JAIIB AFM Module-C Unit 6 : Capital Structure and Cost Of Capital

JAIIB Paper 3 AFM Module C Unit 6 : Capital Structure and Cost Of Capital (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 3 (Accounting and Financial Management for Bankers) includes an important topic called “Capital Structure and Cost Of Capital”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 3 (AFM) Module C (FINANCIAL MANAGEMENT ) Unit 6 : Capital Structure and Cost Of Capital Aspirants must go through this article to better understand the topic, Capital Structure and Cost Of Capital, and practice using our Online Mock Test Series to strengthen their knowledge of Capital Structure and Cost Of Capital. Unit 6 : Capital Structure and Cost Of Capital

Introduction

  • A business firm needs money to carry on its business.
  • The money is required for creating fixed assets like factory building, plant and machinery, office equipment etc.
  • For creating these assets, the firm has to arrange for money which cannot be repaid in a short period of time.
  • Money is also required for current assets like purchasing raw materials, converting them into finished goods and selling on credit to customers.
  • These current assets are partly financed by the short term sources of money like credit by suppliers and bank overdrafts. But a portion is to be financed by long term sources also.

So, the firm has to arrange for money for long term for two purposes:

  •  1st: Creating fixed assets and
  • 2nd:  Partly financing the current assets required to be held by the firm, also called the working capital.
  • The long term sources of capital, used by the firm to part finance the total working capital requirements is the margin money or better known as the Net Working Capital (NWC).

Meaning of Capital Structure 

  • This long term money required by the firm is known as the capital.

Now, this long term money can be from two sources:

  • EQUITY or owner’s money
  • DEBT

DIFFERENCE: Equity is the risk capital put in the business by the owners who get return on their investment by way of profits earned by the firm while the debt providers are not owners of the firm and they lend the money to the firm on agreed terms of repayment and interest payment.

The purpose of these lenders is to earn interest on their surplus funds and at the same time not to take any business risk as they do not share profit or loss of the firm.

Capital Structure is referred to as the proportion of debt and equity in the total long term funds raised by the firm.

Illustration:

A firm starts its business by raising total long term funds of Rs. 500 lakh, to meet its requirements, as under: 

  • Equity capital 200 lakh
  • Debt capital 300 lakh

This gives a capital structure of 60% debt capital (300/500) and 40% equity capital (200/500)

Leverage/Gearing 

  • If the ratio of debt capital is very high, it is called Highly Leveraged or highly geared firm.
  •  If the ratio of debt capital is low; it is called a Low Leveraged or low geared firm.

Examples of debt capital are:

    • Term loans.
    • Debentures,
    • Corporate deposits,
    • Fixed deposits from public, etc.

Examples of equity capital include:

    • Partners’ capital in a firm,
    • Equity and preference shares issued by a company,
    • Retained (undistributed) profits.

Factors Influencing Decision On Capital Structure Of A Firm

The decision on proportion of debt and equity, as also the instruments through which these two are to be sourced, is influenced by various factors, the main of which are as under:

Norms prevailing in the financial system:

  • The banks and financial which are the prominent source of debt financing, have their lending policies and norms .
  • They will not permit a borrowing firm to violate the prescribed debt equity norms.
  • For example, if a company applies for a term loan to set up cement factory with 90% debt and 10% equity, the Indian lender will not approve it and ask the company to improve the structure of the project (to say 60% debt and 40% equity).
  • In capital market also, the investors will not subscribe to the debt or equity instruments of a company if the debt equity proportion is beyond a reasonable point.
  • Rating agencies also take note of the proportion of debt and equity, in their analysis, while assigning a rating to any financial instrument of the company

Degree of control:

  • If the promoters of a company, do not want to dilute their voting rights beyond a point, they will not issue further equity capital to outsiders.
  • In such a case, they will prefer additional funds by issuing debt instruments like debentures.

Trading on Equity

  • This concept is based on the premise that the firm will earn more profit by deploying funds than the cost of those funds.
  • For example, if the cost of borrowing Rs. 1 crore is Rs. 12 lakh in a year, the firm will earn Rs. 15 lakh by investing 1 crore during the year. The surplus of Rs. 3 lakh will be additional profit for the owner over and above the profit earned by investing the capital which they have brought in the firm.
  • Thus, more the debt taken by a firm, more will be the profit on each rupee of the equity capital. Trading on equity means taking advantage of equity capital to borrow funds on reasonable basis.

