CAPITAL STRUCTURE By Dr Simmi khurana

The introduction of debt capital in the capital structure increase the earning per share of the equity shareholders. At the same time it increases the risk also, which is the risk of insolvency due to non-availability of earning available to equity shareholder. As such increasing the debt component beyond certain limit will not increase the earning per share. There are various theories of capital structure. One view is that the valuation of a firm and its cost of capital may be affected by the change in financial mix. The other view is that it is independent of its capital structure.

These views have been classified as following four theories of capital structure:1. Net income approach 2. Net operating income approach 3. Traditional approach 4. Modigliani-Millar approach

For this purpose following assumptions have been made:1. Firms use only long-term debt capital or equity share capital to raise funds. 2. Corporate income tax does not exist. 3. Firms follow policy of paying 100% of its earnings by way of dividend. 4. Operating earning are not expected to grow

Following definition and symbols are also used. S = market value of equity shares B = market value of Debt V = Total market value of firm NOI = Net operating Income I = Total interest payment NI = Net income available to shareholders. EBIT Overall cost of capital = V

1. Net Income approach:-

According to this approach as proposed by Durand, there exists a direct relationship between the capital structure and valuation of the firm and cost of capital. By the firm and cost of capital. By the introduction of additional debt capital in the capital structure, the valuation of the firm can be increased and cost of capital can be reduced and vice versa.

Example:Present Position
8% Debenture NOI I NI Equity capitalization rate Market value of equity shares Market value of debenture(B) Total value of firm V=S+B Over cost of capital 6,00,000 1,50,000 40,000 1,02,000 10% 10,20,000 6,00,000

50% increase
9,00,000 1,50,000 72,000 78,000 10% 7,80,000 9,00,000

50% Decrease in debt Capital

3,00,000 1,50,000 24,000 1,26,000 10% 12,60,000 3,00,000

16,20,000 9.26%

16,80,000 8.93%

15,60,000 9.62%

It can be seen that by the increase in debenture, the total value of the firm increases and the cost of capital reduces and vice versa. However it will hold good only if the cost of debenture i.e. the ratio of interest is less than the capitalization rate.

According to this approach, also proposed by Durand, the valuation of the firm and its cost of capital are independent of capital structure. Any change in the capital structure does not affect the value of the firm or cost of capital, though, the further introduction of debt capital may increase equity capitalization rate and vice versa.

Present Position (Rs.) 8% Debenture Over all capitalization rate 6,00,000 10%

50% increase in debt capita (Rs.) 9,00,000 10%

50% decrease in debt capital (Rs.) 3,00,000 10%

EBIT
Total value of firm Over all cost of capital EBIT/V Market value of debenture (B) Market value of Equity Share (S) i.e. V- B I Equity capitalization rate EBIT- I V-B

1,50,000
15,00,000 1,50,000 10% 6,00,000 9,00,000

1,50,000
15,00,000 1,50,000 10% 9,00,000 6,00,000

1,50,000
15,00,000 1,50,000 10% 3,00,000 12,00,000

48,000 1,02,000 9,00,000 11.3%

72,000 78,000 6,00,000 13%

24000 1,26,000 12,00,000 10.5%

The above shows that market value of the firm remains unaffected by change in the capital structure. However, the introduction of additional debenture increases the equity capitalization rate and vice versa.

This is the mean between two extreme approaches of net income approach on the one hand and net operating income on the other hand. It believes the existence of what may be called Optimal Capital Structure. It believes that up to a certain point, additional introduction of debt capital, in spite of increase in cost of debt capital and equity capitalization rate individually, the over all cost of capital will reduce and total value of firm will increase. Beyond the point, the overall cost of capita will tend to rise,

and total value of the firm will tend to reduce. Thus with judicious mix of debt and equity capital, it is possible for the firm to minimize the overall cost of capital and maximize the total value of the firm. Such a capital structure where overall cost of capital is minimum and total value of the firm is maximum is called Optimal Capital Structure.

Example:No Debt EBIT Less interest on debenture NI Cost of equity capital Market value of equity shares (S) Market value of debenture (B) Total value of firm i.e. V=S+B Overall capital cost i.e. EBIT V 1,50,000 1,50,000 10% 15,00,000 15,00,000 10% 5% Debenture Rs. 3,00,000 1,50,000 15,000 1,35,000 11% 1,35,000 3,00,000 15,27,273 9.82% 8% Debenture Rs. 6,00,000 1,50,000 48,000 1,02,000 12% 1,02,000 6,00,000 14,50,000 10.34%

It is evident that in the no debenture position and in a position where debenture are issued to the extent of 6 lacs the cost of capital is not the minimum but when debentures are issued to the extent of 3 lacs the cost of capital is minimum and value of the firm is maximum, hence that is the optimal capital structure.

