A project on:

V/s

Submitted to : Prof. Kamal

Submitted ByDhaval Shah 49Sohil Jewani 41Murtuza Bhanpurawala 37Aamir Ansari 36

A C K N O W L E D G E M E N T

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On the completion of this Project, I wish to great fully acknowledge,

by taking this opportunity to express my sincere gratitude to Prof. Kamal

for giving me kind support and co-operation and her guidance and useful

suggestions that proved very useful in this Project. Once again thank all

the people who have directly or indirectly help in this Project.

Lastly, I sincerely thank all my friends who have always given their

encouraging support and been a great help all the time at various stage of

development of this Project.

Index Debt vs. Equity -- Advantages and Disadvantages 4

Cost of Capital 6

Specific Cost of Capital 7

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MAJOR CONSIDERATIONS IN CAPITAL STRUCTURE 11

PLANNING

CAPITAL STRUCTURE THEORIES 14

Bibliography 20

Debt vs. Equity -- Advantages and Disadvantages

In order to expand, it is necessary for business owners to tap financial resources. Business owners can utilize a variety of financing resources, initially broken into two categories, debt and equity. "Debt" involves borrowing money to be repaid, plus interest. "Equity" involves raising

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money by selling interests in the company. The following table discusses the advantages and disadvantages of debt financing as compared to equity financing.

ADVANTAGES OF DEBT COMPARED TO EQUITY Because the lender does not have a claim to equity in the business,

debt does not dilute the owner's ownership interest in the company.

A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth.

Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for.

Interest on the debt can be deducted on the company's tax return, lowering the actual cost of the loan to the company.

Raising debt capital is less complicated because the company is not required to

comply with state and federal securities laws and regulations.

The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.

DISADVANTAGES OF DEBT COMPARED TO EQUITY Unlike equity, debt must at some

point be repaid.

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Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt.

Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company.

Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options and non-core business opportunities.

The larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.

The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.

Cost of Capital

The cost of capital is an important input in the capital budgeting decision.

Conceptually, it refers to the discount rate that would be used in

determining the present value of estimated future benefits associated

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with projects. In operational terms, it is defined as weighted average cost

of each type of capital. It is visualized as being composed of several

elements, the elements being the cost of each component of the capital.

The term component means different sources of funds are received by a

firm. The long-term sources of funds are:-

I. Debt

II. Preference Shares

III. Equity Capital

IV. Retained Earning

Each source of fund or component of capital has its cost, called the

specific cost of capital. When these are combined to overall cost of

capital, it results in the weighted /average/combined cost of capital.

Therefore, the compensation of the cost of capital, involves two steps:

1. Calculation of the specific cost of cash of each type of capital- debt,

preference shares, ordinary or equity shares and retained earnings

2. Calculation of the weighted average cost of capital by combining

the specific cost.

There are two approaches to it by:-

Book Value (BV)

Market value (MV)

Specific Cost of Capital (We have covered only that portion)

Cost of DebtPerpetual Debt

Ki = I / SVKd = I / SV (1-t)

Where,Ki = Cost of debt before taxKd = Cost of debt after taxI = Annual interest payment

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SV = Amount of debt/net sale proceeds of debentures (bonds)t = Tax rate

The explicit cost of debt is the interest rate as per contract adjusted for tax and the cost of raising the debt.

However, debt has an implicit cost also. This arises due to the fact that if the debt content rises above the optimal level, investors will start considering the company to be too risky and, therefore, their expectations from equity shares will rise. This rise in the cost of equity shares is actually the implicit cost of debt.

Cost of Preference SharesIrredeemable

Kp = Dp (1+D1) / P0 (1-f)Where,Kp = Cost of preference share capitalDp = Annual dividendP0 = Sale pricef = Floatation costDt = Dividend tax

In the case of preference shares, the dividend rate can be taken as its cost since it is this amount which the company intends to pay against preference shares. As in the case of debt, the issue expenses or the discount/premium on issue/redemption has also to be taken into account.

Since dividend of preference shares is not allowed as deduction from income for income tax purposes, there is no question of tax advantage in the case of cost of preference shares. It would, thus, be seen that both in the case of debt as well as preference shares, cost of capital is calculated by reference to the obligations incurred and proceeds received. The net proceeds received must be taken into account in working out the cost of capital

Cost of Equity CapitalDividend Valuation Approach (with growth)

Ke = D1 / Po (1-f) + g%Where,Ke = cost of equity capitalD1= expected dividend per share at the end of the yearP0 = current market price

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f = Floatation costg = Growth in expected dividends

Calculation of the cost of ordinary shares involves a complex procedure. This is because unlike debt and preference shares there is no fixed rate of interest or dividend against ordinary shares. Hence, to assign a certain cost of equity share capital is not a question of mere calculation. It requires an understanding of many factors basically concerning the behavior of investors and their expectations. Since there can be different interpretations of investor’s behavior, there are many approaches regarding calculation of cost of equity shares.

