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Presidency College
Hebbal – Kempapura, Bengaluru – 560024
www.presidencycollege.ac.in
Chapter 3-
Capital Structure & leverages

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Introduction
After deciding about the sources of funds. It
is necessary to understand & estimate the
current & future need of the required
amount of capital
Capital Structure
It refers to the mix of sources from which
the long term funds required by a business
are raised

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Definition
Capital Structure
“ refers to the composition or make up
of its capitalization and it includes all
long term capital resources viz : loans,
reserves, shares & bonds

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GOALS/PRINCIPLES OF CAPITAL STRUCTURE
MANAGEMENT
1. Cost Principle
Minimize Cost of Financing & Maximise Earnings Per
Share
Debt Capital is cheaper than equity capital
2. Risk Principle
Should not accept unduly high risk
Debt capital is a risky form of capital
Equity capital is the least risk option
3.Control Principle
Keep a control over the owners position
Equity directly affects the controlling position of the
owner
Preference & Debt capital hardly affects it

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4. Flexibility Principle
Able to cater the future requirement of funds
5. Timing Principle
Seize the market opportunities, should be able to minimize
cost of raising funds & obtain substantial savings

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FACTORS AFFECTING CAPITAL
STRUCTURE
A. INTERNAL FACTORS B. EXTERNAL FACTORS C.GENERAL FACTORS
1. Cost Factors 1. General Economic
Conditions
1. Constitution of the
Company
2. Risk Factor 2. Behavior of Interest Rates 2. Characteristics of
Company
3. Control Factor 3. Policy of Lending
Institutions
3.Stability of Earnings
4. Transferability 4. Taxation Policies 4. Attitude of
Management
5. Financial Leverage 5. Statutory Restrictions

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Capitalisation
The term refers to the total amount of long
term funds available to the company ie it
includes shares & debentures issued by
the company and also long term loans
taken from financial institutions

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Sources of Capital funds
SHORT TERM SOURCES MEDIUM TERM
SOURCES
LONG TERM SOURCES
1. Trade Credit 1. Public deposits 1. Equity shares
2. Bank Credit 2.Medium term loans 2. Retained earnings
3. Accounts receivable 3. Retention of profits 3. Preference shares
4.Factoring 4. Debentures
5. Inventory 5, Term loans
6. Commercial papers 6. Public deposits
7. Bills discounting 7. Innovative
8. Customer advances

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COST Ocost Cost of
capital F CAPITAL
Cost of capital is the rate return the firm requires
from investment in order to increase the value of the
firm in the market place.
Hampton
 The sources of capital of a firm must be in the form of
preference shares, equity shares, debt and retained earnings.
 In simple cost of capital of a firm is the weighted average
cost of their different sources of financing.

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Components Of Cost Of
Capital
A firm’s cost of capital include 3 components :
1) Return at zero risk level :- It relates to the expected
rate of return when a project involves no financial
or business risk.
2) Business risk premium :- Generally business risk
premium is determined by the capital budgeting
decisions for investment proposals. If the firm
selects a project which has more than the normal
risk, the suppliers of the funds for the project will
naturally expect a higher rate of return than the
normal rate. Thus the cost of capital increases.

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structure of the firm. A firm which has
higher debt content in its capital
structure should have more risk than a
firm which has comparatively low debt
content.

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The above 3 components of cost of capital may be
written in the form of the following equation.
K=r0+ b + f
Where,
K= cost of capital
r0 = return at 0 risk level
b= business risk premium
f= financial risk premium

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Classification Of Cost Of
Capital
1) Historical cost and Future cost
2) Specific cost and Composite cost
3) Average cost and Marginal cost
4) Explicit cost and Implicit cost
Historical cost and Future cost :-
Historical cost are the costs which are incurred for
the procurement of funds based upon the existing
capital structure of the firm. It is a book cost.

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Future cost is the cost which is relate to
estimated for the future. Simply it is the cost to be
incurred for raising new funds.
Specific cost and composite cost:-
Specific cost refers to the cost which is
associated with the particular sources of capital.
E.g.- Cost of Equity
Composite cost is the combined
cost of different sources of capital taken together.
E.g.- Cost of debt, cost of equity & Cost of
pref.shares.

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Average cost and Marginal cost:-
the combined cost of various
as equity shares, debentures,
Average cost is
sources of capital such
preference shares.
Marginal cost of capital is the average
cost of capital which has to be incurred due to new funds
raised by the company for their financial requirements.
Explicit cost and Implicit cost:-
Explicit cost is the cut-off rate or internal rate of
return.
Implicit cost is the rate of return
related to the best investment opportunity of the firm and its
shareholders that will be foregone in order to take up a
particular project.

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Computation Of Cost Of Capital
Computation of the Cost of Capital involves;
I. Computation of specific costs.
II. Computation of composite cost.

