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8/13/2019 Presentation of capital budgeting
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8/13/2019 Presentation of capital budgeting
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PROJECT PRESENTATION BY: MuhammadAhmedKhan
RoheelGhulamMuhammad
MuhammadIsmailUmar
WaqasHafeez
MuhammadBilalAsif
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What is Capital Structure?
Balance SheetCurrent CurrentAssets Liabilities
DebtFixed Preference
Ordinaryshares
FinancialStructure
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What is Capital Structure?
Balance Sheet Current CurrentAssets Liabilities
DebtFixed Preference sharesAssets
Ordinary sharesCapitalStructure
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Whatiscapitalstructure?
Combinationofcapitaliscalled
capitalstructure.Thefirmmayuse
onlyequity,oronlydebt,ora
combinationofequity+debt,oracombinationof
equity+debt+preferencesharesor
mayuseothersimilarcombinations.
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CONT The Capital structure of business can bemeasured by the ratio of various kinds ofpermanent loan and equity capital to totalcapital - Schwarty
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CapitalStructure
Capitalstructureincludesonlylong
termdebtandtotalstockholder
investment.
CapitalStructure=LongTermDebt+
PreferredStock+NetWorth
OR
CapitalStructure=TotalAssets
CurrentLiabilities.
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Howshouldyoudesigncapital
structure?1. Itshouldminimizecostofcapital
2. Itshouldreducerisks
3. Itshouldgiverequiredflexibility4. Itshouldproviderequiredcontrolto
theowners
5. Itshouldenablethecompanytohaveadequatefinance.
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capitalstructuredecisions?
Meaning of risk = variability in income iscalled risk. Business risk = it is the situation, when theEBIT may vary due to change in capital
structure. It is influenced by the ratio offixed cost in total cost. If the ratio of fixedcost is higher, business risk is higher. Financial risk = it is the variability in EPS
due to change in capital structure. It iscaused due to leverage. If leverage ismore, variability will be more and thusfinancial risk will be more.
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Basic Terms used in Capital Structure
Financial Risk Increasedfinancialriskthatcomeswith
increaseduseofdebt
Cost of Capital Interestrateonborrowingsaftertax
WACC Costofdebt,preferredstock,equityand
reservesandsurplus
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CONT EPS= Earnings Per ShareProfitaftertaxandpreferencedividend/numberofequityshares.
Diluted EPS Derivedafterredemptionofpreferenceshares.
Obtainedafterconvertedpreferenceshares,
convertibledebenturesandbonusissues
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FinancingDecision
Howshouldtheinvestmentprojectbefinanced?
Doesthewayinwhichtheinvestmentprojectsare financedmatter?
Howdoesfinancingaffecttheshareholdersrisk,
returnandvalue? Doesthereexistanoptimumfinancingmixin
termsofthemaximumvaluetothefirmsshareholders?
Cantheoptimumfinancingmixbedeterminedinpracticeforacompany?
Whatfactorsinpracticeshouldacompanyconsiderindesigningitsfinancingpolicy?
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DeterminantsofCapitalStructure
SeasonalVariations
TaxbenefitofDebt
Flexibility
Control
IndustryLeverageRatios
AgencyCosts
IndustryLifeCycle
DegreeofCompetition
CompanyCharacteristics
RequirementsofInvestors
TimingofPublicIssue
LegalRequirements
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CAPITALSTRUCTUREOF
MULTINATIONALFIRMS Capitalstructureforthemultinationalfirminvolvesachoicebetweendebtandequityfinancingacrossallits
subsidiaries.AMNCcanhavemoredebtinitscapitalstructureifitscashflowsaremorestableandithasalowcreditrisk.
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Optimal capital structure
Capitalstructureorcombinationof
debtandequitythatleadstothe
maximumvalueofthefirm
Maximizesthevalueofthecompany
Minimizethecompanyscostofcapital
O C S
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OptimalCapitalStructure
Itisthatcapitalstructureatthatlevelofdebtequityproportionwherethemarketvaluepershareismaximumandthecostofcapitalisminimum.
Features: Profitability
solvency
Flexibility
Conservation control
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These considerations should be kept in mind whilemaximizing the value of the firm IfROI>thefixedcostoffunds,thecompany
shouldprefertoraisethefundshavingafixedcost,suchas,debentures,LoansandPSC.Itwill
increaseEPSofthefirm.
