Capital Structure - What It Is and Why It Matters

Capital structure means the mixture of share capital and other long term liabilities. In the company, we know that liability of each shareholder is limited but how much be the total liability of shareholder is the important question? It can be decided by choosing best capital structure. In capital structure, we include, equity share capital, preference share capital, debenture and long term debt. Suppose, our company's capital structure may show 50% equity share capital, 30% pref. share capital and 20% debentures. But all companies' capital structure may not be equal because different business need different type of capital structure which will be suitable according to the need of business.

Some of companies want to become smart. They slowly decrease equity share capital and increases loan excessively which may be very risky because these company has to pay fixed cost of interest and has to manage repayment of loan after some time. Some mistake in it, may be risky for its solvency. So, decision relating to capital structure is very important for company The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital. Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the perfect

capital structure in terms of risk / reward payoff for shareholders. This is true for Fortune 500 companies and for small business owners trying to determine how much of their startup money should come from a bank loan without endangering the business.

Equity Capital: This refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types: 1.) contributed capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership and 2.) retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion. Many consider equity capital to be the most expensive type of capital a company can utilize because its "cost" is the return the firm must earn to attract investment. A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.

Debt Capital: The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The safest type is generally considered long-term bonds because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime. Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart and General Electric that amount to billions of dollars in 24-hour loans from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills. The cost of debt capital in the capital structure depends on the health of the company's balance sheet - a triple AAA rated firm is going to be able to borrow at extremely low rates versus a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital.

Other Forms of Capital: There are actually other forms of capital, such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, that can drastically increase return on equity but don't cost the company anything. This was one of the secrets to Sam Walton's success at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter & Gamble, in effect, using PG's money to grow his retailer. In the case of an insurance company, the policyholder "float"

represents money that doesn't belong to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure

Many middle class individuals believe that the goal in life is to be debt-free (see Should I Pay Off My Debt Or Invest?). When you reach the upper echelons of finance, however, that idea is almost anathema. Many of the most successful companies in the world base their capital structure on one simple consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure. Of course, how much debt you take on comes down to how secure the revenues your business generates are - if you sell an indispensable product that people simply must have, the debt will be much lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom comes into play. The great managers

have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher return products, and more. To truly understand the idea of capital structure, you need to take a few moments to read Return on Equity: The DuPont Model to understand how the capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a doughnut shop or are considering investing in publicly traded stocks, it's knowledge you simply must have.

INTRODUCTION OF RELIANCE GROUP OF INDUSTRIES

Reliance Industries Limited (RIL) (BSE: 500325, NSE: RELIANCE,

LSE: RIGD) is an Indian conglomerate company headquartered in Mumbai, Maharashtra, India. The company operates in three segments: petrochemicals, refining and oil & gas. Its others segment includes textile, retail business, special economic zone (SEZ) development and telecom / broadband business. RIL is one of the largest publicly traded company in India by market capitalisation and is the second largest company in India by revenue after Indian Oil Corporation. It is also India's largest private sector company by revenue and profit. The company is ranked 99th on Fortune Global 500 list of the world's biggest corporations for the year 2012.

Products
The company's petrochemicals, refining, and oil and gas-related operations form the incore of its business, other dividors of the company include cloth, retail business and special economic zone (SEZ) development. Reliance Retail has entered into the fresh foods market as Reliance Fresh.

RIL is to invest $10 billion over the next few years in its new aerospace division which will design, develop, manufacture, equipment and components, including airframe, engine, radars, avionics and accessories for military an

BUSINESSES DIVISIONS
Major subsidiaries and associates

Reliance Life Sciences centres its profit-making ventures around medical, plant and industrial biotechnology opportunities. Specifically, this company specializes in manufacturing, branding, and marketing Reliance Industries' products in bio-pharmaceuticals, pharmaceuticals, clinical research services, regenerative medicine, molecular medicine, novel therapeutics, biofuels, plant biotechnology, and industrial biotechnology sectors of the medical buisness industry.

Reliance Institute of Life Sciences (Rils), established by Dhirubhai Ambani Foundation, is an institution offering higher education in various fields of life sciences and related technologies.

Reliance Logistics (P) Limited is a single-window company selling transportation, distribution, warehousing, logistics, and supply chain-related products, supported by in-house state of the art telematics and telemetry solutions.

Reliance Clinical Research Services (RCRS), a contract research organisation (CRO) and wholly owned subsidiary of Reliance Life Sciences,

specialises in the clinical research services industry. Its clients ar primarilly pharmaceutical, biotechnology, and medical device companies.

Reliance Solar, the solar energy subsidiary of Reliance, aims to produce and retail solar energy systems primarily to remote and rural areas and to bring about a 'transformation in the quality of life'.

Relicord is a stem-cell banking service owned by Reliance Industries. Infotel Broadband is a broadband service provider which gained 4G licences for operating across India, now it is wholly owned by RIL for 48 billion (US$873.6 million).

Reliance Industrial Infrastructure Limited

Reliance Industrial Infrastructure Limited (RIIL) was incorporated in September 1988 as Chembur Patalganga Pipelines Limited, with the main objective being to build and operate cross-country pipelines for transporting petroleum products. The company's name was subsequently changed to CPPL Limited in September 1992, and thereafter to its present name, Reliance Industrial Infrastructure Limited, in March 1994. It has been promoted by Mr. Satyapal Jain and his associates. The company set up a 200-millimetre diameter twin pipeline system that connects the Bharat Petroleum refinery at Mahul, Maharashtra, to Reliance's petrochemical complex at Patalaganga, Maharashtra. The pipeline carries petroleum products

including naphtha and kerosene. It has commissioned facilities like the supervisory control and data acquisition system and the cathodic protection system, a jackwell at River Tapi, and a raw water pipeline system at Hazira. The infrastructure company constructed a 70,000 kl petrochemical product storage and distribution terminal at the Jawaharlal Nehru Port Trust (JNPT) Area in Maharashtra.ambani RIIL is mainly engaged in the business of setting up and operating industrial infrastructure. The company is also engaged in related activities involving leasing and providing services connected with computer software and data processing.

