capital structure of tcs
DESCRIPTION
group presentation on cpaital structure of TCSTRANSCRIPT
![Page 1: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/1.jpg)
Capital Structure
![Page 2: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/2.jpg)
Benefits of Using Other People’s MoneyDebt
→Financial leverage is the ability that owners have, to use other people’s money at fixed rates to make higher rates of return than would have been possible by using all of their own money. It represents one of the main benefits of taking on debt.
→Firms that take on debt as part of their capital structure are therefore known as leveraged firms while those that do not are known as unlevered firms.
![Page 3: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/3.jpg)
How does the mechanism work?
![Page 4: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/4.jpg)
Earnings per Share as a Measure of the Benefits of Borrowing
®One way to measure the benefits of leverage is to compare the EPS of firms with different capital structures under good and bad economic conditions.
®Let us consider 3 equal-sized firms: one with no debt, one with 50% debt, and one with 99.75% debt.
![Page 5: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/5.jpg)
Capital Structure Three Identical Firms
Earnings per Share as a Measure of the Benefits of Borrowing
Company needs to raise $10,000 capital, its shares are sold @ $25
![Page 6: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/6.jpg)
→ Assuming a cost of debt of 10% for all firms and identical EBIT ($2000), EPS is calculated and shown
→ Earnings per Share of Firms with Different Capital Structures
→ If the firm’s EBIT covers its interest cost, higher leverage benefits the stockholders resulting in higher EPS
Earnings per Share as a Measure of the Benefits of Borrowing
![Page 7: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/7.jpg)
→ However, if the firm’s EBIT does not cover its interest cost, the reverse is true, as shown
Earnings per Share of Firms with Different Capital Structures
Bottom-lineLeverage is a two-edged sword; benefiting firms in good times and hurting them in bad times
Earnings per Share as a Measure of the Benefits of Borrowing
![Page 8: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/8.jpg)
®The search continues for seeking that level of EBIT that makes the capital structure decision irrelevant, resulting in similar EPS
®The Break Even EBIT has an answer
![Page 9: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/9.jpg)
To calculate the break-even EBIT, we use the following method: 1. We first calculate the EPS of two firms, Company 1 and
Company 2; set them equal; and solve for the EBIT:EPS = (EBIT – I)/no: of sharesEPS* =( EBIT – 0)/400 = (EBIT -$500)/200400(EBIT-$500) = 200(EBIT-0)2EBIT-$1000 = EBITEBIT = $1000
2. Next, we calculate each firm’s EPS at the break-even EBIT, i.e., $1000:
Company 1’s EPS = 1000/400 = $2.50Company 2’s EPS = (1000-500)/200 = $2.50Company 3’s EPS = (1000-997.5)/1= $2.50
Break-Even Earnings for Different Capital Structures
![Page 10: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/10.jpg)
Break-Even Earnings for Different Capital Structures
→At a certain level of EBIT, known as the break-even EBIT, all three firms will have the same EPS, as shown
→Earnings per Share of Firms with Different Capital Structures
![Page 11: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/11.jpg)
→Below an EBIT of $1000, e.g., $800, leverage hurts and vice-versa, as shown
Earnings per share and earnings for three different capital structures.
Break-Even Earnings for Different Capital Structures
![Page 12: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/12.jpg)
Bottom line
®At an EBIT of $1,000, capital structure of the firm becomes irrelevant, justified by the fact at the different capital structure leads to the same EPS value
![Page 13: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/13.jpg)
1. In order to meet its financing requirements, Google is contemplating at two possible capital structures. Presently the firm is an all equity firm with a $12 million in assets and 2 million shares outstanding. The market value of each stock is $6.0. the CEO is thinking of leveraging the firm by selling 6 million of debt financing and retiring the stock in debt for equity swap. The annual cost of debt is 8%. What is the break – even EBIT for Google with the two possible capital structures.
