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Hypothetical Model on Cost of finance & Capital structure
SUBMITTED TO:
Dr. Paresh Shah
SUBMITTED BY:
Shreyash Bhanvadia (05) Lovely Ganeriwal(18)
Rohit Mehta (30) Unnati Modi (31)
Upasana Modi (32)
Som-Lalit Institute of Management Studies
2009-10
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Capital Structure
Introduction
Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level of capital, it will earn high profit and they can provide more dividends to its shareholders.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:1. Maximize the value of the firm.2. Minimize the overall cost of capital.
Meaning of 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 sources 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.
According to the definition of Prasanna Chandra, “The composition of a firm’s financing consists of equity, preference, and debt”.
According to the definition of R.H. Wessel, “The long term sources of fund employed in a business enterprise”.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance.Normally the following forms of capital structure are popular in practice.• Equity shares only.• Equity and preference shares only.• Equity and Debentures only.• Equity shares, preference shares and debentures.
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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.
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Factors Determining Capital Structure
The following factors are considered while deciding the capital structure of the firm:
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.
(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.
Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, long term funds from external sources. Hence the company must consider government policy regarding the capital structure.
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Capital Structure Theories
Capital structure is the major part of the firm’s 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.
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
Capital structure theories are based on certain assumption to analysis in a single and convenient manner:• 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
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.
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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: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+BV = Value of firmS = Market value of equityB = Market value of debt
Market value of the equity can be ascertained by the following formula:
where,NI = Earnings available to equity shareholderKe = Cost of equity/equity capitalization rate
Format for calculating value of the firm on the basis of NI approach.
Net Operating Income (NOI) Approach This is just the opposite of 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.
NI approach is based on the following important assumptions; The overall cost of capital remains constant; There are no corporate taxes; The market capitalizes the value of the firm as a whole;
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Value of the firm (V) can be calculated with the help of the following formula
Where,V = Value of the firmEBIT = Earnings before interest and taxKo = Overall cost of capital
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.Modigliani and Miller approach is based on the following important assumptions:
• There is a perfect capital market.• There are no retained earnings.• There are no corporate taxes.• The investors act rationally.• The dividend pay-out ratio is 100%.• The business consists of the same level of business risk.
Value of the firm can be calculated with the help of the following formula:
Where,EBIT = Earnings before interest and taxKo = Overall cost of capitalt = Tax rate
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Cost of Capital
Introduction
Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal provided by the business concern. It is used as a discount rate in determining the present value of future cash flows associated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rate of return.
When the firms are using different sources of finance, the finance manager must take careful decision with regard to the cost of capital; because it is closely associated with the value of the firm and the earning capacity of the firm.
Meaning of 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.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.
Importance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
Importance to Capital Budgeting Decision
Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to Structure Decision
Capital structure is the mix or proportion of the different kinds of long term securities.A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.
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Importance to Evolution of Financial Performance
Cost of capital is one of the important determining which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
Importance to Other Financial Decisions
Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
Measurement of Cost of Capital
It refers to the cost of each specific sources of finance like:• Cost of equity• Cost of debt• Cost of preference share• Cost of retained earnings
Cost of Equity
Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value.Conceptually the cost of equity capital (Ke) defined as the “Minimum rate of return that a firm must earn on the equity financed portion of an investment project in order to leave unchanged the market price of the shares”.
Cost of equity can be calculated from the following approach:• Dividend price (D/P) approach• Dividend price plus growth (D/P + g) approach• Earning price (E/P) approach• Realized yield approach.
Cost of Debt
Cost of debt is the after tax cost of long-term funds through borrowing. Debt may be issued at par, at premium or at discount.
Cost of Preference Share Capital
Cost of preference share capital is the annual preference share dividend by the net proceeds from the sale of preference share.There are two types of preference shares irredeemable and redeemable.
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Cost of redeemable preference share capital is calculated with the help of the following formula:
Where,Kp = Cost of preference shareDp = Fixed preference dividendNp = Net proceeds of an equity share
Cost of irredeemable preference share is calculated with the help of the following formula:
Where,Kp = Cost of preference shareDp= Fixed preference shareP = Par value of debtNp = Net proceeds of the preference sharen = Number of maturity period.
