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

| February 25, 2017

Question
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 needs

Solution:

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 profits

Companies 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 opportunities

Companies 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 needs

Companies 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:

Particulars

Amt. \$m

Total Asset

150

Debt

75

Equity

75

Net Income (PAT)

15

ROE

20%

Computation of ROE with changed capital structure

Particulars

Amt. \$m

Total Asset

150.00

Debt

135.00

Equity

15.00

PAT

15.00

PBT

21.43

4.50

EBIT

25.93

Less: Interest on revised debt

8.10

PBT

17.83

Less: Tax @ 30%

5.35

PAT

12.48

ROE

83.2%

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