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Financing Decision

Unit 5
Capital Structure
Capital structure ordinarily implies the
proportion of debt and equity in the total
capital of a company. Capital of a
company may broadly be categorized in to
“equity” and “debt”.
• The long term funds requirements of the
firm is generally met from the following
sources
• Equity share capital
• Preference share capital
• Retained earnings
• Debenture and bonds
Ordinarily, increase in debt in the
capital structure i.e. improvement in
the debt equity ratio implies greater
amount of interest payments.
A negative correlation always exist
between Cost of capital and
profitability. So, increase on cost of
capital means decrease in
profitability. Since acceptance of more
and more debt means payment of
greater amount of interest, the
What is 'Overcapitalization'
• When a company has issued more debt
and equity than its assets are worth. An
overcapitalized company might be paying
more than it needs to in interest and
dividends. Reducing debt, buying back
shares and restructuring the company are
possible solutions to this problem
Undercapitalization'
• When a company does not have sufficient
capital to conduct normal business
operations and pay creditors. This can occur
when the company is not generating enough
cash flow or is unable to access forms of
financing such as debt or equity. If a
company can't generate capital over time, it
increases its chance of going bankrupt as it
loses the ability to service its debts.
Undercapitalized companies also tend to
choose high-cost sources of capital, such as
short-term credit, over lower-cost forms such
as equity or long-term debt.
• On the other hand, if any changes in the
capital structure by way of increasing the
proportions of debt can have favourable
effect on profitability, then such change i.e.
increase in debt may be considered
beneficial to the company.

Optimum capital structure


• The optimal capital structure indicates
the best debt-to-equity ratio for a firm that
maximizes its value. Putting it simple, the
optimal capital structure for a company is
the one which proffers a balance between
Feature of Optimal Capital
Structure
a) The relationship of debt and equity in an optimal
capital structure is made in such a manner that the
market value per equity share becomes
maximum.
b) Optimal capital structure maintains the financial
stability of the firm.
c) Under optimal capital structure the
FINANCE manager determines the proportion of
debt and equity in such a manner that the
financial risk remains low.
d) The advantage of the leverage offered by
corporate taxes is taken into account in achieving
the optimal capital structure.
• The primary factors that influence a
company's capital-structure decision are:
1. Business Risk
Excluding debt, business risk is the basic risk of the
company's operations. The greater the business risk, the
lower the optimal debt ratio.
As an example, let's compare a utility company with a retail
apparel company. A utility company generally has more
stability in earnings. The company has les risk in its business
given its stable revenue stream. However, a retail apparel
company has the potential for a bit more variability in its
earnings. Since the sales of a retail apparel company are
driven primarily by trends in the fashion industry, the
business risk of a retail apparel company is much higher.
Thus, a retail apparel company would have a lower optimal
debt ratio so that investors feel comfortable with the
company's ability to meet its responsibilities with the capital
structure in both good times and bad.
2. Company's Tax Exposure
• 3. Financial Flexibility
This is essentially the firm's ability to raise capital in
bad times. It should come as no surprise that
companies typically have no problem raising capital
when sales are growing and earnings are strong.
However, given a company's strong cash flow in the
good times, raising capital is not as hard. Companies
should make an effort to be prudent when raising
capital in the good times, not stretching its capabilities
too far. The lower a company's debt level, the more
financial flexibility a company has.

The airline industry is a good example. In good times,


the industry generates significant amounts of sales
and thus cash flow. However, in bad times, that
situation is reversed and the industry is in a position
where it needs to borrow funds. If an airline becomes
4. Management Style

Management styles range from aggressive to conservative. The more


conservative a management's approach is, the less inclined it is to use
debt to increase profits. An aggressive management may try to grow the
firm quickly, using significant amounts of debt to ramp up the growth of the
company's earnings per share (EPS).
5. Growth Rate

Firms that are in the growth stage of their cycle typically finance that
growth through debt, borrowing money to grow faster. The conflict that
arises with this method is that the revenues of growth firms are typically
unstable and unproven. As such, a high debt load is usually not
appropriate.
More stable and mature firms typically need less debt to finance growth as
its revenues are stable and proven. These firms also generate cash flow,
which can be used to finance projects when they arise.
6.Market Conditions
Market conditions can have a significant impact on a company's capital-
structure condition. Suppose a firm needs to borrow funds for a new plant.
If the market is struggling, meaning investors are limiting companies'
access to capital because of market concerns, the interest rate to borrow
COST OF CAPITAL
• Cost of capital is defined as the minimum
rate of return that a firm must earn in its
investments so that the market value per
share remains unchanged.
• Cost of capital is to be determined to help
in managerial decision making like
acceptance of capital investments
proposals, appraisal of profitability and
viability of subunits, raising of additional
finances
Cost of capital consist of the following
elements.

