Cost of Capital and

Capital Structure
Weights and Cost of financing to create
value of firm
 Weighted average cost of capital
• Expected average future cost of funds over the long run
– Calculated by weighting the cost of each specific type of
capital by its proportion in the company’s capital structure

• Need cost of specific capital

– Previously discussed

• Need weights for specific capital

– Book value weights vs. Market value weights
– Historical weights vs. Target weights
Narain
Weighted Average Cost of Capital

Source of Borrowing Ownership WACC

Financing (Debt) (Equity) (Hurdle Rate)
Cost of
8% 12%
Financing
Weight 1 25% 75% 11.0%
Weight 2 50% 50% 10.0%
Weight 3 75% 25% 9.0%
Weight 4 90% 10% 8.4%
Weight 5 100% 0% 8.0%

Narain
How can we reduce hurdle rate?

Narain
 Is it so ???
A manufacturing firm presently has the following cost structure for
the factory:
variable costs: 60% of the sales
fixed cost: Rs. 1,00,000
The current level of sales is Rs. 10,00,000 and 5,000 equity shares
are outstanding. The expected sales for the next year are:
a) Expected sales (downturn) = 8,00,000
b) Expected sales (upturn) = 12,00,000
If tax rate is 50%, determine the impact on the Earnings Per Share.
What if the firm also has to pay interest of Rs. 50,000 p.a.

Narain
 Exercise
• Current sales: 20,000 units
• Sales price: Rs. 5/-
• Variable operating cost: Rs. 2/-
• Fixed operating costs: Rs. 10,000
• Interest payable: Rs. 20,000
• Taxes: 40%
• Preference Share Dividend: Rs. 12,000 p.a.
• Outstanding equity Shares: 5,000 shares
Determine the impact on the EPS if sales are
expected to increase to 30,000 units
Narain
 Impact of Leverage
• Favourable impact
– It increases the benefit in the form of the Earnings
available to the shareholders
• Unfavourable impact
– It increases the variability of the return to the
shareholders
– Total firm risk = business risk x DFL
– CVEPS = CVEBIT x DFLEBIT
• EBIT-EPS analysis & the optimal capital structure

Narain
 EBIT – EPS Analysis
A firm has equity share capital of Rs. 10 lakhs. The firm
needs Rs. 10 lakhs for its expansion plans. It has
following options to raise this money:
1. Entire financing by issuing equity shares at par
2. 50% equity shares & 50% by way of 5%Debentures
3. 50% equity & 50% by way of 5% Preference shares
If the EBIT level will be Rs. 1,20,000 , tax rate is 35%
and 10,000 outstanding equity shares with market
price of Rs. 100 per share, Which financing plan
should the firm select?
What if EBIT level falls to Rs. 80,000?
Narain
 Exercise
Determine the indifference point at which earnings to
equity shares of a corporate firm will be the same from
the following data:
Funds required: Rs. 50,000
Existing no. of equity shares: 5,000 @ Rs. 10/-
Existing 10% debentures: Rs. 20,000
Tax rate: 35%
Financing Plans: (1) Issue 2,000 equity shares @ Rs. 25/-
(2) Issue 15% debentures
Narain
 Capital Structure & Value of Firm

• Higher leverage involves higher EPS for increased

operating activity
• Higher leverage involves higher financial risk
– Risk of possible insolvency arising out of inadequacy
of available cash as well as
– Variability in the earnings available to equity
shareholders
• Two opinions about the impact of financing decision:
1. Close relationship between leverage & firm’s value
2. Financing mix has no impact on shareholder’s wealth
Narain
Theories of capital structures

Various explanations for capital structure

decisions:
1. Net Income Approach

2. Net Operating Income Approach

3. Modigilani-Miller Approach

4. Traditional Approach
Narain
 Theoretical assumptions
1. No corporate or personal income tax
2. No bankruptcy costs
3. Only two sources of financing: Risk free Debt &
Equity
4. No costs of or delay in reshuffling of proportion
of debt
5. Firm has 100% dividend payout policy
6. Constant expected operating earnings of the firm
7. Homogenous operating expectations of the
investors in the market
Narain
 Symbols
• Net operating earnings = Y
• Annual Interest charges = I
• Earnings available to equity shareholders = E=Y-I
• Market value of Debt = D
• Market value of equity shares = S
• Cost of debt ki = I/D
• Cost of equity ke = E/S
• Value of firm V = D+S
• Weighted average cost of capital
k0 = ki(D/V) + ke(S/V)
= Y/V
Narain
 Net Income Approach
• If D-E ratio is increased, the proportion of cheaper
sources of funds (debt) increases
• The weighted average cost of capital declines
• Value of the firm increases
• Market price of equity shares will increase

ke
Cost of
capital k0
ki

Extent of leverage
Narain
Net Operating Income Approach
• Increase in the use of debt increase the return to
equity shareholders
• But this benefit is offset by the loss arising out of
the increase in the cost of equity
• Weighted average cost of capital and hence, the
value of the firm, remains the same
ke
Cost of
capital
k0
ki

Extent of leverage
Narain
 Modigliani-Miller Approach
• Supports the Net Operating Income Approach
• That is, there is no relation between capital structure
decision and the value of the firm, if there is no income
tax
• But offers a behavioural explanation
• It does not matter how the pie of firm’s value is
distributed among the suppliers of funds
• Investors can take up Home-Made Leverage for
substituting personal leverage for corporate leverage
• The process of arbitrage will ensure that the value of
leveraged firm is equal to the value of unleveraged firm

Narain
 Arbitrage illustration
• There are two firms: A and B
• Both has the same degree of business risk
• Net operating income of the two firms are: Rs.
2,00,000
• Firm A is not leveraged
• While firm B has 12% bonds of Rs.6,00,000
• Suppose by following the traditional theory, firm
B has higher cost of equity, 16% than firm A, 15%.

Narain
 MM with corporate taxes

Two propositions
1. The value of a leveraged firm is equal to the
value of and unleveraged firm in the same risk
class plus gains from leverage
VL=VU + t.D
2. The cost of equity of a leveraged firm is cost of
equity of unleveraged firm in same risk class plus
risk premium of it over the cost of debt times the
after tax financial leverage
keL=keU+(keU - kd)(1-t)(D/S)
Narain
 Traditional Approach
• Till a point cost of debt will enhance firm’s value
• Beyond this point risk factors will starts affecting
the firm’s value adversely.
ke

k0

Cost of ki
capital

D* Extent of leverage Narain

 Illustration
• A company gives following information:
• Total assets: Rs. 1000 lac
• EBIT: Rs. 200 lac
• Tax rate: 35%
• The details of financing are:
Case Proportion of Cost of Debt No. of equity Cost of Equity
Debt shares
1 0% - 2,00,000 12%
2 15% 8% 1,70,000 13%
3 30% 9% 1,40,000 14%
4 45% 12% 1,10,000 16%
5 60% 15% 80,000 20%

Narain
 Factors in Capital Structure
1. Profitability
– EBIT-EPS analysis
– Coverage ratio
2. Liquidity: servicing of fixed charges from cash flows
3. Control
4. Market signalling
5. Nature of industry: sales fluctuation, life cycle,
competition, Industry leverage ratio
6. Company factors: size, goodwill
7. Permission of existing stakeholders
8. Tax planning
Narain