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Chapter-1 Capital Structure Planning & Policy

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E5-E6 Core CAPITAL STRUCTURE PLANNING & POLICY

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Introduction:

Capital structure refers to the mix of long-term sources of funds, such as debentures, long-term debt, preference share capital and equity share capital including reserves and surpluses (i.e. retained earnings). Some companies do not plan their capital structure, and it develops as a result of the financial decisions taken by the financial manager without any formal planning. These companies may prosper in the short-run, but ultimately they may face considerable difficulties in raising funds to finance their activities. With

unplanned capital structure, these companies may also fail to economize the use of their funds. Consequently, it is being increasingly realized that a company should plan its capital structure to maximize the use of the funds and to be able to adapt more easily to the changing conditions.

Theoretically, the financial manager should plan an optimum capital structure for his company. The optimum capital structure is obtained when the market value per share is maximum. In practice, the determination of an optimum capital structure is a formidable task, and one has to go beyond the theory. There are significant variations among industries and among individual companies within an industry in terms of capital structure. Since a number of factors influence the capital structure decision of a

company, the judgment of the person making the capital structure decision plays a crucial part. Two similar companies can have different capital structures if the decision makers differ in their judgment of the significance of various factors. A totally theoretical model perhaps cannot adequately handle all those factors which affect the capital structure decision. These factors are highly psychological, complex and qualitative and do not always follow accepted theory, since capital markets are not perfect and the decision has to be taken under imperfect knowledge and risk. The board of directors or the chief financial officer (CEO) of a company should develop an appropriate capital structure which is most advantageous to the company. This can be done only when all those analyzed and balanced. The capital structure should be planned generally keeping in

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view the interests of the equity shareholders and the financial requirements of a company. The equity shareholders, being the owners of the company and the providers of risk capital (equity) would be concerned about the ways of financing a companys operations. However, the interests of other groups, such as employees, customers, creditors, society and government, should also be given reasonable consideration.

A sound or appropriate capital structure should have the following features:

Return: The capital structure of the company should be most advantageous. Subject to other considerations, it should generate maximum returns to the shareholders without adding additional cost to them. Risk: The use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be sued, otherwise its use should be avoided. Flexibility: The capital structure should be flexible. It should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. Capacity: The capital structure should be determined within the debt capacity of the company and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors fixed charges and principal sum. Control: The capital structure should involve minimum risk of loss of control of the company. The owners of closely-held companies are particularly concerned about dilution of control.

Approaches to establish appropriate capital structure: The capital structure will be planned initially when a company is incorporated. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. The financial manager

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has also to deal with an existing capital structure. The company needs funds to finance its activities continuously. Every time when funds have to be procured, the financial manager weighs the pros and cons of various sources of finance and selects the most advantageous sources keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances. The following are the three most common approaches to decide about a firms capital structure: EBIT-EPS approach for analyzing the impact of debt on EPS Valuation approach for determining the impact of debt on the shareholders value Cash flow approach for analyzing the firms ability to service debt

In addition to these approaches governing the capital structure decisions, many other factors such as control, flexibility, or marketability are also considered in practice.

EBIT-EPS Approach: The use of fixed cost sources of finance, such as debt and preference share capital to finance the assets of the company, is known as financial leverage or trading on equity. If the assets financed with the use of debt yield a return greater than the cost of debt, the earning per share also increases without an increase in the owners investment. The earnings per share also increase when the preference share capital is used to acquire assets. But the leverage impact is more pronounced in case of debt because (i) the cost of debits usually lower than the cost of preference share capital and (ii) the interest paid on debt is tax deductible.

Because of its effect on the earnings per share, financial leverage is an important consideration in planning the capital structure of a company. The companies with high level of the earnings before interest and taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders equity. One common method

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of examining the impact of leverage is to analyze the relationship between EPS and various possible levels of EBIT under alternative methods of financing.

Illustration: Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary shares of Rs.10 per share. The firm wants to raise Rs.250,000 to finance its investments and is considering three alternative methods of financing (i) to issue 25,000 ordinary shares at Rs.10 each, (ii) to borrow Rs.2,50,000 at 8 per cent rate of interest, (iii) to issue 2,500 preference shares of Rs.100 each at an 8 per cent rate of dividend. If the firms earnings before interest and taxes after additional investment are Rs.3,12,500 and the tax rate is 50 per cent, the effect on the earnings per share under the three financing alternatives will be as follows:

Table: EPS under alternative financing favourable EBIT:

Equity Financing Rs.

Debt Financing Rs.

Preference Financing Rs.

