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CAPITAL
STRUCTURE
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INTRODUCTION
In order to run and manage acompany, funds are needed. If
funds are inadequate, the businesssuffers and if the funds are notproperly managed, the entire
organization suffers. It is necessarythat correct estimate of optimumcapital structure which shall help
the organization to run its work
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MEANINGThe term capital structure refersto the relationship between the
various long- term financing suchas debentures, preference capital,equity share capital.
There should be a proper mix ofdebt and equity capital in financingthe firms assets. The use of longterm debt and reference ca ital
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FINANCIAL BREAK
EVEN POINTIt may be defined as that level ofEBIT which is just equal to pay total
financial charges i.e. interest andpreference dividend.
EBIT= interest+ preferencedividend.
At this point earning per share is
equal to zero.
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FINANCIAL BREAK
EVEN POINT(a) when the capital structureconsists of equity share capital and
debt only and no preference capitalis employed:financial break even point = fixed
intrest charges.
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Financial break even
point(b) When the capital structureconsists of equity, preference and
debt:
FBEP = I + Dp/(1-t)
Where, I = fixed interest chargesDp = preference dividend
(1-t) = tax rate
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NETINCOME
APPROACHUnder net income approach cost ofequity and cost of debt are
constant as debt is replaced forequity in capital structure, beingless expensive , it causes the
overall cost of capital decreasethat ultimately approaches the costof debt with 100% debt ratio.
Under net income approach, the
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ASSUMPTION(1)There are no taxes.
(2)The risk perception of investor
is not changed by use of debt.
(3)Debt is replaced for equity
(4) Firm uses only two sources offinance i.e. equity and debt.
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formulaeV = S+D
S = EBIT- I/ equity capitalizationrate
Ko = EBIT/ V
V= value of firm
S= value of equity shares
D= value of debt
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EXAMPLES(a) A company expects a net
income of Rs. 80,000. it has Rs.
2,00,000. 8% debentures. Theequity capitalization rate of thecompany is 10% calculate the
value of the firm and overallcapitalization rate according tothe net income approach.
b If the debt is increased to Rs.
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NET OPERATING
INCOME APPROACHThe change in capital structure of acompany does not affect the
market value of the firm andoverall cost of capital remainssame. In other words, the overall
cost of capital remains samewhether debt or equity mix is50:50, 20:80, 0: 100. thus, there is
nothing as optimal capital
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ASSUMPTION(1)The overall cost of capital
remains constant.
(2)The risk perception of investoris changed by use of debt.
(3) increase in Cost of equityoffsets the benefits of usingcheaper source of finance.
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NET OPERATING
INCOME APPROACHV = EBIT/ K0
S = V D
Ke = EBIT- I/ V- D
V= value of firm
Ko = overall cost of capital.
S= market value of a equity
D = market value of debt
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EXAMPLE
(a) A company expects a netoperating income of Rs.
1,00,000. it has Rs. 5,00,000.6% debentures. The overallcapitalization rate is 10%.
Calculate the value of the firmand the equity capitalizationrate according to the net
operating income approach.
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TRADITIONAL
APPROACHThe value of firm can be increasedinitially or cost of capital can be
decreased by using more debt asdebt is cheaper source of financethan equity. Like, net income
approach this approach impliescost of capital decreases only within reasonable limit and reaching
the minimum level, it starts
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TRADITIONAL
APPROACHV = S+D
Ko = EBIT/V
Ke = EBIT- I/S
S = EBIT- I/ Ke
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EXAMPLE
Net operating income2,00,000
Total investment10,00,000
Equity capitalization rate:(a) If the firm uses no debt
10%
b If the firm uses Rs. 4 00 000
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MODIGILANI & MILLER
APPROACHIt does not agree with traditionalview. As per MM approach value of
firm depends upon the earningrather than the way in which theassets have been financed. MM
approach is identical with netoperating income ,if taxes areignored. it is identical with net
income approach, if taxes are
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ARBITRAGE PROCESS
This process involves purchasingsecurities whose prices are lower
and selling those securities whoseprices are higher in the relatedmarket.
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THANKS