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Capital Structure
Financial Management Author: I M Pandey
Equity includes:
Capital Structure
Is the knowledge about capital structure important?
Yes
Because it influences shareholders return and risks
Which in turn may influence the market value of the share of the company
Financial leverage
What is meant by financial leverage?
The use of fixed-charges source of funds (debt and preference shares) along with owners equity (ordinary shares) in the capital structure
Payout Policy
Since capital structure decisions affect the value of a firm, the firm would like to have a capital structure which would maximise market value
Effect on Return
Effect on Risk
Note: the value of a firm is the sum of the values of all its securities
Therefore:
calculate the value of equity, then calculate the value of debt and then add them together
Value of firm
Value of firm = value of equity + value of debt
WACC
Calculate the firms overall expected rate of return (I.e. cost of capital)
NetOperati ngIncome ValueofFir m
The firm overall cost of capital is also known as the weighted average cost of capital (WACC)
There is an alternative way to calculate WACC (k0)
E D + kd V V 7500 5,000 k0 = 0.0933 + 0.06 12500 12,500 k0 = 0.0933 60% + 0.06 40% k0 = ke k0 = 8%
k0 = ke
Recall: cost of equity is 9.33% and cost of debt is 6%. I.e. cost of debt is less than cost of equity.
Therefore, it pays to have a capital structure with more debts than equity
I.e. as the ratio of debt to total capital increases, the overall cost of capital (WACC) falls
E D + kd V V
1575.6 14216.7 + 0.06 15792.3 15792.3 = 0.0933 10% + 0.06 90% = 6.33% k 0 = 0.0933
Comparing results: When value of Debt to total value of firm increased from 40% to 90%:
the overall cost of capital fell from 8% to 6.33% The value of firm increased from 12500 to 15792
I.e. firms value increases with more debt