FM II-1

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All About ACCOUNTING..!!

1

Financial Mgmt

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2

Capital

Structure

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Definition

The capital structure of a firm is the mix of different securities

issued by the firm to finance its operations.

Securities

Bonds, bank loans

Ordinary shares (common stock)

Preference shares (preferred stock)

What is Capital Structure?

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What is Capital Structure? Balance SheetCurrent Current

Assets Liabilities

Debt

Fixed Preference

Assets shares

Ordinary

shares

FinancialStructure

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What is Capital Structure? Balance SheetCurrent Current

Assets Liabilities

Debt

Fixed Preference

Assets shares

Ordinary

shares

CapitalStructure

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Sources of capital Ordinary shares (common

stock)

Preference shares (preferredstock)

Loan capital

1. Bank loans

2. Debentures

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Ordinary shares (common stock)

Risk finance

Dividends are only paid if profits are made and

only after other claimants have been paid e.g.

lenders and preference shareholders

A high rate of return is required

Provide voting rights the power to hire and fire

directors

No tax benefit, unlike borrowing

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Preference shares

Lower risk than ordinary shares and a lower dividend

Fixed dividend - payment before ordinary shareholders

and in a liquidation situation

No voting rights - unless dividend payments are in arrears

Cumulative - dividends accrue in the event that the issuer

does not make timely dividend payments

Participating - an extra dividend is possible

Redeemable - company may buy back at a fixed future

date

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Loan capital

Financial instruments that pay a certain rate of interest

until the maturity date of the loan and then return the

principal (capital sum borrowed)

Bank loans or corporate bonds

Interest on debt is allowed against tax

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Why should we care about capital structure?

By altering capital structure firms have the

opportunity to change their cost of capital and

therefore the market value of the firm

What is an optimal capital structure?

An optimal capital structure is one that

minimizes the firms cost of capital and thusmaximizes firm value

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A Chemical company is planning to expand. Currently the

company is financed completely by equity. it has 15000

equity shares of 100/- each. The company requires 25 lakh

for expansion. The three alternative of financing are as

follows

1. Issue 25000 equity shares of 100/- each

2. To issue 25000,8% debenture of 100/- each

3. To issue 25000, 8% Preference Share of 100/- each

The company expects earning before interest and tax as

800000/-.If Corporate tax is 50%, Suggest the company

which alternative to go with.

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A Ltd Company has equity share financing of 600,000/-

divided into shares of 100/- each. it required further

300000/- for expansion. The company has following

schemes.

1. All by equity shares of 100/- each

2. 100,000/- from equity and rest by 10% bank loan

3. 100,000/- from equity and rest by 8% preference shares

If company expects EBIT of 150000/-, and corporate tax is

50%. Suggest the company the most appropriate scheme.

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Cost of Capital

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Cost of capital of a firm is the minimum rate of return

expected by its investors.

It is the weighted average cost of various source of funds

used by the firm

Also it can be defined as cost of obtaining the funds

It is used in capital budgeting as it is used as the minimum

rate of return required from an investment i.e. it is a cut

off rate.

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Determination of cost of capital is not easy because lot of

uncertainty and risk is involved in the computation of cost

of capital.

It involves two steps

1. Computation of cost of each source of finance

2. Computation of weighted average cost of capital

Determination of Cost of Capital

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cost of Debt is

the rate of interest payable on the debt.

adjusted for flotation costs (any costs associated with

issuing new bonds), and

adjusted for taxes

Cost of Debt

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1. A fixed Dividend is paid.

2. No tax rebate is given

3. Floatation cost can be incurred

4. Can be issued or redeemed in premium or discount

Cost of Preference Share

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X ltd issues 10000, 10% preference share of 100/- each. Cost

of issue of preference share is 2/- per share. The tax rate

for the company is 50%

Calculate cost of Preference Share

1. If shares are issues at par

2. If shares are issued at premium of 10%

3. IF shares are issued at discount of 5%

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A company issues 10000, 10% preference shares of 100/-redeemable after 10 years at a premium of 5%.The cost

of issue is 2/- per share.

Calculate cost of Preference Share

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There are 2 sources of Common Equity:

1) Internal common equity (retained earnings), and

2) External common equity (new common stock

issue)

Cost of Equity Shares

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Since the stockholders own the firms retainedearnings, the cost is simply the stockholders

required rate of return.

Because

If managers are investing stockholders funds,

stockholders will expect to earn an acceptable

rate of return.

