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    Capital Structure

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    ruchit gupta
    The document compares the weighted average cost of capital (WACC) and value of a firm under different levels of leverage. It shows that WACC initially decreases as debt ratio increases from 0% to 40%, reaching an optimal leverage. Beyond 40% debt ratio, WACC and firm value starts increasing, suggesting higher financial risk. The optimal capital structure balances the tax benefit of debt against the rising financial risk of higher leverage.

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    Capital Structure

    Uploaded by

    ruchit gupta
    74 views13 pages
    The document compares the weighted average cost of capital (WACC) and value of a firm under different levels of leverage. It shows that WACC initially decreases as debt ratio increases from 0% to 40%, reaching an optimal leverage. Beyond 40% debt ratio, WACC and firm value starts increasing, suggesting higher financial risk. The optimal capital structure balances the tax benefit of debt against the rising financial risk of higher leverage.

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    The document compares the weighted average cost of capital (WACC) and value of a firm under different levels of leverage. It shows that WACC initially decreases as debt ratio increases from 0% to 40%, reaching an optimal leverage. Beyond 40% debt ratio, WACC and firm value starts increasing, suggesting higher financial risk. The optimal capital structure balances the tax benefit of debt against the rising financial risk of higher leverage.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    74 views13 pages

    Capital Structure

    Uploaded by

    ruchit gupta
    The document compares the weighted average cost of capital (WACC) and value of a firm under different levels of leverage. It shows that WACC initially decreases as debt ratio increases from 0% to 40%, reaching an optimal leverage. Beyond 40% debt ratio, WACC and firm value starts increasing, suggesting higher financial risk. The optimal capital structure balances the tax benefit of debt against the rising financial risk of higher leverage.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    of 13

    UL L

    Equity 500 300


    Debt @ 8% 0 200
    Total Funds 500 500
    D/E Ratio 0 0.67
    Kd 0 8%
    Ke 15% 15%
    WACC 15% 12.20%
    EBIT 100 100
    Less Int 0 16
    EBT 100 84
    Less Tax @ 50% 50 42
    EAT 50 42
    Total Earnings to All investros 50 58
    Relative advantage of debt 1.16
    Net Income Approach
    1 2 3 4 5
    Equity 500 400 300 200 100 0
    16%
    Debt @ 8% 0 100 200 300 400 500
    14%
    Total Funds 500 500 500 500 500 500
    Debt Ratio 0% 20% 40% 60% 80% 100% 12%

    Equity Ratio 100% 80% 60% 40% 20% 0% 10%


    Kd 8% 8% 8% 8% 8% 8% 8%
    Ke 15% 15% 15% 15% 15% 15% 6%
    WACC 15.00% 13.60% 12.20% 10.80% 9.40% 8.00%
    4%
    2%
    NOI 100 100 100 100 100 100
    Less Int 0 8 16 24 32 40 0%
    0% 20%
    NI 100 92 84 76 68 60
    Value of Equity 666.667 613.333 560.000 506.667 453.333 400.000
    Value of Debt 0 100 200 300 400 500
    Value of the Firm 666.67 713.33 760.00 806.67 853.33 900.00
    Chart Title
    16%
    14%
    12%
    10%
    8%
    6%
    4%
    2%
    0%
    0% 20% 40% 60% 80% 100%

    Kd Ke WACC
    Net Operating Income Approach
    Equity 500 400 300 200 100 0
    Debt @ 8% 0 100 200 300 400 500
    Total Funds 500 500 500 500 500 500
    Debt Ratio 0% 20% 40% 60% 80% 100%
    Equity Ratio 100% 80% 60% 40% 20% 0% 0.4
    Kd 8% 8% 8% 8% 8% 8% 0.35
    WACC 15.00% 15.00% 15.00% 15.00% 15.00% 15.00%
    0.3
    0.25
    NOI 100 100 100 100 100 100
    Less Int 0 8 16 24 32 40 0.2
    NI 100 92 84 76 68 60 0.15
    Value of the Firm (NOI/Kw) 666.67 666.67 666.67 666.67 666.67 666.67 0.1
    Value of Debt 0 100 200 300 400 500 0.05
    Value of Equity 666.67 566.67 466.67 366.67 266.67 166.67 0
    Cost of Equity (Ke) 1 2
    15.00% 16.24% 18.00% 20.73% 25.50% 36.00%

    Value of equity PAT/Ke


    Value of the firm EBIT/Kw

    CAPM Ke = Rf + {b*(Rm-Rf)}
    All Equity or unlevered
    Kd 0.08 0.08 0.08 0.08 0.08 0.08
    WACC 0.15 0.15 0.15 0.15 0.15 0.15
    Cost of Equity (Ke) 15.00% 16.24% 18.00% 20.73% 25.50% 36.00%

    Chart Title
    0.4
    0.35
    0.3
    0.25
    0.2
    0.15
    0.1
    0.05
    0
    1 2 3 4 5 6

    Kd WACC Cost of Equity (Ke)


