FM

Table of Contents

Capital Structure ........................................................................................................................ 1

Introduction: ............................................................................................................................... 2
Optimal Capital Structure: ..................................................................................................... 3
Dynamics of Debt and Equity: ............................................................................................... 4
Assumptions of Capital Structure: ......................................................................................... 4
Theories of Capital Structure: ................................................................................................ 4
1. Net Income Approach: ....................................................................................................... 5
2. Net Operating Income Approach: ...................................................................................... 7
3. Traditional Approach: ........................................................................................................ 8
Financial Leverage and Value of Firm:................................................................................ 11
Capital Budgeting .................................................................................................................... 13
Introduction: ............................................................................................................................. 13
1. Payback Period: ................................................................................................................ 13
2. Net Present Value: (NPV) ................................................................................................ 14
3. Internal Rate of Return: .................................................................................................... 14
4. Profitability Index: (Benefit to Cost Ratio) ...................................................................... 15
Involvement of Risk in Capital Budgeting: ............................................................................. 16
1. Project Specific Risk: ....................................................................................................... 16
2. Industry Specific Risk: ..................................................................................................... 16
3. Competition Risk: ............................................................................................................ 17
4. Market Risk: ..................................................................................................................... 17
5. Stand-Alone Risk: ............................................................................................................ 17

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Capital Structure

Introduction:
Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its
operations and finance its assets. The structure is typically expressed as a debt-to-equity or
debt-to-capital ratio.

Debt/Equity (D/E) Ratio, calculated by dividing a company's total liabilities by its

stockholders' equity, is a debt ratio used to measure a company's financial leverage. The D/E
ratio indicates how much debt a company is using to finance its assets relative to the value of
shareholders' equity. The debt-to-capital ratio is calculated by taking the company's interest-
bearing debt, both short- and long-term liabilities and dividing it by the total capital. Total
capital is all interest-bearing debt plus shareholders' equity, which may include items such as
common stock, preferred stock and minority interest.

Debt and equity capital are used to fund a business’ operations, capital expenditures,
acquisitions and other investments. There are tradeoffs firms have to make when they decide
whether to raise debt or equity and managers will balance the two try and find the optimal
capital structure.

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Optimal Capital Structure:

The optimal capital structure of a firm is often defined as the proportion of debt and equity
that result in the lowest weighted average cost of capital (WACC) for the firm. This technical
definition is not always used in practice, and firms often have a strategic or philosophical
view of what the structure should be.

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Dynamics of Debt and Equity:

Debt investors take less risk because they have the first claim on the assets of the business in
the event of bankruptcy. For this reason, they accept a lower rate of return, and thus the firm
has a lower cost of capital when it issues debt compared to equity.

Equity investors take more risk as they only receive the residual value after debt investors
have been repaid. In exchange for this risk equity investors expect a higher rate of return and
therefore the implied cost of equity is greater than that of debt.

Assumptions of Capital Structure:

 There are only two sources of funds that are; debt and equity.
 Total assets of the firm are known and constant.
 There are no retained earnings; it means that company pays 100% of dividend.
 Operating profit is known and there is no growth in profit.
 Business risk is given and that should remain constant.
 There is no tax. (Personal or Corporate)
 Cost of debt will be less than cost of equity.

Theories of Capital Structure:

 Net Income Approach
 Net Operating Income Approach
 Traditional Approach

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1. Net Income Approach:

Net Income Approach was presented by Durand. The

theory suggests increasing value of the firm by
decreasing the overall cost of capital which is measured
in terms of Weighted Average Cost of Capital. This can
be done by having a higher proportion of debt, which is
a cheaper source of finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts
where the weights are the amount of capital raised from each source.

Formula:

Required Rate of Return x Amount of Equity + Rate of Interest x Amount

of Debt

WACC = Total Amount of Capital (Debt + Equity)

According to Net Income Approach, change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and also the value
of the company. The Net Income Approach suggests that with the increase in leverage
(proportion of debt), the WACC decreases and the value of firm increases.
On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the
value of the firm decreases.
Assumptions of Net Income Approach:
Net Income Approach makes certain assumptions which are as follows:

 The increase in debt will not affect the confidence levels of the investors.
 The cost of debt is less than the cost of equity.
 There are no taxes levied.

Graph:

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Example 1.1
Riser’s company has the following data; EBIT 2 Lac, Ke 10%, Kd 6%, and Debt 5 Lac.
Find the value of the firm and also WACC.

