A project on:

V/s

Submitted to: Prof. Kamal

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Submitted By
Dhaval Shah 49
Sohil Jewani 41
Murtuza Bhanpurawala 37
Aamir Ansari 36

A C K N O W L E D G E M E N T

On the completion of this Project, I wish to great fully acknowledge,

by taking this opportunity to express my sincere gratitude to Prof. Kamal

for giving me kind support and co-operation and her guidance and useful

suggestions that proved very useful in this Project. Once again thank all

the people who have directly or indirectly help in this Project.

Lastly, I sincerely thank all my friends who have always given their

encouraging support and been a great help all the time at various stage of

development of this Project.

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 Index
 Debt vs. Equity -- Advantages and Disadvantages 4

 Cost of Capital 6

 Specific Cost of Capital 7

 MAJOR CONSIDERATIONS IN CAPITAL STRUCTURE 11

PLANNING

 CAPITAL STRUCTURE THEORIES 14

 Bibliography 20

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 Debt vs. Equity -- Advantages and
Disadvantages

In order to expand, it is necessary for business owners to tap financial

resources. Business owners can utilize a variety of financing resources,
initially broken into two categories, debt and equity. "Debt" involves
borrowing money to be repaid, plus interest. "Equity" involves raising
money by selling interests in the company. The following table discusses
the advantages and disadvantages of debt financing as compared to
equity financing.

ADVANTAGES OF DEBT COMPARED TO EQUITY

 Because the lender does not have a claim to equity in the business,
debt does not dilute the owner's ownership interest in the company.

 A lender is entitled only to repayment of the agreed-upon principal of

the loan plus interest, and has no direct claim on future profits of the
business. If the company is successful, the owners reap a larger
portion of the rewards than they would if they had sold stock in the
company to investors in order to finance the growth.

 Except in the case of variable rate loans, principal and interest

obligations are known amounts which can be forecasted and planned
for.

 Interest on the debt can be deducted on the company's tax return,

lowering the actual cost of the loan to the company.

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 Raising debt capital is less complicated because the company is not
required to comply with state and federal securities laws and
regulations.

 The company is not required to send periodic mailings to large

numbers of investors, hold periodic meetings of shareholders, and
seek the vote of shareholders before taking certain actions.

DISADVANTAGES OF DEBT COMPARED TO EQUITY

 Unlike equity, debt must at some point be repaid.

 Interest is a fixed cost which raises the company's break-even point.

High interest costs during difficult financial periods can increase the
risk of insolvency. Companies that are too highly leveraged (that have
large amounts of debt as compared to equity) often find it difficult to
grow because of the high cost
of servicing the debt.

 Cash flow is required for both

principal and interest
payments and must be
budgeted for. Most loans are
not repayable in varying
amounts over time based on
the business cycles of the
company.

 Debt instruments often contain

restrictions on the company's
activities, preventing management
from pursuing alternative financing
options and non-core business
opportunities.

 The larger a company's debt-equity

ratio, the more risky the company is
considered by lenders and investors.
Accordingly, a business is limited as
to the amount of debt it can carry.

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 The company is usually required to
pledge assets of the company to the
lender as collateral, and owners of the
company are in some cases required to
personally guarantee repayment of the
loan.

Cost of Capital

The cost of capital is an important input in the capital budgeting decision.

Conceptually, it refers to the discount rate that would be used in
determining the present value of estimated future benefits associated
with projects. In operational terms, it is defined as weighted average cost
of each type of capital. It is visualized as being composed of several
elements, the elements being the cost of each component of the capital.
The term component means different sources of funds are received by a
firm. The long-term sources of funds are:-

I. Debt
II. Preference Shares
III. Equity Capital
IV. Retained Earning

Each source of fund or component of capital has its cost, called the
specific cost of capital. When these are combined to overall cost of
capital, it results in the weighted /average/combined cost of capital.
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Therefore, the compensation of the cost of capital, involves two steps:
1. Calculation of the specific cost of cash of each type of capital- debt,
preference shares, ordinary or equity shares and retained earnings
2. Calculation of the weighted average cost of capital by combining the
specific cost.
There are two approaches to it by:-
Book Value (BV)
Market value (MV)

Specific Cost of Capital

(We have covered only that portion)

Cost of Debt
Perpetual Debt
Ki = I / SV
Kd = I / SV (1-t)
Where,
Ki = Cost of debt before tax
Kd = Cost of debt after tax
I = Annual interest payment
SV = Amount of debt/net sale proceeds of debentures (bonds)
t = Tax rate

The explicit cost of debt is the interest rate as per contract adjusted for
tax and the cost of raising the debt.

