Amity Business School

Amity Business School

MBA Class of 2010, Semester II
FINANCIAL MANAGEMENT
MODULE III

Cost of Capital & Capital Structure

Amity Business School

INTRODUCTION
Financing decision is raising the necessary
funds to meet our investment expenditures.
Most of the investment is done through
borrowed funds.
So, while making an investment decision it
is necessary to see whether adequate funds
are available or not.
Because without a financing decision
investment decision is not possible and
without investment decision financing
decision has no purpose

Amity Business School

In financing decision company has to decide its

capital structure. In this the debt & equity ratio
is decided. It also termed as debt equity mix.
The capital structure or financing decision
indicates the left side (Liabilities) of the balance
sheet whereas investment decision shows right
side (Assets) of the balance sheet. The capital
structure shows the proportionate relationship
between debt & equity.

Amity Business School

That is how these two decisions are

correlated.
In financing decision, we not only have
to look at availability of funds but also at
its cost.
We have to pay in future, that is why the
cost of capital is very significant
decision.
It (cost of capital) has two dimensional
impacts like it affects both the
investment and financing decision

Amity Business School

Qualities of Optimum Capital Structure

Simplicity
Flexibility
Minimum Cost of Capital
Adequate Liquidity
Minimum Risk
Legal Requirements
Maximum Returns
Control

Amity Business School

Factors Affecting Capital Structure

Simplicity
Flexibility
Minimum Cost of Capital
Adequate Liquidity
Minimum Risk
Legal Requirements
Maximum Returns
Control

Amity Business School

Floatation Cost
Control
Cost of Capital
Flexibility
Interest Coverage Ratio

Amity Business School

Theories of Capital Structure

Net income Approach:
According to this approach, a firm can
minimize the weighted average cost of
capital and increase the value of firm as
well as market price of equity of shares
by using debt financing to the maximum
possible extent.

Amity Business School

Assumptions of NI Approach
The cost of debt is less than the cost of
equity.
No Taxes
The risk perception of investors is not
changed by the use of debt.

Amity Business School

V=S+D
Where V=Total market value of a firm
S= Market value of equity shares
S=Earnings Available to Equity Share
holders (NI)/Equity capitalization rate
D= Market value of Debt
Ko = EBIT/ V

Amity Business School

Practical Problem
A Company expects a net income of
Rs.50,000. It has Rs.2,00,000, 8%
Debentures. The Equity capitalization
rate of the company is 10%.
Calculate the value of the firm and
overall capitalization rate according
to NI approach ( ignore taxes)

Amity Business School

Net Operating Income Approach

Suggested by Durand
Opposite to NI Approach
According to this: Change in capital structure of a
company does not affect the market value of the firm
and the overall cost of capital remains constant
irrespective of the method of financing.
It implies that the overall cost of capital remain same
whether the Debt- equity is 50:50 or 20:80
NO OPTIMUM CAPITAL STRUCTURE, EVERY STRUCTURE
IS OPTIMUM

Amity Business School

Assumptions of NOI Approach

The market capitalizes the value
of the firm as a whole;
The business risk remains
constant at every level of debt
equity mix
There are no corporate taxes

Amity Business School

V =EBIT/ Ko
V = Value of a firm
EBIT=Net operating Income or Earnings
before interest and taxes
Ko = Overall cost of capital

Amity Business School

Practical Problems

Amity Business School

The Traditional Approach

Intermediate Approach
According to this: the value of firm can be
increased initially or the cost of capital can be
decreased by using more debt as the debt is a
cheaper source of funds than equity. Beyond a
particular point, the cost of equity increases
because increased debt increases the financial
risk of the equity shareholders.

Amity Business School

The advantage of cheaper debt at this point is

offset by increased cost of equity.

After this there comes a stage, when the

increased cost of equity cannot by offset by the
advantage of low cost debt. Thus overall cost of
capital, decreases up to a certain point, remains
more or less unchanged for moderate increase
in debt thereafter; and increases beyond a
certain point.

Amity Business School

Modigliani and Miller Approach

In the absence of taxes
Arbitrage Process

Amity Business School

Practical Problems

Amity Business School

Cost of Capital

Amity Business School

Meaning
Cost of Capital means cost of obtaining
funds i.e. average rate of return that the
investors in a firm would expect for
supplying funds to the firm.
OR
It is the minimum rate of return which a firm,
must and is expected to earn on its
investments so as to maintain the market
value of its shares

Amity Business School

Significance of Cost of capital

Helpful in capital Budgeting
Helpful in capital structure decisions
Helpful in evaluating the financial
performance
Basis for other financial decisions like
dividend policy, working capital decisions
etc.

Amity Business School

Classification of Cost of capital

Historical cost and Future cost

Specific cost and composite cost
Explicit cost and Implicit cost
Average cost and Marginal cost

Amity Business School

Computation of Cost
Cost of Specific Source of finance
Composite Cost of Capital

Amity Business School

Cost of Debt
In case of Irredeemable debt
Kdb = I/P
Kdb = Before tax cost of debt
I
= Interest
P
= Principal
Kdb = I/NP
Where NP= Net proceeds
Kda = Kdb(1-t)
t
= tax rate

Amity Business School

Redeemable debt
Kdb = I + 1/n (RV-NP)/ (RV+NP)
Kda = Kdb (1-t)
At Premium
= I + 1/n (RV-NP)/ (RV+NP)

Amity Business School

Cost of Preference Capital

Kp = D/P
Where D = Annual Preference dividend
P = preference Share Capital
(Proceeds)
Kp = D/NP
Redeemable Preference Shares
Kpr = D+1/n( MV-NP)/1/2 (MV+NP)
Where MV = Maturity value of Preference
shares

Amity Business School

Cost of Equity Share Capital

Dividend yield Method
Ke = D/NP or D/MP
Where D = Expected dividend per share
NP =Net Proceeds per share
MP = Market Price per share
Dividend yield plus growth in dividend
method
Ke = D1 /NP + G
Or D0 (1+g) / NP + G

Amity Business School

Earning Yield Method

Ke = Earnings per share / Net Proceeds
Or
= Earnings per share / Market Price
per share

Amity Business School

Cost of Retained Earnings

Kr = D /NP + G
Where Kr = Cost of retained earnings
D = expected dividend
NP = Net Proceeds of share issue
G = Rate of Growth

Amity Business School

Weighted Average cost of Capital

Weighted Av. Cost of capital is the
average cost of the costs of various
sources of financing. Also known as
Composite cost of capital
Weights are assigned either on Book
value basis or Market Value basis.

Amity Business School

Marginal Cost of Capital

Cost of Capital of the additional funds is called
the Marginal Cost of Capital.
If the additional financing uses more than one
source, say a combination of debt and equity,
then the WACC of new financing is called the
Weighted Marginal Cost of Capital ( WMCC)

Amity Business School

Calculation of WMCC
1. The WMCC is calculated on the
basis of market value weights
because the new funds are to be
raised at the market values.
2. The specific cost of capital can be
accurately calculated.