Ifdebtisusedasasourceoffinance,thefirmsavesaconsiderableamountinpaymentoftaxas
interestisallowedasadeductibleexpensein
computationoftax.
Itshouldalsoavoidunduefinancialriskattached
withtheuseofincreaseddebtfinancing
TheCapitalstructureshouldbeflexible.
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PATTERN OF CAPITAL STRUCTURE Completeequitysharecapital
Differentproportionsofequityandpreferencesharecapital
Differentproportionsofequityanddebenture(debt)capital
Differentproportionsofequity,preferenceanddebenture(debt)capital.
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APPROACHES TO DETERMINE APPROPRIATECAPITAL STRUCTURE
EBITEPSApproachThisapproachishelpfultoanalyzetheimpactofdebtonearningspershare.
ValuationApproachThisapproach
determinestheimpactofdebtuseontheshareholdersvalue.
CashFlowApproach-Thisapproach
analysesthefirmsdebtservicecapacity.
Th i f C i l S
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TheoriesofCapitalStructure
NetIncomeApproach
NetOperatingIncomeApproach
ModiglianiandMillerApproach TraditionalApproach.
N t I A h
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NetIncomeApproach
A change in the proportion in capital structure
will lead to a corresponding change in cost of
capital and Value of the firm.
Assumptions:(i) There are no taxes;
(ii) Cost of debt is less than the cost of equity;
(iii) Use of debt in capital structure does not change the
riskperception of investors.
(iv) Cost of debt and cost of equity remains constant;
A ti f NI Th
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AssumptionsofNITheory
Firsttherearenotaxes.
Secondthecostofdebtislessthan
thecostofequity.
Thirdtheuseofdebtdoesnot
changetheriskperceptionof
investor.
N t O ti I A h
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NetOperatingIncomeApproach
The essence of this approach is that the capital
structure decision of a firm is irrelevant.
Any change in leverage will not lead to any changein the total value of the firm and the market price of
shares as well as the overall cost of capital is
independent of the degree of leverage.Cost of debt
(Ki)remains constant. There are no corporate
taxes.
A ti f NOI Th
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AssumptionsofNOITheory
Thesplitoftotalcapitalizationbetweendebtandequityisnotessentialorrelevant.
Theequityshareholdersandotherinvestorsi.e.themarketcapitalizesthevalueofthefirmasawhole.
Thebusinessriskateachlevelofdebt-equitymixremainsconstant.Therefore,overallcostofcapitalalsoremainsconstant.
Thecorporateincometaxdoesnotexist
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Modigliani and Miller Approach Thisapproachwasdevelopedby
Prof.FrancoModiglianiandMertan
Miller.
Accordingtothisapproach,total
valueofthefirmisindependentofits
capitalstructure.
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CONT Modigliani and Miller Approach (MM)
Theydevelopedthecapital-structureirrelevanceproposition.
The basic M&M proposition is based on the following key
assumptions: The basic M&M proposition is based on the following key assumptions:
Notaxes
Notransactioncosts
Nobankruptcycosts
Equivalenceinborrowingcostsforbothcompaniesand
investors
Symmetryofmarketinformation,meaningcompaniesand
investorshavethesameinformation Noeffectofdebtonacompany'searningsbeforeinterestand
taxes
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MMApproachWithoutTax:PropositionI MMs Proposition I states that the firms value is independent of its capital
structure. With personal leverage, shareholders can receive exactly the same
return,withthesamerisk,fromaleveredfirmandanunleveredfirm.Thus,theywill
sellsharesoftheover-pricedfirmandbuysharesoftheunder-pricedfirmuntilthe
twovaluesequate.Thisiscalledarbitrage.
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MMsPropositionII Thecostofequity foraleveredfirmequals theconstantoverallcostofcapital
plusariskpremiumthatequalsthespreadbetweentheoverallcostofcapital
and the cost of debt multiplied by the firms debt-equity ratio. For financial
leverage to be irrelevant, the overall cost of capital must remain constant,
regardlessoftheamountofdebtemployed.Thisimpliesthatthecostofequitymustriseasfinancialriskincreases.
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MMHypothesisWithCorporateTax Under current laws in most countries, debt has an important advantage over
equity: interest payments on debt are tax deductible, whereas dividend
paymentsand retainedearningsarenot. Investorsina levered firm receive in
the aggregate the unlevered cash flow plus an amount equal to the tax
deduction on interest.Capitalising the first component of cash flowat the all-equityrateandthesecondatthecostofdebtshowsthatthevalueofthelevered
firmisequaltothevalueoftheunleveredfirmplustheinteresttaxshieldwhich
istaxratetimesthedebt(iftheshieldisfullyusable).