Cost of Retained Earning

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Since the stockholders own the firms retainedearnings,

Dividend Growth Model

Kc = D1/Po + g

Cost of equity shares

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Dividend Growth Model

knc = + g


DD11

NPoNPo

Net proceeds to the firmNet proceeds to the firm

after flotation costs!after flotation costs!

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Companys share are quoted in the market at 20/-. The company pays a dividend of 1/- per share.

And the investor expects a growth rate of 5%

1. Calculate cost of equity

2. If anticipated growth rate is 6% pa, calculate the M.P

per share


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The shares of a company are selling at 40/- pershare and it had paid dividend of 4/- per share

last year. the growth rate is 5%.

1. Compute the companys cost of equity

2. If the anticipated growth rate is 7%per annum,

calculate the MP per share


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The weighted cost of capital is just the weightedaverage cost of all of the financing sources.

Also known as composite cost of capital or

overall cost of capital

Here weight is proportion of various source of

financing

Weight can be either market value of book value

where book value is given preference

Weighted Average Cost of Capital

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Weighted Cost of CapitalWeighted Cost of Capital

CapitalCapitalSource Cost StructureSource Cost Structure

debt 6% 20%debt 6% 20%

preferred 10% 10%preferred 10% 10%

common 16% 70%common 16% 70%

i h d C f C i l

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Weighted Cost of CapitalWeighted Cost of Capital(20% debt, 10% preferred, 70% common)(20% debt, 10% preferred, 70% common)

Weighted cost of capital =.20 (6%) + .10 (10%) + .70 (16)

= 13.4%

W i h d A C f C i l

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A firm has following capital structure and cost ofvarious source.

Debt 1500,000 10%

Preference share 1200,000 10%

Equity Share 1800,000 12%

Retained Earring - 1500,000-11%

Calculate WACC


W i ht d A C t f C it l

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A firm has following capital structure

Equity share- 20000 shares of 100/- each=

20,00,000

10% preference share of 100/- each= 800,000/-

12% Debenture=12,00,000

The market price of the companys share is 110/-per share. Growth rate expected is 6%expected

dividend is 10/-

Calculate weighted average cost of capital if tax



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In the above question assume that there is aexpansion program and the company intends to

borrow a fund of 20 lacs at 14% interest rate

what will be revised WACC

With this investment plan the company expects a

Market price of 105/- and dividend of 12 per

share



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X ltd has following capital structure

10% debenture= 300,000/-

9% preference share = 200,000/-

5000 equity share of 100/- each = 500,000/-

The equity share of the company are quoted at

102/- and the company is expected to declare adividend of 9 per share. Growth rate being 5%

Calculate WACC



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Assuming in the above situation the company raisesfurther 500,000/- from term loan of 12%,

calculate revised WACC. The company will

increase its dividend in a such a case to 10/- also

there is a increase of business risk because of

this and there fore there is a decrease of M.P to

96/-


M i l C t f C it l

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The marginal cost of capital is the weightedaverage cost of new capital calculated by using

the marginal weights

The marginal cost of capital may be equal toaverage cost of capital to the extent :

1. The proportion of additional capital does not

changes

2. The cost of component remains constant.

Marginal Cost of Capital


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The marginal A firm has the following capitalstructure and after-tax cost for the different

sources of funds used:

Debt 450000/- - 7%

Pref Capital 375000/- -10%

Equity Capital 675000/- - 15%

Calculate the weighted average cost of capital



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A firm has the following capital structure and

The firm wishes to raise further 600,000/- for

expansion project

Debt 300,000/-

Preference Capital 150000/-

Equity Capital 150000/-

Assuming that specific costs do not change,

compute the marginal cost of capital.



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A firm has the following capital structure and

The firm wishes to raise further 600,000/- for

expansion project

Debt 300,000/-

Preference Capital 150000/-

Equity Capital 150000/-

Assuming that specific costs do not change,

compute the marginal cost of capital.


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Point of

Indifference

What is Point of indifference ?

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Break Even Point , Equivalency Point, Or Indifference point refers

to that EBIT level at which EPS remains the same irrespective of

different alternatives of debt-equity mix.

At this level Rate of return on capital is equal to the cost of debt .

Current (unlevered) Proposed (levered)

(EBIT-Int1)(1-T) = (EBIT-Int2)(1-T)

S 1 S 2

What is Point of indifference?

What is Point of indifference ?

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All About ACCOUNTING..!!What is Point of indifference?

Debt

No Debt

Advantage

to debt

Disadvantage

to debt

Break-even

pointEPS

EBIT2,000 3,0000.00

2.00

4.00

6.00

8.00

10.00

Documents

FM II-1