INTRODUCTION TO FINANCE

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SECTION 2 CAPITAL STRUCTURE & COST OF CAPITAL

I. Capital Structure Every organization requires funds to operate a business, in the finance world, these funds are known as Capital. Capital structure refers to the way a Company finances its assets through some combination of equity, debt, or hybrid securities. Capital structure of a Company may comprise following: Equity Shares Preference Shares Bonds Bank Loan Debentures

Equity Shares: Its an instrument that signifies an ownership position (called equity) in a Company, and represents a claim on its proportional share in the Company 's assets and profits. Ownership in the company is determined by the number of shares a person owns divided by the total number of shares issued. For example, if a company has issued 1000 shares and a person owns 50 of them, then he/she owns 5% of the company. Equity share also provides voting rights, which give shareholders a proportional vote in certain corporate decisions. Equity shares can only be issued by a Public Company. A company is not obliged to pay dividends to equity shareholders unless there are profits, even if there are profits, company may decide to reinvest the same. Preference Shares: Its a share which receives a specific dividend that is paid before any dividends are paid to equity share holders, and which takes precedence over equity share in the event of a liquidation. Like equity share, preference shares represent partial ownership in a company, although preference share shareholders do not enjoy any of the voting rights of equity shareholders. Also unlike equity share, preference shares pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preference shares are that the investor has a greater claim on the company's assets than equity shareholders. Preference shareholders always receive their dividends first and, in the event the company goes bankrupt, Preference shareholders are paid off before equity shareholders. In general, there are four different types of Preference shares: cumulative preferred, non-cumulative, participating, and convertible preferred share. Difference between Equity and Preference shares: Claims Preference shareholders have claim on the assets and income of the Company prior to equity(ordinary) shareholders. Whereas, equity shareholders have only residual claim on Companys assets pr income Dividend In case of Preference shareholders, dividend rate is fixed, whereas in case of Equity shareholders dividend rate is not fixed Redemption Both Redeemable and Irredeemable preference shares can be issued. Redeemable preference shares have a maturity. Irredeemable preference shares dont have a maturity. Equity shares have no maturity date Conversion A company can issue convertible Preference Shares wherein after a specified date, such shares can be converted into equity. There is no concept of convertible equity shares Bonds: It is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in

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INTRODUCTION TO FINANCE

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the case of equities. On the hand, a bond holder has a greater claim on an issuer's income than a shareholder in the case of financial distress (this is true for all creditors). Bonds are often divided into different categories based on tax status, credit quality, issuer type, maturity and secured/unsecured (and there are several other ways to classify bonds as well). U.S. Treasury bonds are generally considered the safest unsecured bonds, since the possibility of the Treasury defaulting on payments is almost zero. The yield from a bond is made up of three components: coupon interest, capital gains and interest on interest (if a bond pays no coupon interest, the only yield will be capital gains). A bond might be sold at above or below par (the amount paid out at maturity), but the market price will approach par value as the bond approaches maturity. A riskier bond has to provide a higher payout to compensate for that additional risk. Some bonds are tax-exempt, and these are typically issued by municipal, county or state governments, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax. Debentures: Its an unsecured debt backed only by the integrity of the borrower, not by collateral, and documented by an agreement called an indenture. One example is an unsecured bond. Bank Loan: An arrangement in which a Bank gives money to a borrower, and the borrower agrees to repay the money, usually along with interest, at some future point(s) in time. Usually, there is a predetermined time for repaying a loan. Generally a bank loan is backed by assets belonging to the borrower in order to decrease the risk assumed by the Bank. The assets may be forfeited to the Bank if the borrower fails to make the necessary payments.

II. Cost of Capital

The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk. Cost of capital includes the cost of debt, cost of preference shares and the cost of equity. In financial theory, cost of capital is the return that stockholders require.

Cost of Equity
A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. There are two models to determine cost of Equity namely:

Dividend Growth Model Capital Asset Pricing Model (CAPM)

1. Dividend Growth Model Under this model, cost of equity is the return(dividends) that shareholders expect on their investment Ke = [ {D0 (1+g)}/P0 ] + g Where Ke = Cost of Equity D0 = Current Dividend g = Growth rate of Dividends P0 = Market Price of the share

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INTRODUCTION TO FINANCE

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Example If a Company has issued equity shares which are currently quoted at Rs 125 each. The company paid dividend of Rs 10 per share and expects a growth rate of 5% then cost of equity will be calculated as follows: Ke = {10 (1+.05)/125} + .05 = 0.134 or 13.4% Calculating the growth rate Following methods can be used of calculating the growth rate of Dividends (g) a) Retention Ratio Method g= bxr Where, b = Profit retention ratio (or profits not distributed as dividends) r = Return on Equity (or Return on Investment) 2. The capital asset pricing model (CAPM) This model describes the relationship between risk and expected return and that is used in the pricing of risky securities.