Cost of Retained EarningCost of reserves

Kr = Ke

Where,Kr = Cost of retained earningKe = Cost of equity capital

The profits retained by a company and used in the expansion of business also entail cost. The cost of retained earnings as the same as that of the equity shares. However, if the cost of equity shares is determined on the basis of realized values approach or D/P + g approach, the question of working out a separate cost of reserves is not relevant since the cost of reserves is automatically included in the cost of equity share capital. 

Let us take an example of Weighted Average CostA company has got various alternatives to design their capital structure and it is unable to choose which one to select. The company can go for 100% debt or 100% equity or else a combination of both. In this case to know which alternative is most effective we have to calculate weighted average cost of capital and the combination which has got the lowest cost of capital should be selected.

Alternatives

Cost of debt

Cost of equity

Weight of debt

Weight of equity

Product {debt}

Product {equity}

Summation of product

1 6 13 0.00 1.00 0 13.00 13.00

2 6 13 0.10 0.90 0.60 11.70 12.30

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3 6.5 14 0.20 0.80 1.30 11.20 12.50

4 6.5 15 0.30 0.70 1.95 10.50 12.45

5 7 16 0.40 0.60 2.80 9.60 12.40

6 7.5 18 0.50 0.50 3.75 9.00 12.75

7 9 20 0.60 0.40 5.40 8.00 13.40

8 10 22 0.70 0.30 7.00 6.60 13.60

9 11 24 0.80 0.20 8.80 4.80 13.60

10 13 26 0.90 0.10 11.7 2.60 14.30

11 15 28 1 0 15 0 15

From the table we can see that neither going for 100% equity is cost effective or 100% debt. We can see that going for 10% debt and 90% equity is the best alternative in this case but it can differ depending on the cost and weight of debt and equity.

CATIPAL STRUCTURE THEORIES

Optimum Capital Structure 

The capital structure is said to be optimum capital structure when the firm has selected such a combination of equity and debt so that the wealth of firm is maximum. At this capital structure the cost of capital is minimum and market price per share is maximum. It is however, difficult to find out optimum debt and equity mix where the capital structure would be optimum because it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In theory one can speak of an optimum capital structure but in practice appropriate capital structure is more realistic term than the former.

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Features on an appropriate capital structure  

1. Profitability: The most profitable capital structure is one that tends to minimize cost of financing and maximize earning per equity share.  

2. Flexibility: The capital structure should be such that company can raise funds whenever needed. 

3. Conservation: The debt content in the capital structure should not exceed the limit which the company can bear. 

4. Solvency: The capital structure should be such that firm does not run the risk of becoming insolvent. 

5. Control: The capital structure should be so devised that it involves minimum risk of loss of control of the company.

MAJOR CONSIDERATIONS IN CAPITAL STRUCTURE PLANNING 

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There are three major considerations: Risk Cost of capital Control

These help the finance manager in determining the proportion in which he can raise funds from various sources. Although, three factors, i.e., risk, cost and control determine the capital structure of a particular business undertaking at a given point of time. The finance manager attempts to design the capital structure in such a manner that his risk and costs are the least and the control of the existing manager is diluted to the least extent. However, there are also subsidiary factors like marketability of the issue, maneuverability and flexibility of the capital structure and timing for raising the funds. Structuring capital is a shrewd financial management decision and is something which makes or mars the fortunes of the company. These factors are discussed here under.

Risk in Capital Structure Risk is of two kinds, i.e., financial risk and Business risk. Here we are concerned primarily with the financial risk. Financial risk also is of two types: 1. Risk of cash insolvency: 

If a firm raises more debt, its risk of cash insolvency increases. This is due to two reasons. Firstly, higher proportion of debt in the capital structure increases the commitments of the company with regard to fixed charges. This means that a company stands committed to pay a higher amount of interest irrespective of the fact whether it has cash or not. Secondly, there is a possibility that the supplier of funds may withdraw the funds at any given point of time. Thus the long-term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. This risk is not there in the case of equity shares. 2. Risk of variation in the expected earnings available to equity share-holders: 

In case a firm has higher debt content in capital structure, the risk of variations in expected earnings available to equity shareholders will be

