Lecture - 5 capital structure
Sunday, November 22, 2020
12:02 PM
We invest /= combination of equity and debt (loan) 
Leverage ratio=  how much we borrowed and how much we invest 
Borrow = cost for it = interest
Equity = cost for it = dividends
WACC  = cost of debt , proportion of debt
                 cost of equity, proportion of equity
Cost of debt is tax free and it is less
Cost of equity is taxable and cost is high 
Particulars
Option 1
Option 2 
Option 3
Investment = 10,000
5% Debt = 40%= RO 4,000
Equity = 60%
=RO 6,000
5% Debt 50%=RO 5,000
Equity 50%=RO 5,000
5% Debt 80%=RO8,000
Equity 20%=RO 2,000
Tax = 20%
Profit before interest and tax (PBIT = 1000)
PBIT
1,000
1,000
1,000
Less interest
(200)
Profit before tax
800
750
600
Tax @ 20%
Profit after tax(PAT)
640
600
480
EPS (PAT/N)
0.1067
0.1200
0.240
If we borrow less we pay more tax(160)  (option 1) and EPS will also be less ( 0.1067)
If we borrow more, (option 3) we pay less tax (120) and EPS will be more (0.240) 
If we borrow more and more, the credibility will decrease , the rate of interest will increase.
Option 1 - Interest = 4000 x (5/100) = 200 
Option 2 - Interest = 5000 x (5/100) = 250 
Option 3 - Interest =8,000x (5/100) = 400
Tax = Profit before tax x tax rate
Option 1 =   800 x (20/100) = 160 
Option 2 =   750 x (20/100) = 150 
Option 1 =   600 x (20/100) = 120 
EPS     Share are RO 1.000 (assume) 
Option 1 = 640/6000 = 0.1067 earnings per share
Option 2 = 600/5000 = 0.12 earnings per share
Option 3 = 480/2000 = 0.24 earnings per share
Gearing = combination of debt and equity 
L = leverage (equity + debt)  ; U = unleverage ( Total equity)
Business in financed = the combination 
Refer the above example ; % of debt and % of equity
Every business need appropriate gearing = neither more investment nor less investment 
Time value of money = 
Gearing = Leverage = Debt / (debt + equity)
Option 1 = Debt 4000; equity 6000
     gearing = 4000/(4000 +6000)=0.4 or 40%
Option 2 = 5000/(5000 +5000)=0.5 or 50%
Option 3 = 8000/(8000 + 2000)=0.8  or 80%(high exposure)
Anyone borrows loan, they should plan very systematically to pay off loans on time with interest 
2007
LT Borrowing = Debt(Total non-current liabilities )
                         = 25,000
Total Equity = 40,500
Gearing = 25,000 / (25000 +40,500)=0.3817 or 38.17% - 2007
Gearing Ratio = 21,500/(21,500+29500) = 0.4216
                          = 42.17 % = 2006
2007 = 38.17%
2006 = 42.17%
In 2006, 42.17% of the company was financed using debt, this fell to 38.17% by 2007
2006 more debt, by 2007 the company repaid the debt, lower risk, lower exposure 
SME = small and medium enterprises 
People will start with small amount of investment and slowly they make it BIG
RO10,000
Borrowing is not important, what is important, 
How best we invest the borrowed money in the business 
Bonds / debt / loan 
Or 
Public Debt = equity 
IPO = Initial Public Offer (way of financial resource to be raised by the firm from public in the form of equity
24th November, 2020
PBIT
Less = interest
PBT
Less tax
Firm will pay tax after paying interest 
Debt/bonds/ loans = fixed rate of interest & fixed duration 
Disadvantage:
Equity shareholders will have voting rights (they have the right to frame the policies and decision making ) 
Higher the debt lower the credit ratings, higher the risk) 
Taxes =dividend tax, capital gain tax & direct tax and indirect tax 
Capital structure = combination of debt & equity in the total capital
In perfect markets leverage is irrelavant 
All equity = U = unleveraged 
C = 300 ; r = 0.15
Debt = 0 ; L = 0
 WACC = re(1 - L)   + L (1 - t) rd
RC's equity value =    Perpetuity =  c/ r  =  300 / 0.15 = 2,000
Total value of firm = value of equity + value of Debt
                                 = 2,000      + 0   = 2,000 
WACC = re(1 - L)   + L (1 - t) rd
                     =  0.15 x 1   + 0  = 0.15 or    15%
Total value of the Firm = 2,000
Value of debt = 1,000, payoff equity of 1,000
Value of equity = (value of firm - value of debt)
                             = 2,000 - 1,000 
Value of equity = 1,000
Total firm value = 1,000 + 1,000 = 2,000 
Value of RC s = 1,000
In proposition 1 
The value of unleveraged firm and leverage firm will REMAIN SAME
Proposition II
You borrow, the equity is very expensive 
Debt = 1,000 @ 10%
Annual interest expenses = 1,000 x 0.10 = 100
Annual expected cash flow = cash flow - interest expenses
                                                 =     300       -    100
                                                = 200
 return on equity (re)  = annual expected cash flow/ equity value
                                           =   200  / 1000 = 0.20 or 20% 
In proposition I the return on equity = 15% whereas in proposition the return on equity = 20%
ini
Wd   = value of debt / value of firm 
         = 1,000 / 2,000 = 0.5 
We    value of equity / value of firm
        = 1,000 / 2000 = 0.5 
 rDAT  =  rDBT   =  10% or 0.10;  re  = 20% or 0.20
WACC = (0.20 x 0.5) + (0.10 x 0.5) = 0.15 or 15%
Perfect markets (NO  TAXES)
Propositon 1  = WACC 15%
