FM Unit4 New
FM Unit4 New
FM Unit4 New
The capital structure is how a firm finances its overall operations and growth by using
different sources of funds.
A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity.
when people refer to capital structure they are most likely to referring to a firm's debt to
equity ratio which provide insight into how risky a company is
Objective are
Cost of capital
is an important concept in financial management. Every firm needs funds for making
investments. These funds can be procured from different types of investors, that is,
equity shareholders, preference shareholders, debt-holders, etc. These investors while
providing the funds to the firm will have an expectation of receiving a minimum
return from the firm. This minimum returns expected by the investors depends upon
the risk-appetite of the investors and also on the characteristics of the firm. This
minimum return required by the investors is called Cost of Capital of the firm.
Therefore, while making investment decisions, the firm chooses that alternative which
generates at least that much return which is expected by the investors of the firm.
Otherwise, the firm will not take up that alternative.
In order to maximize the value of the firm, the cost of all the different sources of the
funds must be minimized.
Cost of long term debts and bonds (Long term borrowings)- Cost of long term
borrowings refers to the cost of borrowing funds to the firm. This is the minimum
return which is expected by the investors from the firm who supply long term debts to
the firm.
Cost of preference share capital- Companies can also raise funds through preference
shares. The cost of capital of preference shares refers to the minimum amount of
returns expected by the preference shareholders of the company. The preference share
capital is differentiated from equity share capital on the basis of these two features-
(a) The preference shares are entitled to receive dividends at fixed rate.
(b) In case of liquidation of the company, preference shareholders get
capital repayment in priority over the equity shareholders.
Cost of equity share capital- The minimum rate of return expected by the equity
shareholders of the company is known as cost of equity share capital. It is represented
by ke and has three sub parts-
(a) Zero-growth dividends- It is assumed under this method that
dividends will remain constant at the current level for the assumed
perpetual life of the firm. Ke= D1/Po
Where, D1= Expected dividend at the end of year 1 and Po= Current
market price of the share.
(b) Constant growth rates in dividends perpetually- Under this method,
dividends are assumed to grow at a constant rate, g, per annum.
Ke= (D1/Po)+g
Where, g= Growth rate per annum, D1= Do(1+g) and Do= Current
dividend paid by the firm.
WACC can be defined as the rate of return that must be earned by a firm in order to
satisfy the requirements of all the different investors of the firm.
Once the specific cost of capital of each of the sources, debt, equity share capital,
preference share capital and retained earnings is found out, the next step is to
calculate the overall value of the firm, represented by ko and also called WACC.
Traditional Approach: