Capital Structure Theories and Calculation of Cost of Capital for Desklib

Question 1.
Answer.
Capital refer to the permanent finance that is invested in the business. Long term funds that are
invested in business can be categorized into two types i.e. Debt or Equity. Debt is the funds that
business borrows from outside sources like bonds, commercial papers, loans, debentures etc. Debts
funds have a fixed interest rate bearing on the lender. Whereas, equity refers to the funds that the
owner of the business invests like shares, retained earnings etc. Equity funds do not have any fixed
interest bearings on the business. All profits and loss are to be borne by the equity owners. The basic
point that is to be noted for determining capital structure is the proportion of borrowed capital or
owned funds invested in the business. Issue of debentures, shares, long term borrowing, and loans are
the sources through which long term funds can be raised. The main difference between the two types of
funds is the fixed rate of interest to be paid in case of debt whether there is profit or not, which is not
the case in equity which, requires dividends to be paid but only in case of availability of sufficient profits.
Returns which are available for shareholders are affected by the capital structure decisions.
There are four types of Capital structure theories:
1. NI (Net Income) Approach
2. NOI (Net Operating Income) Approach
3. Modigliani Miller (MM) Approach
4. Traditional Approach
Following are the assumptions for capital structure theories:
1. No corporate taxes will be there.
2. Debt and Equity are the only two sources of finance for the firms.
3. Dividend pay-out (DP) ratio is 100% i.e firm distributes all its income to its shareholders as
dividend and retained earnings is 0.
4. Total assets will be given and will not change, investment decisions which are given will be
constant.
5. There is perpetual life for the firm.
6. Earnings before interest and tax of a firm will not grow.
7. Total financing of the firm remains the same. Firm’s leverage will be altered only by selling
shares.
8. Business risk is not dependent upon capital structure and will remain constant.
9. Deferred tax is ignored as accounting only.
Capital structure = Debt + Equity
Book Value = Shareholders’ Equity + Long term liabilities, long term debts.
Cost of Debt i.e. D 287,900,000.00
Cost of Equity i.e. C 1,006,000,000.00
Cost of Capital (Debt+Equity) 1,293,900,000.00

Market Value = No. of shares x Share price + No. of bonds x Bond price.
Market Value
(Bond Price*Number of Bonds)
Cost of Debt i.e. D
Short Term Debt 54,900,000.00
Bonds 22,135,000,000.00 22,189,900,000.00
Cost of Equity i.e. C 3,060,000,000.00
Cost of Capital 25,249,900,000.00

Question 2.
Answer.
Calculation of Cost of Equity:
(i) Using CAPM.
Risk Free Rate of Return i.e. Rf 4
Market Rate of Return i.e. Rm 12
Beta
1.
1
Per Capital Asset Pricing Model, Cost of Equity
= Rf+ (Rm-Rf)Beta 12.8%
Debt
28
8
Equity
100
6
First we will ungear the Beta usinf formula
BEquity = BAsset + {(1-t) D/E}*BAsset
(ii) Using Dividend Growth Model.
Re = D1/P0 + g
Equity Value
1006
million
Shares Outstanding (75+10-5) 80 million
Face Value 12.575
Dividend (%) 11.67%
Dividend ($) 1.4675025
Price (P0) 36
Growth(g) 12.50%
Re 16.58%
Cost of Debt
Interest
Rate Debt
Weighted Average Cost
of Debt
Sinking Fund
Debenture
First Issue 6.99 133,000,000.00
Second Issue 7.46 100,000,000.00
233,000,000.00
Yield to maturity compounded on semi-annual basis
Effective annual yield- APR Formula
(1+r/m)m-1
where m=2