Upload
vishal-modi
View
221
Download
0
Embed Size (px)
Citation preview
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
1/18
CapitalstructureSidharth
TenpaSurenderVishalKavya
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
2/18
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
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
3/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
4/18
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
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
5/18
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
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
6/18
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
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
7/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
8/18
CAPITAL STRUCTURE
THEORIES
1. Net Income Approach
2. Traditional Approach
3. Net Operating Income Approach
4. Modigliani And Miller Approach
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
9/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
10/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
11/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
12/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
13/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
14/18
Factors that influence Capital
Structure Decisions
Business Risk
Company's Tax Exposure
Management Style
Financial Flexibility
Growth Rate
Market Condition
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
15/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
16/18
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).
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
17/18
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.
8/2/2019 Capital Sructure Final Pptsssssssssssssssss
18/18
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.