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Capital Structure
0 Is the proportion of debt and preference and equity
2.
3.
4.
Traditional Approach
Assumptions
1.
There are only two sources of funds used by a firm: perpetual riskless
The dividend pay out ratio is 100. ie, the total earnings are paid out as dividend to the shareholders and there are no retained earnings.
3.
4. 5.
6.
7.
firm.
2.
3.
The use of debt does not change the risk perception of the investors
structure of a firm.
firm is not affected by the change in Capital Structure, the Weighted Average Cost of Capital is said to be constant.
0 The valuation of the firm and its cost of capital is
Assumptions of NOI
1. The market capitalizes the value of the firm as a whole. Thus
Assumptions of MM Model
1.
2.
3. 4.
5.
6.
7.
4. Traditional Approach
0 It is a compromise between NI & NOI approach 0 According to this view the cost of capital can be reduced or
Capital Structure
Cost of Capital
0 COC is the rate of return that a firm must earn on its project/
used in determining the PV of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not
Cost of Capital
0 It can also be defined as the rate at which an
may be in the form of the interest which the company may be required to pay to the suppliers of funds.
of the funds of company. i.e rate of return which the company would have earned if the funds are not invested.
raised by a firm
0 The cost associated with each source is called its specific cost 0 When these specific costs are multiplied with the respective
Calculating WACC
Source of Capital Equity Preference Share Proportion 0.6 0.05 Specific Cost 16% 14% 9.6% 0.7% WC
Debt
0.35
8.4%
Capitalisation
0 In the context of financial planning, capitalisation
Capitalisation Theories
1. Cost Theory
2. Earning Theory
Cost Theory
0 According to the cost theory of capitalisation, the amount of
capital required by the company is calculated by adding up the cost of its fixed assets, the amount of working capital, and the cost of establishing the business.
0 Simple Approach 0 Used in new companies
Earning Theory
0 According to earning theory, the capital requirement of a
Examples
1. If the average annual earning of a company is Rs. 5 lakh and
the normal rate of return on the capital employed in case of companies in the same industry is 10%, then the amount of capitalisation is Rs. 50 lakh.
2. If a new company expects to earn an average annual income of
Rs. 3 lakh and the normal rate of return of the industry is 5%,
Earning Theory
0 More a rational approach
Over Capitalisation
0 A company is said to be over-capitalised if its capital
Over Capitalisation
0 In other words, if a companys actual rate of earnings is less
required.
0 Liberal dividend policy. 0 Underestimation of capitalisation rate or overestimation of
Under Capitalisation
0 Under-capitalisation is just the reverse of over-capitalisation. 0 Here, capital employed is less than its proper capitalisation 0 i.e., the amount of capital invested is not justified by its annual earnings. 0 Alternatively, if a companys actual rate of earnings is more than the
Under Capitalisation
0 Under-capitalisation is indicative of a sound financial
position and may lead to increase in the market value of companys shares.
0 However, it can encourage competition as high rate of