OPTIMUM CAPITAL STRUCTURE

INTRODUCTION

The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes its value. Putting it simple, the optimal capital structure for a company is the one which proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firms cost of capital. Theoretically, debt financing usually proffers the lowest cost of capital because of its tax deductibility. However, it is seldom the optimal structure for as debt increases, it increases the companys risk. The short and long term debt ratio of a company should also be considered while examining the capital structure. Capital structure is most commonly referred as a firms debt-to-equity ratio, which gives an insight into the level of risk of a company for the potential investors. Estimating an optimal capital is a key requirement of a companys corporate finance department. Estimating the Optimal Capital Structure There are numerous ways in which a companys optimal capital structure can be estimated. the most commonly used ones are: Method 1 One method of estimating a companys optimal capital structure is utilizing the average or median capital structure of the principle companies engaged in the market approach. This approach is helpful as the appraiser is well aware about which companies are included in the analysis and the degree to which they are related to the subject company. However, this method features a limitation that fluctuations in market prices and the spread out nature of debt offerings and retirements might cause the actual capital structure of a principle company to be significantly different from the target capital structure.

Method 2 This method is applied if the risk of a company did not change because of the nature of its capital structure, and a company would wish as much debt as possible, as the interest payments are tax deductible and debt financing is always cheaper than equity financing. The main objective of this method is determining the debt level at which the benefits of increased debt does not overshadow the increased risks and potential costs associated with a economically distressed company.

Numerical questions based on OPTIMUM CAPITAL STRUCTURE

Q1. A company has 10,000 shares of Rs.100 each. It has also 10% of Rs. 12,00,000 debt. The operating profit is Rs. 2,40,000. The required rate of return on equity is 20%. Find out Weighted Average Cost of Capital (WACC) under the Modigliani Millar approach assuming (a) No tax and (b) Tax rate is 30%. Solution (a) When there is no tax: KeL = 0.20 + (0.20-0.10) (12,00,000/12,00,000) 0.30 = 30.0% WACC = (0.10 x 12,00,000/24,00,000) + (0.30x12,00,000/24,00,000) = 0.05+0.15=0.20=20.0% (b) In case of 30% tax rate: KeU = [2,40,000 (1-0.30)/12,00,000] = 0.14 = 14.0% KeL = [2,40,000-1,20,000) (1-0.30)]/12,00,000 = 0.07 = 7.0% WACC = {0.10x12,00,000/24,00,000 [1-0.30] + (0.07x12,00,000/24,00,000) =0.035+0.035=0.07=7.0%

Question 2 : A company wishes to determine the optimum capital structure. From the following selected information supplied to you, determine the optimal structure of the company. Situation 1 2 3 Solution Situation 1 2 3 kd(%) 9 6 5 ke(%) 10 11 14 W1(B/V) 0.8 0.5 0.2 W2(S/V) 0.2 0.5 0.8 k0(%) 9.2 8.5 12.2 Debt 4,00,000 2,50,000 1,00,000 Equity 1,00,000 2,50,000 4,00,000 After tax cost of debt (%) 9 6 5 k2(%) 10 11 14

The optimal capital structure for the company is in situation 2, when it uses 50% debt and 50% equity, as its cost of capital at this level of debt is minimum.

Question 3: A company has a capital of Rs. 10,00,000 with an equity capitalisation rate of 14% with no taxes. The finance manager likes to introduce financial leverage for which he has the following information :

Debt (Rs)

Interest Rate %

Equity capitalisation rate for a given level of debt% 14.0 15.0 16.0 17.0 17.5 18.0 20.0 24.0

1,00,000 2,00,000 3,00,000 4,00,000 5,00,000 6,00,000 7,00,000

8.0 8.0 9.0 9.0 9.5 9.5 10.5

Find equity capitalisation rate based on M-M Approach and the amount of debt that denotes the optimal capital structure. Solution: M-M View : Debt Kd Ko Debt/Equity Ke=Ko+(Ko-Ko)D/E

1,00,000 2,00,000 3,00,000 4,00,000 5,00,000 6,00,000 7,00,000

0.080 0.080 0.090 0.090 0.095 0.095 0.105

0.14 0.14 0.14 0.14 0.14 0.14 0.14 0.14

1,00,000/9,00,000 2,00,000/8,00,000 3,00,000/7,00,000 4,00,000/6,00,000 5,00,000/5,00,000 6,00,000/4,00,000 7,00,000/3,00,000

0.1400 0.1467 0.1550 0.1614 0.1733 0.1850 0.2075 0.2217

The M-M Approach assumes that leverage does not influence the weighted average cost of capital. Rather it is the cost of equity that rises with growing degree of leverage. Ques 4 In considering the most desirable capital structure of a company, the following estimates of the cost of debt and equity capital (after tax) have been made at various levels of debt-equity mix. Debt as percentage of total capital employed 0 10 20 30 40 50 60 Cost of debt (percent) 5.0 5.0 5.0 5.5 6.0 6.5 7.0 Cost of Equity (percent) 12.0 12.0 12.5 13.0 14.0 16.0 20.0

You are required to determine the optimal debt-equity mix for the company by calculating the composite cost of capital.

Solution : Kd(%) 5.0 5.0 5.0 5.5 6.0 6.5 7.0 Ke(%) 12.0 12.0 12.5 13.0 14.0 16.0 20.0 W1(B/V) 0.0 0.1 0.2 0.3 0.4 0.5 0.6 W2S/V=(1B/V) 1.0 0.9 0.8 0.7 0.6 0.5 0.4 Kd(W1)+Ke(W2)= Ko (%) 12.00 11.30 11.00 10.75 10.80 11.25 12.20

Optimum debt equity mix for the company is at a point where the composite cost of capital is minimum. When debt is 30% of the total capital employed the ko is minimum. Therefore 30% debt and 70% equity mix is the optimal debt-equity mix for any company.

Submitted to Dr. Shiv Prasad

Submitted byAshutosh Pednekar MBA-I SEM II FMS-MDS University,Ajmer