PROJECT PRESENTATION BY:

Muhammad Ahmed Khan

Roheel Ghulam Muhammad

Muhammad Ismail Umar Waqas Hafeez

Muhammad Bilal Asif

What is Capital Structure?

Balance Sheet Current Current Assets Liabilities

Fixed

Debt Preference

Financial Structure

Ordinary shares

What is Capital Structure?

Balance Sheet
Current Assets Fixed Assets Current Liabilities Debt Preference shares Ordinary shares

Capital Structure

What is capital structure?

Combination of capital is called capital structure. The firm may use only equity, or only debt, or a combination of equity + debt, or a combination of equity+debt+preference shares or may use other similar combinations.

CONT.
The Capital structure of business can be measured by the ratio of various kinds of permanent loan and equity capital to total capital. - Schwarty

Capital Structure
Capital structure includes only long term debt and total stockholder investment. Capital Structure = Long Term Debt + Preferred Stock + Net Worth OR Capital Structure = Total Assets Current Liabilities.

How should you design capital structure?

1. 2. 3. 4. It should minimize cost of capital It should reduce risks It should give required flexibility It should provide required control to the owners 5. It should enable the company to have adequate finance.

What are the risks associated with capital structure decisions?

Meaning of risk = variability in income is called risk. Business risk = it is the situation, when the EBIT may vary due to change in capital structure. It is influenced by the ratio of fixed cost in total cost. If the ratio of fixed cost is higher, business risk is higher. Financial risk = it is the variability in EPS due to change in capital structure. It is caused due to leverage. If leverage is more, variability will be more and thus financial risk will be more.

Basic Terms used in Capital Structure Financial Risk

Increased financial risk that comes with increased use of debt

Cost of Capital
Interest rate on borrowings after tax

WACC
Cost of debt, preferred stock, equity and reserves and surplus

CONT.
EPS= Earnings Per Share Profit after tax and preference dividend / number of
equity shares.

Diluted EPS
Derived after redemption of preference shares. Obtained after converted preference shares, convertible debentures and bonus issues

Questions while Making the Financing Decision

How should the investment project be financed? Does the way in which the investment projects are financed matter? How does financing affect the shareholders risk, return and value? Does there exist an optimum financing mix in terms of the maximum value to the firms shareholders? Can the optimum financing mix be determined in practice for a company? What factors in practice should a company consider in designing its financing policy?

Determinants of Capital Structure

Seasonal Variations Tax benefit of Debt Flexibility Control Industry Leverage Ratios Agency Costs

Industry Life Cycle

Degree of Competition Company Characteristics Requirements of Investors

Timing of Public Issue

Legal Requirements

CAPITAL STRUCTURE OF MULTINATIONAL FIRMS

Capital structure for the multinational firm involves a choice between debt and equity financing across all its subsidiaries. A MNC can have more debt in its capital structure if its cash flows are more stable and it has a low credit risk.

Optimal capital structure Capital structure or combination of debt and equity that leads to the maximum value of the firm Maximizes the value of the company Minimize the companys cost of capital

Optimal Capital Structure

It is that capital structure at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum. Features:
Profitability solvency Flexibility Conservation control

These considerations should be kept in mind while maximizing the value of the firm!!!!
If ROI > the fixed cost of funds, the company should prefer to raise the funds having a fixed cost, such as, debentures, Loans and PSC. It will increase EPS of the firm. If debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax.

It should also avoid undue financial risk attached with the use of increased debt financing
The Capital structure should be flexible.

PATTERN OF CAPITAL STRUCTURE

Complete equity share capital

Different proportions of equity and preference share capital

Different proportions of equity and debenture (debt) capital Different proportions of equity, preference and debenture (debt) capital.

APPROACHES TO DETERMINE APPROPRIATE CAPITAL STRUCTURE

EBI T EPS Approach This approach is helpful to analyze the impact of debt on earnings per share. Valuation Approach This approach determines the impact of debt use on the share holders value. Cash Flow Approach - This approach analyses the firms debt service capacity.

