Hypothetical Model on Cost of

finance & Capital structure

SUBMITTED TO:

Dr. Paresh Shah

SUBMITTED BY:

Shreyash Bhanvadia (05)

Lovely Ganeriwal(18)
Rohit Mehta (30)
Unnati Modi (31)
Upasana Modi (32)

Som-Lalit Institute of Management Studies

2009-10

Capital Structure
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Introduction

Capital is the major part of all kinds of business activities, which are
decided by the size, and nature of the business concern. Capital may be
raised with the help of various sources. If the company maintains proper
and adequate level of capital, it will earn high profit and they can provide
more dividends to its shareholders.

Objectives of Capital Structure

Decision of capital structure aims at the following two important

objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.

Meaning of Capital Structure

Capital structure refers to the kinds of securities and the proportionate

amounts that make up capitalization. It is the mix of different sources of
long-term sources such as equity shares, preference shares, debentures,
long-term loans and retained earnings.
The term capital structure refers to the relationship between the various
long-term sources financing such as equity capital, preference share
capital and debt capital. Deciding the suitable capital structure is the
important decision of the financial management because it is closely
related to the value of the firm.
Capital structure is the permanent financing of the company represented
primarily by long-term debt and equity.
• According to the definition of Prasanna Chandra, “The
composition of a firm’s financing consists of equity, preference, and
debt”.
• According to the definition of R.H. Wessel, “The long term sources
of fund employed in a business enterprise”.

Forms of Capital Structure

Capital structure pattern varies from company to company and the

availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.

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Optimum Capital Structure
• Optimum capital structure is the capital structure at which the
weighted average cost of capital is minimum and thereby the value
of the firm is maximum.
• Optimum capital structure may be defined as the capital structure
or combination of debt and equity, that leads to the maximum value
of the firm.

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 Factors Determining Capital Structure

The following factors are considered while deciding the capital structure of
the firm:

Leverage

It is the basic and important factor, which affect the capital structure. It
uses the fixed cost financing such as debt, equity and preference share
capital. It is closely related to the overall cost of capital.

Cost of Capital

Cost of capital constitutes the major part for deciding the capital structure
of a firm.
Normally long- term finance such as equity and debt consist of fixed cost
while mobilization.
When the cost of capital increases, value of the firm will also decrease.
Hence the firm must take careful steps to reduce the cost of capital.
(a) Nature of the business: Use of fixed interest/dividend bearing
finance depends upon the nature of the business. If the business
consists of long period of operation, it will apply for equity than
debt, and it will reduce the cost of capital.
(b) Size of the company: It also affects the capital structure of a
firm. If the firm belongs to large scale, it can manage the financial
requirements with the help of internal sources. But if it is small size,
they will go for external finance. It consists of high cost of capital.
(c) Legal requirements: Legal requirements are also one of the
considerations while dividing the capital structure of a firm. For
example, banking companies are restricted to raise funds from
some sources.
(d) Requirement of investors: In order to collect funds from
different type of investors, it will be appropriate for the companies
to issue different sources of securities.

Government policy

Promoter contribution is fixed by the company Act. It restricts to mobilize

large, long term funds from external sources. Hence the company must
consider government policy regarding the capital structure.

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Capital Structure Theories

Capital structure is the major part of the firm’s financial decision which affects
the value of the firm and it leads to change EBIT and market value of the shares.
There is a relationship among the capital structure, cost of capital and value of
the firm. The aim of effective capital structure is to maximize the value of the
firm and to reduce the cost of capital.
There are two major theories explaining the relationship between capital
structure, cost of capital and value of the firm.

Traditional Approach

It is the mix of Net Income approach and Net Operating Income approach.
Hence, it is also called as intermediate approach. According to the
traditional approach, mix of debt and equity capital can increase the value
of the firm by reducing overall cost of capital up to certain level of debt.
Traditional approach states that the Ko decreases only within the
responsible limit of financial leverage and when reaching the minimum
level, it starts increasing with financial leverage.

Assumptions

Capital structure theories are based on certain assumption to analysis in a

single and convenient manner:
• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.

Net Income (NI) Approach

According to this approach, the capital structure decision is relevant to the

valuation of the firm. In other words, a change in the capital structure

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leads to a corresponding change in the overall cost of capital as well as
the total value of the firm.

According to this approach, use more debt finance to reduce the overall
cost of capital and increase the value of firm.
Net income approach is based on the following three important
assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
where,
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following formula:

where,
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate

Format for calculating value of the firm on the basis of NI approach.

