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Capital Structure

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Published in: Financial Management
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Meaning and approaches

Simran / Chandigarh

13 years of teaching experience

Qualification: M.Com

Teaches: Accountancy, Business Studies, Economics, Statistics, Financial Management, BBA Subjects, Management Subjects

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  1. CAPITAL STRUCTURE
  2. The theory of Capital structure is closely related to the firm's cost of capital. Many debates over whether an optimal capital Structure exists are found in the financial literature. Capital Structure Theories Assumptions 1. There are only two sources of funds i.e., the equity and the debt, which is having fixed interest. 2. Total assets of the firm are given and there would be no change in the investment decisions of the firm 3. The firm has a policy of distributing entire profits among the shareholders implying that there is no retained earnings
  3. 4. 5. 6. 7. The operating profits of the firm are given and are not expected to grow The business risk complexion of the firm is given and is constant and is not affected by the financing mix. There is no corporate or personal taxes The investors have the same subjective probability distribution of expected operating profits of the firm
  4. Definitions and notations used in capital structure E = Total market value of the Equity D = Total market value of the Debt V = Total market value of the firm lee, D + E I = Total Interest Payment NOP = Net Operating Profit i.e., EBIT NP = Net Profit or Profit after tax (PAT) Do = Dividend paid by the company at time 0 (i.e., now) DI = Expected dividend at end of year 1 PO = Current market price of the share
  5. PI = Expected market price of the share after 1 year Kd = After tax cost of debt lee, I / D Ke = Cost of Equity lee, DI / PO Ko = Overall cost of capital lee, WACC = NOP EBIT
  6. NET INCOME APPROACH (CAPITAL STRUCTURE MATTERS) As suggested by Durand, this theory states that there is a relationship between capital structure and the value of the firm. The firm can affect its value by increasing or decreasing the debt proportion in the overall financing mix. ASSUMPTIONS 1) There are no taxes — corporate or personal. 2) is less than Ke
  7. 3) Both K d and Ke remain constant and increase in financial leverage has a change in Ko. As the degree of financial leverage (D/E) increases, Ko decreases as the proportion of debt increases. Cost of capital % Leverage (degree)
  8. A company's expected annual net operating (EBIT) is Rs 50,000. The company has Rs 200,000, 10 % debentures. The equity capitalization(Ke) of the company is 12.5%. Net operating Income Less: Interest on debentures Earnings available to equity holders, PAT Equity Capitalization Rate Ke Market Value of Equity, E = PAT/Ke Market Value of Debt Total Value of the firm, E + D = V Overall cost of capital, = EBIT/V Or O. 10(200000/440000) + 0.125(240000/440000) Rs 50000 20000 30000 0.125 240000 200000 440000 11-360/0 = 11.36%
  9. Debentures raised to Rs 300000. Net Operating Income Less : Interest on debentures Earnings available to equity holders Equity Capitalization Rate,Ke Market Value of Equity =PAT/Ke Market Value of Debt,D 50000 30000 20000 0.125 160000 300000 460000 Total Value Ko = 50000 460000 = 10.9%
  10. Decrease in Value Net Operating Income Less: Interest on Debentures Earnings available to equity holders Equity capitalization rate, Ke Market Value of Equity, E Market Value of Debt , D Total Value of the firm 50000 420000 50000 10000 40000 0.125 320000 100000 420000
  11. Critical Appraisal It ignores the most important aspects of leverage that the market price depends upon the risk which varies in direct relation to the changing proportion of debt in the capital structure
  12. NET OPERATING INCOME APPROACH ' Advocated by David Durand. ' Market Value depends on the Net Operating Income & Business Risk. ' According to the Net Operating Income approach, the overall capitalization rate & the cost of debt remains constant for all degrees of leverage. Value of the firm is determined by the equation: V = EBIT ko
  13. Cost of Debt 10% NOI Overall cost of Ko Total Market Value Total Value of debt Total Market Value of Equity Equity Capitalisation Rate Equity Capitalisation = Rate 50000 0.125 400000 300000 100000 200/0 12.5% 20000 1000000 50000 0.125 400000 200000 200000 1 50/0 12.5% 30000 200000 50000 0.125 400000 100000 300000 13.33% 12.5% 10000 300000
