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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.
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.
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
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?
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