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CAPITAL STRUCTURE Meaning of capital structure Capital structure refers to the make up of a firms capitalization. In other words, it represents the mix of different sources of long-term funds such as equity shares, preference shares long-term loans, retained earnings etc. in the total capitalization of the company The term capitalization is used for long term funds. For example, a company has equity shares of Rs.1, 00,000, debentures of Rs.1, 00,000, preference shares of Rs.1, 00,000 and retained earnings of Rs.50, 000. The firm capitalization is Rs.3, 50,000 The term capital structure is used for the mix of capitalization. Capital structure and financial structure Capital structure is differing from financial structure. Financial structure refers to the way the firms assets are financed. In other words , it includes both long term and short term sources of funds. Capital structure is the permanent financing of the company represented primarily by long-term debt and shareholders funds but excluding all short-term credit. Thus, a companys capital structure is only a part of its financial structure. Patterns of capital structure In case of new company the capital structure may be of any of the following four patterns 1. Capital structure with equity shares only 2. Capital structure with both equity and preference shares 3. Capital structure with equity shares and debentures 4. Capital structure with equity shares, preference shares and debentures The choice of appropriate capital structure depends on a number of factors such as the nature of the companys business, regularity of earnings, conditions of the money market, attitude of the investor, etc. The effect of the changes in debt-equity mix on EPS of the company can be understood with the help of the following example.

Capital structure

PROBLEMS: A limited has a share capital of Rs.1, 00,000 divided into shares of Rs.10.00 each. It has major expansion programme requiring an investment of another Rs.50, 000. The management is considering the following alternatives for raising this amount. 1. Issue of 5,000 equity shares of Rs.10 each 2. Issue of 5, 000 12% preference shares of Rs.10 each 3. Issue of 10% debentures of Rs.50, 000. The companys present earnings before interest and tax (EBIT) are Rs.40,000 p.a. you are required to calculate the effect of each of the above modes on financing of the earnings per shares (EPS) presuming: a) EBIT continues to be the same even after expansion b) EBIT increases by Rs.10, 000 2. Good shape company has currently an ordinary share capital of Rs.25, 00,000 consisting of 25,000 shares of Rs.100 each. The management is planning to raise another Rs.20, 00,000 to finance a major programme of expansion through one of four possible financing plans. The options are 1. Entirely through ordinary shares 2. Rs.10, 00,000 through ordinary shares and Rs.10, 00,000 through long-term borrowings at 8 percent interest per annum 3. Rs.5, 00,000 through ordinary shares and Rs.15, 00,000 through long-term borrowings at 9 percent interest per annum 4. Rs. 10, 00,000 through ordinary shares and Rs.10, 00,000 through preference shares with 5 percent dividend The companys expected earnings before interest and tax (EBIT) will be Rs.8, 00,000.assuming a corporate tax rate is 50 per cent. Determine the EPS in each alternative, and comment on the implications of financial leverage. OPTIMUM CAPITAL STRUCTURE A firm should try to maintain an optimum capital structure with a view to maintain financial stability. The optimum capital structure is obtained when the market value per share is the maximum. It may, therefore, be defined as that relationship of debt and equity securities which maximizes the value of a companys share in the stock exchange.

Capital structure

3 In case a company borrows and this borrowing helps in increasing the value of the companys share in the stock exchange, it can be said that the borrowings has helped the company in moving towards its optimum capital structure. In case borrowings results in fall in market value of the companys equity shares, it can be said that the borrowing has moved the company away from its optimum capital structure. The objective of the firm should therefore be select a financing or debt equity mix which will lead to maximum value of the firm. CAPITAL STRUCTURE THEORIES In order to achieve the goal of identifying an optimum debt-equity mix, it is necessary for the finance manager to be conversant with the basic theories underlying the capital structure of corporate enterprises. There are three major theories/approaches explaining the relationship between capital structure, cost of capital and value of the firm. 1. Net income (NI) approach 2. Net operating income (NOI) approach 3. Modigilani_Miller (MM) approach NET INCOME (NI) APPROACH This approach has been suggested by Durand. According to this approach, capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure causes a corresponding change in the overall cost of capital as well s the total value of the firm. According to this approach, higher debt content in the capital structure will result in decline in the overall or weighted average cost of capital. This will cause increase in the value of the firm and consequently increase in the value of equity shares of the company. NI approach is based on the following three assumptions 1. There are no corporate taxes 2. The cost of debt is less than cost of equity 3. The debt content does not change the risk perception of the investors. The value of the firm on the basis of NI approach can be ascertained as follows V=S+B V = value of the firm;S = market value of the equity;B = market value of the debt