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Computation of Specific Cost includes;
A. Cost of Debt
B. Cost of Preference Shares
C. Cost of Equity Shares
D. Cost of Retained Earnings

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Computation of Specific
Cost
A. Cost of Debt :-It is the rate of return which is
expected by lenders.
Cost of Debt(K d) =
𝐼
𝑁𝑃
Where,
K d = Cost of Debt
I = Interest
NP = Net proceeds

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A1) When debt is issued at par:
• NP = Face value-Issued expenses
• A2) When debt issued at
premium:
• NP = Face value + Premium –
Issue expenses
• A3) When debt issued at
discount:
• NP = Face value – Discount –
Issue expenses

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Cost of redeemable debt(before tax)
Redeemable debt refers to the debt which is to be
redeemed or repayable after the expiry of a fixed period
of time.
K d(before tax) = I+(𝑃−𝑁𝑃)/n
(𝑃+𝑁𝑃)/2
Where,
I = Annual Interest Payment
P = Par Value Of Debentures
NP = Net Proceeds Of Debentures
n= No. Of Years To Maturity

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Cost of redeemable debt(after tax)
K d(after tax) = K d (before tax) × (1-T)
Cost of Existing Debt
Cost of Existing debt(Before tax) = Annual cost before tax
Average value of debt

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Average value of Debt
AV = 𝐍𝐏+𝐑𝐕
𝟐
Where,
AV = Average Value
NP = Net Proceeds
RV = Redemption Value

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B. Cost of Preference Share Capital
Normally a fixed rate of dividend is payable
on preference shares. But in the practical sense
preference dividend is regularly paid by the companies
when they earn sufficient amount of profit.
B.1) Cost of irredeemable preference share capital
KP=DP/NP
Where,
KP=Cost of pref.share capital
DP=Fixed preference dividend
NP=Net proceeds of pref . shares

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Problem
A company
Rs.1,00,000 by issuing 10% preference shares
raises preference share capital of
of
Rs.100 each. Compute the cost of preference capital
when they are issued at
a) 10% premium.
b) At 10% discount.

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Solutio
n:
a)When preference shares are issued at a premium of
10%.
KP=DP/NP
Where,
DP=Rs.10,000(@10% on Rs.1,00,000)
NP=Rs.1,10,000(Rs.1,00,000+Rs.10,000)
i.e., =
10,000
1,10,000
= 9.09%

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b)When preference shares are issued at a
discount of 10%
KP=DPNP
=
10,000
90,000(1,00,000−10,000)
= 11.11%

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B2)Cost of redeemable preference shares
Redeemable preference shares are
those which are to be redeemed after the expiry of
specified period of time.
KP= 𝐶+(𝐷−𝑁𝑃)/𝑛
(𝐷+𝑁𝑃)/2
C= annual dividend
D= par value of preference shares
n= no . of years to maturity
NP=net proceeds

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Proble
m:
A company issues 10% redeemable preference shares
for Rs.1,00,000 redeemable at the end of the 10th year
from the year of their issue. The underwriting cost is
5%. Calculate the effective cost of preference share
capital.

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Solutio
n:
KP= 𝐶+(𝐷−𝑁𝑃)/𝑛
(𝐷+𝑁𝑃)/2
Where,
C=10,000
D=1,00,000
n=10 year
NP=95,000
= 10,000+ 1,00,00−95,000 /10
1,00,000+95,000/2
= 10,000+5,000
97,500
=10.77%

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C. Cost of Equity Capital
Cost of equity capital may be defined as
the minimum rate of return that a firm must earn on it
investment, and also the market price of the equity
shares on unchanged.
C1)Dividend price method
Ke=D/NP
Where,
Ke=Cost of equity capital
D=Expected dividend per share
NP=Net proceeds per share

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C2)Dividend price plus growth
In this method cost of equity capital is
calculated on the basis of the dividend yield and the
growth rate in dividend.
Ke=D/NP + g
Where,
D=Expected dividend per share
NP=Net proceeds per share
g=Growth rate in dividends

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C3)Earning price approach
Ke=EPS/NP
Where,
K e=Cost of equity capital
EPS=Earning per share
NP=Net proceeds

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CAPM
The capital asset pricing model (CAPM) is a
financial model that calculates the
expected rate of return for an asset or
investment.
It is based on the idea that the expected
return of an asset is equal to the risk-free
rate of return plus a risk premium that
reflects the asset's beta.

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Diversifiable Risk
• Diversifiable risk, also known as
unsystematic risk, is the risk of an
investment that can be reduced or
eliminated through diversification. This
type of risk is specific to a particular
company or industry, and it is not
correlated with the overall market.
• Some examples of diversifiable risk
include:
Company Risk Industry-specific
risk:Country-specific risk

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Non Diversifiable Risk
Non-diversifiable risk, also known as systematic risk, is the risk of an
investment that cannot be reduced or eliminated through
diversification. This type of risk is correlated with the overall market,
and it affects all assets to some degree. Some examples of non-
diversifiable risk include:
• Market risk: This type of risk is the risk of loss due to fluctuations
in the overall market. For example, if the stock market experiences
a decline, all stocks will likely decline in value.
• Inflation risk: This type of risk is the risk of loss due to inflation.
Inflation can erode the purchasing power of an investment, and it
can make it more difficult to achieve investment goals.
• Interest rate risk: This type of risk is the risk of loss due to
changes in interest rates. When interest rates rise, the value of
bonds typically declines.
• Political risk: This type of risk is the risk of loss due to political
instability. For example, if a country experiences a coup or a civil
war, this could have a negative impact on the value of investments
in that country.