However, debt has an implicit cost also. This arises due to the fact that if
the debt content rises above the optimal level, investors will start
considering the company to be too risky and, therefore, their expectations
from equity shares will rise. This rise in the cost of equity shares is
actually the implicit cost of debt.

Cost of Preference Shares

Irredeemable
Kp = Dp (1+D1) / P0 (1-f)
Where,
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Kp = Cost of preference share capital
Dp = Annual dividend
P0 = Sale price
f = Floatation cost
Dt = Dividend tax

In the case of preference shares, the dividend rate can be taken as its
cost since it is this amount which the company intends to pay against
preference shares. As in the case of debt, the issue expenses or the
discount/premium on issue/redemption has also to be taken into account.

Since dividend of preference shares is not allowed as deduction from

income for income tax purposes, there is no question of tax advantage in
the case of cost of preference shares.
 
It would, thus, be seen that both in the case of debt as well as preference
shares, cost of capital is calculated by reference to the obligations
incurred and proceeds received. The net proceeds received must be taken
into account in working out the cost of capital

Cost of Equity Capital

Dividend Valuation Approach (with growth)
Ke = D1 / Po (1-f) + g%
Where,
Ke = cost of equity capital
D1= expected dividend per share at the end of the year
P0 = current market price
f = Floatation cost
g = Growth in expected dividends

Calculation of the cost of ordinary shares involves a complex procedure.

This is because unlike debt and preference shares there is no fixed rate of
interest or dividend against ordinary shares. Hence, to assign a certain
cost of equity share capital is not a question of mere calculation. It
requires an understanding of many factors basically concerning the
behavior of investors and their expectations. Since there can be different
interpretations of investor’s behavior, there are many approaches
regarding calculation of cost of equity shares.

Cost of Retained Earning

Cost of reserves

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 Kr = Ke
Where,
Kr = Cost of retained earning
Ke = Cost of equity capital

The profits retained by a company and used in the expansion of business

also entail cost. The cost of retained earnings as the same as that of the
equity shares. However, if the cost of equity shares is determined on the
basis of realized values approach or D/P + g approach, the question of
working out a separate cost of reserves is not relevant since the cost of
reserves is automatically included in the cost of equity share capital.
 
Let us take an example of Weighted Average Cost
A company has got various alternatives to design their capital structure
and it is unable to choose which one to select. The company can go for
100% debt or 100% equity or else a combination of both. In this case to
know which alternative is most effective we have to calculate weighted
average cost of capital and the combination which has got the lowest cost
of capital should be selected.

Alternati Cost of Cost of Weight Weight Product Product Summation of

ves debt equity of debt of {debt} {equity} product
equity
1 6 13 0.00 1.00 0 13.00 13.00

2 6 13 0.10 0.90 0.60 11.70 12.30

3 6.5 14 0.20 0.80 1.30 11.20 12.50

4 6.5 15 0.30 0.70 1.95 10.50 12.45

5 7 16 0.40 0.60 2.80 9.60 12.40

6 7.5 18 0.50 0.50 3.75 9.00 12.75

7 9 20 0.60 0.40 5.40 8.00 13.40

8 10 22 0.70 0.30 7.00 6.60 13.60

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9 11 24 0.80 0.20 8.80 4.80 13.60

10 13 26 0.90 0.10 11.7 2.60 14.30

11 15 28 1 0 15 0 15

From the table we can see that neither going for 100% equity is cost
effective or 100% debt. We can see that going for 10% debt and 90%
equity is the best alternative in this case but it can differ depending on
the cost and weight of debt and equity.

CATIPAL STRUCTURE THEORIES

Optimum Capital Structure

 
The capital structure is said to be optimum capital structure when the firm
has selected such a combination of equity and debt so that the wealth of
firm is maximum. At this capital structure the cost of capital is minimum
and market price per share is maximum.
 
It is however, difficult to find out optimum debt and equity mix where the
capital structure would be optimum because it is difficult to measure a fall
in the market value of an equity share on account of increase in risk due
to high debt content in the capital structure.
 
In theory one can speak of an optimum capital structure but in practice
appropriate capital structure is more realistic term than the former.

Features on an appropriate capital structure

  
1. Profitability:
The most profitable capital structure is one that tends to minimize cost of
financing and maximize earning per equity share.
  
2. Flexibility:

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The capital structure should be such that company can raise funds
whenever needed.
 