Cost of Debt

  • Debt is like a double edged sword.
  • Companies want to take advantage of the fact that interest paid on debt is tax-deductible. But, a high proportion of debt results in increased return on each unit of equity capital only when business conditions are good.
  • Adverse business conditions, over a prolonged period of time, result in debt cost affecting the viability and ultimately the solvency of the firm.

Size of the firm and its business plans

  • The capital structure of a firm also depends on the size of the firm, its business model and market practices also.
  • A firm with little intention of future expansion, may not keep a high equity capital base and may prefer higher proportion of debt because the debt is easier to be repaid.
  • Reduction in equity capital is more difficult as share buy-back is subject to strict regulatory compliance and is a slow process.

Theories/Approaches On Capital Structuring

There are many theories/approaches which establish the relationship between financial leverage, weighted average cost of capital and the total value of the firm.

  • Net Income Approach
  • Net Operating Income Approach and 
  • Traditional Position

Net Income Approach 

  • Net Income Approach was put forth by David Durand.
  • This approach assumes that the cost of debt and the cost of equity remain same irrespective of the proportion of debt and equity.
  • As the cost of debt < the cost of equity, the overall cost of capital (WACC) can be decreased through higher debt proportion, thus increasing the value of the firm

Net Operating Income Approach (NOI) 

  • Net Operating Income Approach, developed by David Durand, assumes that the WACC or the value of a firm remains unaffected by the change of debt proportion in the capital structure.
  • According to this approach, the benefit that a firm derives by debt is negated by the simultaneous increase in the required rate of return by the equity shareholders as the increased debt increases the risk perception of the firm, mainly bankruptcy risk.
  • According to this approach, the market value is dependent on the operating income and the business risks of the firm.
  • Both these factors are not impacted by the financial leverage.
  • Financial leverage does not impact the operating income of the firm. Therefore, change in proportion of debt and equity does not make any change in the value of the firm.

Traditional Position 

  • The traditional position takes into account a different but more realistic approach towards cost of debt capital and cost of equity capital. According to this approach, when the proportion of debt capital increases in the capital structure of a firm, the cost of debt will start increasing beyond a point.
  • This is because the creditors will be wary of higher risk due to enhanced leverage of the firm.
  • This theory also assumes that the cost of equity capital also increases with increasing leverage.
  • It remains constant up to a certain level of leverage, gradually increases thereafter and beyond a point, shows sharp increase.
  • Due to this type of relationship between leverage and costs of debt and equity capitals, as the leverage of a firm increases, WACC may show decline up to a point, remain constant up to another point and increase thereafter

Assumptions in the Approaches on Capital Structuring 

  • Both Net Income and Net Operating Income approaches assume that the increase in debt will not affect the risk perception of the creditors and the rate of interest (cost) of debt will not change with leverage. However, the traditional approach assumed otherwise
  • All firms distribute the entire profit to the equity holders.
  • For the sake of simplicity, total capital is assumed to be comprising of only debt capital and equity capital.
  • There is no income tax, individual as well as on the firm.
  • The business conditions will remain same so that the operating profit is not changed.
  • There is no transaction cost and the frim can change its capital structure whenever it wants so.
  • There are no redeemable sources in the capital composition of the firm and will continue for long time.
  • Capital market is perfect and all investors are rational.

Taxation & Capital Structure

  • When determining a firm’s capital structure, taxation must be taken into consideration.
  • As we have discussed earlier, Earnings Before Interest and Tax (EBIT) of a firm will not be affected by the capital structure of the firm.
  • If a firm has EBIT of Rs. 100 lakh with 100% debt and 0% equity, it will have the same EBIT of Rs. 1 lakh with capital structure of 0% debt and 100% equity.
  • What will change is the net profit of the firm i.e. the profit after paying interest and tax.

Illustration: 

Firm ABC, having total capital of Rs. 2 lakh, has EBIT of Rs. 1 lakh for the year. Income tax for the firm (Corporate tax) is at 25%. Rate of interest on debt is 12% p.a.

Let us consider the following 3 scenario: 

  • Scenario A: Debt 100%, Equity capital 0%
  • Scenario B: Debt 50%, Equity capital 50%
  • Scenario C: Debt 0%, Equity capital 100%

It can be observed from the above table that the combined income on debt and equity capital increases as the leverage of the firm increases.

