Financial MGMT: All About ACCOUNTING..!!

All About ACCOUNTING..!!
Financial Mgmt
1
Capital
Structure
2
What is Capital Structure? All About ACCOUNTING..!!
Definition
The capital structure of a firm is the mix of different securities

issued by the firm to finance its operations.
Securities
• Bonds, bank loans
• Ordinary shares (common stock)
• Preference shares (preferred stock)
3
What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities
Debt Financial
Fixed Preference Structure
Assets shares
Ordinary
shares
4
What is “Capital Structure”?

Balance Sheet
Current Current
Assets Liabilities
Debt
Fixed Preference
Assets shares Capital
Structure
Ordinary
shares
5
Sources of capital
• Ordinary shares (common
stock)
• Preference shares (preferred
stock)
• Loan capital
1. Bank loans
2. Debentures
6
Ordinary shares (common stock)
• Risk finance
• Dividends are only paid if profits are made and

only after other claimants have been paid e.g.
lenders and preference shareholders
• A high rate of return is required
• Provide voting rights – the power to hire and fire

directors
• No tax benefit, unlike borrowing

7
Preference shares
• Lower risk than ordinary shares – and a lower dividend
• Fixed dividend - payment before ordinary shareholders

and in a liquidation situation
• No voting rights - unless dividend payments are in arrears
• Cumulative - dividends accrue in the event that the issuer

does not make timely dividend payments
• Participating - an extra dividend is possible
• Redeemable - company may buy back at a fixed future

date
8
Loan capital
• Financial instruments that pay a certain rate of interest

until the maturity date of the loan and then return the
principal (capital sum borrowed)
• Bank loans or corporate bonds
• Interest on debt is allowed against tax
9
Why should we care about capital structure?
• By altering capital structure firms have the

opportunity to change their cost of capital and –
therefore – the market value of the firm
What is an optimal capital structure?

 An optimal capital structure is one that
minimizes the firm’s cost of capital and thus
maximizes firm value
10
Maximizes firm value
• We can maximize the firms value by following

our objective of wealth maximization.
• Wealth maximization can be done with the help

of maximizing EPS of the company
11
A Chemical company is planning to expand. Currently the

company is financed completely by equity. it has 15000
equity shares of 100/- each. The company requires 25 lakh
for expansion. The three alternative of financing are as
follows
1. Issue 25000 equity shares of 100/- each
2. To issue 25000,8% debenture of 100/- each
3. To issue 25000, 8% Preference Share of 100/- each
The company expects earning before interest and tax as

800000/-.If Corporate tax is 50%, Suggest the company
which alternative to go with.
12
A Ltd Company has equity share financing of 600,000/-

divided into shares of 100/- each. it required further
300000/- for expansion. The company has following
schemes.
1. All by equity shares of 100/- each
2. 100,000/- from equity and rest by 10% bank loan
3. 100,000/- from equity and rest by 8% preference shares
If company expects EBIT of 150000/-, and corporate tax is

50%. Suggest the company the most appropriate scheme.
13
Cost of Capital
14
• Cost of capital of a firm is the minimum rate of return

expected by its investors.
• It is the weighted average cost of various source of funds

used by the firm
• Also it can be defined as cost of obtaining the funds
• It is used in capital budgeting as it is used as the minimum

rate of return required from an investment i.e. it is a cut
off rate.
15
Determination of Cost of Capital All About ACCOUNTING..!!
Determination of cost of capital is not easy because lot of

uncertainty and risk is involved in the computation of cost
of capital.
It involves two steps
1. Computation of cost of each source of finance
2. Computation of weighted average cost of capital
16
Cost of Debt All About ACCOUNTING..!!
cost of Debt is
• the rate of interest payable on the debt.
• adjusted for flotation costs (any costs associated with

issuing new bonds), and
• adjusted for taxes
17
Cost of Debt All About ACCOUNTING..!!
Calculate cost of Debt if
1. X ltd issues 50000/-, 8% debenture at par. The tax rate for

the company is 50%
2. Y ltd issues 50000/-, 8% debenture at premium of 10%.the

tax rate applicable is 60%
3. A ltd issues 50000/-, 8% debenture at discount of 5%.the