This approach closely resembles the net operating income approach. According to this approach, the net value of the firm and cost of capital is independent of its capital structure. The argument is that overall cost of capital is the weighted average of cost of debt capital and cost of equity capital. The cost of equity capital depends on shareholders expectations. Now if the shareholders expect 10% from a certain company, they already take into consideration debt capital in the capital structure.

Assumptions:

1. Perfect capital market- securities are infinitely divisible, investors are free to buy/sell securities, investors can borrow without restrictions on the same terms and conditions as firms, there are no transaction cost, each investor has the same information and it is readily available without any cost, investors are rational and they behave rationally \2. All investors have the same expectation of the firms operating income (EBIT) 3. Business risk is equal among all the firms within the similar operating environment 4. Dividend payout ratio is 100% 5. There is no taxes (removed later) 6.MM propositions prove that if all the assumption are met the

market value of the firms is equal irrespective of leverage

 MM

Approach without tax: Here analyzed the impact of leverage under the assumption that there is no corporate or personal tax on the basis of two propositions Proposition I: the value of the firm is established by capitalizing its expected net operating income (EBIT) at a constant over all cost of capital V(L) = V(U) = EBIT/WACC = EBIT/K0 Here L is the levered and U is unlevered firm :

Here as per the proposition I, both L and U firms have the same business risk and the standard deviation is the same

Proposition II:

The cost of equity to a levered firm is equal to the cost of equity to an unlevered firm in the same risk class plus a risk premium whose size depends on both the differentials between an unlevered firms cost of debt and equity and the amount of debt used.

K0(L) = K0(U) +Risk premium

= Ke(U) +(Ke(U) Kd)(D/S)

Here D is the market value of debt and S is the market value of equity and Kd is the cost of debt

 Taken

together the two MM propositions imply that the inclusion of more debt in the capital structure will not increase the value of the firm, because the benefit of cheap debt will be exactly offset by an increase in the riskiness, hence the cost of equity will move up. So MM argues that in the world of no tax, both firms value and its WACC would be unaffected by its leverage decision

Capital structure decision

Capital structure means max of long-term sources of funds i.e., the % of various items that can constitute the capital of the firm It means deciding how much percentage of : Preference share Debenture Loan from financial institutions & from banks Equity shares including reserves and surplus
Companies plan their capital structure to maximize their use of funds and also to adopt more easily to changing conditions The optimum capital structure is the one which maximize the market value of shares, everything else remaining the same

 The

goal of the capital should be to maximise the wealth of the share holders maximising the long term price per share

 The

aim of capital structure should be to minimize the cost of financing and maximize earning per share.
is cheaper, interest is a deductible expense and therefore there is savings in income tax,rate of interest is fixed, and expectation of returns by provider of debt is limited as compared to equity shareholder but it increases the risk of the equity shareholders.

Debt

 Dividend

is not considered as an expense.Dividend distribution tax is to be paid by the company as per the latest income tax rules. Raising small amount is not easy and condition of capital marke tis to be seen for raising capital through equity.

 The

capital structure should not increase unduly risk for the equity share holders. Equity: less risky, no contractual payment so as to bring insolvency.
Debt:

contractual payment of interest and principal irrespective of profit and loss of the company. This leads to the risk of insolvency and brings bad reputation in case of default in repayment.

 Paying

dividend is not a contractual payment and therefore there is no risk of insolvency in case of non-payment. If dividend is paid to equity share holders the preference shareholders have first right. In the case of winding up also they have first right as compared to the equity shareholders. This does not increase the risk in anyway.

 While

planning capital structure it should be seen that the control of owners should not be diluted. Right issue will not dilute the control as it is issued in the same ratio as existing shares, but the public issue may dilute the control.

 Ideal

capital structure should be able to cater to additional fund requirements in the future. The provider of debt always look at:: Debt equity ratio. Availability of assets as security. If the company is risky,the debt will be costly and may contain lot of restrictive clauses like not to declare dividend beyond certain limit etc.

 The

ideal capital structure should be able to seize the market opportunities like Boom period :able to raise equity at good premium. Depression: debt at lowest interest rate.

 Before

deciding the capital structure of a company one should have a look at various factors ,which affects the capital structure. The factors are: 1.Internal 2.External and 3.General.