Proposition II = WACC 15%
100% equity (U)
50% equity + 50 % Debt (L)
Value of equity 
2,000
1,000
Total value of the firm 
2,000
2,000
Required return on equity 
15%
20%
WACC
15%
15%
In proposition II, the cost of equity is increased from 15% to 20% , risk also increases 
Debt is increasing , risk will also increases 
PBIT
Interest (assume 5% interest) 
PBT
-tax (paying taxes after paying interest) 
PAT
Dividends(more profits more dividends/cost of equity will also increases
Retained earnings 
The value of the firm will maximum = completely debt(in practical , it never happens) 
After corporate income tax cash flow = expected annual cash flow (1 - tax rate)
  =  300 (1 -0.40) = 300 (0.6) = 180  C
Value of equity = perpetuity =  c/ r  = 180 / 0.15 = 1,200
       Unleveraged (No debt)
Vu    =  Value of equity =  1,200
WACC = re(1 - L)   +   L ( 1- t) rd 
                 0.15 (1)  + 0 = 0.15 or 15%
Debt = 1,000 @ 10%
Tax rate = 40%
Expected annual Cash flow ( c) = 300
Annual interest expenses = value of debt x rate of interest 
                                                  1,000 x 0.10 = 100 
(PBIT -I)(1-t)
Annual expected cash flow    =  300
Less = interest expenses         = (100)
Profit before taxes                        200
Less taxes @40% (200 x 0.40)=(80 )
After corporate tax cash flow =  120  C
Value of equity = perpertuity = c / r  = 120 / 0.20 = 600 
Total value of the firm = value of equity + value of Debt
                                        = 600  + 1000 = 1600 ( V)
Wd  =  value of debt / total value of firm 
         = 1000 / 1600 = 0.625 
We    = value of equity / total value of firm
         = 600 / 1600 = 0.375 
rDAT   = rdbt ( 1 - t)  = 0.10 ( 1- 0.40) = 0.06 or 6%
  re     =   20% or 0.20
WACC =  (0.20 x0.375)  +  (0.06 x 0.625) = 0.1125 
WACC = 0.1125 or 11.25%
Equity 100% (U)
Equity 37.5% + debt 62.5% (L)
 Value of equity 
1200
600
Total value of the firm
1200
1600 (D=1,000 +E=600)
Required return on equity
15%
20%
WACC
15%
11.25%
If investor invest as a 100% equity, the WACC is higher, whereas a combination of debt and equity, the WACC is lesser
When a firm borrow more, they pay more interest but less taxes, the advantage of taxes will be received by equity shareholders
Unleveraged RC pay taxes = C x tax rate
                                            =  300 x 0.4 = 120 
Leverage RC pay taxes = (C- interest ) x tax rate
                              = (300 - 100) x 0.40 = 80 
Savings = 120 - 80 = 40 in annual income tax
The value of this savings = c/r
C = 40;  r = rate of interest = 0.10
Value of savings = 40 / 0.10 = 400 (gain belongs to shareholders) V 
VL = Vu +tax saving on Vdebt
  VL  =  1200 + 400 = 1600 
29th November, 2020
Advantage of Debt = tax advantage 
Firm will pay interest and then tax
When debt is taken, we pay more interest and less tax 
Opportunity cost = which is the best available option
More debt more advantage
More debt less credit ratings more borrowing cost (rate of interest) 
WACC = cost of debt + cost of equity
Standard rule says that the best (optimal) capital structure combination is where the WACC is minimum
More and more debt borrowing = cost of borrowing will increasing automatically the WACC will also be increased.
Example = 60% borrowing 40% equity (very positive combination)
  90% borrowing and 10% equity (very risk combination) 
Slowing the WACC line is going down, if a firm /investor goes on borrowing the WACC is increase ( cost will be high) 
Every investor/firm must decide to what extent we can manage WACC and borrow debt 
Financial Distress :  
overburdening of loan amount 
Investor should not take loan to pay of loan
Investor is losing his wealth in stock market 
Direct costs: (Quantitative)-measure
Legal notice , 
Insolvent 
Monetary amount is very less 
INDIRECT COST  - Qualitative
Sell off the assets, pay off liabilities , pay to the shareholders (last )
Lost sales and loss of goodwill = the firm or investor is not giving a positive message to the market.
Borrowing will have implications 
Shareholders - bond holders (borrowing) 
If loan amount is available at a less rate with less accountability - decisions are going to be aggressive - it will have a drastic impact in long term
Equity component will be less and debt component will be more 
The priority will be for repayment of interest and principal amount then only it will be available to equity shareholders 
I am already doing the business
A portion of profits will be retained and reinvested or created in the form of RESERVES 
In case of need, when we need finance
I will check my internal resources- first step
Borrow (less cost) - second option 
Last option is issue of equity shares = selling the ownership to outsiders
Stock price will decrease 
Shareholders = 29 participants 
Value of the firm = 5800 RO
Value per share = 5800 / 29 = 200 value par share 
Issue additional shares
Existing 29 + new 20 shares
Value of the firm = 5800 will remain same
Value per share = 5800 / (29 +20) = 118.3673 (here the value of the share will decrease) 