Posted: October 8th, 2023

Explain, in your own words, whenand howthe composition of capital

Explain, in your own words, whenand howthe
composition of capital (the mix of debt and equity) does not affect the value
of the firm (i.e. the total value of debt and equity to creditors and
shareholders).Solution:The capital structure of an firm usually
comprise equity capital and debts. The objective of optimal capital structure
is to minimize the overall capital cost of the firm and thereby increase in its
value. The weighted average cost of capital (WACC) of a firm is given as –WACC = {Cost of equity (Ke) X
Weighted of equity (We)} + {Cost of
debts (Kd) X Weight of Debts (Wd)}Value of a firm is given as-
Value of a firm = Value of Equity
+ Value of Debts
Given the same amount of earnings
for equity the value of equity rises when the cost of equity decreases.
Similarly, for a given amount of earnings, the value of debts increases when
the cost of debts decreases. In nut shell, the value of firm would rise, if the
overall WACC decrease and vice versa.
Franco Modigliani and Merton
Millar (MM) produced capital structure irrelevance theory. They argued that the
capital structure of firm does not affect its value. For this, following
assumptions were made:
1. There is not taxation.
2. All investors have same
expectation of earnings from firm.
3. There is no transaction cost.
4. The capital market for Debt and
Equity are perfect.The equity holders of the firm
bears higher risk than the debts-holders and hence require higher rate of
return. In other word, the cost of equity usually remains higher than the cost
of debts.
Suppose a firm has 50% equity and
50% debts in its capital and cost of equity of equity and debts are 10% and 8%
respectively. So the WACC is 9% and say the value of firm is $ 10,000.
Now, the firm increase debts to
60% of total capital and reduce its equity weight to 40%. The increase in debts
would increase the leverage and the resulting financial risk for the equity
holders. Therefore, the equity holders would ask higher rate of return for the
higher financial risk. Consequently, the cost of equity would go up to say
10.5% and the overall WACC of firm would still be 9% { .60 X .08 + .40 X
0.105}. Given the same earnings from firm, the value of firm would remain same
due to same WACC.
Hence, if the given assumptions
hold, the value of firm will not change due to change in capital structure. The
value of firm would change only for change in total earnings.Discuss this statement:“leverage gives the illusion of higher
returns”.Solution:
There are two types of leverage:
(i) Operating leverage (ii) Financial leverage
Operating leverage: This leverage
arises due to fixed operating cost in business operations. The degree of
leverage can be determined by the ratio of fixed cost to variable cost of
operation to the company. If the ratio of fixed cost is high, then the company
is said to have higher operage.
Financial leverage: This leverage
arises due to the use of fixed cost capital in the capital structure of the
company. Higher the use of fixed cost capital like debts, higher the financial
leverage.With higher operating leverage, a
company can make higher profits with few sales, as the margin ratio { (sales- variable cost)/ Sales} is higher.
But, higher operating leverage also increases operating risk of the company. If
the company could not make sufficient sale to cover higher fixed cost, it may
lead to losses with magnifying impacts.Similarly, higher financial
leverage required higher earnings to meet the higher financial fixed cost.
Suppose, interest rate of debts is 8% .Therefore, this requires company to
generate more than 8% return on its assets. If the Return on assets fall below
the cost of fixed capital, the profitability and return on equity would fall.
This may also lead to condition of financial distress wherein the cost of
capital to the company may rise up substantially, and may require company to
liquidate its assets to meet the fixed payments.Would you expect the companies below to distribute a relatively
high or low proportion of current earnings?
Companies that have experienced an unexpected decline in profits
Growth companies with valuable future investment opportunities
Mature companies with cash that exceed future investment needsSolution:
Dividend distribution depends on
the current position and future investment need of the company. If company is
having good opportunities for investment
which will maximise the wealth of shareholders, company will distribute low
proportion of current earning or will announce zero dividend and vice versa.Companies that have experienced an unexpected decline in profitsCompanies will distribute
relatively high proportion of current earnings. Since the profit has been
declining there are relatively fewer investment opportunities and thus dividend
pay out will be higher.Growth companies with valuable future investment opportunitiesCompanies will distribute
relatively low proportion of current earnings due to ploughing back of profit
to meet the increasing investment needs.Mature companies with cash that exceed future investment needsCompanies will distribute
relatively high proportion of current earnings as the company is having
excessive cash that is sufficient to meet future investment need.You have been hired as a consultant to the board of directors of a
company. A board member asks you to craft a short presentation to the board
advising on the relevance of taxation issues (dividends vs capital gain) for
dividend policy.Solution:Taxation is an important external
factor for all financial decisions. Investor always looks at after tax return
from any investment. Therefore, it is necessary for the entity to devise such a
dividend policy that can benefit target investor and thereby get more funds at
ease and at lesser cost.The income form investment in
company can be two form - (i) periodic dividends (ii) capital gain/loss on the sale/redemption
of investment. The period dividend income to investor is charged with normal
tax rate prevailing in the respective year of income. On other hand, the
capital gain/loss is chargeable to tax in the year of sale only and that too at
capital gain tax rate, which may be less than or higher than the normal tax
rate.If the tax rate for the investor
for periodic dividend in less than the capital gain tax rate, then the investor
would prefer a dividend policy which provide for regular period dividend. On
the other hand, if the capital gain tax is beneficial to the investor in
compared to normal taxation, then investor would prefer the company to
re-plough the periodic earning and not to declare the dividend.Apart from above, the taxation
system applicable to the company & investor may also affect dividend
policy. In case of double taxation system, the earnings of corporate are taxed
first at corporate level and then again taxed when distributed as dividend in
hand on investor.
In case of Split-rate system of
corporate taxes, the distributed earnings are taxed at different rates than the
rate applicable for retained earnings. If the rate of tax on distributed
earnings is low, then the investor with low tax bracket would prefer periodic
dividends then the capital gain.It is also notable that capital
gains taxes do not have to be paid until the shares are sold, whereas taxes on
dividends must be paid in the year of received. Therefore, availability
of/preference to liquidity with investor would also affect the dividend policy.Calculate the after tax return on equity (ROE) for the following
firm:Total value of assets: $150m
Capital structure: 50% equity, 50% debt
Return on assets: 10%
Interest rate: 6%
Tax rate: 30%What happens to the ROE if the capital structure changes to 10%
equity and 90% debt? What does this illustrate?Solution:ParticularsAmt.
$mTotal
Asset150Debt75Equity75Net
Income (PAT)15ROE20%Computation
of ROE with changed capital structureParticularsAmt.
$mTotal
Asset150.00Debt135.00Equity15.00PAT15.00PBT21.43Add:
Interest (75*6%)4.50EBIT25.93Less:
Interest on revised debt8.10PBT17.83Less:
Tax @ 30%5.35PAT12.48ROE83.2%

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