Capital Sructure Final Pptsssssssssssssssss

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CapitalstructureSidharth

TenpaSurenderVishalKavya


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INTRODUCTION

We may not know what a capital structure is

or why you should even concern yourself with

it, but the concept is extremely importantbecause it can influence not only the return a

company earns for its shareholders, but

whether or not a firm survives in a recession or

depression. Sit back, relax, and prepare to

learn everything you ever wanted to knowabout investments and the capital structure

of the companies


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CAPITAL STRUCTURE WHAT IT IS

AND WHY IT MATTERS

The term capital structure refers to the percentageof capital (money) at work in a business by type.Broadly speaking, there are two forms of capital:equity capital and debt capital. Each has its ownbenefits and drawbacks and a substantial part ofwise corporate stewardship and management isattempting to find the perfect capital structure interms of risk / reward payoff for shareholders. This is

true for big companies and for small businessowners trying to determine how much of theirstartup money should come from a bank loanwithout endangering the business.


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Meaning:

Combination of debt and equity that afirm uses to fund its long term financing.

Capital structure of a company refers tothe composition of its capitalization and itincludes all long term capital sources i.e.,loans, reserves, shares and bonds.

Gerestenbeg


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Choosing a Capital Structure

What is the primary goal of financialmanagers?

Maximize stockholder wealth

We want to choose the capital structurethat will maximize stockholder wealth

We can maximize stockholder wealth by

maximizing the value of the firm orminimizing the WACC


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Optimal capital structure

The OCM can be defined as that

capital structure or combination of debt

and equity that leads to the maximumvalue of the firm

OCM maximises the value of thecompany and hence the wealth of its

owners and minimise the companys costof capital


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Following consideration should be kept inmind while maximizing the value of the firm:

If ROI > the fixed cost of funds

If debt is used as a source of finance, thefirm saves a considerable amount inpayment of tax as interest is allowed as adeductible expense in computation oftax.

The Capital structure should be flexible.


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CAPITAL STRUCTURE

THEORIES

1. Net Income Approach

2. Traditional Approach

3. Net Operating Income Approach

4. Modigliani And Miller Approach


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Net Income Approach

suggested by the David Durand.

Exist Direct relationship between capital structure and net

income

The capital structure decision is relevant to the valuation of

the firm. In other words, a change in the capital structure

leads to a corresponding change in the overall cost of capital

as well as the total value of the firm.

According to this approach, use more debt finance to reduce

the overall cost of capital and increase the value of firm.


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Net Operating Income

Approach

Capital Structure decision is irrelevant to the

valuation of the firm.

The market value of the firm is not at all affected

by the capital structure changes.

According to this approach, the change in capital

structure will not lead to any change in the totalvalue of the firm and market price of shares as well

as the overall cost of capital.


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TRADITIONAL APPROACH

Up to a certain point additionalintroduction of debt reduces the cost of

capital and increases the value of thefirm.

But beyond a point if you borrow moredebt the cost will increase and value will

decrease.


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Modigliani and Miller Approach

Modigliani and Miller approach states that the

financing decision of a firm does not affect the

market value of a firm in a perfect capital market.

In other words MM approach maintains that the

average cost of capital does not change with change

in the debt weighted equity mix or capitalstructures of the firm.


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important assumptions:

There is a perfect capital market.

There are no retained earnings.

There are no corporate taxes.

The investors act rationally.

The dividend payout ratio is 100%. The business consists of the same level of business

risk.


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Factors that influence Capital

Structure Decisions

Business Risk

Company's Tax Exposure

Management Style

Financial Flexibility

Growth Rate

Market Condition


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1.Business Risk

Excluding debt, business risk is the basic risk of the company's

operations. The greater the business risk, the lower the optimal debt

ratio.

As an example, let's compare a utility company with a retail apparel

company. A utility company generally has more stability in earnings.

The company has less risk in its business given its stable revenue

stream. However, a retail apparel company has the potential for a bitmore variability in its earnings. Since the sales of a retail apparel

company are driven primarily by trends in the fashion industry, the

business risk of a retail apparel company is much higher. Thus, a retail

apparel company would have a lower optimal debt ratio so that

investors feel comfortable with the company's ability to meet itsresponsibilities with the capital structure in both good times and bad.


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Company's Tax Exposure

Debt payments are tax deductible. As such, if a company'stax rate is high, using debt as a means of financing a project

is attractive because the tax deductibility of the debt

payments protects some income from taxes.

Management Style : Management styles range from

aggressive to conservative. The more conservative a

management's approach is, the less inclined it is to use debt

to increase profits. An aggressive management may try to

grow the firm quickly, using significant amounts of debt to

ramp up the growth of the company's earnings per share(EPS).


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Financial Flexibility

This is essentially the firm's ability to raise capital in bad times. It should comeas no surprise that companies typically have no problem raising capital when sales

are growing and earnings are strong. However, given a company's strong cash

flow in the good times, raising capital is not as hard. Companies should make an

effort to be prudent when raising capital in the good times, not stretching its

capabilities too far. The lower a company's debt level, the more financial

flexibility a company has.

The airline industry is a good example. In good times, the industry generates

significant amounts of sales and thus cash flow. However, in bad times, that

situation is reversed and the industry is in a position where it needs to borrow

funds. If an airline becomes too debt ridden, it may have a decreased ability to

raise debt capital during these bad times because investors may doubt the

airline's ability to service its existing debt when it has new debt loaded on top.


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Growth Rate

Firms that are in the growth stage of their cycle typically finance that growth through debt,

borrowing money to grow faster. The conflict that arises with this method is that the revenues

of growth firms are typically unstable and unproven. As such, a high debt load is usually not

appropriate.

More stable and mature firms typically need less debt to finance growth as its revenues are

stable and proven. These firms also generate cash flow, which can be used to finance projects

when they arise.

Market Condition

Market conditions can have a significant impact on a company's capital-structure condition.

Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning

investors are limiting companies' access to capital because of market concerns, the interest

rate to borrow may be higher than a company would want to pay. In that situation, it may be

prudent for a company to wait until market conditions return to a more normal state before the

company tries to access funds for the plant.

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