Capital structure

4 Market value of the equity can be ascertained by as follows S = NI / ke S = market value of the equity; NI = Earnings available for equity share holders ke = equity capitalization rate. The principal for overall cost of capital k = EBIT / V k = cost of capital; EBIT = earnings before interest and tax; V = value of the firm PROBLEMS 1. X limited is expecting an annual EBIT of Rs.1, 00,000. The company has Rs.4, 00,000 in 10% debentures. The cost of equity capital or capitalization rate is 12.5%. You are required to calculate the total value of the firm also state the over all cost of capital. 2. X limited is expecting an annual EBIT of Rs., 1, 00,000. The company has Rs.4, 00,000 in 10% debentures. The equity capitalization rate is 12.5%. The company decides to raise Rs.1, 00,000 by issue of 10% debentures and use the proceeds thereof to redeem equity shares. You are required to calculate the total value of the firm and also the overall cost of capital. 3. X limited is expecting annual EBIT of Rs.1, 00,000. The company has Rs.4, 00,000 in 10% debenture. The equity capitalization is 12.5%. The company desires to redeem debentures of Rs.1, 00,000 by issuing additional equity shares of Rs.1, 00,000. You are required to calculate the value of the firm and the overall cost of capital. NET OPERATING INCOME (NOI) APPROACH This approach has also been suggested by Durand. This is just opposite of Net Income approach. According to this approach, the market value of the firm is not at all affected by the capital structure changes. Assumptions 1. The overall cost of capital (k) remains constant for all degrees of debt-equity mix 2. There are no corporate taxes 3. The use of debt having low cost increases the risk of equity shareholders, this result in increase in equity capitalization rate. Thus, the advantage of debt is set off exactly by increase in the equity capitalization rate.

Capital structure

5 According to NOI approach, the value of a firm can be determined by the following equation: V = EBIT / k V = value of the firm k = overall cost of capital Value of the equity The value of the equity (S) is a residual value, which is determined by deducting the total value of debt (B) from the total value of the firm (V). Thus, the value of equity (S) can be determined by the following equation: S = V- B S = value of the equity V = value of the firm B = value of the debt Optimum capital structure According to NOI approach, the total value of the firm remains constant irrespective of the debt equity mix or the degree of leverage. The market price of equity shares will, therefore, also not change in debt-equity mix. Hence, there is nothing like optimum capital structure. Any capital structure will be optimum according to this approach. PROBLEMS 1.XY limited has an EBIT of Rs.1, 00,000. The cost of debt is 10% and the outstanding debt amounts to Rs.4, 00,000. Presuming the overall capitalization rate is 12.5%, calculate the total value of the firm and the equity capitalization rate. Increase in debt In case of the firm raised the debt content for reducing its equity content, the total value of the firm would remain unchanged. However the equity capitalization rate would go up. This is clear with the following problem. 2.XY limited has an EBIT of Rs.1, 00,000. The cost of debt is 10% and the outstanding debt amounts to Rs.4, 00,000. The overall capitalization rate is 12.5%. The company decides to raise a sum of Rs.1, 00,000 through debt at 10% and uses the proceeds to pay off the equity shareholders. You are required to calculate the total value of the firm and also the equity capitalization rate.