Net Operating Income (NOI) Approach

This is just the opposite of the Net Income approach. According to this
approach, Capital Structure decision is irrelevant to the valuation of the
firm. The market value of the firm is not at all affected by the capital
structure changes.

According to this approach, the change in capital structure will not lead to
any change in the total value of the firm and market price of shares as
well as the overall cost of capital.

NI approach is based on the following important assumptions;

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 • The overall cost of capital remains constant;
• There are no corporate taxes;
• The market capitalizes the value of the firm as a whole;

Value of the firm (V) can be calculated with the help of the following
formula

Where,
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital

Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm
does not affect the market value of a firm in a perfect capital market. In
other words MM approach maintains that the average cost of capital does
not change with change in the debt weighted equity mix or capital
structures of the firm.
Modigliani and Miller approach is based on the following important
assumptions:
• There is a perfect capital market.
• There are no retained earnings.
• There are no corporate taxes.
• The investors act rationally.
• The dividend pay-out ratio is 100%.
• The business consists of the same level of business risk.

Value of the firm can be calculated with the help of the following formula:

Where,
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
t = Tax rate

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 Cost of Capital

Introduction

Cost of capital is an integral part of investment decision as it is used to

measure the worth of investment proposal provided by the business
concern. It is used as a discount rate in determining the present value of
future cash flows associated with capital projects. Cost of capital is also
called as cut-off rate, target rate, hurdle rate and required rate of return.

When the firms are using different sources of finance, the finance
manager must take careful decision with regard to the cost of capital;
because it is closely associated with the value of the firm and the earning
capacity of the firm.

Meaning of Cost of Capital

Cost of capital is the rate of return that a firm must earn on its project
investments to maintain its market value and attract funds.

Cost of capital is the required rate of return on its investments which

belongs to equity, debt and retained earnings. If a firm fails to earn return
at the expected rate, the market value of the shares will fall and it will
result in the reduction of overall wealth of the shareholders.

According to the definition of Solomon Ezra, “Cost of capital is the

minimum required rate of earnings or the cut-off rate of capital
expenditure”.

Importance of Cost of Capital

Computation of cost of capital is a very important part of the financial

management to decide the capital structure of the business concern.

Importance to Capital Budgeting Decision

Capital budget decision largely depends on the cost of capital of each

source. According to net present value method, present value of cash
inflow must be more than the present value of cash outflow. Hence, cost
of capital is used to capital budgeting decision.

Importance to Structure Decision

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Capital structure is the mix or proportion of the different kinds of long
term securities.
A firm uses particular type of sources if the cost of capital is suitable.
Hence, cost of capital helps to take decision regarding structure.

Importance to Evolution of Financial Performance

Cost of capital is one of the important determining which affects the

capital budgeting, capital structure and value of the firm. Hence, it helps
to evaluate the financial performance of the firm.

Importance to Other Financial Decisions

Apart from the above points, cost of capital is also used in some other
areas such as, market value of share, earning capacity of securities etc.
hence, it plays a major part in the financial management.

Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings

Cost of Equity

Cost of equity capital is the rate at which investors discount the expected
dividends of the firm to determine its share value.
Conceptually the cost of equity capital (Ke) defined as the “Minimum rate
of return that a firm must earn on the equity financed portion of an
investment project in order to leave unchanged the market price of the
shares”.

Cost of equity can be calculated from the following approach:

• Dividend price (D/P) approach
• Dividend price plus growth (D/P + g) approach
• Earning price (E/P) approach
• Realized yield approach.

Cost of Debt

Cost of debt is the after tax cost of long-term funds through borrowing.
Debt may be issued at par, at premium or at discount.

Cost of Preference Share Capital

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Cost of preference share capital is the annual preference share dividend
by the net proceeds from the sale of preference share.
There are two types of preference shares irredeemable and redeemable.

Cost of redeemable preference share capital is calculated with the help of

the following formula:

Where,
Kp = Cost of preference share
Dp = Fixed preference dividend
Np = Net proceeds of an equity share

Cost of irredeemable preference share is calculated with the help of the

following formula:

Where,
Kp = Cost of preference share
Dp= Fixed preference share
P = Par value of debt
Np = Net proceeds of the preference share
n = Number of maturity period.

