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Capital Structure
Capital structure can be defined as the mix of owned capital (equity, reserves & surplus) and borrowed capital (debentures, loans from banks, financial institutions) Maximization of shareholders wealth is prime objective of a financial manager. The same may be achieved if an optimal capital structure is designed for the company. Planning a capital structure is a highly psychological, complex and qualitative process. It involves balancing the shareholders expectations (risk & returns) and capital requirements of the firm.
Return: ability to generate maximum returns to the shareholders, i.e. maximize EPS and market price per share. Cost: minimizes the cost of capital (WACC). Debt is cheaper than equity due to tax shield on interest & no benefit on dividends. Risk: insolvency risk associated with high debt component.
Control: avoid dilution of management control, hence debt preferred to new equity shares.
Flexibility: altering capital structure without much costs & delays, to raise funds whenever required. Capacity: ability to generate profits to pay interest and principal.
Value of a firm depends upon earnings of a firm and its cost of capital (i.e. WACC).
Earnings are a function of investment decisions, operating efficiencies, & WACC is a function of its capital structure.
Value of firm is derived by capitalizing the earnings by its cost of capital (WACC). Value of Firm = Earnings / WACC Thus, value of a firm varies due to changes in the earnings of a company or its cost of capital, or both. Capital structure cannot affect the total earnings of a firm (EBIT), but it can affect the residual shareholders earnings.
WACC
Weighted Average Cost of Capital Also called the hurdle rate
V=D+E
Costs of Financing
Cost of Debt
YTM is a good estimate
Example WACC
Equity Information
5,00,000 shares Rs 80 per share
Beta = 1.15
Market risk prem. = 9% Risk-free rate = 5%
Cost of equity?
Cost of debt?
Example WACC
Capital structure weights?
E = 5,00,000 shares (Rs 80/share) = Rs 4,00,00,000 D = Rs1,00,00,000 V=4+1= Rs 5,00,00,000 What is the WACC? WACC = kE (E/V) +kD (D/V) = 0.1535(4/5) + 0.08(1/5) = 0.1228+0.016 =0.1338 or 13.38%
Firms use only two sources of funds equity & debt. No change in investment decisions of the firm, i.e. no change in total assets.
ke, ko
ke
kd
ko kd
As the proportion of debt (Kd) in capital structure increases, the WACC (Ko) reduces.
Debt
Cost ke
At a point, it settles
But after this point, (Ko) increases, due to increase in the cost of equity. (Ke)
ko
kd
Debt
Cost ke
ko kd
Debt
MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm. Further, the MM model adds a behavioural justification in favour of the NOI approach (personal leverage) Assumptions
o
o o
o
o
Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible. Investors can borrow without restrictions at par with the firms. Investors are rational & informed of risk-return of all securities No corporate income tax, and no transaction costs. 100 % dividend payout ratio, i.e. no profits retention
Value of firm is equal to the capitalized value of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC).
Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT Expected WACC
As per MM, identical firms (except capital structure) will have the same level of earnings. As per MM approach, if market values of identical firms are different, arbitrage process will take place. In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.
Total market value is not altered by the capital structure (the total size of the pies are the same). M&M assume an absence of taxes and market imperfections. Investors can substitute personal for corporate financial leverage.
M&M Proposition II
Cost of equity is equal to the capitalisation rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity capitalisation rate and cost of debt times the ratio of debt to equity Debt financing increases financial risk.
Cost of equity depends on business risk and financial risk.
Arbitrage Example
Consider two firms that are identical in every respect EXCEPT:
Company NL -- no financial leverage Company L -- Rs30,000 of 12% debt Market value of debt for Company L equals its par value Required return on equity -- Company NL is 15% -- Company L is 16% NOI for each firm is Rs10,000
3. Buy 1% of the stock in Company NL for Rs666.67. This leaves you with Rs33.33 for other investments (Rs400 + Rs300 - Rs666.67).
x 16% = Rs100 return on Company NL Rs300 x 12% = Rs36 interest paid Rs64 net return (Rs100 - Rs36) AND Rs33.33 left over. This reduces the required net investment to Rs366.67 to earn Rs64.
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.
costs
ke with no leverage
ke without bankruptcy costs
Premium for financial risk Premium for business risk Risk-free rate
Rf
Financial Leverage (B / S)
Agency Costs
Agency Costs -- Costs associated with monitoring management to ensure that it behaves in ways consistent with the firms contractual agreements with creditors and shareholders.
Monitoring includes bonding of agents, auditing financial statements, and explicitly restricting management decisions or actions. Costs are borne by shareholders. Monitoring costs, like bankruptcy costs, tend to rise at an increasing rate with financial leverage.
As financial leverage increases, tax-shield benefits increase as do bankruptcy and agency costs.