This is because of 100% tax exemption provided under the IT Rules on interest paid on debt. So, should the firms go for more debt capital in comparison to the equity capital?  The answer is not so simple. We have discussed earlier the perils of disproportionately high debt for the firm, including the risk of bankruptcy. Also, as the leverage increases, the investors will have a higher risk perception of the firm and the cost of debt and equity capital may not remain same, as assumed in above.

Concept Of Cost Of Capital

  • The capital of a firm represents its long term sources of funds, shown in the balance sheet as liabilities. It consists of both debt capital and the equity capital.
  • The common perception is that the equity capital of a firm does not involve any cost as it is under no legal obligation to pay to the equity holders. Also, it can be argued that the equity capital includes retained profits, which are earned by the firm and so no cost is involved in using such funds.
  • But, let us think from the point of view of equity holders. They have taken more risk by investing in the firm compared to any other investor. The debt capital investors are assured of a fixed return irrespective of whether the firm earns profits or not. They have legal rights to recover their money from the assets of the firm The preference share-holders also get an assured return on their investment as also preference over the equity share-holders in case of liquidation of the firm.
  • When providers of equity capital are taking maximum amount of risk and also foregoing the opportunity cost of their capital, they expect that the firm will earn for them more than what other investors are getting. If the firm fails to do so, the equity capital investors may like to put their money in other investment avenues.
  • That is why it is said that the cost of equity capital is more than the prevailing market cost of preference and debt capital.
  • Whereas, calculating the cost of preference and debt capital is comparatively simpler, arriving at the cost of equity capital is often a difficult exercise as the risk premium expected by equity capital investors depends on the perception of the investors, to a considerable extent.
  • Why it is important to know the correct cost of capital of the firm?
  • It is important because it provides a benchmark above which the firm should earn from its business.
  • For example, if the firm is appraising an investment proposal on the premise that the cost equity capital is zero, it may approve a project which gives a low rate of return.
  • The cost of capital should correctly represent the opportunity cost of the various components of capital structure of the firm to arrive at the correct benchmark for the firm to evaluate investment proposals.

Cost Of Debt Capital

  • If the firm raises a term loan from a bank or a financial institution, the rate of interest is transparently known.
  • Term loans are not traded in the secondary market and the bank has already fulfilled its expectations of returns on its funds by quoting the interest rate on the term loan.
  • Therefore, no calculation is involved in arriving at the cost of this and the rate of interest charged by the bank is taken as the cost.
  • PROBLEM: In case of bonds and debentures.
  • But what we are talking here is the rate expected by the investors from these debentures in the secondary market.
  • That rate will depend on the coupon rate as also investors’ perception of firm’s risk profile and prevailing market conditions.
  • The return on a bond/ debenture, purchased by an investor in the secondary market, is equal to Yield to Maturity (YTM) of that bond/debenture,
  • The formula for which is:  The computation of YTM by this formula involves trial and error.

The approximate YTM can be calculated by using the formula: 

YTM = {Annual interest payment + (M – P)/n}/ (0.6 × P + 0.4 × M)

where M is the Maturity value,

P is the present market value and

n is the number of years left to maturity.

Illustration: 

A firm’s debentures with face value of Rs.100 and coupon of 10% p.a. are having a current market price of Rs.90. The number of years left to maturity are 4 years. What is the cost of debt capital for the firm?

YTM = {Annual interest payment + (M – P)/n}/ (0.6 × P + 0.4 × M)

YTM = {10+ (100-90)/4}/(0.6 × 90 + 0.4 × 100)

= (10+2.5)/(54 + 40) = 12.5/94

= 13.30%

Cost Of Preference Capital

  • Preference capital carries a fixed rate of interest (called dividend), like debentures but has higher risk perception as it comes after secured creditors in receiving money in case of liquidation of the firm.
  • The interest paid is also not tax deductible.

As in the case of debentures, the approximate cost of preference capital (YTM) can be calculated by using the same formula: 

  • YTM = {Annual interest payment + (M – P)/n}/ (0.6 × P + 0.4 × M)
  • where M is the Maturity value,
  • P is the present market value and
  • n is the number of years left to maturity.

Here the underlying assumption is that the firm will pay the dividends every year and the preference shares will be redeemed on the due date.