Capital structure

6 Market price of share According to NOI approach, the market price per share remains unaffected on account of change in the debt equity mix. MODIGILIANI-MILLER APPROACH Modigiliani-miller (MM) approach is similar to the Net Operating Income (NOI) approach. In other words, according to this approach, the value of the firm is independent of its capital structure. MM approach maintains that the average cost of capital does not change with change in capital structure of the firm. Basic propositions The following are the three basic propositions of the MM approach 1. The overall cost of capital (k) and the value of the firm (V) are independent of the capital structure. In other words k and V are constant for all levels of debt-equity mix. 2. The cost of equity (ke) is equal to capitalization rate of a pure equity stream plus a premium for the financial risk. The financial risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to off set exactly the use of a less expensive source of funds represented by debt. 3. The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. Assumptions: 1. Capital markets are perfect. This means --a) Investors are free to buy and sell securities b) The investors are well informed c) There are no transaction costs 2. The firms can be classified into homogeneous risk classes. All firms within the same class will have the same degree of business risk. 3. All investors have the same expectation of a firms net operating income (EBIT) with which to evaluate the value of any firm 4. The dividend pay-out ratio is 100%. In other words, there are no retained earnings.

Capital structure

Arbitrage process The arbitrage process is the operational justification of MM hypothesis. The term arbitrage refers to an act of buying an asset or security in one market having lower price and selling it in another market at a higher price. The consequence of such action is that the market prices of the securities of the two firms exactly similar in all respects except in their capital structures cannot for long remain different in different markets. Thus, arbitrage process restores equilibrium in value of securities. The arbitrage process can act on buying of an asset in one market and selling it in another to take the advantage of price differentials on the two markets. According to MM approach, because of arbitrage process which does not allow two different securities of same equity, the total value of two firms which are similar in all respects except the extent of leverage will not be different. PROBLEM Refer class notes Features of an appropriate capital structure 1. Profitability 2. Solvency 3. Flexibility 4. Control Factors determining the capital structure 1. Retaining control 2. Nature of the enterprise 3. Purpose of financing 4. Requirements of the investors 5. Size of the company 6. Market sentiments

Capital structure

THE TRADE-OFF THEORY: COSTS OF FINANCIAL DISTRESS ANDAGENCY COSTS It is difficult to believe that a firm will have 100 per cent debt because of tax advantage. Why dont firms in practice borrow 100 per cent? What are the offsetting disadvantages of debt? Miller has shown that personal tax on interest income reduces the attractiveness of debt. The other offsetting disadvantages of debt are grouped under financial distress. Financial distress arises when firm is not able to meet its obligations (payment of interest and principal) to debt-holders can ultimately lead to the insolvency of firm. With higher business risk and financial risk the financial distress is also high. Costs of financial distress Financial distress may ultimately force a company to insolvency. Direct costs of financial distress include costs of insolvency. Insolvency also causes high legal and administrative costs. Financial distress, with or without insolvency, also has many indirect costs. These costs relate to the actions of employees, managers, customers, suppliers and shareholders. Employees of a distressed firm become demoralized, as they worried about their future. Their efficiency and productivity decline. Customers of the financially distressed firm may fear its liquidation, and get concerned about the quality of product or services. they apprehend problems with regard to after sale services and maintenance. Suppliers also curtail or discontinue granting credit to the firm fearing liquidation and liquidity problems of a financially distressed firm. Investors not interested to invest the funds in the distressed firm. Non-availability of funds on acceptable terms could adversely affect the operating performance of the firm. Agency costs The capital structure is also affected by the agency costs. Agency costs arise because of the conflict between managers and shareholders interests, on the one hand and shareholders and debt holders interests, on the other hand. The agency problems arising from the conflicts between shareholders, debt-holders and managers are handled through monitoring and restrictive covenants

Capital structure

Investors require monitoring and restrictive covenants to protect their interests. Debtholders put restrictions on the firm in terms of new debt. Similarly, shareholders create many monitoring mechanisms to ensure that managers raise and invest funds keeping in mind the principle of shareholders wealth maximization. The costs of monitoring and restrictive covenants are called agency costs. The capital structure is also affected by the agency costs. Agency costs arise because of conflict between mangers and shareholders interests, on the one hand and shareholders and debt holders interests, on the other hand. The advantage of debt is that it shaves taxes since interest is a deductible expense. On the other hand, its disadvantage is that it can cause financial distress. Therefore, the capital structure decision of the firm in practice should be governed by the trade-off between tax advantage and costs of financial distress and agency costs.

Capital structure