more valuable than the other, since the over valued company would be sold and the under valued company bought, until the prices equalise. A shareholder in B would do this, replicating Bs actions

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Investor in B (IB) owns 1% of B i.e. 4 IB sell their shares for 4 Return would have been 64 (1% of 6,4 ) IB borrows 3 (1% of Bs debt) @ 12% IB buys 1% of A for 666.7 Net position Return on A 1 . Less interest 36. Net return 64. same as in B but for 33.3 less personal outlay (7 666.7) so could spend on more A

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investor uses personal rather than corporate financial leverage. The equity share price in Company NL rises based on increased share demand. The equity share price in Company L falls based on selling pressures. Arbitrage continues until total firm values are identical for companies NL and L. Therefore, all capital structures are equally as acceptable.

The