3. Conservation:
The debt content in the capital structure should not exceed the limit which
the company can bear.
 
4. Solvency:
The capital structure should be such that firm does not run the risk of
becoming insolvent.
 
5. Control:
The capital structure should be so devised that it involves minimum risk
of loss of control of the company.

MAJOR CONSIDERATIONS IN CAPITAL STRUCTURE

PLANNING
 

There are three major considerations:

 Risk
 Cost of capital
 Control
These help the finance manager in determining the proportion in which he
can raise funds from various sources.
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Although, three factors, i.e., risk, cost and control determine the capital
structure of a particular business undertaking at a given point of time.
The finance manager attempts to design the capital structure in such a
manner that his risk and costs are the least and the control of the existing
manager is diluted to the least extent. However, there are also subsidiary
factors like marketability of the issue, maneuverability and flexibility of
the capital structure and timing for raising the funds. Structuring capital is
a shrewd financial management decision and is something which makes
or mars the fortunes of the company. These factors are discussed here
under.

Risk in Capital Structure

 
Risk is of two kinds, i.e., financial risk and Business risk. Here we are
concerned primarily with the financial risk. Financial risk also is of two
types:
 
1. Risk of cash insolvency: 

If a firm raises more debt, its risk of cash insolvency increases. This is
due to two reasons. Firstly, higher proportion of debt in the capital
structure increases the commitments of the company with regard to fixed
charges. This means that a company stands committed to pay a higher
amount of interest irrespective of the fact whether it has cash or not.
Secondly, there is a possibility that the supplier of funds may withdraw
the funds at any given point of time. Thus the long-term creditors may
have to be paid back in installments, even if sufficient cash to do so does
not exist. This risk is not there in the case of equity shares.
 
2. Risk of variation in the expected earnings available to equity
share-holders: 

In case a firm has higher debt content in capital structure, the risk of
variations in expected earnings available to equity shareholders will be
higher. This is because of trading on equity. We have know that financial
leverage works both ways, i.e., it enhances the shareholders’ return by a
high magnitude or brings it down sharply depending upon whether the
return on investment is higher or lower than the rate of interest. Thus
there will be lower probability that equity shareholders will enjoy a stable
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dividend if the debt content is high in the capital structure. In other
words, the relative dispersion of expected earnings available to equity
shareholders will be greater if the capital structure of a firm has higher
debt content.
 
The financial risk involved in various sources of finance can be understood
by taking the example of debentures. A company has to pay interest
charges on debentures even when it does not make any profit. Also the
principal sum has to be repaid under the stipulated agreement. The
debenture holders also have a charge against the assets of the company.
Thus, they can enforce a sale of the assets in case the company fails to
meet its contractual obligations. Debentures also increase the risk of
variation in the expected earnings available to equity shareholders
through leverage effect, i.e., if the return on investment remains higher
than the interest rate, shareholders will get a high return; but if reverse is
the case, shareholders may get no return at all.
 
As compared to debentures, preference shares entail slightly lower risk
for the company, since the payment of dividends on such shares is
contingent upon the earning of profits by the company. Even in the case
of cumulative preference shares, dividends have to be paid only in the
year in which a company makes profits. Again, the repayment of
preference shares has to be redeemable and that too after a stipulated
period. However, preference shares also increase the variations in the
expected earnings available to equity shareholders. From the point of
view of the company, equity shares are the least risky. This is because a
company does not repay equity share capital except on its liquidation.
Also, it may not declare a dividend for years together.
 
In short, financial risk encompasses the volatility of earnings available to
equity shareholders as well as the probability of cash insolvency.

Cost of capital

Cost is an important consideration in capital structure decisions. It is

obvious that a business should be at least capable of earning enough
revenue to meet its cost of capital and finance its growth. Hence, along
with a risk as a factor, the finance manager has to consider the cost
aspect carefully while determining the capital structure.

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Control

Along with cost and risk factors, the control aspect is also an important
consideration in planning the capital structure. When a company issues
further equity shares, it automatically dilutes the controlling interest of
the present owners. Similarly, preference shareholders can have voting
rights and thereby affect the composition of the Board of Directors.
Financial institutions normally stipulate that they shall have one or more
directors on the Board. Hence, when the management agrees to raise
loans from financial institutions, by implication it agrees to forget a part of
its control over the company. It is obvious, therefore, that decisions
concerning capital structure are taken after keeping the control factor in
mind.

CAPITAL STRUCTURE THEORIES

The objective of a firm should be directed towards the maximization of

the value of the firm, the capital structure, or leverage decision should be
examined from the point of view of its impact on the value of the firm. If
the value of the firm can be affected by capital structure or financing
decision, a firm would like to have a capital structure which maximizes
the market value of the firm.
 
