CAPITAL STRUCTURE

Presentation by:JEENIA(2)

AARTI (32)NEHA(34)

SHEENU(36)

MEANING OF CAPITAL STRUCTURE

Capital structure refer to the proportion between the various long term source of finance in the total capital of firm

A financial manager choose that source of finance which include minimum risk as well as minimum cost of capital.

Sources of long term finance

Proprietor’s funds

Equity capital

Preference capital

Reserve and

surplus

Borrowed funds

Long term debts

Importance Capital structure determine the risk assumed

by the firm

Capital structure determine the cost of capital of the firm

It affect the flexibility and liquidity of the firm

It affect the control of the owner of the firm

DETERMINANT OF CAPITAL STRUCTURE Nature and Size of the firm

Stability of the earning

Stages of life cycle of the firm

Cash flow ability of the firm

Cost of capital

Rate of corporate tax

Retaining control

Flexibility

Trading on equity

Legal requirement

Assets structure

Nature of investor

Point of indifferenceIt refer to that EBIT level, at which EPS remain same irrespective of different alternatives of debt-equity mix.

At this level of EBIT return on capital employed is equal to cost of debt this is also known as break even level of EBIT for alternative financial plan

Point of indifference is calculated as : (X-I1)(1-T)-PD = (X-I2)(1-T)-PD S1 S2

Where X = point of indifference I1 = int. under alternative financial plan 1 I2= int. under alternative financial plan 2 T = tax rate PD = pref. dividend S1 = amount of equity share under financial plan 1 S2= amount of equity share under financial plan 2

Net income approach Net operating

income approach

Traditional approach

Modigliani and miller approach

Capital structure theories

NET INCOME (NI) THEORIES This theory is suggested by “David Durand”

Acc. to this approach the value of the firm is increase and decrease overall cost of capital by increasing the proportion of debt financing in capital structure

It is due to the fact that debt is generally a cheaper sources of finance because:

1. Interest rate are lower than the dividend rate

2. Benefit of tax because int. is deductible expense

ASSUMPTION OF NET INCOME APPROACH The cost of debt is lower than cost of equity

The risk perception of the investor is not changed by the use of debt

There is no corporate tax

The effect of leverage on the cost of capital under NI approach

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NET OPERATING INCOME APPROACH

This theory was propounded by “David Durand” and is also known as irrelevant theory.

Acc. to this theory, the total market value of the firm is not affected by the change in the capital structure and the overall cost of capital remain constant irrespective of debt-equity ratio.

ASSUMPTION OF NET OPERATING INCOME APPROACH

The market capitalizes the value of the firm as a whole. Thus, the split between debt and equity is not important

The cost of debt is lower than cost of equity

The risk perception of the investor is not changed by the use of debt

There is no corporate tax

The effect of leverage on the cost of capital under NOI approach

TRADITIONAL APPROACH This approach is the midway of NI approach and NOI

approach. And also known as intermediate approach.

Acc. to this, the value of firm can be increased initially or cost of capital can be decreased by using more debt as the debt is a cheaper source of fund than equity

After that optimum capital structure can be reached by a proper debt-equity mix

But after a particular point if the proportion of debt is increased, then the overall cost of capital start increasing and market value begin to decline

MODIGLIANI-MILLER APPROACH

They have given two approach

1. In the absence of corporate taxes

2. When corporate taxes exist

Assumption :-

Capital market are perfect

Homogeneous risk classes of firm

Expectations about the net operating income

100% payout ration

No corporate tax

IN THE ABSENCE OF CORPORATE TAXES

Acc. To this theory total value of a firm must be constant irrespective of degree of leverage, i.e. debt-equity ratio. This can be justified by arbitrage process .This approach is similar to the net operating income approach when taxes are ignoredIt means capital structure decision of a firm is not affect its market value.

WHEN CORPORATE TAX ARE ASSUMED TO EXIST

Acc. to this value of the firm increase and cost of capital decrease with the use of debt if corporate tax are considered. This is because of Benefit of tax because int. on tax is deductible expense

Optimum capital structure

Optimum capital structure is a capital structure at which market value per share is maximum and the cost of capital is minimum

Quality of a sound capital structure

Simplicity

flexibility

Minimum risk

Minimum cost of capital

Sufficient liquidity

Retaining control

Avoidance of unnecessary restriction

EBIT-EPS analysis EPS = (EBIT-I)(I-t)-PD nWhere :

EPS = earning per shareEBIT = earning before int. and taxI = int. charged per annumt = tax ratePD = preference dividendn = no. of equity shares

Q-ABC company has currently an all equity structure consisting of 15000 equity shares of rs.100 each. The management is planning to raise another rs.25 lakhs to finance a major programme of expansion and it consider three alternative method of financing

To issue 25000 equity share of rs.100 each To issue 25000, 8% debenture of rs.100 each To issue 25000, preference share of rs.100 each the company EBIT will be 8 lakhs. Assuming a

corporate tax of 50%, determine earning per share in each alternative

Alternative 1 equity financing

Alternative 2 debt financing

Alter. 3 pref. share financing

EBIT 8.00 8.00 8.00Less int. - 2.00 -Earning after int. but before tax

8.00 6.00 8.00

Less tax @50% 4.00 3.00 4.00EAT 4.00 3.00 4.00Less pref. dividend

- - 2.00

E available to equity shareholders

4.00 3.00 2.00

No. of equity share

40000 15000 15000

400000 300000 200000EPS Rs.10 Rs.20 Rs.13.33

Reference Goel DK, Management accounting and

financial management, APC Gupta Shashi K., financial management and

policy, kalyani publication

Thank you