Itisassumedthatthefirmwillborrowthesameamountofdebtinperpetuityand
willalwaysbeabletousethetaxshield.Also,itignoresbankruptcyandagency
costs.
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ArbitragePROCESS
TheMM approach illustrates the arbitrage processwith reference to valuation in terms of two firms
which are exactly similar in all respects except
leveragesothatoneofthemhasdebtinitscapital
structurewhiletheotherdoesnot.
Tounderstandtheprocessletushaveanexample
Modigliani miller approach
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Modigliani-millerapproach
Feature
1. Capitalmarketsareperfect
2. Homogeneousriskclassesoffirm
3. Expectationsaboutthenetoperatingincome
4. Dividendpayoutratio100%
5. Nocorporatetaxes
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Limitations of MM Approach Investors cannot borrow on the same
terms and conditions of a firm
Personal leverage is not substitute for
corporate leverage Existence of transaction cost
Institutional restriction on personal
leverage Asymmetric information
Existence of corporate tax
Assumptions
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Assumptions
a. Information is available at free of costb. The same information is available for all
investors
c. Securities are infinitely divisible
d. Investors are free to buy or sell securitiese. There is no transaction cost
f. There are no bankruptcy costs
g. Investors can borrow without restrictions as the
same terms on which a firm can borrowh. Dividend payout ratio is 100 percent
i. EBIT is not affected by the use of debt
Traditional Approach
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TraditionalApproach
Thisapproachwasgivenby
Soloman.
Thisapproachisthemidwaybetween
NIApproachandNOIApproach.
Traditional approach says judicious use
of debt helps increase value of firm and
reduce cost of capital
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CONT Traditional Approach (TA) TheorythatwhentheWeightedAverageCostofCapital(WACC)isminimized.
The Traditional Theory of Capital Structure says that afirm's value increases to a certain level of debt capital,after which it tends to remain constant and eventuallybegins to decrease.
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Factors affecting capital structure INTERNAL Financialleverage
Risk
Growthandstability
Retainingcontrol
Costofcapital Cashflows
Flexibility
Purposeoffinance
Assetstructure
EXTERNAL Sizeofthecompany
Natureoftheindustry
Investors
Costofinflation
Legalrequirements Periodoffinance
Levelofinterestrate
Levelofbusinessactivity
Availabilityoffunds Taxationpolicy
Levelofstockprices
Conditionsofthecapitalmarket
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Alternative Approach to Capital Structure Analysis Using theBetaIncorporating Hamadas quation
Capital structure in the real world
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Capitalstructureintherealworld
Trade-off theory Pecking order theory Agency Costs
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Trade-off theory Trade-offtheoryallows
thebankruptcycosttoexist.Itstatesthatthereisanadvantageto
financingwithdebt(namely,thetax
benefitsofdebt)andthatthereisacostoffinancingwithdebt(the
bankruptcycostsandthefinancial
distresscostsofdebt).
http://en.wikipedia.org/wiki/Bankruptcyhttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Tax_benefits_of_debthttp://en.wikipedia.org/wiki/Bankruptcy8/13/2019 Presentation of capital budgeting
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Pecking order theory Itstatesthatcompaniesprioritizetheir
sourcesoffinancing(frominternal
financingtoequity)accordingtothelawof
leasteffort,orofleastresistance,preferringtoraiseequityasafinancing
meansoflastresort.Hence:internal
financingisusedfirst;whenthatis
depleted,thendebtisissued;andwhenitisnolongersensibletoissueanymore
debt,equityisissued
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Capital structure in a perfect
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Capitalstructureinaperfect
market
ModiglianiandMillermadetwo
findings
1-Thevalueofacompanyis
independentofitscapitalstructure
2-Thecostofequityforaleveraged
firmisequaltothecostofequityfor
anunleveragedfirm,plusanaddedpremiumforfinancialrisk
FeaturesofAnAppropriateCapitalStructure
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pp p p
capitalstructureisthatcapitalstructureatthatlevelofdebtequity
proportionwherethemarketvaluepershareismaximumandthecostof
capitalisminimum.
Appropriatecapitalstructureshouldhavethefollowingfeatures
Profitability/Return
Solvency/Risk
Flexibility
Conservation/Capacity
Control
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