Ke = Rf + (Rm-Rf)
Where: Rf = Risk Free Return = Systematic Risk of the Security Rm = Expected Market Return The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)). A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

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INTRODUCTION TO FINANCE

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Cost of Retained Earnings

Retained earnings are the profits not distributed to the equity shareholders as dividends. Since retained earnings belong to equity shareholders hence the cost of retained earnings is equal to cost of equity shares. i.e

Ke = K r
Where Ke = cost of equity Kr = Cost of Retained Earnings

Cost of Debt
A Company may issue a debenture or bond at par, premium or discount to its face value. The contractual rate of interest or the coupon rate forms the basis of calculating the cost of debt. Irredeemable Debt

Kd = I (1-t)/SV
Where

Kd = Cost of debt t = Tax rate SV = Issue price/Market price minus flotation cost Example - A company issued 10% Debentures of Rs 100 each at 5% premium. Tax rate is 40%. Calculate cost of debt. Solution I = 100 x 10% = 10 , t = 0.40 , SV = 100 x 5% + 100 = 105

Kd = 10 (1-0.4)/105 = 6/105 = 5.7%

Redeemable Debt

Kd = [I + {(RV-SV)}/n](1-t)/{(RV+SV)/2}
Where

Kd = Cost of debt t = Tax rate SV = Issue price/Market price minus flotation cost RV = Redemption Value

Example - A company issued 15% Debentures of Rs 100 each at 5% discount redeemable at 10% premium after 10 years. Floation cost is 4%.. Tax rate is 40%. Calculate cost of debt. Solution I = 100 x 15% = 15 , t = 0.40 , SV =(100 - 100 x 5%) 100 x 4% = 95 - 4 = 91, RV = 100 + 100 x 10% = 110

Kd = [15 + {(110-91)}/10](1-0.4)/{(110+91)/2} = {15+(19/10)}x0.6/100.5 = (16.9x0.6)/100.5 = 10.1%

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INTRODUCTION TO FINANCE

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Cost of Preference Shares

A Company may issue Preference Shares at par, premium or discount to its face value. Irredeemable Preference Shares

Kp = D /P0
Where

Kp = Cost of Preference D = Preference Dividend P0 = Issue price/Market price minus flotation cost

Redeemable Preference Shares

Kd = [I + {(RV-SV)}/n](1-t)/{(RV+SV)/2}
Where

Kp = Cost of Preference D = Preference Dividend SV = Sales Value = Issue price/Market price minus flotation cost RV = Redemption Value

Weighted Average Cost of Capital (WACC)

WACC =( Ke x E + Kd x D + Kp x P +Kr x R)/ (E+D+P+R)

Where: Ke = cost of equity Kd = cost of debt Kp= cost of Preference shares Kr = Cost of Retained Earnings E = Book value of the firm's equity D = Book value of the firm's debt P= Book value of the firm's Preference Shares R = Book value of the firm's Retained Earnings Businesses often discount cash flows at WACC to determine the Net Present Value (NPV) of a project, using the formula: NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Weighted Average Cost Of Capital WACC

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Broadly speaking, a companys assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

III. Capital Structure Theories

Capital structure refer to the mix or proportion of different sources of finance (debt and equity) to total capitalization. A firm should select such a financing-mix which maximizes its value/the shareholders wealth (or minimizes its overall cost of capital). Such a capital structure is referred to as the optimum capital structure. Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital and valuation. The four important theories are: (i) Net income (NI) approach and (ii)Net operating income(NOI) approach, (iii) Modigliani and Miller (MM) approach and ASSUMPTIONS 1. There are only two sources of funds used by a firm: perpetual debt and ordinary shares. 2. There are no corporate taxes. This assumption is removed later. 3. The dividend/payout ratio is 100%. That is total earnings are paid out as dividend to the shareholders and there are no retained earnings. 4. The total assets are given and do not change. The investment decisions are, in other words, assumed to be constant. 5. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debts and reduce the equity capital. 6. The operating profits(EBIT) are not expected to grow. 7. All inventories are assumed to have the same subjective probability distribution of the future expected EBIT for a given firm. 8. Business risk is constant over time and is assumed to be independent of its capital structure. 9. Perpetual life of the firm. Definitions AND SYMBOLS: In addition to the above assumptions, we shall make use of some symbols in our analysis of capital structure theories: S= total market value of equity B= total market value of debt I= total interest payments

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INTRODUCTION TO FINANCE V= total market value of the firm (V=S +B) S = (EBIT-I)/Ke or EBT/Ke Net income (NI) approach

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According to the NI approach, capital structure is relevant as its affects the cost of capital and valuation of the firm. The core of this approach is that as the ratio of less expensive source of funds (i.e., debt) increases in the capital structure, the cost of capital (ko) decreases and valuation (V) of the firm increases. With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure and which the (ko) would be the lowest, the v of the firm the highest and market price per share the maximum.

