finValuation – Over and Under Valuation

Capital Structure and Kinds of Capital

Impact of Capital Modifications with real time examples
Case Study on Future Capital Structure – Design Capital Structure

Capital Structure Policy:

Capital Structure Policy typically underlines the trade-off between risk and return.
The Optimal Capital Structure is the one that strikes a balance between risk and
return in order to achieve the goal of maximizing the value of the firm.
Debt - Equity Ratio:
D/E = (Short Term Debt + Long Term Debt + Other Fixed Payments) /
Shareholder's Equity
It is the Financial Ratio indicating the relative proportion of shareholders' equity
and debt used to finance a company's assets. It is a Long Term Solvency Ratio that
indicates the soundness of long-term financial policies of the company.
Debt-to-asset Ratio:
This ratio measures the percentage of total assets financed with Debts, thus higher
the ratio means a weaker solvency.
Debt to asset = total debt / total assets
Debt to Capital Ratio:
This ratio measures the percentage of company’s capital (total debt + shareholder
equity) represented by debt.
Debt to Capital = Total Debt / Total Debt + Total Shareholder’s Equity
Financial Leverage:
Financial Leverage = Average Total Assets / Average Total Equity
Operating Leverage = Contribution Margin / Net Operating Income
* Contribution margin = Sales – Variable Cost

Leverage
Leverage results from the use of fixed-cost assets or funds to magnify returns to
the firm's owners.
Generally, Increase in leverage result in increase in risk and return, whereas
decreasing leverage results in decrease in risk and return.
Financial Leverage:
Financial leverage results from the presence of fixed financial cost in the firms’
income stream.
It is the potential use of fixed financial costs to magnify the effects of changes in
EBIT on the firm’s EPS.
The two fixed financial cost most commonly found on the income statement are:
1). Interest on Debt 2). Preferred Stock Dividends
The degree of Financial Leverage measures the sensitivity of changes in EPS to
changes in EBIT.
 Choosing Operate Capital Structure
Capital Restructure involves changing the amount of leverage a firm has without
affecting the total assets.
The Firm can increase the leverage by,
Issuing new debt and repurchasing outstanding shares.
The Firm can decrease the leverage by,
Issuing new shares and retire outstanding debt.

We always choose the capital structure that maximize the shareholder’s wealth.
We can maximize the shareholder’s wealth by maximizing the value of the firm
(or) minimizing the WACC.
WACC is the appropriate discount rate for the risk of the firm’s assets. Decreasing
in the WACC increases the value of the firm.
We can find the Value of the firm by discounting the firm’s expected future cash
flows at the discount rate.

Effect of Leverage
How does the Leverage affect the EPS and ROE of the Firm?
1. When we increase the amount of debt financing, we increase the fixed
interest expense
2. If we have a really good year, then we pay our fixed cost and we have more
left over for our stockholders
3. If we have a really bad year, we still have to pay our fixed costs and we
have less left over for our stockholders
“Leverage amplifies the variation in both EPS and ROE”
Both EPS and ROE are much more sensitive to changes in EBIT. When EBIT is
high, leverage is Beneficial.
Notes: If we increase the amount of debt in a restructuring, we are implicitly
decreasing the amount of outstanding shares.

Cost of Capital: It is the rate of return that a firm must earn on its project
investments to maintain the market value of its stock.