Unit 3 & Unit 4
Short Notes for WordPress

Capital Structure means the mix of long-term sources of funds a company uses — mainly Equity (owner's money) and Debt (borrowed money). It answers the question: "How should a company finance its long-term assets and operations?"

• Cost of Capital: Right mix minimizes WACC → lower financing cost
• EPS: Using debt (fixed interest) magnifies EPS through financial leverage
• Financial Risk: Too much debt → higher risk of not paying interest
• Firm Value: Optimal mix maximizes market value of shares
• Control: Debt doesn't dilute ownership. Equity does.

An ideal capital structure achieves the perfect balance between risk and return, minimizes WACC, and maximizes firm value. Here are its 5 key features:

• Trading on Equity: If ROA > Interest rate → use more debt. Surplus return goes to equity shareholders. Example: Earn 18%, borrow at 10% → extra 8% goes to shareholders.
• Nature of Industry: Capital-intensive industries (Steel, Power) use more debt. Service industries (IT, Consulting) use less. TCS debt-to-equity ≈ 0.1 vs Tata Steel ≈ 1.5.
• Stability of Earnings: Stable earnings (utilities, FMCG) → can afford more debt. Volatile earnings (airlines, hotels) → use less debt.
• Tax Benefit (Tax Shield): Interest is tax-deductible. At 30% tax, borrowing at 10% actually costs only 7%. This makes debt attractive. Higher tax bracket = more benefit.
• Control: Promoters who want to stay in control prefer debt over equity (debt holders can't vote).
• Market Conditions: Bull market → issue equity at high prices. Low interest rate period → borrow cheap debt. Example: Many Indian cos rushed to borrow in 2020–21 (COVID low-rate era).
• Size of Company: Large companies (Reliance, TCS) access bonds, NCDs, multiple banks. Small MSMEs depend mostly on bank loans.
• Credit Rating: AAA rated company borrows cheaply. Lower rating = higher interest. Companies manage capital structure to protect credit rating.
• Flexibility: Keep some unused borrowing capacity for emergencies and growth opportunities.

The NI Approach says: Capital structure DOES affect firm value. By using more debt (which is cheaper), the company reduces its WACC, which increases firm value.

• Cost of Debt (Kd) stays constant regardless of debt level
• Cost of Equity (Ke) also stays constant regardless of debt level
• No taxes (simplified assumption)

Since debt is cheaper than equity (Kd < Ke), more debt → lower WACC → higher firm value (V = EBIT/Ko). So the NI Approach says: use MAXIMUM DEBT (100% debt) to maximize firm value.

The NOI Approach is the exact opposite of the NI Approach. It says: capital structure does NOT affect firm value at all. The firm's value depends only on its EBIT and overall risk class.

When a company uses more debt, equity shareholders see MORE risk and demand HIGHER returns (Ke rises). This rise in Ke exactly cancels the benefit of cheaper debt. So WACC stays the same and firm value stays the same — no matter how much debt is used.

The Traditional Approach is the most practical and widely accepted theory. It takes a middle position between NI and NOI. It says: an optimal capital structure exists at moderate debt levels where WACC is minimum and firm value is maximum.

MM Hypothesis was given by Franco Modigliani and Merton Miller (both Nobel Prize winners). It comes in two versions:

In a PERFECT CAPITAL MARKET (no taxes, no transaction costs, all investors rational), firm value is INDEPENDENT of capital structure. It doesn't matter how you finance — what matters is your earning power (EBIT).

Key Mechanism — Arbitrage (Homemade Leverage): If an unlevered firm is undervalued, investors will borrow personally and buy its shares — replicating what the company would do through corporate leverage. This arbitrage brings both firms to equal value.

When TAXES are included, debt has a powerful advantage — the Interest Tax Shield. Interest is tax-deductible. This means the government subsidizes your debt! Value of tax shield = Tax Rate × Debt Amount.

Capital Budgeting is the process of planning, evaluating, and selecting long-term investment decisions. It answers: "Should we build a new factory? Buy new machines? Launch a new product?" These decisions involve large money + long time + high risk.

• Large Money: Decisions involve hundreds or thousands of crores — wrong decision = massive loss
• Long Period: Effects last 5, 10, 20+ years — need careful long-term analysis
• Irreversible: Once factory is built, hard to undo. Once machine is bought, hard to sell at full price
• Strategic: These decisions define company's future direction (EV, digital, expansion)
• Wealth Impact: Good investments → positive NPV → higher share price → shareholder wealth created

NPV is the most recommended method for capital budgeting. It calculates the difference between the Present Value of all future cash inflows and the initial investment. If positive, project creates value. If negative, it destroys value.

r = discount rate (WACC/Cost of Capital). t = year. Σ = sum of all years.

• NPV > 0 → ACCEPT — project creates value (returns more than cost of capital)
• NPV < 0 → REJECT — project destroys value
• NPV = 0 → Indifferent — project exactly covers cost of capital
• For mutually exclusive projects: choose the one with HIGHER NPV

IRR is the discount rate at which the NPV of a project becomes exactly ZERO. It is the rate of return the project itself generates. "Internal" means it depends only on the project's own cash flows.

• IRR > Cost of Capital → ACCEPT — project returns more than minimum required
• IRR < Cost of Capital → REJECT — project returns less than required
• Between projects: choose the one with HIGHER IRR

PI measures how much present value you get per rupee invested. It is especially useful when a company has limited funds (capital rationing) and needs to rank projects by efficiency.

• PI > 1 → ACCEPT (returns more than cost)
• PI < 1 → REJECT
• Under capital rationing: Rank projects by PI — choose highest PI first

Payback Period = time taken for cumulative cash inflows to recover the initial investment. Quick and simple — but ignores time value of money.

ARR measures average annual accounting profit as a percentage of average investment. Simple to use with readily available data — but ignores time value of money.

Working Capital is the money a business needs for its day-to-day operations — buying raw materials, paying wages, covering utility bills. Without adequate working capital, even a profitable company can fail. This is called the "profitable but bankrupt" paradox.

• Nature of Business: Manufacturing (high WC) vs Services (low WC)
• Length of Operating Cycle: Longer cycle = more WC needed
• Credit Policy: More credit given to customers = more debtors = more WC needed
• Seasonality: Seasonal businesses (umbrellas, ACs, woolens) need variable WC
• Rate of Growth: Faster growing company = more WC needed
• Price Level (Inflation): Rising prices = same physical stock costs more

The Operating Cycle (also called Cash Conversion Cycle) is the time taken to convert cash → raw materials → WIP → finished goods → debtors → cash again. It's the full circle of working capital flow.

The Balance Sheet Method lists all expected Current Assets and Current Liabilities at their projected levels and computes the Net Working Capital required. It is the most structured and widely used method.