CORPORATE FINANCE- MODULE- 4 – FINANCING DECISIONS

Learning Outcomes:
4a) Develop appropriate capital structure for different types of organizations.
4b) Examine how the specific and WACC influence the capital structure of an Organization.
1. Financing alternatives – Equity, preferences, Debentures* 2. Capital Structure. Theories of
Capital structure – MM Theory, Traditional theory, 3. Capital Structure in practice,4. A survey of
Indian firms’ and MNCs’ capital structure*, Leverages, cost of capital – 5. Specific cost of
capital, WACC.

Cost of Capital CHAPTER-14-PRASANNACHANDRA

 Minimum rate of return which a company is expected to earn from a proposed project so as to
make no reduction in the earning per share to equity shareholders and its market price.
 In economic terms there are two approaches to define CoC:
1. It is the borrowing rate of the firm, at which it can acquire funds to finance the proposed project
2. It is the lending rate which the firm could have earned if the firm would have invested elsewhere
CoC is a combined cost of each type of source by which a firm raises funds.
 Also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return, standard
return, etc.
 Assumption: that the firm’s business and financial risks are unaffected by the acceptance and
financing of projects.
Significance
 Capital Budgeting Decisions
 Designing the Corporate Financial Structure
 Deciding about the method of financing – in lieu with capital market fluctuations
 Performance of top management
 Other areas – eg., dividend policy, working capital
 Cost of Equity Capital: the cost of obtaining funds through the sale of common stock.
 Cost of Preference Shares
 Cost of Debt
 Cost of Retained Earnings
Cost of Debt: Yield to the maturity of the instrument.

𝑛
𝐼 𝐹
𝑃0 = +
𝑡
(1 + 𝑟𝐷 ) (1 + 𝑟𝐷 )𝑛
𝑡=1

Trial and error method:

𝐼 + ((𝐹 − 𝑃0 )
𝑟𝐷 = 𝑛
0.6𝑃0 + 0.4𝐹

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 1

  Cost of debt is the after-tax cost of long-term funds through borrowing.
 Net cash proceeds are the funds actually received from the sale of security.
 Flotation cost is the total cost of issuing and selling securities.
 = I/SV; where I is annual interest payment (coupon payment); SV is sale proceeds of
bond/debenture.
 =I(1-T)/SV; where T is tax rate.
Example: A 12% perpetual debt of nominal value of Rs.100000. Tax rate is 50%. Cost of debt
when issued at i. Par, ii. At discount of 5% and iii. premium of 10%.
i. At par = 12000/100000=12%
=12%(1-0.5)=6%
ii. At discount of 5%, that is value received is 95,000.
=12000/95000=12.63%
=12.63%(1-0.5)=6.32%
iii. At a premium of 10%, that is value received is 110,000.
=12000/110,000=10.91%
=10.91%(1-0.5)=5.45%
So here (ii) 6.32% is highest cost followed by (i) 6% or (iii) 5.45%.
Cost of Preference Capital
Same as debt formula
Cost of Equity Capital
 is defined as the minimum rate of return that a firm must earn on the equity-financed portion of
an investment project in order to leave unchanged the market price of the shares.
 It is the rate at which investors discount the expected dividends of the firm to determine its share
value.
 The two approaches to measure ke are i. Capital Asset Pricing and ii. Dividend Discount
model.
 The CAPM explains the behavior of security prices and provides a mechanism whereby investors
could assess the impact of proposed security investment on their overall portfolio risk and return.
In other words, it formally describes the risk-return trade-off for securities.
 The basic assumption of CAPM are related to
A. the efficiency of the market, and
B. investor preferences.

 𝑟𝐸 = 𝑅𝑓 + 𝛽𝐸 (𝐸 (𝑅𝑚 ) − 𝑅𝑓 )

Where,
= cost of equity capital;
= the rate of return required on a risk free asset/security/investment
= required rate of return on the market portfolio of assets that can be viewed as the average
rate of return on all assets
= the beta coefficient.
for market portfolios is 1, while it is 0 for risk-free investments.
Risk to which security investment is exposed to are of 2 types

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 2

  Dividend Discount – Dividend Valuation model or Dividend Growth model approach:
assumes that the value of a share equals the present value of all future dividends that it is expected
to provide over an indefinite period.
 accordingly, is defined as the discount rate that equates the present value of all expected future
dividends per share with the net proceeds of the sale (or the current market price) of a share.

