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PRESENTATION
Capital Structure and
Cost Of Capital Theories
Meaning of Capital Structure
From Shares
(a) Equity Share capital
(b) Preference Share Capital
From Debentures
Factors Influencing Capital Structure
• Internal Factors
• External Factors
Internal Factors
Size of Business
Nature of Business
Regularity and Certainty of Income
Assets Structure
Age of the Firm
Desire to Retain Control
Future Plans Operating Ratio
Trading on Equity
Period and Purpose of Financing
Factors Influencing Capital Structure
External Factors
Capital Market Conditions
Nature of Investors
Statutory Requirements
Taxation Policy
Policies of Financial Institutions
Cost of Financing
Seasonal Variations
Economic Fluctuations
Nature of Competition
Optimal Capital Structure
The optimal or the best capital structure
implies the most economical and safe ratio
between various types of securities.
It is that mix of debt and equity which
maximizes the value of the company and
minimizes the cost of capital.
Essentials of a sound or optimal
Capital structure
Minimum Cost of Capital
Minimum Risk
Maximum Return
Maximum Control
Safety
Simplicity
Flexibility
Attractive Rules
Commensurate to Legal Requirements
Theories of Capital structure
Net Income (NI) Theory
Net Operating Income (NOI) Theory
Traditional Theory
Modigliani-Miller (M-M) Theory
Net income (NI) Theory
This theory was propounded by “David Durand” and
is also known as “Fixed ‘Ke’ Theory”.
According to this theory a firm can increase the
value of the firm and reduce the overall cost of
capital by increasing the proportion of debt in its
capital structure to the maximum possible extent.
It is due to the fact that debt is, generally a cheaper
source of funds because:
(i) Interest rates are lower than dividend rates due
to element of risk,
(ii) The benefit of tax as the interest is deductible
expense for income tax purpose.
Net Operating Income Theory
𝐸𝐵𝐼𝑇
𝐾0 =
𝑉
Where,
Ko = Overall Cost of Capital or Capitalization
Rate
V = Value of the firm
Computation
Value of Unlevered Firm
𝑬𝑩𝑰𝑻(𝟏−𝑻)
𝑽𝒖 =
𝑲𝒆
Value of Levered Firm
VL =𝑽𝒖 + 𝑫𝒕
Where,
Vu : Value of Unlevered Firm
VL :Value of Levered Firm
D : Amount of Debt
t : tax rate
Computation of the Total Value of the
Firm
𝑬𝑩𝑰𝑻
V=
𝑲𝒐
Where,
Ko = Overall cost of capital
Project-B
Net investments 90000
CFAT Estimates PVAIF12%,15yrs PV NPV
Pessimistic 13500 6.811 91948.5 1948.5
Most likely 15000 6.811 102165 12165
Optimistic 18000 6.811 122598 32598
Sensitivity Analysis
• The NPV calculations of both the projects suggest that the
projects are equally desirable on the basis of the most likely
estimates of cash flows.
However, the Project– A is riskier than Project – B because its
NPV can be negative to the extent of TK. 21,890 but there is no
possibility of incurring any losses with project B as all the NPVs
are positive. As the two projects are mutually exclusive, the
actual selection of the projects depends on decision maker’s
attitude towards the risk. If he is ready to take risk, he will select
Project A, because it has the potential of yielding NPV much
higher than (TK. 53031) Project B. But if he is risk averse, he will
select project B.
Scenarios Analysis
• The another way to examine the risk of investment is to
analyze the impact of alternative combination of variables ,
called the scenarios , on the project NPV.
EXAMPLE:- In the expected scenario, it may be possible to
increase the sales volume of 1 lac units to 1,25000 units . If the
company reduces the selling price from TK. 15 to TK. 13.50,
resorts to aggressive advertisement campaign, their by
increasing unit variable cost to TK. 7.1( 5% increase) & fixed cost
is TK. 44,000.
Calculate the NPV.
OPTIMISTIC :-1,25,000
PESSIMISTIC:-75,000
NEUTRAL:- 1,00,000
Scenarios Analysis
REVENUE = 1250 *!6.50=20625(TK)
Variables Base value Pessimistic Optimistic
(TK.)
Sales volume 1000 750 1250