Cost of Retained Earnings

Retained earnings is one of the sources of finance for investment

proposal; it is different from other sources like debt, equity and preference
shares. Cost of retained earnings is the same as the cost of an equivalent
fully subscripted issue of additional shares, which is measured by the cost
of equity capital. Cost of retained earnings can be calculated with the help
of the following formula:
Kr =Ke (1 – t) (1 – b)
Where,
Kr=Cost of retained earnings
Ke=Cost of equity
t=Tax rate
b=Brokerage cost

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Analysis of Capital Structure and Cost of Capital

Mahindra and Mahindra Financial

Services Ltd.

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Introduction of Mahindra & Mahindra Financial Services
Ltd. (MMFSL)

MMFSL is one of India’s leading non-banking finance companies focused

on the rural and semi-urban sectors providing finance for Utility Vehicles
(UVs), tractors and cars. MMFSL is a subsidiary of Mahindra & Mahindra
Limited, a leading tractor and UV manufacturer with over 60 years’
experience in the Indian market.

Their goal is to be the preferred provider of retail financing services in the

rural and semi-urban areas of India, while strategy is to provide a range of
financial products and services to their customers through nationwide
distribution network. They seek to position themselves between the
organised banking sector and local money lenders, offering customers
competitive, flexible and speedy lending services.

MMFSL principally finance UVs used both for commercial and personal
purposes, tractors and cars. While they predominantly finance M&M UVs
and tractors, they have continued to expand their lending to vehicles not
manufactured by Mahindra & Mahindra Ltd.

Vision

MMFSL’s vision is to be the leading Rural Finance Company and continue

to retain the leadership position for Mahindra Products.

Mission

• To be recognised as the premier provider of financial services on the

basis of their contribution to sale of Mahindra range of vehicles,
tractors, services and help M&M protect its sale through availability of
finance.

• To specialise in financing products based on applications and build

on the competence developed in its focus area. To target all segments
of vehicle financing and deploy the skills acquired through an in-depth
understanding of the chosen product market.

• To provide products and services tailored to the needs of M&M,

most favoured customer, and always meet their needs. In case of
demand-supply mismatch of funds, to do everything to find a solution.

• To help M&M develop better products by providing first-hand

information received from the target market.

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 Capital Structure of MMFSL from 2005-06 to 2008-09

Particulars 2006 2007 2008 2009

(in. Rs Crores)
Equity 732.78 778.24 1,314.27 1,469.16
Debt 3,882.95 4,911.24 5,068.18 5,213.01

Notes:

• The above chart shows the constant change in the debt-equity ratio
made by the company.

• The company has decreased it debt level from 84% to 78%

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 Cost of Capital Calculations

Earning Price Approach

Cost of Equity (Earnings Price Approach)

Particulars 2006 2007 2008 2009

EPS 12.58 15.72 18.58 22.14

MPS 231 217 280 245
Ke= (EPS/MPS)*100 5.45 7.24 6.64 9.04

Cost of Debt
Particulars 2006 2007 2008 2009

Interest (1) 219.44 324.13 456 509.86

Total Debt (2) 3,882.95 4,911.24 5,068.18 5,213.01
Cost of Debt (with tax) 5.65 6.60 9.00 9.78
Cost of Debt
(without tax) 3.96 4.62 6.30 6.85

Weighted Average Cost of Capital

Particulars 2006 2007 2008 2009

Cost of Equity 5.45 7.24 6.64 9.04

Weight Assigned 1 1 1 1

Cost of Debt 3.96 4.62 6.3 6.85

Weight Assigned 5.76 6.31 3.86 3.55

Weighted Equity 5.45 7.24 6.64 9.04

Weighted Debt 22.81 29.15 24.32 24.32
Total Weight 6.76 7.31 4.86 4.55

WACC 4.18 4.98 6.37 7.33

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 Return on Investments
Particulars 2006 2007 2008 2009

Profit 375.38 518.98 715.69 824.39

Total Cap Employed 4,615.73 5,689.48 6,382.45 6,682.17
ROI 8.13 9.12 11.21 12.34

Difference Between ROI and WACC

Particulars 2006 2007 2008 2009

Difference 3.95 4.14 4.84 5.01

Difference Between Cost of Debt and Cost of Equity

Particulars 2006 2007 2008 2009

Difference -1.49 -2.62 -0.34 -2.19

Notes:
• Earning Price Method is the most appropriate method only when the
dividend pay-out ratio is 100%.

• The difference between ROI and WACC is positive and is continuously

growing over the years. So, should better go for retained earning rather
than giving dividends.

• In this case, suppose, dividend pay-out ratio is 100%, then cost of

equity is higher than cost of debt. So, company should go for Debts
rather than going for equity capital.