1. Cost of Equity share capital(Ke)


2. Cost of Preferred share capital(Kp)
3. Cost of Term loans from financial
institutions and banks, Debenture and
bonds(Kd)
4. Cost of Retained earnings(Kr)
Cost of Equity share capital(Ke)

• Cost of equity share capital is that part


of cost of capital which is payable to equity
shareholder. Every shareholder gets
shares for getting return on it. So, for
company point of view, it will be cost and
company must EARN MORE than cost of
equity capital in order to leave unaffected
the market value of its shares.
A.Cost of Equity Capital (Ke) (Dividend
Growth Model)
1.An equity share of the company is
currently for Rs 100.The company paid
dividend of Rs 12 per share at the end of
last year and the dividend expect to grow
at rate of 16%.
Ans:13.92 & 29.92%

2.Suppose XYZ ltd paid a dividend of Rs 4


per share last year. The stock currently
sales for Rs 60 per share. You estimate
• 3.The equity of Mercury Ltd are traded in the
market at Rs 90 each. The expected current
year dividend per share is Nu 18.The
subsequent growth in dividends is expected
at the rate of 6%.Calculate the cost of equity
capital.
• Ans 26%
4.The ABC co just issued a dividend of Nu
2.45 per share on its common stock. The
company is expected to maintain a constant
6% growth rate in its dividend indefinitely. If
the stock sells for Nu 45 a share, what is the
company's cost of capital. Ans 11.4%
5.Watta Corporation’s last dividend was Nu
B.Cost of Preferred Stock (Kp)
• Preference shareholders are entitled to get a
fixed rate of dividend if the company earns
profit.
Redeemable
Redeemable preference share is very
commonly seen preference share which has
a maturity date on which date the company
will repay the capital amount to the
preference shareholders and discontinue the
dividend payment thereon.
Irredeemable preference shares
• is little different from other types of
preference shares. It does not have any
maturity date which makes this
instrument very similar to equity except
that the dividend of these shares is fixed and
1.Cost of Irredeemable Preference Share:
KP = DP /Po
Where, DP = Preference dividend and
Po = Current price of the preferred stock
1.Hold up Bank has an issue of
irredeemable preferred stock with Rs 6
stated dividend that just sold for Rs 92 per
share. What is banks cost of preferred
stock?
Ans:6.52%

2.Alabama corporation Co had two issues of


irredeemable preferred stock that traded
on the NYSE.One issue paid Rs 1.30
annually per share and sold for Rs 23.78
per share. The other paid Rs 1.46 per
share annually and sold for Rs 24.30 per
share. What is Alabama’s cost of preferred
3.Green fields ltd has issued 10,00,000
irredeemable preference share of Rs 150
each at a coupon rate of 14% p.a..The
issue expenses are Rs 15 per share.
Calculate the cost of preference share
capital

Solution:DP /Po

21/135=15.55%
Redeemable
4.Dell ltd has Rs 100 preference share
redeemable at a premium of 10% with 15
years maturity. The coupon rate is
12%.Floatation cost is 5%.sale price is Rs
95.Calculate the cost of preference shares.
Ans:Kp= 12+(110-90)/15 =
(12+1.33)/100=0.133 0r 13.33%
(110+90)/2

5.XYZ ltd has Rs 100 preference share


redeemable at a premium of 10% with 20
6.ABC ltd has Rs 200 preference share
redeemable at a premium of 10% with 20
years maturity. The coupon rate is
12%.Floatation cost is 5%.sale price is Rs
190.Calculate the cost of preference shares.
Cost of debt Capital(Kd)

• Debt is the external source of financing. Cost of debt


is simply the interest paid by the firm on debt. But
interest paid on debt is a tax-deductible expenditure;
hence effective cost of capital is lower than the
amount of interest paid.
• Again, debt may be redeemable or irredeemable.
Redeemable debts are those which will be repaid to
the suppliers of debt after a specific period, while
irredeemable or perpetual debt is not repaid back
to the suppliers of debt—only interest on this is paid
regularly.
a)Cost of irredeemable debt (Kd)
a)Irredeemable Preference share
Kd=I(1-t)
NP
Where,
Kd=Cost of Debt
I=Annual interest payments
T= company's effective corporate tax rate
Np=net proceeds of issue of
debentures,bonds,term loans etc
1.Vishnu steels Ltd has issued 30,000
irredeemable 14% debentures of Rs 150
each. The cost of floatation of debentures
is 5% of the total issued amount. The
company's taxation rate is 40%.Calculate
the cost of the debt.
• Ans=8.84%