There are broadly four approaches in this regard. These are:
 
1. Net Income Approach (N.I. approach)

2. Net Operating Income Approach (N.O.I. approach)

3. Traditional Theory

4. Modigliani and Miller Approach

 
These approaches analysis relationship between the leverage, cost of
capital and the value of the firm in different ways. However, the following
assumptions are made to understand these relationships.
 
1. There are only two sources of funds viz., debt and equity.

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 2. The total assets of firm are given. The degree of leverage can be
changed by selling debt to purchase shares or selling shares to
retire debt.

3. There are no retained earnings. It implies that entire profits are

distributed among shareholders.

4. The operating profit of firm is given and expected to grow.

5. The business risk is assumed to be constant and is not affected by

the financing mix decision.

6. There are no corporate or personal taxes.

7. The investors have the same subjective probability distribution of

expected earnings.

Net Income Approach (NI-approach)

 
This approach has been suggested by Durand. According to this approach
a firm can increase its value or lower the overall cost of capital by
increasing the proportion of debt in the capital structure. In other words,
if the degree of financial leverage increases the weighted average cost of
capital will decline with every increase in the debt content in total funds
employed, while the value of firm will increase. Reverse will happen in a
converse situation.
 
Net income approach is based on the following three assumptions:
I. There are no corporate taxes
II. The cost of debt is less than cost of equity or equity capitalization rate.
III. The use of debt content does not change at risk perception of investors
as a result both the kd (debt capitalization rate) and kc (equity-
capitalization rate) remains constant.
 
The value of the firm on the basis of Net Income Approach can be
ascertained as follows:
 V = S + D
 Where,
V = Value of the firm
S = Market value of equity

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D = Market value of debt
 
Market value of equity (S) = NI/Kc
Where,
NI = Earnings available for equity shareholders.
Kc = Equity Capitalization rate
 
Under, NI approach, the value of the firm will be maximum at a point
where weighted average cost of capital is minimum. Thus, the theory
suggests total or maximum possible debt financing for minimizing the cost
of capital. The N.I. Approach can be illustrated with help of the following
example.
 
The overall cost of capital under this approach is:

Overall cost of capital = (NPBIT) / (Value of the firm)

Net operating Income (NOI) Approach

 
According to this approach, the market value of the firm is not affected by
the capital structure changes. The market value of the firm is ascertained
by capitalizing the net operating income at the overall cost of capital
which is constant. The market value of the firm is determined as follows:
 
Market value of the firm (V) = (Earnings before interest and tax) /
(Overall cost of capital)
 
The value of equity can be determined by the following equation
 
Value of equity (S) = V (market value of firm) – D (Market value of debt)
 
And the cost of equity = (Earnings after interest and before tax) /
(market value of firm (V) - Market value of debt (D))
 
The Net Operating Income Approach is based on the following
assumptions:
 
a. The overall cost of capital remains constant for all degree of debt
equity mix.

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b. The market capitalizes the value of firm as a whole. Thus the split
between debt and equity is not important.

c. The use of less costly debt funds increases the risk of shareholders.
This causes the equity capitalization rate to increase. Thus, the
advantage of debt is set off exactly by increase in equity capitalization
rate.

d. There are no corporate taxes

e. The cost of debt is constant.

 
Under NOI approach since overall cost of capital is constant, therefore
there is no optimal capital structure rather every capital structure is as
good as any other and so every capital structure is optimal one.

Traditional Approach
 
The traditional approach is also called an intermediate approach as it
takes a midway between NI approach (that the value of the firm can be
increased by increasing financial leverage) and NOI approach (that the
value of firm is constant irrespective of the degree of financial leverage).
According to this approach the firm should strive to reach the optimal
capital structure. At the optimal capital structure the overall cost of
capital will be minimum and the value of the firm is maximum. It further
states that the value of the firm increases with financial leverage upto a
certain point. Beyond this point the increase in financial leverage will
increase its overall cost of capital and hence the value of firm will decline.
This is because the benefits of use of debt may be so large that even after
off-setting the effect of increase in cost of equity, the overall cost of
capital may still go down. However, if financial leverage increases beyond
an acceptable limit the risk of debt investor may also increase,
consequently cost of debt also starts increasing. The increasing cost of
equity owing to increased financial risk and increasing cost of debt makes
the overall cost of capital to increase.
 
