Sri Krishna College of Technology
School of Management
FM-UNIT 3
Capital Structure
Sri Krishna College of Technology
School of Management
Sri Krishna College of Technology
School of Management
Name of the Faculty: KARTHIKEYAN N
Subject Code & Title:18PNC209 & FINANCIAL
MANAGEMENT
Academic Year: 2018-2019
Class & Trimester: I year – 02 Trimester
Regulations: 2018
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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Sri Krishna College of Technology
School of Management
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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Sri Krishna College of Technology
School of Management
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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Sri Krishna College of Technology
School of Management
Session No.- 1
• Topics to be covered:
• Cost of Capital
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
• Learning Objectives
- What is Cost of Capital
- How to Calculate Weighted Cost of Capital
- How to find out the optimal capital mix
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
- OBE- Understand, Apply, Analyse
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School of Management
Cost of Capital (K˳)
Provides Capital
Investor/ Company
Owner
Return for the Capital Invested
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School of Management
K˳- From Investor’s View Point
• “The measurement of the sacrifice made by the investor
in capital formation”
• e.g- A invests in a firm’s equity stock for Rs.10000 and
not in a bank which may give him 7% as interest.
Here A has sacrifices 7% interest
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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K˳- From Firm’s Point
• “It is the minimum required rate of return needed to
justify the use of capital”
• e.g- A firm raises 100000 by issuing debentures. For this
the firm has to justify by providing a return(10%)
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K˳- From Capital Expenditure Point
• “Minimum required rate of return used to value cash
flows”
• e.g- A firm is planning to invest in a project that requires
Rs 20 Lacs as investment & provides cash flow for a
period of 5 years.
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
K˳- Definition
• “ Cost of Capital is the minimum rate of return the firm
must pay to the fund suppliers who have provided the
capital”
• “ Cost of Capital is the minimum required rate of
earnings or the cut-off rate of capital expenditure”-
Solomon Ezra
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Sources of
Funds
Long-
Equity Preference Short-Debt
Term Debt
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• Cost of Capital is also known as
• Weighted Average Cost of Capital (WACC)
• Composite Cost of Capital
• Combined Cost of Capital
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• Concepts in K˳
• Rate of Return - What the firm requires to earn from its
investment in projects.
• Minimum Rate of Return- What the firm requires to
maintain as the market value of the share
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• K˳ is used as
• basis of investment projects and
• evaluating the alternative sources of finance
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• K˳ can be calculated by
• Computing Overall Cost of Capital (WACC)
• Computation of Specific Cost of Capital
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School of Management
Computing Overall Cost of Capital (WACC)- Steps
Step 1: Determination of the type of funds to be raised
and their individual share in the total capitalisation of
the firm
Step 2: Computation of cost of each type of funds.
Step 3: Assigning weights to specific costs.
Step 4: Multiplying the cost of each of the sources by
the appropriate assigned weights.
Step 5: Multiply the Source of fund amount with after tax
cost. You will get weighted cost.
Step 6: Divide the total weighted cost by the total
amount to get WACC
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School of Management
Overall Cost of Capital (K˳ )= Total Weighted Cost*100
or
(Total Cost/Total Capital)*100
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Sri Krishna College of Technology
School of Management
Points to Ponder
• Cost of Capital (K˳)- Return for the Capital Invested
• The measurement of the sacrifice made by the investor in capital
formation
• It is the minimum required rate of return needed to justify the use
of capital
• Minimum required rate of return used to value cash flows.
• Cost of Capital is the minimum required rate of earnings
• K˳ can be calculated by
• Computing Overall Cost of Capital (WACC)
• Computation of Specific Cost of Capital
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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Sri Krishna College of Technology
School of Management
Key words
• Return
• sacrifice
• minimum required rate of return
• WACC
• Specific Cost of Capital
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MCQ
1. Cost of Capital means
a.)Minimum Rate of Return b.) Maximum Rate of Return c.) Return on
Investment d.) Expenses
2. K˳ is used as evaluating the alternative sources of finance
a.)True b.) False
3. Measurement of the sacrifice made by the investor in capital formation is
called as
a.) Cost of Capital b.) Profit c.) Return d.) Expenses
4. Cost of Capital is also known as
a.)WACC b.)Composite Cost of Capital c.)Combined Cost of Capital d.)All
5. Cost of Capital should be always maximum
a.)True b.) False
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
Learning Outcomes
• At the end of the course, a student will come
• To understand Cost of Capital
• To apply cost of capital techniques
• To determine the optimum capital mix and analyse it.