Ans=8.89%
Redeemable Debt
1.Calculate the approximate cost of
companies Debenture capital, when it
decides to issue 10,000 Nos of 14% non-
convertible debenture, each face value of
Rs 100 at par. The debentures are
redeemable at a premium of 10% after 10
years. the realization is expected to be Rs
92 per debenture and the tax rate
applicable to the company is 40%
• Ans=9.39%
2.Calculate the approximate cost of
companies Debenture capital, when it
decides to issue 20,000 Nos of 13% non-
convertible debenture, each face value of
Rs 100 at par. The debentures are
redeemable at a premium of 10% after 10
years. the realization is expected to be Rs
95 per debenture and the tax rate
applicable to the company is 35%
Redeemable Debt
3.Surya Industries Ltd has raised funds
through issue of 10,000 debentures of Rs
150 each at a discount of Rs 10 per
debenture with 10 Years maturity. The
coupon rate is 16%.The floatation cost is
Rs 5 per debenture. The debentures are
redeemable with a 10% premium. The
corporate taxation rate is 40%.Calculate
the cost of debentures.
• 4.Raj Industries Ltd has raised funds
through issue of 20,000 debentures of Rs
140 each at a discount of Rs 10 per
debenture with 10 Years maturity. The
coupon rate is 18%.The floatation cost is
Rs 5 per debenture. The debentures are
redeemable with a 10% premium. The
corporate taxation rate is 40%.Calculate
the cost of debentures.
5.X ltd issues 12% debenture of face value
of Rs 100 each and realize Rs 95 per
share. The debenture are redeemable
after 10 years at a premium of
10%.Assume 50% as income tax.
Calculate the cost of Debt?
D.Cost of Retained Earnings (Kr)
• Retained earnings are one of the
important internal sources of FINANCE.
Profit available to equity can be distributed
as dividend; but a proportion of that is
distributed and remaining is kept for
reinvestment. So retained earnings is the
dividend foregone by the equity
shareholders.
• Since equity shareholders are the actual
claimants of the retained earnings, the
cost of retained earnings, is equivalent to
D.Cost of Retained Earnings (Kr)
Kr=D(1-T)
Kr=Cost of retained earnings
D=Dividend rate
T=Tax rate of individuals.
1.The dividend paid on equity share capital
of Spectrum ltd is 24%.The personal
taxation of individual share holders is
35%.Calculate the cost of retained
earnings.
Answer: 24%(1-0.35)=15.6%
Mix Questions
1.K ltd has issued 20,00,000 irredeemable
preference share of Rs 140 each at a
coupon rate of 15% p.a..The issue
expenses are Rs 15 per share. Calculate
the cost of preference share capital
2. X Ltd has issued 30,000 irredeemable
13% debentures of Rs 100 each. The cost
of floatation of debentures is 5% of the
total issued amount. The company's
taxation rate is 50%.Calculate the cost of
the debt.
• 3.S ltd paid a dividend of Rs 4 per share
last year. The stock currently sales for Rs
70 per share. You estimate that the
dividend will grow steadily at a rate of 7%
per year in to the definite future. What is
the Cost of The equity capital?

• 4. P Ltd are traded in the market at Rs 80


each. The expected current year dividend
per share is Nu 17.The subsequent growth
in dividends is expected at the rate of
4%.Calculate the cost of equity capital.
• 5.karma Co had two issues of
irredeemable preferred stock that traded
on the BSE.One issue paid Rs 2.30
annually per share and sold for Rs 24.90
per share. The other paid Rs 1.30 per
share annually and sold for Rs 24.30 per
share. What is Karma’s cost of preferred
stock?
• 6. S Ltd has raised funds through issue of
40,000 debentures of Rs 140 each at a
discount of Rs 10 per debenture with 10
Years maturity. The coupon rate is
15%.The floatation cost is Rs 5 per
7.XYZ ltd has Rs 100 preference share
redeemable at a premium of 10% with 15
years maturity. The coupon rate is
12.5%.Floatation cost is 5%.sale price is
Rs 90.Calculate the cost of preference
shares.
WACC
• Weighted average cost of capital (WACC) is the average rate of return a
company expects to compensate all its different investors or 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.

The weights are the fraction of each financing source in the company's
target capital structure.
• WACC = [(E/V) *Ke +(P/V) *Kp + (D/V)*Kd (1-tax) ]
E = Market value of the company's equity
P=market value of the company’s preference
D = Market value of the company's debt
V = Total Market Value of the company (E +P+ D)
E/V = percentage of financing that is equity
P/V=percentage of financing that is preference

