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Capital structure ppt

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Aarti Choudhary

The document discusses capital structure and its theories. It defines capital structure as the proportion of long-term debt and equity used to finance a company's assets. A company's capital structure determines its risk and cost of capital. There are several theories on capital structure including the net income, net operating income, traditional, and Modigliani-Miller approaches. The optimal capital structure balances minimum costs and risks. Factors like tax rates, control, flexibility, and legal requirements influence a company's choice of capital structure.

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STRUCTUR E Presentation by: JEENIA(2) AARTI (32) NEHA(34) SHEENU(36)
MEANING OF CAPITAL STRUCTURE Capital structure refer to the proportion between the various long term source of finance in the total capital of firm A financial manager choose that source of finance which include minimum risk as well as minimum cost of capital.
Sources of long term finance Proprietor’s funds Equity capital Preference capital Reserve and surplus Borrowed funds Long term debts
 Capital structure determine the risk assumed by the firm  Capital structure determine the cost of capital of the firm  It affect the flexibility and liquidity of the firm  It affect the control of the owner of the firm
 Nature and Size of the firm  Stability of the earning  Stages of life cycle of the firm  Cash flow ability of the firm  Cost of capital
 Rate of corporate tax  Retaining control  Flexibility  Trading on equity  Legal requirement  Assets structure  Nature of investor
It refer to that EBIT level, at which EPS remain same irrespective of different alternatives of debt- equity mix. At this level of EBIT return on capital employed is equal to cost of debt this is also known as break even level of EBIT for alternative financial plan
(X-I1)(1-T)-PD = (X-I2)(1-T)-PD S1 S2 Where  X = point of indifference  I1 = int. under alternative financial plan 1  I2= int. under alternative financial plan 2  T = tax rate  PD = pref. dividend  S1 = amount of equity share under financial plan 1  S2= amount of equity share under financial plan 2
Capital structure ppt
Net income approach Net operating income approach Traditional approach Modigliani and miller approach Capital structure theories
NET INCOME (NI) THEORIES  This theory is suggested by “David Durand”  Acc. to this approach the value of the firm is increase and decrease overall cost of capital by increasing the proportion of debt financing in capital structure  It is due to the fact that debt is generally a cheaper sources of finance because: 1. Interest rate are lower than the dividend rate 2. Benefit of tax because int. is deductible expense
ASSUMPTION OF NET INCOME APPROACH  The cost of debt is lower than cost of equity  The risk perception of the investor is not changed by the use of debt  There is no corporate tax
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NET OPERATING INCOME APPROACH  This theory was propounded by “David Durand” and is also known as irrelevant theory.  Acc. to this theory, the total market value of the firm is not affected by the change in the capital structure and the overall cost of capital remain constant irrespective of debt-equity ratio.
ASSUMPTION OF NET OPERATING INCOME APPROACH  The market capitalizes the value of the firm as a whole. Thus, the split between debt and equity is not important  The cost of debt is lower than cost of equity  The risk perception of the investor is not changed by the use of debt  There is no corporate tax
Capital structure ppt
TRADITIONALAPPROACH  This approach is the midway of NI approach and NOI approach. And also known as intermediate approach.  Acc. to this, the value of firm can be increased initially or cost of capital can be decreased by using more debt as the debt is a cheaper source of fund than equity After that optimum capital structure can be reached by a proper debt-equity mix But after a particular point if the proportion of debt is increased, then the overall cost of capital start increasing and market value begin to decline
Capital structure ppt
MODIGLIANI-MILLER APPROACH  They have given two approach 1. In the absence of corporate taxes 2. When corporate taxes exist
Assumption :-  Capital market are perfect  Homogeneous risk classes of firm  Expectations about the net operating income  100% payout ration  No corporate tax
IN THE ABSENCE OF CORPORATE TAXES Acc. To this theory total value of a firm must be constant irrespective of degree of leverage, i.e. debt-equity ratio. This can be justified by arbitrage process . This approach is similar to the net operating income approach when taxes are ignored It means capital structure decision of a firm is not affect its market value.
WHEN CORPORATE TAX ARE ASSUMED TO EXIST Acc. to this value of the firm increase and cost of capital decrease with the use of debt if corporate tax are considered. This is because of Benefit of tax because int. on tax is deductible expense
 Optimum capital structure is a capital structure at which market value per share is maximum and the cost of capital is minimum
Simplicity flexibility Minimum risk Minimum cost of capital Sufficient liquidity Retaining control Avoidance of unnecessary restriction
 EPS = (EBIT-I)(I-t)-PD n Where : EPS = earning per share EBIT = earning before int. and tax I = int. charged per annum t = tax rate PD = preference dividend n = no. of equity shares
Q-ABC company has currently an all equity structure consisting of 15000 equity shares of rs.100 each. The management is planning to raise another rs.25 lakhs to finance a major programme of expansion and it consider three alternative method of financing  To issue 25000 equity share of rs.100 each  To issue 25000, 8% debenture of rs.100 each  To issue 25000, preference share of rs.100 each the company EBIT will be 8 lakhs. Assuming a corporate tax of 50%, determine earning per share in each alternative
Alternative 1 equity financing Alternative 2 debt financing Alter. 3 pref. share financing EBIT 8.00 8.00 8.00 Less int. - 2.00 - Earning after int. but before tax 8.00 6.00 8.00 Less tax @50% 4.00 3.00 4.00 EAT 4.00 3.00 4.00 Less pref. dividend - - 2.00 E available to equity shareholders 4.00 3.00 2.00 No. of equity share 40000 15000 15000 400000 300000 200000 EPS Rs.10 Rs.20 Rs.13.33
 Goel DK, Management accounting and financial management, APC  Gupta Shashi K., financial management and policy, kalyani publication
Capital structure ppt