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CAPITAL ASSET PRICING MODEL
CAPM describes the relationship between
the required rate of return or cost of equity
capital and non diversifiable or relevant
risk of the firm.

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CAPM
• Ke = Rf +b (Km – Rf)
Ke = Cost of Equity capital
Rf = the rate of return required on a risk free
asset/ security / investments
Km = Required rate of return on the market
portfolio of assets that can be viewed as avg
rate of returns on all assets
B = beta coefficient

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Risk-free rate of return
• The risk-free rate of return is the rate of return
that an investor can expect to earn on an
investment with no risk. This is typically the yield
on a government bond.
Market risk premium
• The market risk premium is the additional return
that an investor expects to earn for taking on the
risk of investing in the market. Beta
• Beta is a measure of the volatility of an asset
relative to the market. A beta of 1 means that the
asset's returns are perfectly correlated with the
market, while a beta of 0 means that the asset's
returns are not correlated with the market at all.

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D. Cost of Retained Earnings
It refers to that portion of the profit retained by the
company for future development, business use and
expansion is known as retained earnings.
Kr=Ke(1-t) (1-b)
Where,
Kr=Cost of retained earnings
t=Tax rate
b=Brokerage

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Computation of Composite Cost
Weighted Average Cost of Capital(WACC)
It refers to the weighted average cost of
different sources of finance. It is very important in
financial decision making. Steps involved in
computation of WACC;
• Calculate the cost of each of the sources of finance
is ascertained.
• Assigning weights to specific costs.
• Multiplying the cost of each sources by the
appropriate weights.
• Dividing the total weighted cost by the total
weights.

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Weighted average cost of capital
can be computed the following
formula.
Kw=ΣXW/ΣW
Where,
Kw=Weighted average cost of capital
X=Cost of specific source of finance
W=Weights, proportion of specific source of
finance

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Proble
m
The cost of capital (after tax) of a company is the
specific sources is as follows:
Cost of Debt 4.00%
Cost of Preference shares 11.50%
Cost of Equity Capital 15.50%
Cost of Retained Earnings 14.50%
(assuming external )

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Cont……
…
Capital Structure are
Sources Amount
Debt 3,00,000
Preference Shares 4,00,000
Equity Share Capital 6,00,000
Retained Earnings 2,00,000
15,00,000
Calculate the weighted average cost of capital using
‘Book Value Weight’.

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Solution:
Computation Of Weighted
Average
Cost Of Capital Under Book Value Weights
Sources (a) Amount (b) Proportion(c) After tax
cost(d)
Weighted cost
(e) = (c) X (d)
Debt 300000 0.200(20%) 0.0400 0.0080
Preference
Share capital
400000 0.267(26.7%) 0.1150 0.0307
Equity Share
Capital
600000 0.400(40%) 0.1550 0.0620
Retained
Earnings
200000 0.133(13.3%) 0.1450 0.0193
1500000 1.000(100%) 0.1200
WEIGHTEDAVERAGE COST OF CAPITAL: 12%

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Alternative
Approach
Computation Of Weighted Average Cost Of Capital
Sources (a) Amount (b) Cost (c) Total cost (d) = (b)
X (c)
Debt 300000 4.00% 12000
Preference Share 400000 11.50% 46000
capital
Equity Share Capital 600000 15.50% 93000
Retained Earnings 200000 14.50% 29000
1500000 180000
WEIGHTEDAVERAGE COST OF CAPITAL= 180000/1500000 = 12%

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From the information mentioned in the previous
eg.,compute WACC talking into a/c that the market
value of various sources of funds are as follows:
Sources Market Value
Debt 2,50,000
Preference Shares 4,50,000
Equity and Retained Earnings 10,00,000

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A sum of Rs. 10,00,000 may be allocated between
equity share capital and retained earnings as
follows.
Sources (a) Book value(b) Percentage(c) Market
Value(d)
Equity shares 6,00,000 600000
800000 X 100 =
75%
1000000 X 75%
= 750000
Retained Earnings 200000 200000
800000 X 100 =
25%
1000000 X 25%
= 250000
Thus after computing the market value, WACC is ascertained as follows.

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Computation of WACC(Market-value
Weight)
Sources
(a)
Market Value
Rs.
(b)
Cost
(c)
Total Cost
Rs.
(d) = b×c
Debt 2,50,000 4.00% 10,000
Preference Share 4,50,000 11.50% 51,750
Equity Share
Capital
7,50,000 15.50% 1,16,250
Retained Earnings 2,50,000 14.50% 36,250
17,00,000 2,14,250
WACC=2,14,250/17,00,000 = 12.60%

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