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
Topics to be covered in the next session
• Capital Structure Theories
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
Session No.- 2
• Topics to be covered:
• Capital Structure Theories
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School of Management
• Learning Objectives
- What is Capital structure and its components
- What are the proportion of various sources in the
capital
- How to find the Value of the firm and cost of capital
using capital structure theories
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
- OBE- Understand, Apply, Analyse
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School of Management
Capital Structure
• Capital Structure = Long term sources of Funds (Capital
Components)
• Proportions of various sources of funds in the total
capital
• Capital Structure is a part of Financial Structure
• Financial Structure= Liabilities Side of Balance Sheet
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Capital Structure
Sources of Funds Amount Proportions in
total capital
Equity Share Capital 40 Lacs 40%
Preference Share 10 Lacs 10%
Capital Capital
Structure
Reserves 10 Lacs 10%
Debentures 25 Lacs 25%
Long term Loans 15 Lacs 15%
Total 100 Lacs
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Capital Structure
Short Term
Liabilities- Short
Term Funds
Financial
Structure Liabilities
Long Term
Liabilities-Long
Term Funds
Capital
Structure
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Capital Structure
• Equity Share Capital
• Preference Share
Capital Capital
• Long Term Debt
Structure • Debentures
• Reserves and Surplus
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Capital Structure
• Definition- “Capital Structure may consist of single class
of stock or it may be complicated by several issues of
bonds and preferred stocks, characteristics of which
may vary considerably”- Bogen
• Capital Structure= Long term debt + Preferred stock +
Net Worth
• Capital Structure = Proportion between Debt and Equity
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Theories Capital Structure
“ Explains the relationship of cost of capital and value of
the firm with capital structure”
If there is change in the capital structure
Will the cost of capital change (or) cost of capital
remains constant and what will happen to the value of the
firm?
Ex. Debt-Equity = 1:1, Cost of Capital is 16%
If Debt-Equity =3:1, what will be the cost of capital and
value of the firm?
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Various Theories of Capital Structure
• Traditional Theories
Relevance
• Net Income Approach (NI)
Theories
• Net Operating Income Approach (NOI) Irrelevance
• Modigliani-Miller Approach (MM) Theories
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Theories Capital Structure
• Assumptions
• There are only two sources of funds- Equity and Debt
• The total assets of the company do not change i.e- no
change in the investment decisions
• Entire profits to be distributed among shareholders i.e no
retained earnings.
• Operating profit (EBIT) are not expected to grow.
• Business risk is constant and it is independent of capital
structure and financial risk
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Theories Capital Structure
• Assumptions
• No corporate tax
• Investors are assumed to have same expectation about
profits.
• Dividend Pay out ratio is 100%.
• Firm’s total finance remains constant.
• Firm has an infinite life.
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Why study - Theories Capital Structure
• Value of the firm depends on Capital Structure.
• What portion of capital should be in the form equity and
debt?
• At what portion will the value of the firm will increase?
• How to attain optimum capital structure?
• Value of the firm= Net worth of the firm.
=Equity + Debt
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Theories Capital Structure- Traditional Approach or Intermediate
Approach or WACC Approach
Stage 1:
• Value of the firm can be increased by increasing debt.
• K˳ can be decreased by increasing debt.
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Theories Capital Structure- Traditional Approach or Intermediate
Approach or WACC Approach
Stage 2:
• Increase in debt increases financial risk.
• So equity is more employed and cost of equity increases
and the value of the firm increases.
• Cost of capital remains constant.
• Optimum Capital is said to be reached.
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Theories Capital Structure- Traditional Approach or Intermediate
Approach or WACC Approach
Stage 3:
• More debt and more equity is used to increase the
value of the firm.
• Cost of capital increases as cost of equity and debt
increases.
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School of Management
Theories Capital Structure- Traditional Approach or Intermediate
Approach or WACC Approach
Leverage
Optimum
Capital Stage 3:
Stage 1: K˳
K˳ Structure
Stage 2:
K˳
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Theories Capital Structure- Net Income Approach (NI)
• A Change in the capital structure causes changes in the
K˳ and value of the firm.