D/V = percentage of financing that is debt


Ke = Cost of Equity
Kp=Cost of Preference
kd = Cost of Debt
T= Tax Rate
WACC
Q1.Assume newly formed Corporation ABC
needs to raise Nu1 million in capital so it can
buy office buildings and the equipment
needed to conduct its business. The
company issues and sells
6,000shares of stock at Nu100 each to raise
the first Nu 600,000. Because shareholders
expect a return of 6% on their investment, the
cost of equity is 6%.
• Corporation ABC then sells 400 bonds for
Nu1,000 each to raise the other Nu400,000 in
capital. The people who bought those bonds
expect a 5% return, so ABC's cost of debt is
5%.Corporate tax rate is 35% and Calculate
• Q2.The XYZ has 1.4 million shares of
outstanding. The stock currently sells for
20 per share. The firms debt is publicly
traded and was recently quoted at 93% of
face value. It has a total face value of 5
million, and it is currently priced to yield
11%.The risk free rate is 8%,amd the
market risk premium is 7%.You have
estimated that the company has a beta of
.74.if the corporate tax is 34%.What is the
• Q3.The ABC has 2.4 million shares of
outstanding. The stock currently sells
for 15 per share. The firms debt is
publicly traded and was recently
quoted at 83% of face value. It has a
total face value of 5 million, and it is
currently priced to yield 12%.The risk
free rate is 8%,amd the market risk
premium is 7%.You have estimated
Q4.Multi corporation has a target
capital structure of 50% common
stock,5% preferred stock and
45% debt.Its cost of equity is
16%,the cost of preferred stock is
7.5% and the cost of debt is
9%.The relevant tax rate is
Q5.Titan Mining Corporation has 9 million shares
of common stock outstanding, 0.5 million shares of
preferred stock outstanding, and 120,000 annual
bonds outstanding with a par value of Nu. 1,000
each. Cost of debt is 8.5% and cost of preferred
stock is 7%. The common stock currently sells for
Nu. 34 per share and has a beta of 1.20, the
preferred stock currently sells for Nu. 83 per share,
and the bonds have 15 years to maturity and sells
for 93% of par. The market risk premium is 10%, T-
bills are yielding 5%, and Titan Mining’s tax rate is
35%.
• What is the firm’s market value capital structure?

• What is the cost of Equity Capital?


Q6.A firm is considering a new project which would be
similar in terms of risk to its existing projects. The firm needs
a discount rate for evaluation purposes. The firm has enough
cash on hand to provide the necessary equity financing for
the project. Also, the firm:
• has 1,000,000 common shares outstanding
 current price $11.25 per share
 next year’s dividend expected to be $1 per share
 firm estimates dividends will grow at 5% per year after that
 flotation costs for new shares would be $0.10 per share
• has 150,000 preferred shares outstanding
 current price is $9.50 per share
 dividend is $0.95 per share
 if new preferred are issued, they must be sold at 5% less
than the current market price (to ensure they sell) and involve
direct flotation costs of $0.25 per share

• has a total of $10,000,000 (par value) in debt outstanding.


The debt is in the form of bonds with 10 years left to maturity.
Q7.Given the following information's for Evenflow Power
corporation., find the WACC.Assume the company's tax
rate is 35%.
Debt: 8,000 6.5% coupon bond outstanding,Nu.1,000 par
value,20 years to maturity, selling for 92% of par value; the
bond make semi annual payments.
Common stock: 2,50,000 shares outstanding, selling for
Nu. 57 per share; the beta is 1.05
Preferred Stock: 15,000 shares of 5% preferred stock
outstanding, currently selling for Nu.93 per share.
Market: 8% market risk premium and 4.5% risk free rate.
• Calculate WACC?
Q8.A company is considering the following to
raise additional capital for its expansions
schemes:[M Kishore page 242]
Equity(% od total Debt(% of total Cost of Equity % Cost of debt(pre-
capital) capital) tax) -%
75 25 16 12
50 50 18 14
25 75 24 18

Tax rate is 50% which option would you


recommend ?
Q9.Ab limited estimates the cost of equity and
debt components of its capital for different levels
of debt; equity mix as follows. [M Kishore page
242] Debt as % of total capital Cost of Equity capital % Cost of debt %( before
tax)
0 16 12
20 16 12
40 20 16
60 24 20

• Suggest the best debt: equity mix of the


company. Tax rate applicable to the company is
50%.
• Q10.Titan Mining Corporation has 8.5 million
shares of common stock outstanding, 250,000
shares of 5% preferred stock outstanding, and
135,000 7.5% semiannual bonds outstanding, par
value 1,000 each. The common stock currently
sells for Nu. 34 per share and has a beta of 1.25,
the preferred stock currently sells for Nu.91 per
share, and the bonds have 15 years to maturity
and sells for 114% of par.The market risk
premium is 7.5%, T-bills are yielding 4%, and
Titan Mining’s tax rate is 35%.
(3 marks) What is the firm’s market value capital
structure?
(2 marks) What is the cost of Equity Capital
What is the cost of Preferred Capital
What is the cost of Debt Capital