Solution
Value of Equity = Net Income/Ke

= (EBIT-Interest)/Ke

= (200000-30000)/0.10

= 1700000

Value of Debt = Interest/Kd

= 30000/0.06

= 500000

Value of Firm = Value of Equity + Value of Debt

= 1700000 + 500000

= 2200000

After that we will find the Weighted Average Cost of Capital (WACC)

Required Rate of Return x Amount of Equity + Rate of Interest x Amount

of Debt

WACC = Total Amount of Capital (Debt + Equity)

WACC = (0.10 x 1700000 + 0.06 x 5000000)/2200000

WACC = 200000/2200000
WACC = 0.09%

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2. Net Operating Income Approach:

This approach was presented by Durand. The theory Net

Operating Income Approach suggests that change in debt
of the firm/company or the change in leverage fails to
affect the total value of the firm/company. As per this
approach, the WACC and the total value of a company are
independent of the capital structure decision or financial
leverage of a company.

As per this approach, the market value is dependent on the operating income and the
associated business risk of the firm. Both these factors cannot be impacted by the financial
leverage. Financial leverage can only impact the share of income earned by debt holders and
equity holders but cannot impact the operating incomes of the firm. Therefore, change in debt
to equity ratio cannot make any change in the value of the firm.

It further says that with the increase in the debt component of a company, the company is
faced with higher risk. To compensate that, the equity shareholders expect more returns.
Thus, with an increase in financial leverage, the cost of equity increases.

Assumptions of Net Operating Income Approach:

 The overall capitalization rate remains
constant irrespective of the degree of leverage.
At a given level of EBIT, the value of the firm
would be “EBIT/Overall capitalization rate”
 Value of equity is the difference between total
firm value less value of debt i.e. Value of
Equity = Total Value of the Firm – Value of
Debt
 WACC (Weighted Average Cost of Capital)
remains constant; and with the increase in debt, the cost of equity increases. An
increase in debt in the capital structure results in increased risk for shareholders. As a
compensation of investing in the highly leveraged company, the shareholders expect
higher return resulting in higher cost of equity capital.

Graph:

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Example 2.1
Riser’s company has the following data; EBIT 1 Lac, Ko 10%, Kd 6%, and Interest
12000. Find the value of the firm, equity and debt.

Solution 2.1
Value of Firm = EBIT/Ko

= 100000/0.10

= 1000000

Value of Debt = Interest/Kd

= 12000/0.06

= 200000

Value of Equity = Value of Firm – Value of Debt

= 1000000 – 200000

= 800000

3. Traditional Approach:
The traditional approach to capital structure
advocates that there is a right combination
of equity and debt in the capital structure, at
which the market value of a firm is
maximum.

Debt should exist in the capital structure

only up to a specific point, beyond which,
any increase in leverage would result in the
reduction in value of the firm.

It means that there exists an optimum value

of debt to equity ratio at which the WACC is the lowest and the market value of the firm is
the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of
equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC
increases and market value of the firm starts a downward movement.

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Assumptions under Traditional Approach:

 The rate of interest on debt remains
constant for a certain period and
thereafter with an increase in leverage,
it increases.
 The expected rate by equity
shareholders remains constant or
increase gradually. After that, the
equity shareholders start perceiving a
financial risk and then from the
optimal point and the expected rate
increases speedily.
 As a result of the activity of rate of interest and expected rate of return, the WACC
first decreases and then increases. The lowest point on the curve is optimal capital
structure.

Graph:

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Example 3.1

Consider a fictitious company with the following data:

Particulars Case 1 Case 2 Case 3 Case 4 Case 5

Weight of debt 10% 30% 50% 70% 90%

Weight of equity 90% 70% 50% 30% 10%

Cost of debt 10% 11% 12% 14% 16%

Cost of equity 17% 18% 19% 21% 23%

WACC 16.3% 15.9% 15.5% 16.1% 16.7%

Total Capital 100000

Solution

Case 1

WACC = (0.17*90000 + 0.1*10000)/100000

WACC = 16.3%

Case 3

WACC = (0.19*50000 + 0.12*50000/100000

WACC = 15.5%

Case 5

WACC = (0.23*10000 + 0.16*90000)/100000

WACC = 16.7%

Explanation:

From case 1 to case 3, the company increases its financial leverage and as a result, the debt
increases from 10% to 50% and equity decreases from 90% to 50%. The cost of debt and
equity also rise as stated in the table above because of the company’s higher exposure to risk.
The new WACC is decreased from 16.3% to 15.5%. As observed, with the increase in the
financial leverage of the company, the overall cost of capital reduces, despite the individual

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increases in the cost of debt and equity respectively. The reason being that debt is a cheaper
source of finance.

