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In this chapter
Net income and net operating income approaches Optimal capital structure Factors affecting capital structure EBIT/EPS and ROI & ROCE Analysis Capital Structure Policies in practice
Capital Structure
Capital structure includes only long term debt and total stockholder investment. Capital Structure = Long Term Debt + Preferred Stock + Net Worth OR Capital Structure = Total Assets Current Liabilities.
It is that capital structure at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum. Features:
The benefit of debt. Control Seasonal variations Industry life cycle. Company characteristics Requirement of investors Purpose of finance
Flexibility Industry leverage ratios Degree of competition Agency cost Timing of public issue Period of finance Legal requirements.
3.
4.
Complete equity share capital; Different proportions of equity and preference share capital; Different proportions of equity and debenture (debt) capital an Different proportions of equity, preference and debenture (debt) capital.
In this approach, it is analyzed that how sensitive is EPS to the changes in EBIT under different capital structure.
This approach analyses the relationship between the ROI and ROE for different levels of financial leverage.
Net Income Approach Net Operating Income Approach Modigliani and Miller Approach [MM Hypothesis] Traditional Approach.
E = Total Market Value of Equity. D = Total Market Value of Debt. V = Total Market Value of the Firm. I = Annual Interest payment. NI = Net Income. NOI = Net Operating Income. Ee = Earning Available to Equity Shareholder.
A change in the proportion in capital structure will lead to a corresponding change in Ko and V. Assumptions:
(i) There are no taxes; (ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the perception of investors. (iv) Cost of debt and cost of equity remains constant;
risk
Net Income [NI] = EBIT Debenture Interest. Value of the Firm [V] = Market Value of Equity [E] + Market Value of Debt [D] Market Value of Equity [E] = Net Income [NI] / Cost of Equity [Ke] Cost of Capital [Ko] = EBIT / V * 100
Value of the Firm [V] = EBIT / Ko Market Value of Equity [E] = V D Cost of Equity/ Equity Capitalization Rate [Ke] = Ee / E or EBIT I / V - D
MM Hypothesis
This approach was developed by Prof. Franco Modigliani and Mertan Miller. According to this approach, total value of the firm is independent of its capital structure.
Assumptions
a. b. c. d.
e.
f. g.
h.
i.
Information is available at free of cost The same information is available for all investors Securities are infinitely divisible Investors are free to buy or sell securities There is no transaction cost There are no bankruptcy costs Investors can borrow without restrictions as the same terms on which a firm can borrow Dividend payout ratio is 100 percent EBIT is not affected by the use of debt
Propositions:
I. Ko and V are independent of capital structure II. Ke = to capitalisation rate of the pure equity plus a premium for financial risk. Ke increases with the use of more debt. Increased Ke off set exactly the use of a less expensive source of funds (debt) III.The cut of rate for investment purposes is completely independent of the way in which an investment is financed.
Refers to an act of buying an asset or security in one market at lower price and selling it is an other market at higher price. Steps in working out Arbitrage Process: Step 1: Investors Current Position: In this step there is a need to find out the current investment and income (return). Step 2: Calculation of Savings in Investment by moving from levered firm to unlevered firm. Savings in investment is equals to total funds [Funds raise by sale of shares plus funds raised by personnel borrowing] minus same percentage of investment. Here the income will be same which was earning in previous firm. Step 3: Calculation of Increased Income, by investing total funds available.
Limitations of MM Approach
Investors cannot borrow on the same terms and conditions of a firm Personal leverage is not substitute for corporate leverage Existence of transaction cost Institutional restriction on personal leverage Asymmetric information Existence of corporate tax
Traditional Approach
This approach was given by Soloman. This approach is the midway between NI Approach and NOI Approach. Traditional approach says judicious use of debt helps increase value of firm and reduce cost of capital
Main Prepositions
1. The pretax cost of debt (Ki) remains more or less constant up to a certain degree of leverage and /but rises thereafter of an increasing rate 2. The cost of equity capital (Ke) remains more or less constant rises slightly up to a certain degree of leverage and rises sharper there after, due to increased perceived risk. 3. The over all cost of capital (Ko), as a result of the behavior of pre-tax cost of debt (Ki) and cost of equity (Ke) behavior the following manner: It
(a) Decreases up to a certain point level of degree of leverage [stage I increasing firm value]; (b) Remains more or less unchanged for moderate increase in leverage thereafter [stage II optimum value of firm], and
(c) Rises sharply beyond certain degree of leverage [stage III decline in firm value].