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 Dividend Price Approach

Cost of Equity (Dividend Payout approach)

Particulars 2006 2007 2008 2009

Dividend Paid/Share 3.5 4 4.5 5.5

MPS 231 217 280 245
Ke =
(DPS/MPS)*100 1.52 1.84 1.61 2.24

Cost of Debt

Particulars 2006 2007 2008 2009

Interest (1) 219.44 324.13 456 509.86

3,882. 4,911. 5,068. 5,213.
Total Debt (2) 95 24 18 01
Cost of Debt (with
tax) 5.65 6.60 9.00 9.78
Cost of Debt
(without tax) 3.96 4.62 6.30 6.85

Weighted Average Cost of Capital

Particulars 2006 2007 2008 2009

Cost of Equity 1.52 1.84 1.61 2.24

Weight Assigned 1 1 1 1

Cost of Debt 3.96 4.62 6.3 6.85

Weight Assigned 5.76 6.31 3.86 3.55

Weighted Equity 1.52 1.84 1.61 2.24

Weighted Debt 22.81 29.15 24.32 24.32
Total Weight 6.76 7.31 4.86 4.55

WACC 3.60 4.24 5.33 5.84

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 Return on Investments

Particulars 2006 2007 2008 2009

Profit 375.38 518.98 715.69 824.39

4,615. 5,689. 6,382. 6,682.
Total Cap Employed 73 48 45 17
ROI 8.13 9.12 11.21 12.34

Difference Between ROI and WACC

Particulars 2006 2007 2008 2009

Difference 4.53 4.88 5.88 6.50

Difference Between Cost of Equity and Cost of

Debt
Particulars 2006 2007 2008 2009

Difference 2.44 2.78 4.69 4.61

Notes:

• Logically, the actual cost of capital of any company is the dividend paid
by the company to its shareholders, so here we have calculated cost of
equity on the basis of Dividend paid per share and Market price of
share.

• For market price of the share we have taken average of 52 week high
and low price of each year.

• The difference between ROI and WACC is positive and is continuously

growing over the years. So, should better go for retained earning rather
than giving dividends.

• Also, the cost of equity is lower than cost of debt, so according to this
approach, the company should go for lowering the debt and issuing
more equity.

• This can one of the basis on which company has continuously reduced
the amount of debt in its company’s capital structure.

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• Out of the total income, 37% is paid as interest and only 11% is
retained back in the business. If the company wants to grow, it should
concentrate more on increasing retained earnings and thereby
decreasing its debts.

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 Preference Share Capital Redeemed
• In 2005, the company was having 6.9% cumulative preference shares.
But the cost of preference was comparatively high in relationship with
cost of equity and cost of debt. So the company redeemed the
preference share capital. Moreover the company came out with Initial
Public Offering in 2006 to reduce its overall cost of capital.

Financial Highlights of the Company

Particulars 2006 2007 2008 2009

Cost of Equity 1.52 1.84 1.61 2.24

Cost of Debt 3.96 4.62 6.3 6.85
WACC 3.6 4.24 5.33 5.84
Interest Coverage
Ratio 1.79 1.66 1.63 1.67
Debt Equity Ratio 5.76 6.31 3.86 3.55
ROCE 8.26 9.26 11.4 12.5
ROE 14.78 17.08 13.46 14.6
EPS 12.58 15.72 18.58 22.14
EBIT (in. Rs 386.7 534.2 736.7 844.2
Crores) 7 9 1 2

EPS Comparison Before and IPO issue of Equity Share

Capital

Before issue of IPO

Year Rs.
2003 7.3
2004 10.7
2005 13.2
After issue of IPO
2006 12.58
2007 15.72
2008 18.58
2009 22.14
After the issue of equity shares in the year 2006, the company has
maintained its constant growth is the EPS.

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Hypothetical Analysis of Capital Structure and Cost of
Capital

Mahindra and Mahindra Financial

Services Ltd.

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 Hypothetical Analysis of Debt-Equity ratio
After changing Debt-
Before Changes Debt-Equity Equity
Sources of Funds Sources of Funds
Mar
Particulars Mar '09 Particulars '09
In Rs.
In Rs. crores crores
Total Share Capital 110
Total Share Capital 95.71 Equity Share Capital 110
Equity Share Capital 95.71 Share Premium 450
Share Application Preference Share
Money 0 Capital 0
Preference Share 1,373.
Capital 0 Reserves 45
Revaluation
Reserves 1,373.45 Reserves 0
Revaluation 1,933.
Reserves 0 Networth 45
4,001.
Networth 1,469.16 Secured Loans 83
Secured Loans 4,466.83 Unsecured Loans 746.18
4,748.
Unsecured Loans 746.18 Total Debt 01
6,681.
Total Debt 5,213.01 Total Liabilities 46
Total Liabilities 6,682.17

Assumptions:

• Company utilized all of its authorized share capital of Rs. 110 crore

• Current market price of MMFSL is approx. Rs. 340. So, we have issued
the shares are Rs. 310. i.e. company would receive Rs. 15 crores as
equity share capital and Rs. 450 as share premium.

