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ON
CAPITAL STRUCTURE OF A
COMPANY
SUBMITTED TO:
MRS. RASHMI CHOUDHARY
SUBMITTED BY:
TANUPRIYA
H-2008-MBA-41
DEFINITION :
Rs
Equity Share Capital 10,00,000
Preference Share Capital 5,00,000
Long-term Loans and Debentures 2,00,000
Capitalization
17,00,000
2) Capital structure refers to the proportionate
amount that makes up capitalisation, is computed as
below:
Rs Proportion/
Mix
Equity Share Capital 10,00,000 58.82%
Preference Share Capital 5,00,000 29.41%
Long-term Loans and Debentures 2,00,000 11.77%
17,00,000 100%
3)Financial structure refers to all the financial
resources , short as well as long-term and is calculated
as: Rs Proportion/Mix
Equity Share Capital 10,00,000 40%
Preference Share Capital 5,00,000 20%
Long-term Loans and 2,00,000 8%
Debentures 6,00,000 24%
Retained Earnings 50,000 2%
Capital surplus 1,50,000 6%
Current Liabilities
25,00,000 100%
FORMS/PATTERNS OF CAPITAL
STRUCTURE
The capital structure of a new company may consist
of the following forms:
a) Equity Shares only
b) Equity and Preference Shares
c) Equity Shares and Debentures
d) Equity Shares, Preference Shares and Debentures.
THEORIES OF CAPITAL STRUCTURE
The important theories of capital
structure are:
1) Net Income Approach
2) Net Operational Income Approach
3) The Traditional Approach
4) Modigliani and Miller Approach
1) NET INCOME APPROACH
The theory propounds that a company can increase its value
and reduce the overall cost of capital by increasing the proportion
of debt in its capital structure. A firm can minimise the weighted
average cost of capital & increase the value of the firm as well as
market price of equity shares by using debt financing to the
maximum possible extent. This approach is based on the
following assumptions:
i. The cost of debt is less than the cost of equity.
ii. There are no taxes.
iii. The risk perception of investors is not changed by the use of debt.
The total market value of a firm on the basis of Net Income Approach
can be ascertained as:
V= S + D
Where, V= Total market value of a firm
S= Market value of equity shares
= Earnings Available to Equity Shareholders (NI)/Equity
Capitalisation Rate
D= Market value of debt.
And, Overall Cost of Capital or Weighted Average Capital can be
calculated as:
K = EBIT/ V
Illustration
A company expects a net income of Rs. 80,000. it has Rs. 2,00,000, 8%
debentures. The equity capitalisation rate of the company is 10%.
Calculate the value of the firm and overall capitalisation rate according to
the net income approach.
Calculation of the value of the
Firm
Rs
Net Income 80,000
Less: Interest on 8% Debentures of Rs. 2,00,000 16,000
Earnings available to equity shareholders
64,000
Equity Capitalisation Rate
10%
Market Value of equity(S)= 64,000*100/10
6,40,000
Market Value of Debentures(D)
2,00,000
Value of the Firm (S+D) 8,40,000
Overall Cost of Capital(k)= Earnings/ Value of the Firm
(EBIT/V)
= 80,000/8,40,000 * 100 = 9.52%
2) Net Operating Income Approach.
This approach says that change in the capital structure of a company does not affect
the market value of the firm and the overall cost of capital remains constant
irrespective of the method of financing. It implies that the overall cost of capital
remains the same whether the debt-equity mix is 50:50 or 20:80.
This theory presumes that:
i. The market capitalises the value of the firm as a whole;
ii. The business risk remains constant at every level of debt equity mix;
iii. There are no corporate taxes.
The reason propounds for such assumptions are that the increased use of debt increases
the financial risk of the equity shareholders and hence the cost of equity increases.
On the other hand the cost of debt remains the constant with the increasing
proportion of debt as the financial risk of the lenders is not effected.
The value of the firm on the basis of Net Operating Income Approach can be determined
as:
V= EBIT/K
Where , V= Value of a firm
EBIT= Net Operating Income or Earning before interest and tax
Ko= Overall cost of Capital
The market value of Equity is
S=V-D
Where, S= Market value of equity
V= total market value of a firm
D= market value of debt
Illustration
A co. expects a net operating income of Rs. 1,00,000. it has Rs. 5,00,000 , 6%
Debentures. The overall capitalisation rate is 10%. Calculate the value of the firm
and the equity capitalisation rate according to Net Income Operating Approach.
Solution: Net operating income = Rs.1,00,000
Overall cost of capital =10%
Market value of the firm(V)=net operating income/ overall cost of capital
[EBIT/k]
=1,00,000 * 100/10 = Rs. 10,00,000
Market value of firm =Rs 10,00,000
Less: market value of debentures =Rs. 5,00,000
Rs.
Net operating Income 2,00,000
Total investment 10,00,000
Equity capitalisation rate:
a)If the firm uses no debt 10%
b)If the firm uses Rs.4,00,000 11%
debentures 13%
c)If the firm uses Rs.6,00,000
Assume that Rs. 4,00,000 deb. Can be raised @ 5% ROI where as Rs. 6,00,000
debentures
deb. Can be raised @ 6% ROI
Computation of Market value of firm, value of shares & the
average cost of capital
(a) No Debt (b)Rs.6,00,000 (c) Rs.6,00,000
5% debentures 6% debentures
Net operating income
Less: Interest i.e., cost of
equity
Rs.2,00,000 Rs.2,00,000 Rs.2,00,000
Earning available to
2,00,000 36000
equity shareholders
Equity capitalisation rate Rs.2,00,000 Rs.1,80,000 Rs.1,64,000