Cost factor: cost is one of the most important factors. Borrowed capital is cheaper as expectation of lenders is less and interest is deductible expense and thus brings in savings in taxes. Risk factor: debt is more risky as it is contractual obligation irrespective of profit or loss of the company while dividend to equity/preference shareholders is not contractual obligation. Control factor: If large amount of equity is issued It will dilute the control, sometimes lenders also want their representative in the board of directors.

 To

maximize the returns to equity shareholders. To issue securities which are easily transferable and marketable. To issue securities in such a way that profit and control of promoters not adversely affected.

General economy Conditions in the country And abroad whether it is boom our depression or market is recovering from depression our moving toward depression. Behavior of interest rate ,future trends in india and abroad. Policy of lending institution if it is too harsh our rigid conditions are imposed the it is better to move for other alternatives. Taxation policy dividend , loans. Statutory restrictions like restriction in the matter of foreign direct investment and foreign institutional investment etc.

 Constitution

of company. If company is private limited our closely held company ,the control of management is of paramount importance. If company is public limited company our widely held company the control will not be diluted easily and cost will be more important.

 Characteristics

of the company in terms of age , size, credit standing play an important role . Venture capital company may go for equity, as returns are uncertain. Very small companies do not have bargaining power and may have to depend on equities in the beginning . As they grow they improve the mix of capital of having debts. Credit standing of the companies have a bearing on what source they want to tap for raising funds.

 Companies

who have stability of earning can have better bargaining power. They can borrow cheap and can take risk. If earning in not stable, then equity is better as it does not have contractual obligatio.

If attitude of management is conservative, the control and risk factor becomes more important and equity is preferred. If aggressive the cost factor become more important and debt will be preferable.

The capital structure of a company planned initially when the company is incorporated. The capital structure should be designed very carefully. Whenever fresh funds are required by the company the finance manager should see that capital structure should not deviate from the target set by the top management.

 The

following are the three approaches to optimum capital structure:

EBIT- EPS approach Valuation approach Cash flow approach

This mean examining the effect of leverage on earning per share. The companies with high level of earnings before interest and taxation (EBIT) can make good use of leverage ( use of fixed cost securities ) to increase return to shareholders.

Example:ABC Ltd. Wanted to purchase fixed assets worth Rs. 80 lacs for execution of a project.

The company has a number of options for financing its project. we take two options as: Rising entire Rs. 80 lacs as equity Raising Rs. 30 lacs as equity capital and Rs. 50 lacs as debt @18% Raising Rs. 30 lacs as equity and Rs. 50 lacs as preferance shares at 18% divident.

The company is required to pay dividend @20% to equity shareholders as other companies of this type were paying this much return and investors will subscribe to their shares only if they hope to get this much return. The taxation rate for the company is 40%. The earning power of ABC Ltd. Is 40%( before taxes and interest).

Rs. 80 lacs as share capital

Rs. 30 lacs as sharecapital plus Rs. 50 lacs as debt @ 18% 32

30 lacs are equity share capital and 50 lacs as preference share @18% 32

Earning on assets of Rs. 80 lacs @40% Less Interest : 18% on Rs. 50 lacs Earning after Interest Taxes @ 40 % Earning after taxes Less preference dividend Earning available to equity shareholders Earning after interest and taxes as % of share capital

32

32 12.8 19.2 19.2 24%

9
23 9.20 13.80 13.80 46%

32 12.8 19.2 9 10.2 34%

If we analysis the result it is seen that the net return on equity is 24% when no debt is used but it is 46% when debt is used and it is 34% when preference share capital is used.
Why it has come down even when the cost of debt and preference capital is same. It is because the interest on debt is an expense and therefore tax deductible while the preference dividend is not an expense and is not tax deductible.

 Supposing in the above example the earning

power of ABC Ltd. Is only 15%.

Rs. 80 lacs as share capital

Earning on assets of Rs. 80 lacs @15% Less Interest : 18% on Rs. 50 lacs Earning after Interest Taxes @40% Earning after taxes Less preference dividend

12 12 4.8 7.2 -

Rs. 30 lacs as 30 lacs are equity sharecapital plus Rs. 50 share capital and 50 lacs as preference lacs as debt @ 18% share of Rs.10 each at 12% 12 12 9 3 1.20 1.8 12 4.8 7.2 6

Earning available to equity shareholders

Earning after interest and taxes as % of share capital

7.2

1.8

1.2

9%

6%

4%

 In

the above case the use of debt has reduced the earning % of shareholders. Because:in this case the earning power (15%) of the company is less than the cost of debt (18%), therefore the return to the shareholder has been reduced as the company has not able to earn the cost of debt. So if the chances of earning more than the cost of debt is there then the use of debt will be beneficial to the share holder and if it not then it will reduce the earning available to shareholders.