    Arbitrage
    UL L Suppose you hold 10% stake in L
    Equity 500 200 Your equity in L 26.8
    Debt 0 300 Your share of EAT in L 4.02
    Total Funds 500 500 You wish to shift to UL with same stake i.e 10%
    Kd 0.00% 11.00% Equity required in UL 40
    Ke 15.00% 15.00% Sell the stake in L 26.8
    Tax 40% 40% Additional equity required 13.2
    you can borrow at 11% hence interest is 1.452
    EBIT 100 100
    Less Int 0 33 Your share of EAT in UL 6
    EBT 100 67 Less Interest on borrowing 1.452
    Less Tax @ 40% 40 26.8 Profit after shifting to levered firm 4.548
    EAT 60 40.2 Net pay off due to shifting using arbitrage 0.528
    Value of Equity 400 268
    Debt Ratio TA Debt Value Equity Value No. of Shares
    0% 40000000 0 40000000 1600000
    10% 40000000 4000000 36000000 1440000
    20% 40000000 8000000 32000000 1280000
    30% 40000000 12000000 28000000 1120000
    40% 40000000 16000000 24000000 960000
    50% 40000000 20000000 20000000 800000
    60% 40000000 24000000 16000000 640000

    Debt Ratio debt Pretax Kd Interest


    0% 0 0 0
    10% 4000000 7.50% 300000
    20% 8000000 8% 640000
    30% 12000000 9% 1080000
    40% 16000000 11% 1760000
    50% 20000000 12.50% 2500000
    60% 24000000 15.50% 3720000

    Debt Ratio EBIT Interest Taxes NI Shares EPS


    0% 8000000 0 3200000 4800000 1600000 3.00
    10% 8000000 300000 3080000 4620000 1440000 3.21
    20% 8000000 640000 2944000 4416000 1280000 3.45
    30% 8000000 1080000 2768000 4152000 1120000 3.71
    40% 8000000 1760000 2496000 3744000 960000 3.90
    50% 8000000 2500000 2200000 3300000 800000 4.13
    60% 8000000 3720000 1712000 2568000 640000 4.01

    Value per
    Debt Ratio EPS Ke Value per share Debt Ratio share
    0% 3 10% 30.00 0 30.00
    10% 3.208333 10.30% 31.15 0.1 31.15
    20% 3.45 10.90% 31.65 0.2 31.65
    30% 3.707143 11.40% 32.52 0.3 32.52
    40% 3.9 12.60% 30.95 0.4 30.95
    50% 4.125 14.80% 27.87 0.5 27.87
    60% 4.0125 17.50% 22.93 0.6 22.93
    35

    30

    25

    20

    15

    10

    0
    0 0.1 0.2 0.3 0.4 0.5 0.6

    Debt Ratio Value per share


    5

    0
    0 0.1 0.2 0.3 0.4 0.5 0.6

    Debt Ratio Value per share


    Traditional Approach
    Equity 500 400 300 200 100 50
    Debt @ 8% 0 100 200 300 400 450
    Total Funds 500 500 500 500 500 500
    D/E Ratio 0% 20% 40% 60% 80% 90%
    Kd 8.00% 8.50% 9.25% 10.40% 11.75% 13.50%

    NOI 100 100 100 100 100 100


    Less Int 0 8.5 18.5 31.2 47 60.75
    EBT 100 91.5 81.5 68.8 53 39.25
    Less Tax @ 40% 40 36.6 32.6 27.52 21.2 15.7
    EAT 60 54.9 48.9 41.28 31.8 23.55
    Ke 12.00% 13.73% 16.30% 20.64% 31.80% 47.10%
    WACC 12.00% 12.68% 13.48% 14.50% 15.76% 16.86%

    Optimum Leverage Value to shareholders is maximum


    Kd 8.00% 8.50% 9.25% 10.40% 11.75% 0.135
    Ke 12.00% 13.73% 16.30% 20.64% 31.80% 0.471
    WACC 0.12 0.1268 0.1348 0.14496 0.1576 0.1686

    Chart Title
    50.00%
    45.00%
    40.00%
    35.00%
    30.00%
    25.00%
    20.00%
    15.00%
    10.00%
    5.00%
    ers is maximum 0.00%
    1 2 3 4 5 6

    Kd Ke WACC
    Current Situation
    Current A B
    Equity 9000000 7000000 5000000
    Debt 1000000 3000000 5000000
    Total Funds 10000000 10000000 10000000
    Ch
    1200010
    Kd 9% 10% 12%
    Ke 12% 13% 18% 1200008
    6.66
    No. of Shares 100000 70000 40000 1200006
    1200004
    EBIT 1200000 1200000 1200000 1200002
    Less: Interest 90000 300000 600000 1200000
    1200000
    EBT 1110000 900000 600000
    1199998
    Less: Tax 444000 360000 240000
    EAT 666000 540000 360000 1199996
    1199994
    Current
    Times Interest Earned Ratio 13.33 4.00 2.00
    (EBIT/INTEREST EXPENSES)

    EPS 6.66 7.71 9.00


    Market Value 5550000 4153846.1538 2000000
    EBIT 1200000
    Tax 40%

    Chart Title
    00010 9.00
    7.71
    00008
    6.66
    00006
    00004
    00002
    1200000 1200000 1200000
    00000
    99998
    99996
    99994
    Current A B

    EBIT EPS

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