CAPITAL STRUCTURE AND COST OF CAPITAL | JAIIB AFM IMPORTANT TOPIC 2024

Capital Structure and Cost of Capital 

Capital structure and cost of capital is a major topic of JAIIB AFM (Accounting and financial management), under these notes we’ll go over the meaning of capital structure, leverage, and factors influencing decisions on the capital structure of a firm, taxation, and capital structure, etc.

Capital is the phrase for this long-term funding that the company needs. Now, there are two possible sources of this long-term funding: equity, or the money of the owners, and debt.

Capital structure is a blend of debt and equity utilized to finance the overall operations of a company.

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Illustration

A company launches its operations by raising a total of 500 lakhs in long-term capital to cover the following needs.

1. 200 lakhs in equity
2. Debt capital of 7,300,000,000

As a result, the capital structure is divided into 60% debt capital (300/500) and 40% equity capital (200/500).

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Factors that affect the decision on the capital structure of a firm

The capital structure and cost of capital are crucial aspects of a firm’s financial management, and various factors, such as business risk, tax policies, and market conditions, can significantly influence the decision on the optimal capital structure.

• Norms that prevail in the Indian financial system 

The banks and financial institutions of the country, which are the prominent source of debt financing, have their lending policies and norms based on the long experience gained in this field.

• Extent of control

In case the company’s promoters don’t wish to diminish their voting rights after a critical point they can choose to not equity capital to outsiders any further in fact under such a situation they prefer to fulfil the company’s need for additional funds by issuing debt instruments for instance debentures.

• Cost of debt 

It’s the most important element that decides the capital structure of a firm. The cost of debt is an effective interest rate that’s paid on the borrowed funds by the company, including loans, bonds, and other debt instruments and it represents compensation that lenders or investors require for the risk of lending their money to any company. Both interest rate and associated fees like underwriting or legal fees etc are included in the cost of debt. 

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Depending on the borrowing agreement it can be both variable and non-variable. 

Companies analyze the current market interest rates for similar debt instruments, adjust for any difference in the risk, and then add a premium to compensate lenders for lending money to the company, and the resulting cost of debt is used in the company’s cost of capital calculations and helps management make decisions about financing projects and investments.

• Firm size and its business plans

Market price, business model, and size of the firm influence the capital structure of a firm. A firm intending to expand may prefer to keep a higher proportion of debt rather than equity since the debt is easier to be repaid. 

Theories on capital structuring

Understanding the relationship between capital structure and cost of capital is crucial for businesses, and there are several theories on capital structuring that can help guide their decision-making.

Ideas and methods for establishing connections between financial leverage, weighted average cost of capital, and total firm cost. The three approaches are given below: 

Net income approach 

Irrespective of the proportion of debt and equity, the cost of debt and the cost of equity remains the same. Since the cost of debt is lower than the cost of equity, the overall cost of capital (WACC) can be decreased through higher debt proportion resultantly increasing the value of the firm.

Net operating income approach 

Operating income and business risk of a firm influence the market value according to this approach while both these factors remain unaffected by the financial leverage and change in debt and equity does not make any change in the value of the firm.

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Traditional position

This approach states:

1. The debt proportion of a company will start to increase when the proportion of debt capital increases in a capital structure of a firm. 
2. Leverage influences the cost of equity.
3. Leverage of a firm increases, WACC may show a decline up to a point, remain constant up to another point, and increase thereafter.

Taxation and capital structure 

Taxation plays a significant role in determining a company’s capital structure and cost of capital, as the tax implications of debt and equity financing can greatly impact a company’s financial decisions.

Taking taxation into account is essential when deciding on a firm’s capital structure. As previously mentioned, the Earnings Before Interest and Tax (EBIT) of the company remains unaffected by its capital structure.

Moving on to the concept of cost of capital refers to the overall cost of obtaining funds (including both debt and equity) for a company. From the investor’s perspective, it represents the necessary rate of return on a company’s existing securities in its portfolio. It is the minimum expected return that investors anticipate for providing capital to the company.

Cost of capital concept

Understanding the relationship between capital structure and cost of capital is crucial for businesses, as the cost of capital concept represents the expenses a company incurs for financing its operations through equity and debt.

It’s the required rate of return on a company’s existing securities according to an investor’s point of view or it’s the minimum rate of return that investors expect for providing capital to the company.

Cost of debt capital 

An interest rate that a company is required to pay to raise debt capital.

• The Y TM computation by this formula involves trial/and error. Using the formula approximate YTIM can be calculated:
• YTM = {Annual interest payment + (M – P)/ n / (0.6 × P + 0.4 x M)
• where M is the Maturity value, P is the present market value and n is the number of years left to maturity.

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Cost of preference capital

Preference capital carries a fixed rate of interest (called a dividend), like debentures but has a higher risk perception as it comes after secured creditors in receiving money in case of liquidation of the firm. No tax is deductible on the interest paid.

As in the case of debentures, the approximate cost of preference capital (Y IM) can be calculated by using the same formula:

• YTM = {Annual interest payment + (M – P)/n}/ (0.6 x P + 0.4 x M)
• where M is the Maturity value, P is the present market value and n is the number of years left to maturity.
• Here the underlying assumption is that the firm will pay the dividends every year and the preference shares will be redeemed on the due date.

Cost of equity capital

It’s the percentage of returns payable by a company to its equity shareholders on their holdings, many approaches have been used for this estimation and the following are some common methods:

• Capital Asset Pricing Model (CAPM) approach: According to this approach, the required rate of return on the equity of a particular company depends on three factors viz. risk-free rate of return, Beta of a company’s share price and the prevailing expected return on a portfolio of equity shares, in the capital market.

Formula:

• Bond Yield plus Risk Premium Approach: Under this approach, an equity risk premium is added to the yield on long-term bonds of the firm. While the yield on long-term bonds of the firm is known in the market, a decision on equity risk premium is a matter of individual investor perception.

• Dividend Growth Model approach: This approach assumes that the current market price of a firm’s equity is equal to the present value of all the dividends expected to be paid by the firm in future, discounted at the required rate of return.

This approach assumes that there will be a study growth in dividends paid by the firm, every year.

Formula

• Earning Price Ratio approach: According to this method, the needed rate of return is determined as follows: The required rate of return = anticipated earnings per share for the following year minus the share’s current market price.

The weighted average cost of capital (WACC)

The WACC is calculated by multiplying the proportion of each component by its cost and adding it after we have determined the costs of each capital component of a corporation.

The factors affecting the Weighted Average Cost of Capital of a firm can be classified as internal and external. Internal factors include capital structure policy, capital investment policy, and dividend policy. External factors include prevailing interest rates, risk perception and market risk premium, and corporate and personal taxes.

The weighted marginal cost of capital

The marginal cost of capital is the rate of return required by investors as more capital is raised by a firm, which is determined by the amount raised from the market.

Optimal capital structure

Optimal capital structure is a mix of debt and equity financing that maximises value while reducing the cost of capital.

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