Theories of Capital Structure

Net Income Approach Net Operating Income Approach Modigliani and Miller Approach Traditional Approach.

Net Income Approach

A change in the proportion in capital structure will lead to a corresponding change in cost of capital and Value of the firm. Assumptions:
(i) There are no taxes; (ii) Cost of debt is less than the cost of equity; (iii) Use of debt in capital structure does not change the risk perception of investors. (iv) Cost of debt and cost of equity remains constant;

Assumptions of NI Theory
First there are no taxes. Second the cost of debt is less than the cost of equity. Third the use of debt does not change the risk perception of investor.

Net Operating Income Approach

The essence of this approach is that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage. Cost of debt (Ki)remains constant. There are no corporate taxes.

Assumptions of NOI Theory

The split of total capitalization between debt and equity is not essential or relevant. The equity shareholders and other investors i.e. the market capitalizes the value of the firm as a whole. The business risk at each level of debtequity mix remains constant. Therefore, overall cost of capital also remains constant. The corporate income tax does not exist

Modigliani and Miller Approach

This approach was developed by Prof. Franco Modigliani and Mertan Miller. According to this approach, total value of the firm is independent of its capital structure.

CONT.
Modigliani and Miller Approach (MM)
They developed the capital-structure irrelevance proposition. The basic M&M proposition is based on the following key assumptions:
The basic M&M proposition is based on the following key assumptions:

No taxes No transaction costs No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes

MM Approach Without Tax: Proposition I

MMs Proposition I states that the firms value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

MMs Proposition II
The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firms debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases.

MM Hypothesis With Corporate Tax

Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the allequity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

Arbitrage PROCESS
The MM approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respects except leverage so that one of them has debt in its capital structure while the other does not.
To understand the process let us have an example

Modigliani- miller approach

Feature 1. Capital markets are perfect 2. Homogeneous risk classes of firm 3. Expectations about the net operating income 4. Dividend payout ratio 100% 5. No corporate taxes

Limitations of MM Approach
Investors cannot borrow on the same terms and conditions of a firm Personal leverage is not substitute for corporate leverage Existence of transaction cost Institutional restriction on personal leverage Asymmetric information Existence of corporate tax

Assumptions
a. Information is available at free of cost b. The same information is available for all investors c. Securities are infinitely divisible d. Investors are free to buy or sell securities e. There is no transaction cost f. There are no bankruptcy costs g. Investors can borrow without restrictions as the same terms on which a firm can borrow h. Dividend payout ratio is 100 percent i. EBIT is not affected by the use of debt

Traditional Approach
This approach was given by Soloman. This approach is the midway between NI Approach and NOI Approach. Traditional approach says judicious use of debt helps increase value of firm and reduce cost of capital

CONT.
Traditional Approach (TA) Theory that when the Weighted Average Cost of Capital (WACC) is minimized. The Traditional Theory of Capital Structure says that a firm's value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease.

Factors affecting capital structure

INTERNAL Financial leverage Risk Growth and stability Retaining control Cost of capital Cash flows Flexibility Purpose of finance Asset structure EXTERNAL Size of the company Nature of the industry Investors Cost of inflation Legal requirements Period of finance Level of interest rate Level of business activity Availability of funds Taxation policy Level of stock prices Conditions of the capital market

Alternative Approach to Capital Structure Analysis Using the Beta

Incorporating Hamadas Equation

Capital structure in the real world

Trade-off theory Pecking order theory Agency Costs

Trade-off theory
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt).

Pecking order theory

It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued

Agency Costs
Asset substitution effect Underinvestment problem (or Debt overhang problem) Free cash flow

Capital structure in a perfect market

Modigliani and Miller made two findings 1- The value of a company is independent of its capital structure 2- The cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk

Features of An Appropriate Capital Structure

capital structure is that capital structure at that level of debt equity

proportion where the market value per share is maximum and the cost of
capital is minimum. Appropriate capital structure should have the following features

Profitability / Return
Solvency / Risk Flexibility Conservation / Capacity Control