• The secured loan amount is decreased to Rs. 4001.83 from Rs.

4466.83.

• With these changes, the Debt equity ratio stands at 2.6, which was
previously 3.55

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 Before Changes in Debt- After Changes in Debt-Equity
Equity Ratio Ratio

Profit & Loss

account of Profit & Loss
Mahindra & account of Mahindra
Mahindra Financial (in. Rs. & Mahindra (in. Rs.
Services Crores) Financial Services Crores)
Income Income
Sales Turnover 1,364.83 Sales Turnover 1,364.83
Excise Duty 0 Excise Duty 0
Net Sales 1,364.83 Net Sales 1,364.83
Other Income 19.83 Other Income 19.83
Stock Adjustments 0 Stock Adjustments 0
Total Income 1,384.66 Total Income 1,384.66
Expenditure Expenditure
Raw Materials 0 Raw Materials 0
Power & Fuel Cost 0 Power & Fuel Cost 0
Employee Cost 117.33 Employee Cost 117.33
Other Manufacturing Other Manufacturing
Expenses 0 Expenses 0
Selling and Admin Selling and Admin
Expenses 356.11 Expenses 356.11
Miscellaneous Miscellaneous
Expenses 67 Expenses 67
Preoperative Exp Preoperative Exp
Capitalised 0 Capitalised 0
Total Expenses 540.44 Total Expenses 540.44

Operating Profit 824.39 Operating Profit 824.39

PBDIT 844.22 PBDIT 844.22
Interest 509.86 Interest 478
PBDT 334.36 PBDT 366.22
Depreciation 7.42 Depreciation 7.42
Other Written Off 1.31 Other Written Off 1.31
Profit Before Tax 325.63 Profit Before Tax 357.49

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Tax 111.11 Tax 121.5466
Reported Net
Profit 214.52 Reported Net Profit 235.9434
Equity Dividend 53.3 Equity Dividend 60.5
Corporate Dividend Corporate Dividend
Tax 9.06 Tax 10.22
Per share data Per share data
(annualised) (annualised)
Shares in issue Shares in issue (in
(lakhs) 969.01 lakhs) 1100
Earning Per Share
(Rs) 22.14 Earning Per Share (Rs) 21.44
Equity Dividend (%) 55 Equity Dividend (%) 55

Notes:

• With the change in the debt equity ratio, interest on debt reduces by
Rs. 31.86 Crores (Cost of debt is 6.85% for the year 2009)

• With this changes the net profit of the company increased by Rs. 20
crores.

• The EPS of the company is almost the same.

• Dividend Paid is 55% (as the same declared for 2008-09)

• The most beneficial part is the debt equity ratio comes down to 2.6
from 3.55 and this will increase the credibility of the company.

• These are just the assumptions and according to our analysis it can be
optimal capital structure as the company’s capital structure is Rs. 110
crores only.

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 Conclusion
After studying the capital structure of MMFSL we can conclude that it is
one of the growing firms in the financial sector, as the EPS of the
company is on a constant rise, especially after the IPO issue in the year
2006, but still company has a burden of debt on it shoulders, which is
actually reducing its profit margins. This is one of the reasons why
company is constantly modifying its capital structure from 2006 to
2009 and has been trying to find optimal capital structure.

By doing hypothetical analysis and utilizing all of the authorized capital

of MMFSL we tried to find out the optimal capital structure and reduced
the Debt equity ratio to 2.6 from 3.55, without having any major
change in the EPS of the company.

Limitation of the Study:

The scope of this project is limited to our understanding of Capital

Structure and Cost of Equity and Debt.

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 Bibliography
Websites:

www.mahindrafinance.com

www.moneycontrol.com

www.icicidirect.com

Reports:

Annual Report MMFSL – 2006-07

Annual Report MMFSL – 2007-08

Annual Report MMFSL – 2008-09

Red Herring Prospectus of MMFSL issued on 2nd February, 2006

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