EBIT Less: Interest PBT Less: Taxes PAT Less: Preference dividend Earning available to ordinary shareholders Shares outstanding EPS

3,12,500 0 3,12,500 1,56,250 1,56,250 0 1,56,250 1,25,000 1.25

3,12,550 20,000 2,92,500 1,46,250 1,46,250 0 1,46,250 1,00,000 1.46

3,12,550 0 3,12,500 1,56,250 1,56,250 20,000 1,36,250 1,00,000 1.36

The firm is able to maximize the earnings per share when it uses debt financing. Though the rate of preference dividend is equal to the rate of interest, EPS is high in case of debt financing because interest charges are tax deductible while preference dividends are not. With increasing levels of EBIT, EPS will increase at a faster rate with a high degree of leverage. However , if a company is not able to earn a rate of return on its assets higher

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than the interest rate (or the preference dividend rate), debt (or preference financing) will have an adverse impact on EPS. Suppose the firm in illustration above has an EBIT of Rs.75,000/- EPS under different methods will be as follows:

Table: EPS under alternative financing methods: Unfavourable EBIT: Equity Financing Rs. EBIT Less: Interest PBT Less: Taxes PAT Less: Preference dividend Earning available to ordinary shareholders Shares outstanding EPS 75,000 0 75,000 37,000 37,500 0 1,56,250 1,25,000 0.30 Debt Financing Rs. 75,000 20,000 55,000 27,500 1,46,250 0 27,500 1,00,000 0.27 Preference Financing Rs. 75,000 0 75,000 37,500 1,56,250 20,000 17,500 1,00,000 0.17

It is obvious that under Unfavourable conditions, i.e. when the rate of return on the total assets is less than the cost of debt, the earnings per share will fall with the degree of leverage.

Limitations of EPS as a Financing decision Criterion: EPS is one of the most widely used measures of the companys performance in practice. As a result of this, in choosing between debt and equity in practice, sometimes too much attention is paid on EPS, which however, has some serious limitations as a financingdecision criterion.

The major shortcoming of the EPS as a financing-decision criterion is that it does not consider risk; it ignores the variability about the expected value of EPS. The belief that investors would be just concerned with the expected EPS is not well founded. Investors in valuing the shares of the company consider both expected value and variability.

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E5-E6 Core Cost of Capital and Valuation Approach:

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The cost of source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest whether it makes profits or not. For ordinary shareholders, the rate of dividends is not fixed and the board of directors has no legal obligation to pay dividends even if the profits are made by the company. The loan of debt-holders is returned within a prescribed period, while

shareholders will have to share the residue only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. This is generally the case even when taxes are not considered; the tax deductibility of interest charges further reduces the cost of debt.

The preference share capital is also cheaper than equity capital, but not as cheap as debt. Thus, using the component, or specific, cost of capital as a criterion for financing decisions and ignoring risk, a firm would always like to employ debt since it is the cheapest source of funds.

Cash flow approach:

One of the features of a sound capital structure is conservatism. Conservation does not mean employing no debt or small amount of debt. Conservatism is related to the fixed charges created by the use of debt or preference capital in the capital structure and the firms ability tp generate cash to meet these fixed charges. In practice, the question of the optimum (appropriate) debt-equity mix boils down to the firms ability to service debt without any threat of insolvency and operating inflexibility. A firm is considered

prudently financed if it is able to service its fixed charges under any reasonably predictable adverse conditions.

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One important ratio which should be examined at the time of planning the capital structure is the ratio of net cash inflows to fixed charges (debt-servicing ratio). It

indicates the number of times the fixed financial obligations are covered by the net cash inflows generated by the company. The greater the coverage, the greater is the amount of debt a company can use. However, a company with a small coverage can also employ a large amount of debt if there are not significant yearly variance in its cash inflows and a small probability of the cash inflows being considerably less to meet fixed charges in a given period. Thus, it is not the average cash inflows but the yearly cash inflows which are important to determine the debt capacity of a company. Fixed financial obligations must be met when due, not on an average or in most years but, always. This requires a full cash flow analysis.

Components of Cash flows: The cash flows should be analyzed over a long period of time, which can cover the various adverse phases, for determining the firms debt policy. The cash flow analysis can be carried out by preparing proforma cash flow statements to show the firms financial conditions under adverse conditions such as a recession. The expected cash flows can be categorized into three groups.

Operating cash flows Non-operating cash flows Financial flows

Practical considerations in determining Capital Structure: Control Widely-held companies Closely-held companies Flexibility Loan covenants Early repay ability Reserve capacity BSNL, India For Internal Circulation Only 8

E5-E6 Core Marketability Market conditions Flotation costs Capacity of raising funds Agency costs

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In practice, it may not be possible for a company to borrow whenever it wants./ lenders may analyze a number of characteristics of the borrower before they decide to lend. What factors do borrowers think are considered by lenders? Borrowing firms managers perceive the following factors in order of importance being considered by lenders: (i) (ii) (iii) (iv) (v) (vi) (vii) profitability quality of management security liquidity existing debt-equity ratio sales growth net worth

(viii) reserve position (ix) fluctuations in profits

QUESTIONS:

1. What do you understand by Capital Structure? 2. Is there any need to plan the Capital Structure? If so why? 3. How do you derive optimal Capital Structure? 4. What are the features of sound Capital Structure? 5. Describe the common approaches to decide Capital Structure.

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E5-E6 Core 6. Explain EBIT-EPS approach. 7. What is the valuation approach? 8. Narrate the method of Cash flow approach. 9. Explain the components of cash flow.

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10. What are the practical considerations in determining the capital structure?

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