RELIANCE RETAIL
Reliance Retail is the retail business wing of the Reliance business. Many brands like Reliance Fresh, Reliance Footprint, Reliance Time Out, Reliance Digital, Reliance Wellness, Reliance Trendz, Reliance Autozone, Reliance Super, Reliance Mart, Reliance iStore, Reliance Home Kitchens, Reliance Market (Cash n Carry) and Reliance Jewel come under the Reliance Retail brand.

Balance sheet
Mar ' 12 Sources of funds Owner's fund Equity share capital 3,271.00 Share application money Preference share capital Reserves & surplus Loan funds Secured loans Unsecured loans Total Uses of funds Fixed assets 6,969.00 10,571.21 11,670.50 10,697.92 6,600.17 1,59,698.00 1,42,799.95 1,25,095.97 1,12,945.44 77,441.55 69.25 1,682.40 3,273.37 3,270.37 1,573.53 1,453.39 Mar ' 11 Mar ' 10 Mar ' 09 Mar ' 08

51,658.00 56,825.47 50,824.19 63,206.56 29,879.51 2,21,596.00 2,13,470.00 1,90,861.03 1,88,492.70 1,17,057.02

Mar ' 12 Gross block Less : revaluation 3,127.00 reserve Less : accumulated

Mar ' 11

Mar ' 10

Mar ' 09

Mar ' 08

2,09,552.00 2,21,251.97 2,15,864.71 1,49,628.70 1,04,229.10

5,467.00

8,804.27

11,784.75 871.26

91,770.00 78,545.50 62,604.82 49,285.64 42,345.47 depreciation Net block Capital work-in4,885.00 progress Investments Net current assets Current assets, loans 1,18,550.00 91,722.78 62,622.05 54,959.78 43,196.37 & advances Less : current liabilities & provisions 70,502.00 65,963.35 51,584.08 45,675.71 32,221.16 54,008.00 37,651.54 23,228.62 21,606.49 22,063.60 12,819.56 12,138.82 69,043.83 23,005.84 1,14,655.00 1,37,239.47 1,44,455.62 88,558.31 61,012.37

Mar ' 12 Total net current

Mar ' 11

Mar ' 10

Mar ' 09

Mar ' 08

48,048.00 25,759.43 11,037.97 9,284.07 assets Miscellaneous expenses not written Total Notes: Book value of unquoted investments Market value of 31,439.00 15,839.31 8,248.22 quoted investments 2,930.63 -

10,975.21

2,21,596.00 2,13,470.00 1,90,861.03 1,88,492.70 1,17,057.02

23,339.00 22,377.26 15,563.83 18,927.65 12,746.75

53,126.09

Contingent liabilities 45,831.00 41,825.13 25,531.21 36,432.69 37,157.61 Number of equity sharesoutstanding (Lacs) 32710.59 32733.74 32703.74 15737.98 14536.49

OPTIMAL CAPITAL STRUCTURE

A firm should select such a financing mix as will maximize the shareholders wealth, such a capital structure is referred to as a optimum capital structure It means a particular arrangement of various components of the structure for both short as well as long term objectives of the firm. It means increases the Earning Per Share (EPS) at maximum level. For designing such a structure, one would need following information. The requirement of capital of the firm Availability of the firm Cost of these components Rate of interest from investment

There are basically four approaches to capital structure decision.

Net Income Approach Net Operating Income Approach Modigliani-Miller Approach Traditional Approach

Net Income Approach

Capital structure decision is relevant to the valuation of the firm, i.e. a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as total value of the firm. If, therefore, degree of leverage as measured by debt-equity ratio increase, the weighted avg. cost of capital will decline, while value of firm as well as market price of share will increase. EBIT I Int. on debt.(10%) EBT ( Net Income) 50000 - 10000 (100000 Debt) 40000

ke = (12.5% Equity share) 40000/12.5% 320000 (equity share) Value of firm=S+B = 320000+100000 V = 420000 There are certain assumptions in net income approach.

NET OPERATING APPROACH

Capital structure decision of a firm is irrelevant to any change in financial leverage & will not lead to any change in total value of the firm & the market price of share as well as overall cost of capital is independent of the degree of leverage.

EBIT (Net Income App.) Nil EBT Cost of Capital(Ko) is 10% V= EBIT Ko Value of firm -

50000 Nil 50000

= 50000 10% = 500000

S= V-B (500000-100000) Vu= S

= 400000

MODIGLIANI-MILLER APPROACH
The MM approach supports the NOI approach relating to independence of the cost of capital for any degree of leverage at any level of debt-equity ratio. The MM approach provides behavioral justification for constant overall cost of capital & therefore total value of the firm.

A co(L) EBIT - I (400000,10%) EBT - T (Tax 40%) EAT Ke15% 200000 40000 160000 64000 96000

B Co(U) 200000 200000 64000 136000

TRADITIONAL APPROACH
It includes some features of NI & NOI. It resembles the NI approach in arguing that the total value of the firm & cost of capital are related to capital structure, with NOI approach, the overall cost of capital remains constant only for certain degree of leverage beyond that certain degree Ko increases & v decreases.