Net operating income(NOI) approach The NOI approach is diametrically opposite to the NI approach. The essence of this approach is the capital structure decision of a corporate does not effect its cost of capital and valuation, and hence, irrelevant. The main argument of NOI is that and increase in the proportion of debt in the capital structure would lead to an increase in the financial risk of the equity holders. To compensate for the increased risk, they would require a higher rate of return (ke) on their investment. As a result, the advantage of the lower cost of debt would exactly be neutralized by the increase in the cost of equity. The cost of debt has two components: (i) explicit, represented by rate of interest, and (ii) implicit, represented by the increased in the cost of equity capital. Therefore, the real cost of debt and equity would be the same and there is nothing like an optimum capital structure. As per NOI, V = EBIT/Ko S = V-B

Modigliani and Miller Approach Modigliani and Miller (MM) concur with NOI and provide a behavioral justification for the irrelevance of capital structure. They maintain that the cost of capital and value of the firm do not change with a change of leverage. They contend that the total value of homogeneous firms that differ only in respect of leverage cannot be different because of the operations of arbitrage. The arbitrage refer to the switching over operations, that is, the investors switch over from over-valued firm (levered firm) to the undervalued firms (unlevered). The essence of arbitrage is that the investors (arbitragers) are able to substitute personal or home-made leverage for corporate leverage. The switching operation drives the total value of the two homogeneous firms equal. The basic premises of (MM) approach, in practice, are of doubtful validity. As a result, the arbitrage process is impeded. To the extent, the arbitrage process is imperfect, it implies that the capital structure matters.

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INTRODUCTION TO FINANCE

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The MM contend that with corporate taxes, debt has a definite advantage as interest paid on debt is taxdeductible and leverage will lower the overall cost of capital. The value of the levered firm(V1) would exceed the value of the unlevered firm(Vu) by an amount equal to levered firms debt multiplied by tax rate.

Factors impacting Capital Structure Decision A host of factors, both quantitative and qualitative including subjective judgment of financial managers, have a bearing of the determination of an optional capital structure of a firm. They are not only highly complex but also conflicting in nature and, therefore, cannot fit entirely into a theoretical frame work. Moreover the weights assigned to various factors also vary widely according to conditions in the economy, the industry and the company itself. Therefore, a corporate should attempt to evolve an appropriate capital structure, given the facts of the particular case. The key factors relevant to designing an appropriate capital structure are, (i) profitability, (ii) liquidity, (iii) control, (iv) leverage ratios in industry, (v) nature of industry, (vi) consultation with investment banks/lenders, (vii) commercial strategy, (viii) timing, (ix) company characteristics and (x) tax planning. PROFITABILITY ASPECT: Keeping in view the primary objective of financial management of maximizing the market value of the firm, the EBIT-EPS analysis should be considered logically by the first step in the direction of designing a firms capital structure. Given the objective of financial management to maximize the share holders wealth, a corporate should carryout profitability analysis in terms of determining the amount of EBIT Indifference point at which its MPS is identical under two proposed financial plans. In general, the higher the level of EBIT than the indifference point and the lower the probability of its downward fluctuation, the greater is the amount debt that can be employed by a corporate. LIQUIDITY ASPECT : EBIT-EPS analysis and coverage ratios are very useful in making explicit the impact of leverage on EPS and on the firms ability to meet its commitments at various levels of EBIT. But the EBIT/ interest ratio is less than a perfect measure to analyse the firms ability to service fixed charges because the firms ability to do so depends on the total payments required, that is, interest and principal, in relation to the cash flow available to met them. Therefore, the analysis of the cash flow ability of the firm to the service fixed charges is an important exercise to be carried out in capital structure planning in addition to profitability analysis. Coverage ratio can also be used to judge the adequacy of EBIT to meet the firms obligations to pay financial charges, interest on loan, preference dividend and repayment of principal. A higher ratio implies that the firm can go for larger proportions of debt in it capital structure. Another major to determine the adequacy of cash flow to meet the fixed obligations in cash budget. A cash budget should be prepared for a range of possible cash inflows with a probability attached to each of them. Since the probability of various cash flow pattern is known, the firm can determine the level of debt it can employ and still remain within an insolvency limit tolerable to the management. The impact of alternative debt policies should also be examined under adverse circumstances/recession conditions. To retain control over management, a firm would prefer use of debt to equity. A debt equity ratio of firm should be similar to those of other companies in the industry. In case sales are subject to wide fluctuations, a firm should employ less debt. Firm subject to keen competition should prefer a greater proportion of equity. The corporate in industry groups which are at their infancy should rely more on equity capital. Investment analysts/ bankers/institutional investors understand the capital market better as well as requirements of investors/lenders. Their opinion is also useful in designing capital structure.

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An appropriate capital structure should provide room for flexibility not in obtaining funds but also in refunding them. Public issues of share as well as debt capital should be made at time when the state of economy as well as capital market is idle to provide the funds. For instance, it will be useful to postpone borrowings if decline in interest rates is expected in the future. The characteristics for company, inter-alia, in terms of size in credit standing are decisive in determining in its capital structure. While large firms enjoying the high credit standing among investors are in a better position to obtain funds from the sources of their choice, the relatively small firms, new firms and firms having poor credit standing have limited option in this regard. The choice of and appropriate debt policy involves trade -off between tax benefits and cost of financial distress. Moreover, the management should consider the implicit cost of the tax subsidy in using debt.

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