Capital Structure and Cost of Capital | PAPER III – ACCOUNTING & FINANCIAL MANAGEMENT FOR BANKERS | MODULE C: FINANCIAL MANAGEMENT

Capital Structure and Cost of Capital

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Descriptive Notes

Capital Structure: Refers to the proportion of debt and equity used by a firm to finance its overall operations and growth. An optimal capital structure balances risk and return and maximizes firm value.

Leverage or Gearing: Leverage indicates the extent to which a firm uses debt in its capital structure. Higher leverage increases financial risk but may also amplify returns.

Factors Influencing Capital Structure Decisions:

• Cost of capital
• Business risk
• Control considerations
• Flexibility and timing
• Market conditions

Theories on Capital Structuring:

• Net Income (NI) Approach: Assumes lower debt increases firm value due to cheaper cost.
• Net Operating Income (NOI) Approach: Firm value remains constant irrespective of capital structure.
• Traditional Approach: Suggests an optimal debt-equity mix exists.

Key Assumptions:

• No taxes (unless stated)
• Constant cost of debt and equity
• Risk perception remains unchanged

Cost of Capital Components:

• Cost of Debt (Kd): After-tax interest rate paid on borrowings.
• Cost of Preference Capital (Kp): Dividend/Net proceeds.
• Cost of Equity (Ke): Estimated using Dividend Discount Model or CAPM.

Weighted Average Cost of Capital (WACC):

WACC is the average cost of capital from all sources, weighted by their respective proportions.

WACC = (E/V × Ke) + (D/V × Kd × (1 – T))

Other Concepts:

• Weighted Marginal Cost of Capital (WMCC): Cost of next rupee of capital raised.
• Optimal Capital Budget: Budget level where marginal return equals marginal cost.
• Floatation Costs: Costs of issuing new securities; increases effective cost.
• Divisional/Project Cost of Capital: Adjusted based on risk profile.

Common Misconceptions:

• Cost of retained earnings is zero
• Debt is always cheaper than equity
• Optimal structure is one-size-fits-all

10 Medium-Hard Mathematical Examples

Example 1: A company issues ₹10 lakh debt at 10% interest. Tax rate is 30%. What is after-tax cost of debt?
Solution: Kd = 10% × (1 – 0.30) = 7%

Example 2: Preference shares worth ₹5 lakh pay ₹50,000 dividend annually. Net proceeds ₹4.8 lakh.
Solution: Kp = ₹50,000 / ₹4,80,000 = 10.42%

Example 3: Equity market price = ₹100, Dividend = ₹8, Growth = 5%.
Solution: Ke = (8/100) + 0.05 = 0.08 + 0.05 = 13%

Example 4: Capital structure: Equity ₹12L (Ke=14%), Debt ₹8L (Kd=10%, Tax=30%).
WACC: (12/20)×14% + (8/20)×10%×(1-0.3) = 8.4% + 2.8% = 11.2%

Example 5: Cost of new equity (floatation 5%), D₁ = ₹6, P₀ = ₹100, g = 6%.
Ke = 6 / 95 + 0.06 = 0.0632 + 0.06 = 12.32%

Example 6: Company raises ₹50L new capital, existing WACC 10%, new capital costs 11%.
WMCC: If average cost changes, marginal cost = 11%

Example 7: Project A: Risk-adjusted return = 14%, WMCC = 13%.
Decision: Accept project (return > WMCC)

Example 8: Equity capital ₹10L, Ke = 12%, retained earnings = ₹2L, ROE = 15%.
Misconception bust: Retained earnings still have cost = 12%

Example 9: Project cost = ₹10L, Financing: 60% equity, 40% debt, Ke = 15%, Kd = 8%, T = 30%.
WACC: 0.6×15% + 0.4×8%×0.7 = 9% + 2.24% = 11.24%

Example 10: Floatation cost on equity is 10%, dividend = ₹4, growth = 4%, P = ₹40.
Ke = 4 / (40×0.9) + 0.04 = 11.11% + 4% = 15.11%

10 MCQs on Capital Structure and Cost of Capital

1. What does WACC stand for?
a) Weighted Accounting Capital Cost
b) Weighted Average Cost of Capital ✔️
c) Weighted Actual Capital Charge
d) Weighted Asset Capital Cost

2. In the Net Operating Income (NOI) approach, firm value is:
a) Dependent on capital structure
b) Maximized by equity
c) Independent of capital structure ✔️
d) Based on dividend policy

3. Which component is adjusted for tax in WACC?
a) Cost of equity
b) Cost of preference
c) Cost of debt ✔️
d) All of the above

4. A high D/E ratio implies:
a) Low leverage
b) High leverage ✔️
c) Zero gearing
d) Less risk

5. Floatation cost affects:
a) Risk
b) Capital base
c) Cost of capital ✔️
d) None

6. The cost of retained earnings is:
a) Zero
b) Equal to cost of debt
c) Equal to cost of equity ✔️
d) Ignored in WACC

7. Traditional theory suggests:
a) No optimum D/E mix
b) Constant firm value
c) Optimum capital structure exists ✔️
d) Ignore taxes

8. Dividend Discount Model helps compute:
a) Kd
b) Kp
c) Ke ✔️
d) ROCE

9. If debt is tax deductible, WACC:
a) Increases
b) Decreases ✔️
c) Becomes zero
d) Is unaffected

10. Which is a misconception?
a) Retained earnings are cost-free ✔️
b) Debt is cheaper than equity
c) Floatation costs increase effective cost
d) Optimal mix improves firm value