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higher. This is because of trading on equity. We have know that financial leverage works both ways, i.e., it enhances the shareholders’ return by a high magnitude or brings it down sharply depending upon whether the return on investment is higher or lower than the rate of interest. Thus there will be lower probability that equity shareholders will enjoy a stable dividend if the debt content is high in the capital structure. In other words, the relative dispersion of expected earnings available to equity shareholders will be greater if the capital structure of a firm has higher debt content. The financial risk involved in various sources of finance can be understood by taking the example of debentures. A company has to pay interest charges on debentures even when it does not make any profit. Also the principal sum has to be repaid under the stipulated agreement. The debenture holders also have a charge against the assets of the company. Thus, they can enforce a sale of the assets in case the company fails to meet its contractual obligations. Debentures also increase the risk of variation in the expected earnings available to equity shareholders through leverage effect, i.e., if the return on investment remains higher than the interest rate, shareholders will get a high return; but if reverse is the case, shareholders may get no return at all. As compared to debentures, preference shares entail slightly lower risk for the company, since the payment of dividends on such shares is contingent upon the earning of profits by the company. Even in the case of cumulative preference shares, dividends have to be paid only in the year in which a company makes profits. Again, the repayment of preference shares has to be redeemable and that too after a stipulated period. However, preference shares also increase the variations in the expected earnings available to equity shareholders. From the point of view of the company, equity shares are the least risky. This is because a company does not repay equity share capital except on its liquidation. Also, it may not declare a dividend for years together. In short, financial risk encompasses the volatility of earnings available to equity shareholders as well as the probability of cash insolvency.

Cost of capital

Cost is an important consideration in capital structure decisions. It is obvious that a business should be at least capable of earning enough revenue to meet its cost of capital and finance its growth. Hence, along

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with a risk as a factor, the finance manager has to consider the cost aspect carefully while determining the capital structure.

Control

Along with cost and risk factors, the control aspect is also an important consideration in planning the capital structure. When a company issues further equity shares, it automatically dilutes the controlling interest of the present owners. Similarly, preference shareholders can have voting rights and thereby affect the composition of the Board of Directors. Financial institutions normally stipulate that they shall have one or more directors on the Board. Hence, when the management agrees to raise loans from financial institutions, by implication it agrees to forget a part of its control over the company. It is obvious, therefore, that decisions concerning capital structure are taken after keeping the control factor in mind.

CAPITAL STRUCTURE THEORIES

The objective of a firm should be directed towards the maximization of the value of the firm, the capital structure, or leverage decision should be examined from the point of view of its impact on the value of the firm. If the value of the firm can be affected by capital structure or financing decision, a firm would like to have a capital structure which maximizes the market value of the firm. There are broadly four approaches in this regard. These are: 

1. Net Income Approach (N.I. approach)

2. Net Operating Income Approach (N.O.I. approach)

3. Traditional Theory

4. Modigliani and Miller Approach These approaches analysis relationship between the leverage, cost of capital and the value of the firm in different ways. However, the following assumptions are made to understand these relationships. 

1. There are only two sources of funds viz., debt and equity.

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2. The total assets of firm are given. The degree of leverage can be changed by selling debt to purchase shares or selling shares to retire debt.

3. There are no retained earnings. It implies that entire profits are distributed among shareholders.

4. The operating profit of firm is given and expected to grow.

5. The business risk is assumed to be constant and is not affected by the financing mix decision.

6. There are no corporate or personal taxes.

7. The investors have the same subjective probability distribution of expected earnings.

Net Income Approach (NI-approach)

 This approach has been suggested by Durand. According to this approach a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words, if the degree of financial leverage increases the weighted average cost of capital will decline with every increase in the debt content in total funds employed, while the value of firm will increase. Reverse will happen in a converse situation. Net income approach is based on the following three assumptions:

I. There are no corporate taxesII. The cost of debt is less than cost of equity or equity capitalization rate.III. The use of debt content does not change at risk perception of investors

as a result both the kd (debt capitalization rate) and kc (equity-capitalization rate) remains constant.

 The value of the firm on the basis of Net Income Approach can be ascertained as follows: V = S + D Where,V = Value of the firmS = Market value of equityD = Market value of debt

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 Market value of equity (S) = NI/Kc

Where,NI = Earnings available for equity shareholders.Kc = Equity Capitalization rate Under, NI approach, the value of the firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimizing the cost of capital. The N.I. Approach can be illustrated with help of the following example. The overall cost of capital under this approach is:

Overall cost of capital = (NPBIT) / (Value of the firm)

Net operating Income (NOI) Approach

 According to this approach, the market value of the firm is not affected by the capital structure changes. The market value of the firm is ascertained by capitalizing the net operating income at the overall cost of capital which is constant. The market value of the firm is determined as follows: Market value of the firm (V) = (Earnings before interest and tax) / (Overall

cost of capital) The value of equity can be determined by the following equation 

Value of equity (S) = V (market value of firm) – D (Market value of debt) And the cost of equity = (Earnings after interest and before tax) / (market

value of firm (V) - Market value of debt (D)) The Net Operating Income Approach is based on the following assumptions: a. The overall cost of capital remains constant for all degree of debt

equity mix.