𝐷(1) 𝐷(1) (1 + 𝑔) 𝐷(1) (1 + 𝑔)2

𝑃0 = 1+ + + ⋯.∞
(1 + r) (1 + r)2 (1 + r)3

This simplifies to 𝐷(1)

𝑃0 =
(r − g)

𝐷(1) 𝐷(1) 𝐷(0) (1+𝑔)

𝑟 = +g = 𝑟 = +𝑔 = +𝑔
𝑃0 𝑃0 𝑃0

 D1 = expected dividend per share

 P0 = net proceeds per share/current market price
 g = growth in expected dividends

Cost of Retained Earnings: Cost of retained earnings is the same as the cost of an equivalent
fully subscribed issue of additional shares, which is measured by the cost of equity capital.
Weighted Average Cost of Capital (WACC)
WACC= (Proportion of Equity) (Cost of Equity) + (Proportion of Preference) (Cost of
Preference) + (Proportion of Debt) (Cost of Debt)
= + + (1 − )
Solved problem: Page No.388 in PC (14.1)
The capital structure of Adamus Ltd., in book value terms is as follows:
Equity capital (20 million shares, Rs.10 par) Rs.200 million
Preference capital, 12% (500000 shares, Rs.100 Par) Rs.50 million
Retained Earnings Rs.350 million
Debentures 14%(1200000 debentures,Rs.100 Par) Rs.120 million
Term Loans, 13% Rs.80 million
-------------------
-
Rs.800 million
The next expected dividend per share is Rs.2.00. The dividend per share is expected to grow at the
rate of 12%. The market price per share is Rs.50.00. Preference stock, redeemable after 10 years, is
currently selling for Rs.85 per share. Debentures, redeemable after 5 years, are selling for Rs.90.00
per debenture. The tax rate for the company is 30%. Calculate the average cost of capital.

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 3

LEVERAGES: CHAPTER- 20-PRASANNACHANDRA
Leverages:
Types: Operating, financial leverage, combined
Format:
Sales --------
Less: VC -----------
________________
Contribution -----------
Less: fixed Operating Ex -------------
_________________
PBI T ----------------
Less Int -------------------
___________________
PBT ----------------
Less: Tax ----------------
___________________
PAT -----------------
Less: Preference Dividend -----------------
___________________
Earnings to Eq.SH --------------
____________________
 The use of the fixed-charges sources of funds, such as debt and preference capital along with the
owners’ equity in the capital structure, is described as financial leverage or gearing or trading
on equity.
 The financial leverage employed by a company is intended to earn more return on the fixed-
charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the
owners’ equity. The rate of return on the owners’ equity is levered above or below the rate of
return on total assets.
 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝐵𝑇 ∆𝑃𝐵𝑇/𝑃𝐵𝑇 𝑃𝐵𝐼𝑇
𝐷𝐹𝐿 = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛𝑃𝐵𝐼𝑇 = ∆𝑃𝐵𝐼𝑇/𝑃𝐵𝐼𝑇 = 𝑃𝐵𝑇

Measures of Financial Leverage

 Debt ratio
 Debt–equity ratio
 Interest coverage
EPS, ROE and ROI are the important figures for analysing the impact of financial leverage

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 4

 Problem: Finex Ltd, has currently a PBIT of Rs 50000. Its fixed interest Expenses are
Rs.30,000:and its tax rate is 50%. It has 10,000 shares outstanding. . Compute Financial
leverage in the following cases:
i) PBIT Rs. 50,000 : ii) PBIT Rs.60,000

Solution: Total value of shares: 100008*10=100000

Case A Case B
PBIT/PBIT 50000 60000
Less: Fixed cost/Interest 30000 30000
expenses
PBT 20000 30000
Less: 50% Tax 10000 15000
PAT 10000 15000
EPS 1 1.5

EPS= PAT/ No.of shares = 10000/10000 = 1 per share : 15000/10000 = 1.5 per share
Degree of financial Leverage:
PBIT= 50000 = 50000/(50000-30000) = 2.5 times
PBIT = 60000 = 60000/ (60000-30000) =2 times

Operating leverage affects a firm’s operating profit (PBIT).

