Project Appraisal

Swagat Kishore Mishra

Department of Economics
Lecture 8
Email: swagat@goa.bits-pilani.ac.in
Tel. 0832-2580207 (O) 08879506995 (M)

September 6, 2014

Course No. ETZC414 Project Appraisal

Outline
COST OF CAPITAL
CAPITAL STRUCTURE OF FIRM
COST OF DEBT
COST OF EQUITY
WEIGHTED AVERAGE COST AND MARGINAL COST

Capital Structure
Capital structure refers to the kinds of securities and the
proportionate amounts that make up capitalization.
It is the mix of different sources of long-term sources such as equity
shares, preference shares, debentures, long-term loans and
retained earnings.
The term capital structure refers to the relationship between the
various long-term source financing such as equity capital,
preference share capital and debt capital.
Deciding the suitable capital structure is the important decision of
the financial management because it is closely related to the value
of the firm.
Capital structure is the permanent financing of the company
represented primarily by long-term debt and equity.

FINANCIAL STRUCTURE
The term financial structure is different from the capital structure.
Financial structure shows the pattern total financing.
It measures the extent to which total funds are available to finance
the total assets of the business.

Financial Structure = Total liabilities

Or
Financial Structure = Capital Structure + Current liabilities

Finance Vs Capital

OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the
weighted average cost of capital is minimum and thereby the value
of the firm is maximum.
Optimum capital structure may be defined as the capital structure
or combination of debt and equity, that leads to the maximum
value of the firm.

CAPITAL STRUCTURE THEORIES

Capital structure is the major part of the firms
financial decision which affects the value of the firm
and it leads to change EBIT and market value of the
shares.
There is a relationship among the capital structure,
cost of capital and value of the firm.
The aim of effective capital structure is to maximize
the value of the firm and to reduce the cost of
capital.

There are two major theories explaining the

relationship between
capital structure,
cost of capital and
value of the firm.

FACTORS DETERMINING CAPITAL STRUCTURE

Leverage
It is the basic and important factor, which affect the capital
structure. It uses the fixed cost financing such as debt, equity
and preference share capital. It is closely related to the overall
cost of capital.

Cost of Capital
Cost of capital constitutes the major part for deciding the capital
structure of a firm. Normally long- term finance such as equity
and debt consist of fixed cost while mobilization. When the cost
of capital increases, value of the firm will also decrease. Hence
the firm must take careful steps to reduce the cost of capital.

Steps to reduce the cost of capital

(a) Nature of the business:
Use of fixed interest/dividend bearing finance depends upon the nature of
the business. If the business consists of long period of operation, it will
apply for equity than debt, and it will reduce the cost of capital.

(b) Size of the company:

It also affects the capital structure of a firm. If the firm belongs to large scale,
it can manage the financial requirements with the help of internal sources.
But if it is small size, they will go for external finance. It consists of high
cost of capital.

(c) Legal requirements:

Legal requirements are also one of the considerations while dividing the
capital structure of a firm. For example, banking companies are restricted
to raise funds from some sources.

(d) Requirement of investors:

In order to collect funds from different type of investors, it will be appropriate
for the companies to issue different sources of securities.

Homework

Distinguish between debt and equity.

What is significance of debt-equity ratio?
What are debentures?
What are preference shares?
Convertible, non-convertible,
reedemable, non-reedemable,
participating and non-participating

Traditional Approach
It is the mix of Net Income approach and Net Operating Income approach.
Hence, it is also called as intermediate approach.
According to the traditional approach, mix of debt and equity capital can
increase the value of the firm by reducing overall cost of capital up to
certain level of debt.
Traditional approach states that the Ko decreases only within the
responsible limit of financial leverage and when reaching the minimum
level, it starts increasing with financial leverage.

Assumptions
There are only two sources of funds used by a firm; debt and shares.

The firm pays 100% of its earning as dividend.

The total assets are given and do not change.
The total finance remains constant.
The operating profits (EBIT) are not expected to grow.
The business risk remains constant.
The firm has a perpetual life.
The investors behave rationally.

Net Income (NI) Approach

Net income approach suggested by the Durand.

According to this approach, the capital structure decision is relevant

to the valuation of the firm. In other words, a change in the capital
structure leads to a corresponding change in the overall cost of
capital as well as the total value of the firm.
According to this approach, use more debt finance to reduce the
overall cost of capital and increase the value of firm.
Net income approach is based on the following three important
assumptions:

Assumptions
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the
investor.
where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt

Market value of the equity can be

ascertained by the following formula:

Net Operating Income (NOI)

Approach
Another modern theory of capital structure, suggested by
Durand. This is just the opposite to the Net Income
approach.
According to this approach, Capital Structure decision is
irrelevant to the valuation of the firm. The market value of
the firm is not at all affected by the capital structure
changes.
According to this approach, the change in capital structure
will not lead to any change in the total value of the firm and
market price of shares as well as the overall cost of capital.

Assumptions

The overall cost of capital remains constant;

There are no corporate taxes;
The market capitalizes the value of the firm as a whole;
Value of the firm (V) can be calculated with the help of the
following formula

Modigliani and Miller Approach

Modigliani and Miller approach states that the financing
decision of a firm does not affect the market value of a firm in
a perfect capital market.
In other words MM approach maintains that the average cost
of capital does not change with change in the debt weighted
equity mix or capital structures of the firm.

Assumptions
There is a perfect capital market.
There are no retained earnings.
There are no corporate taxes.
The investors act rationally.
The dividend payout ratio is 100%.
The business consists of the same level of business risk.

Cost of Capital
Cost of capital is the rate of return that a firm must earn on its

project investments to maintain its market value and attract

funds.
Cost of capital is the required rate of return on its investments

which belongs to equity, debt and retained earnings.

If a firm fails to earn return at the expected rate, the market
value of the shares will fall and it will result in the reduction of

overall wealth of the shareholders.

Assumptions
Cost of capital is based on certain assumptions which are closely associated
while calculating and measuring the cost of capital. It is to be considered
that there are three basic concepts:

1. It is not a cost as such. It is merely a hurdle rate.

2. It is the minimum rate of return.
3. It consists of three important risks such as zero risk level, business risk and
financial risk.
Cost of capital can be measured with the help of the following equation.

Working Capital
Working capital is the capital which is needed to meet the day-to-day
transaction of the business concern.
It may cross working capital and net working capital. Normally working
capital consists of various compositions of current assets such as inventories,
bills, receivable, debtors, cash, and bank balance and prepaid expenses.

Capitalization
Capitalization refers to the process of determining the
quantum of funds that a firm needs to run its business.

Capitalization is only the par value of share capital and

debenture and it does not include reserve and surplus.
According to Guthman and Dougall, capitalization is the
sum of the par value of stocks and bonds outstanding.
Capitalization is the balance sheet value of stocks and
bonds outstands.
Bonneville and Dewey

According to Arhur. S. Dewing, capitalization is the sum

total of the par value of all shares.

TYPES OF CAPITALIZATION
Over Capitalization
Under Capitalization
Water Capitalization

THANK
YOU
September 6, 2014

32