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Capital Structure
It refers to the kinds of securities and the proportionate amounts that make up capitalization. A decision about the proportion among the three types of securities viz., Equity shares, Pref. Shares and Debentures refers to the Capital Structure of an enterprise.
Importance's:
View point that strongly supports the close relationship between leverage and value of a firm. It help to determine various investment decisions Capital Structure decision can influence the value of the firm through earnings available to the share holders.
13.Costs of Floatation
14.Personal Considerations 15.Corporate Tax Rate
16.Legal requirements
Assumptions of NOI
The market capitalizes the value of the firms as a whole. The business risk remains constant at every level of debt equity mix. There are no corporate taxes.
3. Traditional approach
It is also known as intermediate approach. Optimum capital structure can be reached by a proper debt-equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The overall cost of capital decreases up to a certain point, remains unchanged for moderate increase in debt thereafter and increases or rises beyond a certain point. Even the cost of debt may increase at this stage due to increases financial risk.
MM Approach - Assumptions
There are no corporate taxes There is a prefect market Investors act rationally The expected earnings of all the firms have identical risk characteristics Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the actual value of the variables may turn out to be different from their best estimates. The cut-off point of investment in a firm is capitalization rate. All earnings are distributed to the share holders.
1. EBIT-EPS Analysis
It is an approach for selecting capital structure that maximises EPS over the expected range of EBIT. It also shows the impact of various financing alternatives on EPS at various levels of EBIT. This analysis is useful for two reasons: The EPS is a measure of a firms performance- given the P/E ratio, the larger the EPS, the larger would be the value of a firms shares; and To show the value of EPS under various financial alternatives at different levels of EBIT useful to the finance manager in arriving at an appropriate financing decisions. Basic Relationship: EPS = (EBIT Interest) (1 Tax Rate) Dividend No. of Equity shares.
Plan 1 ( Equity)
EBIT
Example
A Company requires an investment outlay of Rs.100 Lakhs, is considering two capital structures: Capital Structure A Capital Structure B Equity 100 50 Debt 50 50 The average cost of debt is fixed at 12 %, the ROI (defined as EBIT dividend by total assets) may vary widely. The tax rate of the firm is 50 %. Based on the above information, find the relationship between ROI and ROE under the capital structure, A&B ,would be as show the graphical representation.
Solution
D/E = 1; r=12%; tax rate = 50 %
Capital Structure A Basis ROI EBIT Interest Profit Before Tax Tax (50%) Profit After Tax
ROE
Capital Structure B 20% 20% 20 0 20 25% 25% 25 0 25 5% 5% 5 5 0 10% 10% 10 5 5 15% 15% 15 5 10 20% 20% 20 5 15 25% 25% 25 5 20
5% 5% 5 0 5
10% 10% 10 0 10
15% 15% 15 0 15
2.5 2.5
5 5
7.5 7.5
10 10
12.5 12.5
0 0
2.5 2.5
5 5
7.5 7.5
10 10
2.50%
5%
7.50%
10%
12.50%
5%
10%
15%
20%
Graphical Presentation
25.00%
20.00%
20%
15.00%
15% 12.50%
ROE
10.00%
10% 7.50%
10%
5%
10%
15% ROI
20%
25%
Interpretation:
1). A is higher than the ROE under Capital Structure B when ROI is less than the cost of debt. 2). ROE is the same when ROI is equal to cost of debt