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Grp-3 Capital Structure and Firm Value

Grp-3 Capital Structure and Firm Value

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Deepak Sood
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19 views

Grp-3 Capital Structure and Firm Value

Grp-3 Capital Structure and Firm Value

Uploaded by

Deepak Sood
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Capital Structure and Firm Value

Group-3

Chintamani Trivedi (34BM14)


Chirag Gupta (34BM15)
Debdutta Sarangi (34BM16)
Deepak Kumar Sood (34BM17)
What is Capital Structure?
 Capital structure is the specific combination of debt
and equity used by a company to finance its overall
operations and growth

 Debt consists of borrowed money that is due back to


the lender, commonly with interest expense

 Equity consists of ownership rights in the company,


without the need to pay back the investment
A Historical perspective
 Looking historically at corporate debt and the appropriate
level of debt, 1980s were the decade of debt since there was
growing use of debt by American non-financial
corporations

 Deals such as the $11 billion purchase of Kraft by Phillip


Morris and the leveraged buyout of RJR Nabisco for $17.6
billion involved huge amounts of borrowing and focused
attention on the issue of debt

 The question was framed in terms of whether the debt was


excessive
Market Value vs. Book Value
Market value based debt - across industries and timelines
Market value based debt – retail stores
and airlines
Firm Value

 The value of a firm is defined to be the sum of the


value of the firm’s debt and the firm’s equity:

V=B+S

 If the goal of the firm’s management is to make the


firm as valuable as possible, then the firm should
pick the debt-equity ratio that makes the pie as big as
possible
Stockholder Interests
There are two important questions:

1.Why should the stockholders care about maximizing


firm value?

Perhaps they should be interested in strategies that maximize


shareholder value

2.What is the ratio of debt-to-equity that maximizes


shareholder value?

As it turns out, changes in capital structure benefit the


stockholders if and only if the value of the firm increases
egree of Operating leverage (DOL)
Degree of operating leverage (DOL), defined as
follows:

%ΔEBIT
DOL = %ΔSales

An alternative way of calculating DOL is


Sales - Variable costs
DOL = Sales – Variable costs – Fixed costs

Measures EBIT Variability with respect to change in Sales and the


impact of fixed costs on the earnings of the firm
Degree of Financial leverage
(DFL)
Degree of Financial leverage (DFL), defined as
follows:

%ΔNPAT % Δ EPS
DFL = %ΔEBIT % ΔEBIT

An alternative way of calculating DFL is


Sales - Variable costs-Fixed costs
DFL = Sales – Variable costs – Fixed costs – Interest

Measures impact of fixed costs of interest on the earnings for the


shareholders.
Modigilani-Miller (M&M) Theory
 The M&M or Modigliani-Miller Theorem is one of the
most important theorems in corporate finance

 The theorem was developed by economists Franco


Modigliani and Merton Miller in 1958

 The main idea of M&M theory is that the capital


structure of a company does not affect its overall value
Assumptions of the M&M Model
Perfect Capital Markets:

1. Perfect competition

2. Firms and investors can borrow/lend at the same rate

3. Equal access to all relevant information

4. No transaction costs

5. No taxes
M&M Proposition I (No Taxes)

 We can create a levered or unlevered position by adjusting


the trading in our own account

 This homemade leverage suggests that capital structure is


irrelevant in determining the value of the firm:

VL = VU
M&M Proposition II (No Taxes)

Leverage increases the risk and return to stockholders:

Rs = R0 + (B / SL) (R0 - RB)

where:

RB is the interest rate (cost of debt)


Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity
The delicate tradeoff i.e. D/E ratio
There are Internal and External factors affecting the
Debt/Equity ratio:

 Degree of risk: Larger debt implies larger interest repayments and potential
bankruptcy risk in case of inability to pay; Equity securities reduce risk since
they need not be repaid and dividends need not be declared

 Increasing owner’s profits: Debt financing offers the ability to increase the
owner’s return without increasing their investment

 Surrendering operational control: A firm is unable to sell bonds without


agreeing to allow the bondholders to excise certain operational controls at the
same time

 Other factors such as Level of interest rates, Level of stock prices, Tax
policy on interest and Dividends
Optimal Capital Structure
 The optimum capital structure implies combination of debt and equity that leads to:
 maximum value of the firm and wealth of its owners
 minimizes company’s cost of capital

 If return on investment is higher than fixed cost of funds at the firm:


 leverage funds having a fixed cost, such as debentures, loans and preference share
capital
 leads to increased earnings per share and market value

 Tax leverage should be used advantageously while using debt since the firm saves
considerably in tax payments as interest is a deductible expense in tax computation

 The firm should avoid undue financial risk attached with increased debt financing since
shareholders might perceive it as high risk thereby impacting the market price of the
shares

 The capital structure should always be kept flexible


Thank You!!

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