EBIT = $960,000, EPS = 0.48
2. Which capital structure should the company choose if the anticipated EBIT for the coming year is $1,000,000?
EPS = $0.50, $0.52
![Page 14: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/14.jpg)
The intriguing question®How much debt should a company
carry and from whom®Basis for “Pecking order Hypothesis”
![Page 15: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/15.jpg)
Firm Value in Miller – Modigliani Framework
®Firm E is an all equity firm with a required rate of return on its assets of 8%. Firm L is a leveraged firm and can borrow in the debt market @6%, what is the cost of equity as the firm L borrows more and more in the debt markets? Solve for each of the three different capital structures:
A. 100% equityB. 50% equity, 50% debtC. 10% equity and 90% debtThe firm earn $100,000 every year forever
![Page 16: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/16.jpg)
Steps 1. Find Cost of Equity of the firm at each capital
structure2. Find WACC of the firm at each capital
structure3. Find the value of the firm using the
appropriate discount rate
![Page 17: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/17.jpg)
04/11/2023 17
“Our performance in 2000 was a success by any measure…The company’s net income reached a record in 2000. We are laser-
focused on earnings per share, and we expect to continue strong earnings performance.”
![Page 18: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/18.jpg)
Debt and the Tax ShieldEBIT Distribution to Claimants under Different Funding Structures
Effect of increasing debt levels on the distribution of a firm’s EBIT
As the firm’s debt level goes from 0% to 90%, with EBIT staying constant at $100,000, government’s share of EBIT (taxes) dwindles from $25,000 to $2,500. The equity holders’ share also gets smaller and smaller as the debt holders receive their interest payments.
![Page 19: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/19.jpg)
04/11/2023 19
Impact of Capital Structure on Firm Value ®Does Debt / Equity policy affect the overall
firm value?®Does Minimizing WACC always result in
maximizing value?
![Page 20: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/20.jpg)
04/11/2023 20
Effect on Operations
• Business risk is 20%• Financial risk is 50%
Business Outcome
Operating cash flow
Interest Cash to shareholders
Bad $ 80 $ 60 $ 20Expected $ 100 $ 60 $ 40Good $120 $ 60 $ 60
![Page 21: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/21.jpg)
04/11/2023 21
Impact of leverage on firm’s cost of capital
Case 1®Firm uses equal levels of debt & equity in its
capital structure®Given tax rate is 40%®Kd is 10%®KE is 16%®WACC is {D/(D+E)} Kd(1-t) + (E/D+E) KE
®WACC = 11%
![Page 22: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/22.jpg)
04/11/2023 22
Case 2®Firm uses 60 % debt – 40 % equity in its capital
structure®Tax rate is 40%®KE is 18%®Kd is 10%®WACC = 10.8%Case 3®All else being equal, KE changes to 20%®New WACC is 11.6%
![Page 23: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/23.jpg)
04/11/2023 23
Let us examine
Should I®Pick the financing mix that maximizes firm
value®Rely on ROE & EPS as appropriate measures of
value®No, they only measure the returns & ignores
the all important element of risk®So, increased earnings does not necessarily
increase firm value if it comes at a cost of increased debt levels
![Page 24: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/24.jpg)
04/11/2023 24
Value
![Page 25: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/25.jpg)
04/11/2023 25
The Epicenter of value®Value that eventually goes to all the claimants ®Earnings Before Interest & Tax (EBIT)
Government Tax
Shareholders Dividends
Debt holders Interest
EBIT
![Page 26: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/26.jpg)
04/11/2023 26
®Investment decision decides the Size of the pie®The Financing decisions decides how the slice
is to be cut®Can firms increase the slice of residual claims
by restricting the outflow in the form of corporate taxes?