Cost of Retained Earnings
Retained earnings is one of the sources of finance for investment proposal; it is different from other sources like debt, equity and preference shares. Cost of retained earnings is the same as the cost of an equivalent fully subscripted issue of additional shares, which is measured by the cost of equity capital. Cost of retained earnings can be calculated with the help of the following formula:
Kr =Ke (1 – t) (1 – b) Where,
Kr=Cost of retained earningsKe=Cost of equityt=Tax rateb=Brokerage cost
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Analysis of Capital Structure and Cost of Capital
Mahindra and Mahindra Financial Services Ltd.
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Introduction of Mahindra & Mahindra Financial Services Ltd. (MMFSL)
MMFSL is one of India’s leading non-banking finance companies focused on the rural and semi-urban sectors providing finance for Utility Vehicles (UVs), tractors and cars. MMFSL is a subsidiary of Mahindra & Mahindra Limited, a leading tractor and UV manufacturer with over 60 years’ experience in the Indian market.
Their goal is to be the preferred provider of retail financing services in the rural and semi-urban areas of India, while strategy is to provide a range of financial products and services to their customers through nationwide distribution network. They seek to position themselves between the organised banking sector and local money lenders, offering customers competitive, flexible and speedy lending services.
MMFSL principally finance UVs used both for commercial and personal purposes, tractors and cars. While they predominantly finance M&M UVs and tractors, they have continued to expand their lending to vehicles not manufactured by Mahindra & Mahindra Ltd.
Vision
MMFSL’s vision is to be the leading Rural Finance Company and continue to retain the leadership position for Mahindra Products.
Mission
To be recognised as the premier provider of financial services on the basis of their contribution to sale of Mahindra range of vehicles, tractors, services and help M&M protect its sale through availability of finance.
To specialise in financing products based on applications and build on the competence developed in its focus area. To target all segments of vehicle financing and deploy the skills acquired through an in-depth understanding of the chosen product market.
To provide products and services tailored to the needs of M&M, most favoured customer, and always meet their needs. In case of demand-supply mismatch of funds, to do everything to find a solution.
To help M&M develop better products by providing first-hand information received from the target market.
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Capital Structure of MMFSL from 2005-06 to 2008-09
Particulars 2006 2007 2008 2009 (in. Rs Crores)
Equity 732.78 778.24 1,314.27 1,469.16
Debt 3,882.95 4,911.24 5,068.18 5,213.01
Notes:
The above chart shows the constant change in the debt-equity ratio made by the company.
The company has decreased it debt level from 84% to 78%
Cost of Capital Calculations
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Earning Price Approach
Cost of Equity (Earnings Price Approach)
Particulars 2006 2007 2008 2009 EPS 12.58 15.72 18.58 22.14MPS 231 217 280 245Ke= (EPS/MPS)*100 5.45 7.24 6.64 9.04
Cost of Debt
Particulars 2006 2007 2008 2009 Interest (1) 219.44 324.13 456 509.86Total Debt (2) 3,882.95 4,911.24 5,068.18 5,213.01Cost of Debt (with tax) 5.65 6.60 9.00 9.78Cost of Debt (without tax) 3.96 4.62 6.30 6.85
Weighted Average Cost of Capital
Particulars 2006 2007 2008 2009 Cost of Equity 5.45 7.24 6.64 9.04Weight Assigned 1 1 1 1 Cost of Debt 3.96 4.62 6.3 6.85Weight Assigned 5.76 6.31 3.86 3.55 Weighted Equity 5.45 7.24 6.64 9.04Weighted Debt 22.81 29.15 24.32 24.32Total Weight 6.76 7.31 4.86 4.55 WACC 4.18 4.98 6.37 7.33
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Return on InvestmentsParticulars 2006 2007 2008 2009 Profit 375.38 518.98 715.69 824.39Total Cap Employed 4,615.73 5,689.48 6,382.45 6,682.17ROI 8.13 9.12 11.21 12.34
Difference Between ROI and WACC
Particulars 2006 2007 2008 2009 Difference 3.95 4.14 4.84 5.01
Difference Between Cost of Debt and Cost of Equity
Particulars 2006 2007 2008 2009 Difference -1.49 -2.62 -0.34 -2.19
Notes:
Earning Price Method is the most appropriate method only when the dividend pay-out ratio is 100%.
The difference between ROI and WACC is positive and is continuously growing over the years. So, should better go for retained earning rather than giving dividends.
