CAPITAL STRUCTURE

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Financial structure VS Capital Structure
Financial structure
1. It includes both long term and short
term sources of funds
2. It means the entire liabilities side of
the balance sheet
3. Financial structures consist of all
sources of capital
4. It will not be more important while
determining the value of the firm
Capital structure
1. It includes only the long term sources
of funds
2. It means only the long term liabilities
of the company
3. It consists of equity, preference and
retained earning capital
4. It is one of the major determination of
the value of the firm
contoh

 From the following information, calculate the capitalization, capital structure and
financial structure
 Balance Sheet
Liabilities Assets
Equity share capital 50.000 Fixed assets 25.000
Preference share capital 5.000 Goodwill 10.000
Debentures 6.000 Stock 15.000
Retained earnings 4.000 Bill receivable 5.000
Bills payable 2.000 Debtors 5.000
Creditors 3.000 Cash and bank 10.000
70.000 70.000
solution

 Calculation of capitalization
No Sources amount
1. Equity share capital 50.000
2. Preference share capital 5.000
3. debentures 6.000
capitalization 61.000
solution

 Calculation of capital structures

No Sources Amount Proportion (%)

1. Equity share capital 50.000 76.92
2. Preference share capital 5.000 7.69
3. Debentures 6.000 9.23
4. Retained earnings 4.000 6.16
65.000 100
solution

 Calculation of financial structure

No Sources Amount Proportion (%)
1. Equity share capital 50.000 71.42
2. Preference share capital 5.000 7.14
3. Debentures 6.000 8.58
4. Retained earnings 4.000 5.72
5. Bills payable 2.000 2.85
6. Creditors 3.000 4.29
70.000 100
OPTIMUM CAPITAL STRUCTURE

  is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum
  may be defined as the capital structure or combination of debt and equity, that leads to
the maximum value of the firm

 Objectives of capital structure :

 1. maximize the value of the firm
 2. minimize the overall cost of capital
Form of capital structure

 1. equity share only

 2. equity and preference shares only
 3. equity and debentures only
 4. equity shares, preference shares and debentures
CAPITAL STRUCTURE THEORIES

 1. Traditional Approach
 It is the mix of net income approach and net operating income approach.
 Assumptions :
 1. there are only two sources of funds used by a firm; debt and share
 2. the firm pays 100% of its earning as dividend
 3. the total assets are given and do not change
 4. the total finance remains constant
 5. the operating profits (EBIT) are expected to grow
 6. the business risk remains constant
 7. the firm has a perpetual life
 8. the investors behave rationally
example

 Compute the market value of the firm, value of shares and the average cost of capital from the
following information :
 Net operating income $ 100.000
 Total investment $ 500.000
 Equity capitalization rate :
 1. if the firm uses no debt 10%
 2. if the firm uses $ 250.000 debentures 11%
 3. if the firm uses $ 400.000 debentures 13%
 Assume that $ 500.000 can be raised at 6% rate of interest whereas $ 400.000 can be raised at 7%
rate of interest
solution

Particulars No debt $ 250.000 $ 400.000

( 6% debentures) (7% debentures)
Net operating income 100.000 100.000 100.000
(-) interest
Cost of debt 15.000 28.000
Earnings available to equity
shareholders 100.000 85.000 72.000
Equity capitalization rate 10% 11% 13%

Market value of shares 100.000/10% = 1.000.000 85.000/11% = 772.727 72.000/13% = 553.846

Market value of firm 1.000.000 772.727 + 250.000= 1.022.727 553.846 + 400.000= 953.846

Average cost of capital = (100.000/1.022.727) x 100% =

Earning X 100% (100.000/1.000.000) x 100 % = 9.78 % (100.000/953.846) x 100% =
Value of firm 10% 10,48%
=EBIT x 100%
V
Net income approch

 The capital structure decision is relevant to the valuation of the firm. In other words, a
change in the capital structure leads to a corresponding change in the overall cost of
capital as well as the total value of the firm
 Assumption :
 1. there are no corporate taxes
 2. the cost debt is less than the cost of equity
 3. the use of debt does not change the risk perception of the investor
Net income approch

 V=S+B
 V = value of firm
 S = market value of equity
 B = market value of debt
 Market value of the equity can be ascertained :
 S = NI/
 NI = earning available to equity shareholder
 = cost of equity/equity capitalization rate
Example

 A company expects a net income of $ 100.000. it has $ 250.000, 8% debenture. The

equity capitalization rate of the company is 10%. Calculate the value of the firm and
overall capitalization rate according to the net income approach.
 If the debenture debts are increased to $ 400.000, what shall be the value of the firm and
the overall capitalization rate?
solution

 Capitalization of the value of the firm

 Net income $ 100.000
 Less : interest (8% x $ 250.000) 20.000
 Earning available to equity share holders 80.000
 Equity capitalization rate 10%
 Market value of equity : 80.000/10% = 800.000
 Market value of debentures 250.000
 Value of firm 1.050.000
solution

 Calculation of overall capitalization rate

 Overall cost of capital (=
X 100% = 9.52%
solution

 Calculation of value of the firm if debenture debt is raised to $ 400.000

 Net income S 100.000
 Less ; interest (8% x 400.000) 32.000
 Earnings available to equity shareholder 68.000
 Equity capitalization rate10%
 Market value of equity : 68.000/10% = 680.000
 Market value of debt 400.000
 Value of firm 1.080.000
 Overall cost of capital ( x 100% = 9.26%
Net operating income approach

 Capital structure decision is irrelevant to the valuation of the firm.

 The change in capital structure will not lead to any change in the total value of the firm
and market price of shares as well as the overall cost of capital.
 Assumptions :
 1. the overall cost of capital remains constant
 2. there are no corporate taxes
 3. the market capitalize the value of the firm as a whole
Net operating income approach

 Value of the firm (V) can be calculated :

 V=
 V = Value of the firm
 EBIT = Earnings before interest and tax
 = overall cost of capital
example

 XYZ Ltd expects a net operating income of $ 200.000. It has $ 800.000, 6 % debentures.
The overall cost capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate (cost of equity) according to the net operating income approach.
 If the debentures debt is increased to $ 1.000.000. what will be the effect on volume of the
firm and the equity capitalization rate?
solution

 Net operating income = $ 200.000

 Overall cost of capital = 10%
 Market value of the firm (V): = = 2.000.000
 Equity capitalization rate ( cost of equity) =
 I = interest of debentures
 V = market value of the firm
 D = market value of debt
solution

 Equity capitalization rate ( cost of equity) =

 Equity capitalization rate ( cost of equity) = x 100%=12,67%
 If the debenture debt is increases to $ 1.000.000, the equity capitalization rate :
 Equity capitalization rate ( cost of equity) =
 Equity capitalization rate ( cost of equity) = x 100%=14%
Modigliani and miller approach

 the average cost of capital does not change with change in capital structure of the firm
 Assumptions :
 There is a perfect capital market
 There are no retained earnings
 There are corporate taxes
 The investors act rationally
 The dividend payout ratio is 100%
 The business consist of the same level of business risk
Modigliani and miller approach

 Value of the firm (V) = (1-t)

 EBIT = Earning before interest and tax
 Ko = overall cost of capital
 T = tax rate
 TUGAS

 Kerjakan hal 64 no. 6, 7 dan 8