 The degree of operating leverage (DOL) is defined as the percentage change in the earnings
before interest and taxes relative to a given percentage change in sales.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝐵𝐼𝑇 ∆𝑃𝐵𝐼𝑇/𝑃𝐵𝐼𝑇 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐷𝑂𝐿 = = =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 ∆𝑄/𝑄 𝑃𝐵𝐼𝑇

 Operating leverage affects a firm’s operating profit (PBIT), while financial leverage affects
profit after tax or the earnings per share.
Problem: A firm is currently selling a product at Rs 1000 per Unit, its Variable costs are Rs.500
per unit, and its Fixed operating costs are Rs.200000. Compute Operating leverage in each of the
following cases:
i) sales of 500 Units
ii) sales of 600 Units

500 Units 600 units

Revenue 500 *1000 500000 600*1000 600000
V.C 500*500 250000 600*500 300000
Contribution 250000 300000
Less: Fixed 200000 200000
operating
cost
PBIT 50000 100000

Operating Leverage: Contribution/EBIT = 250000/50000 : 300000/100000

= 5times : 3 times

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 5

  The degrees of operating and financial leverages is combined to see the effect of total
leverage on EPS associated with a given change in sales.
 The degree of combined leverage (DCL) is given by the following equation:
another way of expressing the degree of combined leverage is as follows:
Combined Leverage = Operating Leverage *Financial Leverage

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝐵𝑇 ∆𝑃𝐵𝑇/𝑃𝐵𝑇 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝐷𝐶𝐿 = = =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 ∆𝑄/𝑄 𝑃𝐵𝑇

Case A Case B
Sales 500 units 600 units
Revenue 500000 600000
Variable Operating Costs 250000 300000
Fixed Operating Costs 200000 200000
PBIT/PBIT 50000 100000
Less: Fixed cost/Interest 30000 30000
expenses
PBT 20000 70000
Less: 50% Tax 10000 35000
PAT 10000 35000
EPS 1 3.5
DTL 12.5 4.29
Case Study: 516 Pg no
The ZBB Ltd.needs Rs 500,000 for construction of a new plant. The following three financial
plans are feasible:

(i) The company may issue 50,000 equity shares at Rs 10 per share.
(ii) The company may issue 25,000 equity shares at Rs 10 per share and 2,500 debentures of
Rs 100 denomination bearing an 8% rate of interest.
(iii) The company may issue 25,000 equity shares at Rs 10 per share and 2,500 preference
shares of Rs 100 denomination bearing an 8% rate of interest.

If the company’s earnings before interest and taxes are Rs 10,000, Rs 20,000, Rs 40,000,
Rs 60,000 and Rs 1,00,000, what are the earnings per share under each of the three
financial plans? Which alternative would you recommend and why? Assume corporate tax
rate to be 50%.
CAPITAL STRUCTURE AND FIRM VALUE (Chapter-19-PC)

Capital structure theories: The term capital structure is used to represent the proportionate
relationship between debt and equity. The various means of financing represent the financial
structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity)
represents the financial structure of a company. Traditionally, short-term borrowings are
excluded from the list of methods of financing the firm’s capital expenditure.

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 6

  Traditional approach and Net income (NI) approach.
 Net operating income (NOI) approach.
 MM hypothesis with and without corporate tax.
 Miller’s hypothesis with corporate and personal taxes.
 Trade-off theory
Net income (NI) approach : According to NI approach both the cost of debt and the cost of equity are
independent of the capital structure; they remain constant regardless of how much debt the firm uses. As
a result, the overall cost of capital declines and the firm value increases with debt.
 This approach has no basis in reality; the optimum capital structure would be 100 per cent debt
financing under NI approach.

Traditional approach :The traditional approach argues that moderate degree of debt can lower
the firm’s overall cost of capital and thereby, increase the firm value. The initial increase in the
cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders
perceive higher risk and the cost of equity rises until a point is reached at which the advantage of
lower cost of debt is more than offset by more expensive equity.

Net operating income (NOI) approach :According to NOI approach the value of the firm and the
weighted average cost of capital are independent of the firm’s capital structure. In the absence of taxes,
an individual holding all the debt and equity securities will receive the same cash flows regardless of the
capital structure and therefore, value of the company is the same.

MM hypothesis without corporate tax - MM’s Proposition I

Assumptions:
 Perfect Capital market
 Rational investors and Managers
 Homogenous Expectations
 Equivalent Risk Classes
 Absence of taxes
 MM’s Proposition I states that the firm’s value is independent of its capital structure. With
personal leverage, shareholders can receive exactly the same return, with the same risk, from a
levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy
shares of the under-priced firm until the two values equate. This is called arbitrage.
MM’s Proposition II :The cost of equity for a levered firm equals the constant overall cost of capital
plus a risk premium that equals the spread between the overall cost of capital and the cost of debt
multiplied by the firm’s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital
must remain constant, regardless of the amount of debt employed. This implies that the cost of equity
must rise as financial risk increases.