![Page 27: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/27.jpg)
04/11/2023 27
Unlevered Firm Levered Firm$ 3,000* @ 10 %
Earnings before Interest & Taxes - EBIT
1,000 1000
Interest on Debt 0 300
Pretax profits 1,000 700
Tax rate @ 40 % 400 280
Profits after taxes 600 420
Payments made to debt & equity
600 720
®Maintaining a target capital structure ®Entire PAT paid out as dividends
The levered firm’s increase in value to the extent of 120 is in essence exactly the amount arising out of tax shield on interest0.10(3,000)(0.4)
Thus Government’s tax revenues decline by 120 (600 – 480)
![Page 28: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/28.jpg)
Capital Structure in a World of Corporate Taxes and no Bankruptcy
Value of firms in world of corporate taxes
As the firm issues more debt, its tax shield increases, and the government’s share of the pie decreases, increasing the value of the equity-holders.→All debt financing is optimal.→The WACC of the firm falls as more debt is added.
![Page 29: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/29.jpg)
04/11/2023 29
® So, can we safely say®VL = VUL + Present value of Tax shield on Debt® VL = VUL + DT
Case®Given: EBIT = 1,000®Tax rate (T) = 40 %® So, Post tax EBIT = 1,000(0.4) = 600®KD = 10%, KEU 12%®V denotes firm value &®CFD & CFE denotes cash floes to debt and equity
holders respectively
![Page 30: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/30.jpg)
04/11/2023 30
Financial Policy Cash Flows Values Unlevered Firm CFD = 0
CFE = 600Taxes = 400
D = CFD / KD =0E = CFE / KEU = 600 / 0.12 = 5,000Value (V) = D+E= 0+5,000 = 5,000
Levered Firm 3,000 Debt issues
CFD = 300CFE = 420Taxes = 280
D = CFD / KD =300 / 0.10 = 3,000VL = VUL + DT = 5,000 + (120) / 0.10VL = 6,200Since, VL = D + E6,200 = 3,000 +ESo, E = 3,200
![Page 31: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/31.jpg)
04/11/2023 31
The Benefit – Cost Tradeoff
Value of the Firm
VU
VL
Leverage
D*
![Page 32: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/32.jpg)
04/11/2023 32
Leverage and tax benefits & its implication on firm value and investors’ cost of capital
• With added leverage, the KE for the levered firm changes, but the question is to what extent
From our earlier calculations,• Market value of equity was $ 3,200• Expected cash flow to equity holders was $ 420• So, the implied cost of equity for the levered firm
(KEL) is,
• E = CFE/KEL, 3,200 = 420/KEL, KEL = 13.125
• So, the additional debt has altered the KE from 12% to 13.125%
![Page 33: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/33.jpg)
04/11/2023 33
®The additional 1.125% (13.125 – 12) is the additional risk premium for financial risk and increases directly with the D/E ratio
Recall,®KEL = Rf + Rbus + Rfin ®Where, Rfin denotes financial risk®Thus: KEL = KEU + Rfin
In this case,®13.125% = 12% + 1.125%
![Page 34: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/34.jpg)
04/11/2023 34
Inference
®The value of the firms, either levered of unlevered can be estimated by discounting its Post tax EBIT with the appropriate WACC
®Value of the firm will be maximum where the WACC is minimum
®Challenge is to estimate the minimum WACC that maximizes the firm value
![Page 35: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/35.jpg)
Debt (D)
Cost of Debt (KD)
Equity Cost of Equity (KE )
WACC
Unlevered Firm
0 10% $5,000 12% 12%
Levered Firm $3,000 10% $3,200 13.125% 9.68%
WACC = (D/D+E)*KD(1-t) + (E/D+E)(KE )
Cost of Capital & Debt Policy
![Page 36: Capital Structure of TCS](https://reader036.vdocument.in/reader036/viewer/2022081721/552792db550346e1358b4861/html5/thumbnails/36.jpg)
04/11/2023 36
Final Thoughts ® Financial leverage magnifies the variability of operating
income, thus increasing the riskiness of the return o equity® As financial leverage, the risk & return required by the
equity holders increases® Financial leverage affects the value of the firm because the
tax deductibility of interest acts as a subsidy to the firm® offsetting the benefits of tax are the costs of financial
distress, agency problem and reduced flexibility® In principal, an optimum debt level exists beyond which
the tax benefits of additional debt are outweighed by its costs