tax rate is 50%
4. B Ltd issues 100,000/-,9% debenture at premium of

10%.The cost of floatation is 2%.Tax rate is 60%
18
Cost of Preference Share All About ACCOUNTING..!!
1. A fixed Dividend is paid.
2. No tax rebate is given
3. Floatation cost can be incurred
4. Can be issued or redeemed in premium or discount
19
X ltd issues 10000, 10% preference share of 100/- each. Cost

of issue of preference share is 2/- per share. The tax rate
for the company is 50%
Calculate cost of Preference Share
1. If shares are issues at par
2. If shares are issued at premium of 10%
3. IF shares are issued at discount of 5%
20
A company issues 10000, 10% preference shares of 100/-

redeemable after 10 years at a premium of 5%.The cost
of issue is 2/- per share.
Calculate cost of Preference Share
21
Cost of Equity Shares All About ACCOUNTING..!!
There are 2 sources of Common Equity:
1) Internal common equity (retained earnings), and
2) External common equity (new common stock

issue)
22
Cost of Retained Earning All About ACCOUNTING..!!
• Since the stockholders own the firm’s retained

earnings, the cost is simply the stockholders’
required rate of return.
Because
• If managers are investing stockholders’ funds,

stockholders will expect to earn an acceptable
rate of return.
23
Cost of equity shares All About ACCOUNTING..!!
• Since the stockholders own the firm’s retained

earnings,
Dividend Growth Model
Kc = D1/Po + g
24
Dividend Growth Model
knc =
D1 +g
NPo
Net proceeds to the firm

after flotation costs!
25
Company’s share are quoted in the market at 20/-.

The company pays a dividend of 1/- per share.
And the investor expects a growth rate of 5%
1. Calculate cost of equity
2. If anticipated growth rate is 6% pa, calculate the M.P

per share
26
The shares of a company are selling at 40/- per

share and it had paid dividend of 4/- per share
last year. the growth rate is 5%.
1. Compute the company’s cost of equity
2. If the anticipated growth rate is 7%per annum,

calculate the MP per share
27
Weighted Average Cost of Capital All About ACCOUNTING..!!
• The weighted cost of capital is just the weighted

average cost of all of the financing sources.
• Also known as composite cost of capital or

overall cost of capital
• Here weight is proportion of various source of

financing
• Weight can be either market value of book value

where book value is given preference
28
Weighted Cost of Capital
Capital
Source Cost Structure
debt 6% 20%
preferred 10% 10%
common 16%29
70%
Weighted Cost of Capital

(20% debt, 10% preferred, 70% common)
Weighted cost of capital =

.20 (6%) + .10 (10%) + .70 (16)
= 13.4%
30
A firm has following capital structure and cost of

various source.
Debt – 1500,000 – 10%
Preference share – 1200,000 – 10%
Equity Share – 1800,000 – 12%
Retained Earring - 1500,000-11%
Calculate WACC
31
A firm has following capital structure
Equity share- 20000 shares of 100/- each=

20,00,000
10% preference share of 100/- each= 800,000/-
12% Debenture=12,00,000
The market price of the company’s share is 110/-

per share. Growth rate expected is 6%expected
dividend is 10/-
Calculate weighted average cost of capital if tax

32
In the above question assume that there is a

expansion program and the company intends to
borrow a fund of 20 lacs at 14% interest rate
what will be revised WACC
With this investment plan the company expects a

Market price of 105/- and dividend of 12 per
share
33
X ltd has following capital structure
10% debenture= 300,000/-
9% preference share = 200,000/-
5000 equity share of 100/- each = 500,000/-
The equity share of the company are quoted at