• As the debt content increases K˳ falls and value of the
firm increases
Capital Structure Overall K˳ Value of the
Changes Changes firm changes
Debt K˳ V
Debt K˳ V
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Theories Capital Structure- Net Income Approach (NI)
Cost of Equity
K˳
Cost of Debt
Cost of Capital
0% 50% 100%
Degree of Leverage
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Theories Capital Structure- Net Income Approach (NI)
• Assumptions of NI Approach:
• The use of debt does not change the risk perception of
investors.
• Cost of debt is less than Cost of Equity.
• Corporate tax does not come.
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Theories Capital Structure- Net Income Approach (NI)
• Implications of NI approach
• When Financial Leverage (Use of debt in the total capital)
increases, the K˳ will decline and the value of the firm
increases
• As the degree of leverage increases, the portion of cheaper
source of funds (debt) in the capital structure increases.
• As a result, WACC tends to decline leading to an increase in
the total level of firm.
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
Theories Capital Structure- Net Income Approach (NI)
• Implications of NI approach
• Value of the firm will increase even the cost of debt and cost
of equity remains constant regardless of the leverage.
• Overall Cost of Capital will be minimum when the protion of
debt in the capital structure is maximum.
• Optimum capital structure exists when the firm employs
100% debt or maximum debt in the capital structure.
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Theories Capital Structure- Net Operating Income Approach (NOI)
Market value of the firm does not change by the changes
in the capital structure.
The overall cost of capital remains fixed.
The debt equity mix is irrelevant on the overall cost of
capital and the value of the firm.
Therefore, there is nothing called as Optimum Capital
Structure.
All capital structure is Optimum.
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Theories Capital Structure- Net Income Approach (NI)
• A Change in the capital structure causes no changes in
the K˳ and value of the firm.
• Value of the firm and the cost of capital remains constant
Capital Structure Overall K˳ Value of the
Changes Changes firm changes
Capital Structure Changes K˳ V
Capital Structure Changes K˳ V
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Theories Capital Structure- Net Operating Income Approach (NOI)
Assumptions:
• The market capitalises the value of the firm as whole
i.e. the split between the debt and equity is irrelevant
• The use of debt increases risk for equity shareholders.
This results in the increase of cost of equity.
• Overall cost of capital remains constant for all debt-
equity mix.
• No corporate tax.
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Theories Capital Structure- Net Income Approach (NI)
Cost of Equity
Cost of Capital
K˳
Cost of Debt
0% 50% 100%
Degree of Leverage
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Theories Capital Structure- Modigliani-Miller Approach (MM)
Assumptions
There is no corporate taxes.
There market is perfect.
Investors are termed rational i.e- they prefer more
profits and less risk.
The expected earnings of all the firms have identical
risk
All earnings are distributed to the share holders.
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Theories Capital Structure- Modigliani-Miller Approach (MM)
3 Basic Propositions of MM
The cost of equity is equal to the capitalisation rate of
a pure equity stream plus a premium of financial risk.
The K˳ and V are independent of leverage and
remains the same.
The cut-off rate for investment is completely
independent.
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Theories Capital Structure- Modigliani-Miller Approach (MM)
MM approach says that the value of the firm is
independent of the components of the capital structure as
the value depends on the earning power and the risk to
which the underlying assets are exposed to it.
MM Approach first had an assumption that corporate tax
was nil
Then MM approach included corporate taxes
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Theories Capital Structure- Modigliani-Miller Approach (MM)
Market Value is not determined by the components of its
capital structure.
It is determined exclusively by its investment decisions.
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Theories Capital Structure- Modigliani-Miller Approach (MM)
Proof of MM-Arbitrage Argument
Arbitrage- Act of buying the security in the market
where the prices are less and simultaneously sell it in
another market where the prices are more.
This brings equilibrium in the market.
