Issues:

Capital structure

What is capital structure? Why is it important? What are the sources of capital available to a company?

What is business risk and financial risk?

What are the relative costs of debt and equity? What are the main theories of capital structure? Is there an optimal capital structure?

What is Capital Structure?

Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities Bonds, bank loans Ordinary shares (common stock), Preference shares (preferred stock) Hybrids, eg warrants, convertible bonds

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference shares Ordinary shares

Fixed Assets

Financial Structure

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference shares Ordinary shares

Fixed Assets

Capital Structure

Sources of capital
Ordinary shares (common stock) Preference shares (preferred stock) Hybrid securities i.e.Convertible bonds Loan capital
Bank loans Corporate bonds

Factors affecting capital structure

Flexibility Risk minimization Control Profitability

Business risk and Financial risk

Firms have business risk generated by what they do But firms adopt additional financial risk when they finance with debt

Risk and the Income Statement

Operating Leverage Financial Leverage

Sales Variable costs Fixed costs EBIT Interest expense Earnings before taxes Taxes Net Income

EPS = Net Income No. of Shares

Why should we care about capital structure?

By altering capital structure firms have the opportunity to change their cost of capital and therefore the market value of the firm, lets say -Cap str I Debt : equity (50:50) Where ke 15%, Kd 10% V=NOI/Ko(WACC) Ko will be -.15x.50+.10x.50 =.125 or 12.5% V will be-10000/.125=80000 Cap str II- Debt :Equity(70:30) with same kd and ke Ko-.10x.70+.15x.30=.115 or 11.5 % V will be 10000/.115=87000

Few terms u should know

E is total value of equity i.e.=Net income /ke Where ke is cost of equity and net income is profit available to equity shareholders D is the value of debt i.e. INT/kd Where INT is interest amount and kd is cost of debt V is total value of Firm i.e. E+D or net operating income /ko(WACC) Where ko is total cost of capital and NOI is EBIT or operating profit That means total amount of investment in Equity and debt

What is an optimal capital structure?

An optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value Cost of Capital:
Each source of financing has a different cost The WACC is the Weighted Average Cost of Capital Capital structure affects the WACC

Capital Structure Theory

Basic question
Is it possible for firms to create value by altering their capital structure?

Major theories
Modigliani and Miller theory Trade-off Theory i.e. traditional theory NI Theory NOI theory

NI theory
Value of the firm is affected by capital structure Assumptions of this theory Kd is less than ke No change in risk No corporate tax