 MM hypothesis with and without corporate tax.

Under current laws in most countries, debt has an important advantage over equity: interest payments on
debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered
firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 7

interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of
debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest
tax shield which is tax rate times the debt (if the shield is fully usable).
It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to
use the tax shield. Also, it ignores bankruptcy and agency costs.
Miller’s hypothesis with corporate and personal taxes.
 To establish an optimum capital structure both corporate and personal taxes paid on operating
income should be minimised. The personal tax rate is difficult to determine because of the differing tax
status of investors, and that capital gains are only taxed when shares are sold.
 Merton miller proposed that the original MM proposition I holds in a world with both corporate
and personal taxes because he assumes the personal tax rate on equity income is zero. Companies will
issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax
rate. At this point, there will be no net tax advantage to companies from issuing additional debt.
It is now widely accepted that the effect of personal taxes is to lower the estimate of the interest tax
shield
Trade off Theory: The optimal debt-equity ration of a firm depends on the trade off between the tax
advantage of debt on the one hand and the financial distress and agency costs on the other hand.
Financial distress arises when a firm is not able to meet its obligations to debt-holders.
For a given level of debt, financial distress occurs because of the business (operating) risk . with higher
business risk, the probability of financial distress becomes greater.
 VL =Vu+ tc D
Value of the Levered firm = Value of the Unlevered firm + tax advantage of debt
Agency Costs: Agency relationship between shareholders and creditors of firms that have substantial
sums of debt.
Pecking Order of Financing : Retained EARNINGS, Debt finance and external equity
Signalling Theory : . Meyers proposed this asymmetric information theory to explain the Pecking order
of financing.
Practical Considerations in Determining Capital Structure
o Control
o Widely-held Companies
o Closely-held Companies
o Flexibility
o Loan Covenants
o Early Repay ability
o Reserve Capacity
o Marketability
o Market Conditions
o Flotation Costs
o Capacity of Raising Funds
o Agency Costs
Case Study
 SumanJoshi, Managing Director of Omega Textiles, was reviewing two very different investment
proposals. The first one is for expanding the capacity in the main line of business and the second
one is for diversifying into a new line of business.
 Suman Joshi asks for your help in estimating Omega’s weighted average cost of capital which he
believes is relevant for evaluating the expansion proposal. He also wants you to estimate the

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 8

 hurdle rate for the new line of business. To enable you to carry out your task, he has provided the
following date.
 The latest balance sheet of Omega is given below.
Liabilities Amount is in Million Assets Amount is in Million
Equity capital 350 Fixed Asset 700
Preference capital 100 Investments 100
Reserves and surplus 200 Current Assets,loans 400
and advances
Debentures 450
Current Liabilities & 100
provisions
1200 1200

Omega’s target capital structure has 50% equity, 10% preference and 40% debt.
Omega hasRs.100 par, 10% coupon, annual payment, noncallable debentures with 8 years to
maturity. These debentures are selling currently @112.
Omega has Rs.100 par, 9%, annual dividend, preference shares with a residual maturity of 5 years.
The market price of these preference shares is Rs.106.
Omega’s equity stock is currently selling at Rs.80 per share. Its last dividend was Rs.280 and the
dividend per share is expected to grow at a rate of 10% in future.
Omega’s equity beta is 1.1, the risk-free rate is 7%, and the market risk premium is estimated to
be 7%.
Omega’s tax rate is 30%
The new business that Omega is considering has different financial chracteristics than Omega’s
existing business. Firms engaged purely in such business have, on average, the following
chracteristics:1.Their capital structure has debt and equity in equal proportions. 2. Their cost of
debt is 11% : 3.Their equity beta is 1.5
a. What is Omega’s post tax cost of debt and preference?
b.What is Omega’s cost of equity as per the dividend discount model and the CAPM?
c.What is Omega’s WACC, using CAPM for the cost of equity?
d.What is the WACC for the new business?

CORPORATE FINANCE-MODULE-4-FINANCING DECISIONS- Dr.SIREESHA NANDURI Page 9