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Capital structure ppt

  • 2. MEANING OF CAPITAL STRUCTURE Capital structure refer to the proportion between the various long term source of finance in the total capital of firm A financial manager choose that source of finance which include minimum risk as well as minimum cost of capital.
  • 4.  Capital structure determine the risk assumed by the firm  Capital structure determine the cost of capital of the firm  It affect the flexibility and liquidity of the firm  It affect the control of the owner of the firm
  • 5.  Nature and Size of the firm  Stability of the earning  Stages of life cycle of the firm  Cash flow ability of the firm  Cost of capital
  • 6.  Rate of corporate tax  Retaining control  Flexibility  Trading on equity  Legal requirement  Assets structure  Nature of investor
  • 7. It refer to that EBIT level, at which EPS remain same irrespective of different alternatives of debt- equity mix. At this level of EBIT return on capital employed is equal to cost of debt this is also known as break even level of EBIT for alternative financial plan
  • 8. (X-I1)(1-T)-PD = (X-I2)(1-T)-PD S1 S2 Where  X = point of indifference  I1 = int. under alternative financial plan 1  I2= int. under alternative financial plan 2  T = tax rate  PD = pref. dividend  S1 = amount of equity share under financial plan 1  S2= amount of equity share under financial plan 2
  • 10. Net income approach Net operating income approach Traditional approach Modigliani and miller approach Capital structure theories
  • 11. NET INCOME (NI) THEORIES  This theory is suggested by “David Durand”  Acc. to this approach the value of the firm is increase and decrease overall cost of capital by increasing the proportion of debt financing in capital structure  It is due to the fact that debt is generally a cheaper sources of finance because: 1. Interest rate are lower than the dividend rate 2. Benefit of tax because int. is deductible expense
  • 12. ASSUMPTION OF NET INCOME APPROACH  The cost of debt is lower than cost of equity  The risk perception of the investor is not changed by the use of debt  There is no corporate tax
  • 14. NET OPERATING INCOME APPROACH  This theory was propounded by “David Durand” and is also known as irrelevant theory.  Acc. to this theory, the total market value of the firm is not affected by the change in the capital structure and the overall cost of capital remain constant irrespective of debt-equity ratio.
  • 15. ASSUMPTION OF NET OPERATING INCOME APPROACH  The market capitalizes the value of the firm as a whole. Thus, the split between debt and equity is not important  The cost of debt is lower than cost of equity  The risk perception of the investor is not changed by the use of debt  There is no corporate tax
  • 17. TRADITIONALAPPROACH  This approach is the midway of NI approach and NOI approach. And also known as intermediate approach.  Acc. to this, the value of firm can be increased initially or cost of capital can be decreased by using more debt as the debt is a cheaper source of fund than equity After that optimum capital structure can be reached by a proper debt-equity mix But after a particular point if the proportion of debt is increased, then the overall cost of capital start increasing and market value begin to decline
  • 19. MODIGLIANI-MILLER APPROACH  They have given two approach 1. In the absence of corporate taxes 2. When corporate taxes exist
  • 20. Assumption :-  Capital market are perfect  Homogeneous risk classes of firm  Expectations about the net operating income  100% payout ration  No corporate tax
  • 21. IN THE ABSENCE OF CORPORATE TAXES Acc. To this theory total value of a firm must be constant irrespective of degree of leverage, i.e. debt-equity ratio. This can be justified by arbitrage process . This approach is similar to the net operating income approach when taxes are ignored It means capital structure decision of a firm is not affect its market value.
  • 22. WHEN CORPORATE TAX ARE ASSUMED TO EXIST Acc. to this value of the firm increase and cost of capital decrease with the use of debt if corporate tax are considered. This is because of Benefit of tax because int. on tax is deductible expense
  • 23.  Optimum capital structure is a capital structure at which market value per share is maximum and the cost of capital is minimum
  • 24. Simplicity flexibility Minimum risk Minimum cost of capital Sufficient liquidity Retaining control Avoidance of unnecessary restriction
  • 25.  EPS = (EBIT-I)(I-t)-PD n Where : EPS = earning per share EBIT = earning before int. and tax I = int. charged per annum t = tax rate PD = preference dividend n = no. of equity shares
  • 26. Q-ABC company has currently an all equity structure consisting of 15000 equity shares of rs.100 each. The management is planning to raise another rs.25 lakhs to finance a major programme of expansion and it consider three alternative method of financing  To issue 25000 equity share of rs.100 each  To issue 25000, 8% debenture of rs.100 each  To issue 25000, preference share of rs.100 each the company EBIT will be 8 lakhs. Assuming a corporate tax of 50%, determine earning per share in each alternative
  • 27. Alternative 1 equity financing Alternative 2 debt financing Alter. 3 pref. share financing EBIT 8.00 8.00 8.00 Less int. - 2.00 - Earning after int. but before tax 8.00 6.00 8.00 Less tax @50% 4.00 3.00 4.00 EAT 4.00 3.00 4.00 Less pref. dividend - - 2.00 E available to equity shareholders 4.00 3.00 2.00 No. of equity share 40000 15000 15000 400000 300000 200000 EPS Rs.10 Rs.20 Rs.13.33
  • 28.  Goel DK, Management accounting and financial management, APC  Gupta Shashi K., financial management and policy, kalyani publication