In this case, suppose, dividend pay-out ratio is 100%, then cost of equity is higher than cost of debt. So, company should go for Debts rather than going for equity capital.
Dividend Price Approach
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Cost of Equity (Dividend Payout approach)
Particulars 2006 2007 2008 2009 Dividend Paid/Share 3.5 4 4.5 5.5MPS 231 217 280 245
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Ke = (DPS/MPS)*100 1.52 1.84 1.61 2.24
Cost of Debt
Particulars 2006 2007 2008 2009 Interest (1) 219.44 324.13 456 509.86Total Debt (2) 3,882.95 4,911.24 5,068.18 5,213.01Cost of Debt (with tax) 5.65 6.60 9.00 9.78Cost of Debt (without tax) 3.96 4.62 6.30 6.85
Weighted Average Cost of Capital
Particulars 2006 2007 2008 2009 Cost of Equity 1.52 1.84 1.61 2.24Weight Assigned 1 1 1 1 Cost of Debt 3.96 4.62 6.3 6.85Weight Assigned 5.76 6.31 3.86 3.55 Weighted Equity 1.52 1.84 1.61 2.24Weighted Debt 22.81 29.15 24.32 24.32Total Weight 6.76 7.31 4.86 4.55 WACC 3.60 4.24 5.33 5.84
Return on Investments
Particulars 2006 2007 2008 2009 Profit 375.38 518.98 715.69 824.39Total Cap Employed 4,615.73 5,689.48 6,382.45 6,682.17ROI 8.13 9.12 11.21 12.34
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Difference Between ROI and WACC
Particulars 2006 2007 2008 2009 Difference 4.53 4.88 5.88 6.50
Difference Between Cost of Equity and Cost of Debt
Particulars 2006 2007 2008 2009 Difference 2.44 2.78 4.69 4.61
Notes:
Logically, the actual cost of capital of any company is the dividend paid by the company to its shareholders, so here we have calculated cost of equity on the basis of Dividend paid per share and Market price of share.
For market price of the share we have taken average of 52 week high and low price of each year.
The difference between ROI and WACC is positive and is continuously growing over the years. So, should better go for retained earning rather than giving dividends.
Also, the cost of equity is lower than cost of debt, so according to this approach, the company should go for lowering the debt and issuing more equity.
This can one of the basis on which company has continuously reduced the amount of debt in its company’s capital structure.
Out of the total income, 37% is paid as interest and only 11% is retained back in the business. If the company wants to grow, it should concentrate more on increasing retained earnings and thereby decreasing its debts.
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Preference Share Capital Redeemed
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In 2005, the company was having 6.9% cumulative preference shares. But the cost of preference was comparatively high in relationship with cost of equity and cost of debt. So the company redeemed the preference share capital. Moreover the company came out with Initial Public Offering in 2006 to reduce its overall cost of capital.
Financial Highlights of the Company
Particulars 2006 2007 2008 2009
Cost of Equity 1.52 1.84 1.61 2.24Cost of Debt 3.96 4.62 6.3 6.85WACC 3.6 4.24 5.33 5.84Interest Coverage Ratio 1.79 1.66 1.63 1.67Debt Equity Ratio 5.76 6.31 3.86 3.55ROCE 8.26 9.26 11.4 12.5ROE 14.78 17.08 13.46 14.6EPS 12.58 15.72 18.58 22.14EBIT (in. Rs Crores) 386.77 534.29 736.71 844.22
EPS Comparison Before and IPO issue of Equity Share Capital
Before issue of IPOYear Rs.2003 7.32004 10.72005 13.2
After issue of IPO2006 12.582007 15.722008 18.582009 22.14
After the issue of equity shares in the year 2006, the company has maintained its constant growth is the EPS.
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Hypothetical Analysis of Capital Structure and Cost of Capital
Mahindra and Mahindra Financial Services Ltd.