Thus as per the traditional approach the cost of capital is a function of
financial leverage and the value of firm can be affected by the judicious
mix of debt and equity in capital structure. The increase of financial
leverage upto a point favourably affects the value of firm. At this point

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the capital structure is optimal & the overall cost of capital will be the
least.

Modigliani and Miller Approach

 
According to this approach the total cost of capital of particular firm is
independent of its methods and level of financing. Modigliani and Miller
argued that the weighted average cost of capital of a firm is completely
independent of its capital structure. In other words, a change in the debt
equity mix does not affect the cost of capital. They gave a simple
argument in support of their approach. They argued that according to the
traditional approach, cost of capital is the weighted average of cost of
debt and cost of equity, etc. The cost of equity, they argued, is
determined from the level of shareholder’s expectations. Now, if
shareholders expect 16% from a particular company, they do take into
account the debt equity ratio and they expect 16^ merely because they
find that 16% covers the particular risk which this company entails.
Suppose, further that the debt content in the capital structure of this
company increases; this means that in the eyes of shareholders, the risk
of the company increases, since debt is a more risky mode of finance.
Hence, shareholders will now start expecting a higher rate of return from
the shares of the company. Hence, each change in the debt equity mix is
automatically offset by a change in the expectations of the shareholders
from the equity share capital. This is because a change in the debt equity
ratio changes the risk element of the company, which in turn changes the
expectations of the shareholders from the particular shares of the
company. Modigliani and Miller, therefore, argued that financial leverage
has nothing to do with the overall cost of capital and the overall cost of
capital of a company is equal to the capitalization rate of pure equity
stream of its class of risk. Hence, financial leverage has no impact on
share market prices or on the cost of capital.
 
 
Modigliani and Miller make the following propositions:
 
1. The total market value of a firm and its cost of capital are independent
of its capital structure. The total market value of the firm is given by
capitalizing the expected stream of operating earnings at a discount rate
considered appropriate for its risk class.
 
2. The cost of equity (Ke) is equal to capitalization rate of pure equity
stream plus a premium for financial risk. The financial risk increases with
more debt content in the capital structure. As a result, K e increases in a
manner to offset exactly the use of less expensive source of funds.

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ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH
 
1. The capital markets are assumed to be perfect. This means that
investors are free to buy and sell securities. They are well informed about
the risk-return on all type of securities. These are no transaction costs.
The investors behave rationally. They can borrow without restrictions on
the same terms as the firms do.
 
2. The firms can be classified into ‘homogeneous risk class’. They belong
to this class if their expected earnings are having identical risk
characteristics.
 
3. All investors have the same expectations from a firm’s net operating
income (EBIT) which are necessary to evaluate the value of a firm.
 
4. The dividend payment ratio is 100%. In other words, there are no
retained earnings.
 
5. There are no corporate taxes. However this assumption has been
removed later.
 
Modigliani and Miller agree that while companies in different industries
face different risks which will result in their earnings being capitalized at
different rates, it is not possible for these companies to affect their
market values, and therefore their overall capitalization rate by use of
leverage. That is, for a company in a particular risk class, the total market
value must be same irrespective of proportion of debt in company’s
capital structure. The support for this hypothesis lies in the presence of
arbitrage in the capital market. They contend that arbitrage will substitute
personal leverage for corporate leverage. This is illustrated below:

Suppose there are two companies A & B in the same risk class. Company
A is financed by equity and company B has a capital structure which
includes debt. If market price of share of company B is higher than
company A, market participants would take advantage of difference by
selling equity shares of company B, borrowing money to equate their
personal leverage to the degree of corporate leverage in company B, and
use these funds to invest in company A. The sale of Company B share will
bring down its price until the market value of company B debt and equity
equals the market value of the company financed only by equity capital.

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Criticism of Modigliani and Miller Approach
 
These propositions have been criticized by numerous authorities. Mostly
criticism is about perfect market assumption and the arbitrage
assumption. MM hypothesis argue that through personnel arbitrage
investors would quickly eliminate any inequalities between the value of
leverages firms and value of unleveraged firms in the same risk class. The
basic-argument here is that individual’s arbitragers, through the use of
personal leverage can alter corporate leverage. This argument is not valid
in the practical world, for it is extremely doubtful that personnel investors
would substitute personal leverage for corporate leverage, since they do,
not have the same risk characteristics. The MM approach assumes
availability of free and upto date information. This also is not normally
valid.

Websites:
www.transtutors.com
www.scribd.com (various authors)

Reference books
Theory and Promblems in Financial Management
By M.Y. Khan and P. K. Jain

Images
Various Sources

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