Cost Of Equity Capital

  • An operating firm can get additional equity capital through internal accruals and/or through issue of fresh equity.
  • Issue of additional equity capital involves a floatation cost which may be low in case of a rights issue and high in case of a public issue of equity shares.
  • For the sake of simplicity, here we will assume the floatation cost to be 0 which means that the cost of equity capital is same in both the cases of retained earnings and additional issue of equity shares.
  • As a company has no commitment to pay any assured dividend every year, the estimation of cost of equity capital becomes difficult.

There are many approaches used for this estimation. Some of the widely used methods are:

Capital Asset Pricing Modelling (CAPM) approach 

  • According to this approach, the required rate of return on the equity of a particular company depends on three factors viz.
  • risk free rate of return,
  • Beta of a company’s share price
  • the prevailing expected return on a portfolio of equity shares, in the capital market.
  • The beta is based on the changes in the return on share of the company vis-à-vis the changes in the return on market portfolio.
  • Higher beta denotes higher sensitivity of return on company’s share. Market portfolio denotes a mix of representative basket of shares of different companies, widely traded in the capital market.

The formula used is:

Required rate of return = Risk free return + Beta (Expected return on market portfolio- Risk free return)

Ra=Rrf+βa × (Rm−Rrf)

where:  Ra=Expected return on a security

Rrf=Risk-free rate

Rm=Expected return of the market

βa=The beta of the security (Rm−Rrf)=Equity market premium

Illustration 

If the Risk free return is 12% p.a. and the expected return on market portfolio is 16%, what will be the required rate of return on a company’s equity capital which has a beta of 1.50?

the required rate = 12 + 1.50 (16-12) = 12 + 6 =18%

Bond Yield plus Risk Premium approach 

  • Under this approach, an equity risk premium is added to the yield on long term bonds of the firm.
  • While the yield on long term bonds of the firm are known in the market, decision on equity risk premium is a matter of individual investor perception.

Illustration 

If the yield on long term bonds of the firm is 12% p.a. and the equity risk premium is 4%, what will be the required rate of return on firm’s equity capital?

The required rate = 12 + 4 =16

Dividend Growth Model approach 

  • This approach assumes that the
  • current market price of firm’s equity = Present value of all the dividends expected to be paid by the firm in future, discounted at the required rate of return.
  • This approach assumes that there will be a study growth in dividend paid by the firm, every year.

The formula, with this assumption is as under: 

  • Present market value = Dividend in first year/ (required rate of return – growth rate per year)
  • Required rate of return = (present market value/Dividend in first year) + growth rate per year

Illustration 

If the present market value of Rs.10 face value, equity shares of the firm is Rs. 100, dividend expected in the first year is 10%. and the expected growth rate in dividend is 4% every year, what will be the required rate of return on firm’s equity capital?

The required rate = (100/10) + 4 = 14%

Earning Price Ratio approach 

Under this approach, the required rate of return is calculated as under:

Required rate of return = Expected earnings per share for the next year/ Present market price of share

Illustration

If the present market value of equity shares of the firm is Rs. 100 and the expected earnings per share for the next year is Rs. 15. what will be the required rate?

RRR = 15/100 = 0.15 = 15%

Weighted Average Cost Of Capital (WACC)

  • Once we have estimated the cost of each component of capital of a firm, the WACC is arrived at by multiplying the proportion of each component with its cost and adding them.

Illustration

The capital structure of a firm is as under:  Equity capital 40% Preference capital 10% Debt capital 50%

The cost of each is estimated as under:  Equity capital 20% Preference capital 15% Debt capital 10%

WACC = (20 × 0.4 + 15 × 0.1 + 10 × 0.5) = 8 + 1.5 + 5 = 14.5%

Factors Affecting The WACC

The factors affecting the Weighted Average Cost of Capital of a firm can be classified under 2 categories, 

Internal factors and the external factors.

  • Internal factors:

The internal factors affecting the Weighted Average Cost of Capital are: 

  • Capital structure policy
  • Capital investment policy
  • Dividend policy
  • External factors:

The external factors affecting the Weighted Average Cost of Capital are: 

  • Prevailing interest rates in the market
  • Risk perception and market risk premium

Rates of corporate and personal taxes

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JAIIB Paper 3 (AFM) Module C Unit 6 – Capital Structure and Cost Of Capital (Ambitious baba)

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