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

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c. The use of less costly debt funds increases the risk of shareholders. This causes the equity capitalization rate to increase. Thus, the advantage of debt is set off exactly by increase in equity capitalization rate.

d. There are no corporate taxes

e. The cost of debt is constant. Under NOI approach since overall cost of capital is constant, therefore there is no optimal capital structure rather every capital structure is as good as any other and so every capital structure is optimal one.

Traditional Approach

 The traditional approach is also called an intermediate approach as it takes a midway between NI approach (that the value of the firm can be increased by increasing financial leverage) and NOI approach (that the value of firm is constant irrespective of the degree of financial leverage). According to this approach the firm should strive to reach the optimal capital structure. At the optimal capital structure the overall cost of capital will be minimum and the value of the firm is maximum. It further states that the value of the firm increases with financial leverage upto a certain point. Beyond this point the increase in financial leverage will increase its overall cost of capital and hence the value of firm will decline. This is because the benefits of use of debt may be so large that even after off-setting the effect of increase in cost of equity, the overall cost of capital may still go down. However, if financial leverage increases beyond an acceptable limit the risk of debt investor may also increase, consequently cost of debt also starts increasing. The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase. Thus as per the traditional approach the cost of capital is a function of financial leverage and the value of firm can be affected by the judicious mix of debt and equity in capital structure. The increase of financial leverage upto a point favourably affects the value of firm. At this point the capital structure is optimal & the overall cost of capital will be the least.

Modigliani and Miller Approach

 

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According to this approach the total cost of capital of particular firm is independent of its methods and level of financing. Modigliani and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital. They gave a simple argument in support of their approach. They argued that according to the traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, they argued, is determined from the level of shareholder’s expectations. Now, if shareholders expect 16% from a particular company, they do take into account the debt equity ratio and they expect 16^ merely because they find that 16% covers the particular risk which this company entails. Suppose, further that the debt content in the capital structure of this company increases; this means that in the eyes of shareholders, the risk of the company increases, since debt is a more risky mode of finance. Hence, shareholders will now start expecting a higher rate of return from the shares of the company. Hence, each change in the debt equity mix is automatically offset by a change in the expectations of the shareholders from the equity share capital. This is because a change in the debt equity ratio changes the risk element of the company, which in turn changes the expectations of the shareholders from the particular shares of the company. Modigliani and Miller, therefore, argued that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital of a company is equal to the capitalization rate of pure equity stream of its class of risk. Hence, financial leverage has no impact on share market prices or on the cost of capital.  

Modigliani and Miller make the following propositions: 1. The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalizing the expected stream of operating earnings at a discount rate considered appropriate for its risk class. 2. The cost of equity (Ke) is equal to capitalization rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to offset exactly the use of less expensive source of funds.

ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH 1. The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities. They are well informed about the risk-return on all type of securities. These are no transaction costs. The investors behave rationally. They can borrow without restrictions on the same terms as the firms do. 

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2. The firms can be classified into ‘homogeneous risk class’. They belong to this class if their expected earnings are having identical risk characteristics. 3. All investors have the same expectations from a firm’s net operating income (EBIT) which are necessary to evaluate the value of a firm. 4. The dividend payment ratio is 100%. In other words, there are no retained earnings. 5. There are no corporate taxes. However this assumption has been removed later. Modigliani and Miller agree that while companies in different industries face different risks which will result in their earnings being capitalized at different rates, it is not possible for these companies to affect their market values, and therefore their overall capitalization rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in company’s capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate leverage. This is illustrated below:

Suppose there are two companies A & B in the same risk class. Company A is financed by equity and company B has a capital structure which includes debt. If market price of share of company B is higher than company A, market participants would take advantage of difference by selling equity shares of company B, borrowing money to equate their personal leverage to the degree of corporate leverage in company B, and use these funds to invest in company A. The sale of Company B share will bring down its price until the market value of company B debt and equity equals the market value of the company financed only by equity capital.

Criticism of Modigliani and Miller Approach These propositions have been criticized by numerous authorities. Mostly criticism is about perfect market assumption and the arbitrage assumption. MM hypothesis argue that through personnel arbitrage investors would quickly eliminate any inequalities between the value of leverages firms and value of unleveraged firms in the same risk class. The basic-argument here is that individual’s arbitragers, through the use of personal leverage can alter corporate leverage. This argument is not valid in the practical world, for it is extremely doubtful that personnel investors

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would substitute personal leverage for corporate leverage, since they do, not have the same risk characteristics. The MM approach assumes availability of free and upto date information. This also is not normally valid.

Websites:www.transtutors.comwww.scribd.com (various authors)

Reference booksTheory and Promblems in Financial ManagementBy M.Y. Khan and P. K. Jain

Images Various Sources

 

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