Now, look at the situation in case 3 to case 5, the company increases its financial leverage
further and as a result, the debt is increased from 50% to 90% and equity from 50% to 10%.
The cost of debt and equity rise further. The new WACC is increased from 15.5% to 16.7%.
As observed, with the increase in the financial leverage of the company, the overall cost of
capital increases. The above exercise shows that increasing the debt reduces WACC, but only
to a certain level. After that level is crossed, a further increase in the debt level increases
WACC and reduces the market value of the company.

Financial Leverage and Value of Firm:

Financial leverage simply means the presence of debt in the capital structure of a firm. In
other words, we can also call it the existence of fixed-charge bearing capital which may
include preference shares along with debentures, term loans etc. The objective of introducing
leverage to the capital is to achieve maximization of wealth of the shareholders.

Financial leverage deals with the profit magnification in general. It is also well known as
gearing or ‘trading on equity’. The concept of financial leverage is not just relevant to
businesses but it is equally true for individuals. Debt is an integral part of the financial
planning of anybody whether it is an individual, firm or a company.

So, here we will prove that financial leverage influences the value of a firm with an example.

Example 3.1

Riser’s company has the following data with 2 plans A & B.

Riser’s & Co Plan A Plan B
Total Assets 100000 100000
Equity (10000 shares at 10 100000 0
each)
Debt and Equity(5000 50000 50000
shares at 10 each)
Interest Rate 10% 10%
EBIT 20000 20000
Solution

1. Plan A
RoE = Net Income/Equity

= (20000/100000) * 100

= 20%

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EPS = Net Income/No. of Shares

= 20000/10000

= 2 Rs. Per share

2. Plan B
Net Income = EBIT – Interest

= 20000 – 5000

= 15000

So, RoE = Net Income/Equity

= (15000/50000) * 100

= 30%

EPS = Net Income/No. of Shares

= 15000/5000

= 3 Rs. Per share

Results: Yes, financial leverage influences the value of firm and shareholder’s wealth.

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Capital Budgeting

Introduction:
Capital budgeting is a technique for evaluating big investment projects. Net Present Value
(NPV), Internal Rate of Return (IRR), Payback Period and Profitability Index are some
prominent capital budgeting techniques widely used in the finance arena. A project is passed
for implementation after it is approved by these
techniques.

Capital budgeting techniques are utilized by the

entrepreneurs in deciding whether to invest in a
particular asset or not. It has to be performed very
carefully because a huge sum of money is invested
in fixed assets such as machinery, plant etc.

The analysis is based on two things via first, the

stream of expected cash flows generated by utilizing
the assets and second, initial or future outlays
expected for acquiring the asset.

 Net Present Value

 Internal Rate of Return
 Payback Period
 Profitability Index

1. Payback Period:

Payback Period is the method of evaluation where no discounting of

cash flow comes into play. The term ‘payback period’ is the period in
which the initial outlay is covered with the revenues.

Example:
Suppose an initial outlay is $100 million and the revenue stream is $40 for the first 4
years.

Solution
The payback period is 2.5 years. Essentially, in 2.5 years, the entrepreneur gets his
investment back and revenue after this period is the profit for him.

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2. Net Present Value: (NPV)

Net present value (NPV) technique is a well-known

method for evaluating investment projects or proposals.
In this technique or method, the present value of all the
future cash flows whether negative (expenses) or positive
(revenues) are calculated using an appropriate
discounting rate and added.

From this sum, the initial outlay is deducted to find out the profit in present terms. If the
figure is positive, the techniques show green signal to the project and vice versa. This figure
is called net present value (NPV).

Example 1.1
Riser’s Company has proposed investment of 1 Lac PKR to start a project. The
company will receive 13% return from this project for each year. This project will be
continues for 5 years. Company has different cash flows from this project and that are;

Year 1 Year 2 Year 3 Year 4 Year 5

20000 30000 50000 20000 15000
Calculate net present value of all future cash inflows.

Solution
𝐶.𝐹 𝐶.𝐹 𝐶.𝐹 𝐶.𝐹 𝐶.𝐹
NPV = (1+𝑘)1 + (1+𝑘)2 + (1+𝑘)3 + (1+𝑘)4 + (1+𝑘)5

20000 30000 50000 20000 15000

NPV = (1+0.13)1 + (1+0.13)2 + (1+0.13)3 + (1+0.13)4 + (1+0.13)5

NPV = [17699 + 23494 + 34652 + 12266 + 8141]

NPV = [96252]

Result
So, the project will not be accepts because of low NPV. If NPV will be more than 1 Lac then
the project must be accepted.