102/- and the company is expected to declare a
dividend of 9 per share. Growth rate being 5%
Calculate WACC
34
Assuming in the above situation the company raises

further 500,000/- from term loan of 12%,
calculate revised WACC. The company will
increase its dividend in a such a case to 10/- also
there is a increase of business risk because of
this and there fore there is a decrease of M.P to
96/-
35
Marginal Cost of Capital All About ACCOUNTING..!!
The marginal cost of capital is the weighted

average cost of new capital calculated by using
the marginal weights
The marginal cost of capital may be equal to

average cost of capital to the extent :
1. The proportion of additional capital does not

changes
2. The cost of component remains constant.
36
The marginal A firm has the following capital

structure and after-tax cost for the different
sources of funds used:
Debt – 450000/- - 7%
Pref Capital – 375000/- -10%
Equity Capital – 675000/- - 15%
Calculate the weighted average cost of capital
37
A firm has the following capital structure and
The firm wishes to raise further 600,000/- for

expansion project
Debt – 300,000/-
Preference Capital – 150000/-
Equity Capital – 150000/-
Assuming that specific costs do not change,

compute the marginal cost of capital.
38
A firm has the following capital structure and
The firm wishes to raise further 600,000/- for

expansion project
Debt – 300,000/-
Preference Capital – 150000/-
Equity Capital – 150000/-
Assuming that specific costs do not change,

compute the marginal cost of capital.
39
Point of
Indifference
40
What is Point of indifference…? All About ACCOUNTING..!!
Break Even Point , Equivalency Point, Or Indifference point refers

to that EBIT level at which EPS remains the same irrespective of
different alternatives of debt-equity mix.
At this level Rate of return on capital is equal to the cost of debt .
Current (unlevered) Proposed (levered)
(EBIT-Int1)(1-T) = (EBIT-Int2)(1-T)
S 1 S 2
41
What is Point of indifference…? All About ACCOUNTING..!!
10.00 Debt
8.00 No Debt
6.00 Break-even Advantage

EPS
point to debt
4.00
2.00
0.00 Disadvantage
to debt
2,000 EBIT 3,000
(2.00)
42

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All About ACCOUNTING..!!

The capital structure of a firm is the mix of different securities

• Bonds, bank loans

• Ordinary shares (common stock)

• Preference shares (preferred stock)

What is “Capital Structure”?

What is “Capital Structure”?

Ordinary shares (common stock)

• Dividends are only paid if profits are made and

• A high rate of return is required

• Provide voting rights – the power to hire and fire

• No tax benefit, unlike borrowing

• Lower risk than ordinary shares – and a lower dividend

• Fixed dividend - payment before ordinary shareholders

• No voting rights - unless dividend payments are in arrears

• Cumulative - dividends accrue in the event that the issuer

• Participating - an extra dividend is possible

• Redeemable - company may buy back at a fixed future

• Financial instruments that pay a certain rate of interest

• Bank loans or corporate bonds

• Interest on debt is allowed against tax

Why should we care about capital structure?

• By altering capital structure firms have the

What is an optimal capital structure?

Maximizes firm value

• We can maximize the firms value by following

• Wealth maximization can be done with the help

A Chemical company is planning to expand. Currently the

1. Issue 25000 equity shares of 100/- each

2. To issue 25000,8% debenture of 100/- each

3. To issue 25000, 8% Preference Share of 100/- each

The company expects earning before interest and tax as

A Ltd Company has equity share financing of 600,000/-

1. All by equity shares of 100/- each

2. 100,000/- from equity and rest by 10% bank loan

3. 100,000/- from equity and rest by 8% preference shares

If company expects EBIT of 150000/-, and corporate tax is

• Cost of capital of a firm is the minimum rate of return

• It is the weighted average cost of various source of funds

• Also it can be defined as cost of obtaining the funds

• It is used in capital budgeting as it is used as the minimum

Determination of cost of capital is not easy because lot of

It involves two steps

1. Computation of cost of each source of finance

2. Computation of weighted average cost of capital

• the rate of interest payable on the debt.

• adjusted for flotation costs (any costs associated with

• adjusted for taxes

Calculate cost of Debt if

1. X ltd issues 50000/-, 8% debenture at par. The tax rate for

2. Y ltd issues 50000/-, 8% debenture at premium of 10%.the

3. A ltd issues 50000/-, 8% debenture at discount of 5%.the

4. B Ltd issues 100,000/-,9% debenture at premium of

1. A fixed Dividend is paid.

2. No tax rebate is given

3. Floatation cost can be incurred

4. Can be issued or redeemed in premium or discount