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Points to Ponder
• Long term sources of Funds (Capital Components)
• Proportions of various sources of funds in the total capital
• Capital Structure= Long term debt + Preferred stock + Net Worth
• Capital Structure = Proportion between Debt and Equity
• Theories Capital Structure
• Traditional Theories
• Net Income Approach (NI)
• Net Operating Income Approach (NOI)
• Modigliani-Miller Approach (MM
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Key words
• Long term
• Proportions
• Debt and Equity
• Theories
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MCQ
1. Proportion between Debt and Equity is called as
a.)Cost of Capital b.) c.) Capital Structure c.) Financial Structure d.)None
2. Capital Structure is a part of Financial Structure
a.)True b.) False
3. Increase in Debt in stage 1 of TT Approach will
a.) Reduce Cost of Capital b.) Increase Cost of Capital c.) Neither Increase
or Decrease d.) None
4. Cost of Capital should be ______according to Optimum Capital Structure
a.)Minimum b.)Maximum c.) Constant d.)None
5. Arbitrage brings equilibrium in the market.
a.)True b.) False
Karthikeyan N- Asst. Prof.,/ Som-SKCT
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School of Management
Learning Outcomes
• At the end of the course, a student will come
• To understand capital structure
• To apply the theories to find out the value of the firm
and the cost of capital
• To analyse the value and cost of capital and find out
the optimal capital structure
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School of Management
Topics to be covered in the next session
• Designing Capital Structure
• Valuation of firms
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School of Management
Session No.- 3
• Topics to be covered:
• Designing Capital Structure
• Valuation of firms
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School of Management
• Learning Objectives
- How to build a capital structure
- How to find the Value of the firm
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School of Management
- OBE- Understand, Apply, Analyse
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Designing Capital Structure
• Capitalisation
Capital Amount
Eq. Sh. Cap 100000
Retained Earnings 600000
Preference Sh. Cap 500000
Debentures 400000
Total (Capitalisation) 1600000
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Designing Capital Structure
The mix of Market Value
Optimum debt-equity in per share
Capital the capital should be
Structure structure Maximum
should be in Cost of
such a way Capital should
be Minimum
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Designing Capital Structure
Features of Optimum Capital Structure
Profitability/ Return
Solvency/Risk
Flexibility
Conservation/Capacity
Control
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Determinants of Capital Structure
Tax Benefits of Debt Timing of public issue.
Flexibility Requirements of investors.
Control Period of finance
Industry Leverage Ratio Purpose of Finance
Seasonal Variations Legal Requirements.
Degree of Competition Nature of enterprise
Industry Life Cycle Size of the company
Agency Costs Market sentiments
Company Characteristics. Cash flow ability
Floating cost
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Patterns or Forms of Capital Structure
Complete Equity Share Capital
Portions of Equity and Preference Share Capital
Portions of Equity and Debenture(Debt) Capital
Portions of Equity, Preference and Debt Capital
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Designing of Capital Structure
High Gear Capital and Low Gear Capital
Debentures Preference Equity Gear
Shares Shares
Contribution High High Low High
Gear
Contribution Low Low High Low
Gear
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Appropriate Capital Structure
EBIT- EPS Approach- How changes in EBIT affects EPS under
different capital structure alternatives
Indifference Point- EPS will be same for two EBIT. Break even EBIT
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Points to Ponder
• Optimum Capital Structure-The mix of debt-equity in the capital
structure should be in such a way Market Value per share should be
Maximum and Cost of Capital should be Minimum
• Patterns or Forms of Capital Structure
• Complete Equity Share Capital
• Portions of Equity and Preference Share Capital
• Portions of Equity and Debenture(Debt) Capital
• Portions of Equity, Preference and Debt Capital
• High Gear Capital and Low Gear Capital
• EBIT- EPS Approach- How changes in EBIT affects EPS under different
capital structure alternatives
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Key words
• Optimum Capital Structure-
• Patterns or Forms of Capital Structure
• High Gear Capital
• Low Gear Capital
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MCQ
1. What is called as Capitalization
a.)Sum total of Capital Structure b.) Sum total of Financial Structure c.)
Sum total of Expenses Statement d.) None
2. Capital Structure is a part of Financial Structure
a.)True b.) False
3. When debt and preference contribution are high then it is called
a.) High Gear Capital b.) Low Gear Capital
4. Market Value should be ______according to Optimum Capital Structure
a.)Minimum b.)Maximum c.) Constant d.)None
5. Excess debt threatens the solvency and liquidity.
a.)True b.) False
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Learning Outcomes
• At the end of the course, a student will able
• To apply the techniques to build capital structure
• To find out the value of the firm and the cost of
capital
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Topics to be covered in the next session
• Unit 4- Capital Budgeting Techniques
Karthikeyan N- Asst. Prof.,/ Som-SKCT