3. Internal Rate of Return:

This method is also a well-known method of evaluation.

This has a severe connection with the first method i.e. Net
Present Value (NPV). In the NPV method, the discounting
rate is assumed to have known to the evaluator.

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On the contrary, the rate of discounting is not known in this method of Internal Rate of
Return (IRR). IRR is found out by equating the NPV equal to 0 with an unknown variable as
the discounting rate.

This discounting rate is found out using trial and error method or extrapolating and
interpolating methods and it is known as Internal Rate of Return (IRR). For evaluation
purpose, IRR is compared with the cost of capital of the organization. If the IRR is greater
than a cost of capital, the project should be accepted and vice versa.

Example 4.1
Initial investment 1 Lac, Five year cash flow is 20000, 30000, 50000, 20000, and 15000.

NPV at 13% is (96252). Calculate IRR.

Solution
We will take interest rate at which one NPV will be negative and other will be positive and
they are 10% and 12%.

Year C.F Low IR (10%) High IR (12%)

0 -100000
1 20000 18181.81 17857.14
2 30000 24793.38 24000
3 50000 37565.74 35714.29
4 20000 13660.27 12738.9
5 15000 9316.77 8522.73
Total 103517.97 (98833.06)

IRR = Low IR + {High IR – Low IR} {(NPV Low IR) / (NPV Low IR – NPV High IR)}

IRR = 0.1 + {0.12 – 0.1} {103517.97 / 103517.97 – (- 98833.06)}

IRR = 11%

4. Profitability Index: (Benefit to Cost Ratio)

The present value of future cash flows requires the

implementation of the time value of money
calculations to equate future cash flows to current
monetary levels. This discounting occurs because
the value of $1 does not equate to the value of $1
received in one year.

Money received closer to the present time is

considered to have more value than money received

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further in the future. The initial investment is the cash flow required at the start of the project.
A profitability index of 1 indicates breakeven, which is seen as an indifferent result. If the
result is less than 1.0, you do not invest in the project. If the result is greater than 1.0, you do
invest in the project.

Formula to Calculate Profitability Index

Profitability Index = Present Value of Future Cash Flows Generated by the Project/Initial
Investment in the Project.

PI = 103517.97/100000

PI = 1.03517

Involvement of Risk in Capital Budgeting:

There are different risks that are involved when we do investment in capital budgeting.

 Project-Specific Risk
 Industry-Specific Risk
 Competition Risk
 Market Risk
 Stand Alone Risk

1. Project Specific Risk:

The project itself or the associated activities of employees in pursuing the project can
increase the riskiness of a capital budgeting project. Management may not accurately predict
cash flows for the project. It may also become apparent that the project, while viable, cannot
meet its original schedule or that it requires different, more expensive material resources than
anticipated.

Businesses can manage some of this risk by undertaking several, similar projects. A set of
similar projects banks on the idea of most projects yielding predictable performance and
limits the damage from the failure of one project failure.

2. Industry Specific Risk:

Abrupt changes to industry-specific regulations, such as changes prompted by an industrial
accident or disaster, increases the risks of capital budgeting projects. Regulatory changes can
increase costs associated with safety management or widely used processes. Scientific
advancement or technological breakthroughs can also increase risks.

If, for example, you invest in new equipment and someone develops new machinery that does
the same work but costs half as much to purchase or run, you end up at a strategic and
financial disadvantage.

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3. Competition Risk:

Unforeseen activities on the part of competitors can increase risk. If a competitor invents a
new process that cuts production costs, it can undermine all of your projections in regard to
your project. On the flip side, if a competitor goes out of business with no warning, it can
radically increase demand on your business.

If your capital budgeting project aims at increasing your production capacity by 50 percent
over the next year, but demand increases 200 percent, you may find it impossible to meet the
demand.

Although, by nature, competition risk arises from uncertainty regarding competitors’ exact
plans and financial status, periodic competitor assessments can help you prepare
contingencies based on competitor weaknesses.

4. Market Risk:

Market risk refers to a broad range of sub-factors that can increase the riskiness of capital
budgeting projects. Changes in interest rates, inflation and stability or instability of economic
growth all impact the risks.

The level of risk aversion investors experience at any given time can also make projects
riskier, as high-risk projects receive far less favorable terms from investors during periods of
economic uncertainty.

5. Stand-Alone Risk:

This risk assumes the project a company intends to pursue is a single asset that is separate
from the company's other assets. It is measured by the variability of the single project alone.
Stand-alone risk does not take into account how the risk of a single asset will affect the
overall corporate risk.

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