Hypothetical Analysis of Debt-Equity ratio
After changing Debt-Equity
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Before Changes Debt-EquitySources of Funds Sources of FundsParticulars Mar '09 Particulars Mar '09
In Rs. crores In Rs.
crores Total Share Capital 110
Total Share Capital 95.71 Equity Share Capital 110Equity Share Capital 95.71 Share Premium 450Share Application Money 0 Preference Share Capital 0Preference Share Capital 0 Reserves 1,373.45Reserves 1,373.45 Revaluation Reserves 0Revaluation Reserves 0 Networth 1,933.45Networth 1,469.16 Secured Loans 4,001.83Secured Loans 4,466.83 Unsecured Loans 746.18Unsecured Loans 746.18 Total Debt 4,748.01Total Debt 5,213.01 Total Liabilities 6,681.46Total Liabilities 6,682.17
Assumptions:
Company utilized all of its authorized share capital of Rs. 110 crore
Current market price of MMFSL is approx. Rs. 340. So, we have issued the shares are Rs. 310. i.e. company would receive Rs. 15 crores as equity share capital and Rs. 450 as share premium.
The secured loan amount is decreased to Rs. 4001.83 from Rs. 4466.83.
With these changes, the Debt equity ratio stands at 2.6, which was previously 3.55
Before Changes in Debt-Equity Ratio After Changes in Debt-Equity Ratio
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Profit & Loss account of Mahindra & Mahindra Financial Services
(in. Rs. Crores)
Profit & Loss account of Mahindra & Mahindra Financial Services
(in. Rs. Crores)
Income Income Sales Turnover 1,364.83 Sales Turnover 1,364.83Excise Duty 0 Excise Duty 0Net Sales 1,364.83 Net Sales 1,364.83Other Income 19.83 Other Income 19.83Stock Adjustments 0 Stock Adjustments 0Total Income 1,384.66 Total Income 1,384.66Expenditure Expenditure Raw Materials 0 Raw Materials 0Power & Fuel Cost 0 Power & Fuel Cost 0Employee Cost 117.33 Employee Cost 117.33Other Manufacturing Expenses 0
Other Manufacturing Expenses 0
Selling and Admin Expenses 356.11 Selling and Admin Expenses 356.11Miscellaneous Expenses 67 Miscellaneous Expenses 67Preoperative Exp Capitalised 0 Preoperative Exp Capitalised 0Total Expenses 540.44 Total Expenses 540.44 Operating Profit 824.39 Operating Profit 824.39PBDIT 844.22 PBDIT 844.22Interest 509.86 Interest 478PBDT 334.36 PBDT 366.22Depreciation 7.42 Depreciation 7.42Other Written Off 1.31 Other Written Off 1.31Profit Before Tax 325.63 Profit Before Tax 357.49Tax 111.11 Tax 121.5466Reported Net Profit 214.52 Reported Net Profit 235.9434Equity Dividend 53.3 Equity Dividend 60.5Corporate Dividend Tax 9.06 Corporate Dividend Tax 10.22Per share data (annualised) Per share data (annualised) Shares in issue (lakhs) 969.01 Shares in issue (in lakhs) 1100Earning Per Share (Rs) 22.14 Earning Per Share (Rs) 21.44Equity Dividend (%) 55 Equity Dividend (%) 55
Notes:
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With the change in the debt equity ratio, interest on debt reduces by Rs. 31.86 Crores (Cost of debt is 6.85% for the year 2009)
With this changes the net profit of the company increased by Rs. 20 crores.
The EPS of the company is almost the same.
Dividend Paid is 55% (as the same declared for 2008-09)
The most beneficial part is the debt equity ratio comes down to 2.6 from 3.55 and this will increase the credibility of the company.
These are just the assumptions and according to our analysis it can be optimal capital structure as the company’s capital structure is Rs. 110 crores only.
Conclusion
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After studying the capital structure of MMFSL we can conclude that it is one of the growing firms in the financial sector, as the EPS of the company is on a constant rise, especially after the IPO issue in the year 2006, but still company has a burden of debt on it shoulders, which is actually reducing its profit margins. This is one of the reasons why company is constantly modifying its capital structure from 2006 to 2009 and has been trying to find optimal capital structure.
By doing hypothetical analysis and utilizing all of the authorized capital of MMFSL we tried to find out the optimal capital structure and reduced the Debt equity ratio to 2.6 from 3.55, without having any major change in the EPS of the company.
Limitation of the Study:
The scope of this project is limited to our understanding of Capital Structure and Cost of Equity and Debt.
Bibliography
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Websites:
www.mahindrafinance.com
www.moneycontrol.com
www.icicidirect.com
Reports:
Annual Report MMFSL – 2006-07
Annual Report MMFSL – 2007-08
Annual Report MMFSL – 2008-09
Red Herring Prospectus of MMFSL issued on 2nd February, 2006
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