  14. ASSUMPTIONS 1) The investors see the firm as a whole and thus capitalizes the total earnings of the firm to find the value of the firm as a whole 2) The overall cost of capital, Ko of the firm is constant and depends upon the business risk which also is assumed to be unchanged 3) Kd is also constant. 4) The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increase in the cost of equity capital i.e., Kee The increase in Ke is such as to completely off set the benefits of employing cheaper debt.
  15. 5) There is no tax V = EBIT - EBIT — Interest
  16. Cost of capital % Leverage (degree)
  17. Traditional Approach A Practical View Point At takes a mid way between the NI approach (that the value of the firm can be increased by increasing the leverage) and the NOI approach (that the value of the firm is constant irrespective of the degree of financial leverage). At states that the value of the firm increases with increase in financial leverage but up to a certain limit only.
  18. > Beyond this limit, the increase in financial leverage will increase its WACC also & hence the value of the firm will decline > The main proposition of this theory is that a firm should make a judicious use of both the debt and the equity to achieve a capital structure which may be called the optimal capital structure
  19. The traditional theory on the relationship between capital structure and the firm value has three stages: First stage: Increasing Value QAt this stage Ke either remains constant or rises slightly with debt QThe cost of Equity, Ke does not increase fast enough to offset the advantage of low- cost debt. 01
  20. Second stage: Optimum value OOnce the firm has reached a certain degree of leverage, increases in leverage has a negligible effect on WACC QBecause the increase in the cost of equity due to the added financial risk just offsets the advantage of low cost debt QWithin that range or at the specific point, WACC will be minimum, & the maximum value of the firm will be obtained
  21. Third Stage: Declining Value QBeyond the acceptable limit of leverage, the value of the firm decreases with leverage as WACC increases with leverage. QThis happens because investors perceive a high degree of financial risk and demand a higher equity capitalization rate, which exceeds the advantage of low cost debt.
  22. The cost of capital U- shaped Cost Stage 2 ke ko kd Stage Stage 1 Optimum leverage point leverage
  23. The cost of capital saucer shaped Cost Stage 1 ko Stage 2 kd Stage Optimum leverage range leverage
  24. The traditional approach is criticized on the point that the value of the firm is a factor of its profitability rather than its financial mix.
  25. Modigliani-Miller Model : Extension of the NOI approach Assumptions 1. 2. 3. 4. 5. The capital markets are perfect and complete information is available to all the investors free of cost. The securities are infinitely divisible. Investors are rational & well informed about the risk return of all the securities There is no corporate income tax The personal leverage & the corporate leverage are perfect substitute Levered firm's cost of capital, kl = Unlevered firm's cost of capital, ku
  26. The MM model argues that if two firms are alike in all respect except that they differ in respect of their financing pattern & their market value , then the investors will develop a tendency to sell the shares of the over valued firm (creating a selling pressure) and to buy the shares of the under valued firm (creating a demand pressure). This buying & selling pressure will continue till the two firms have same market value
  27. The Arbitrage process It refers to an undertaking by a person of two related actions or steps simultaneously in order to derive some benefit e.g. buying by a speculator in one market and selling the same at the same time in some other market. Homemade or Personal Leverage A substitution of risks that investors may undergo in order to move from overpriced shares in highly levered firms to those in unlevered firms by borrowing in personal accounts. Homemade leverage is a situation where individuals borrowing on the exact same terms as large firms can duplicate corporate leverage through purchasing and financing options.
  28. ARBITRAGE PROCESS: It refers to undertaking by a person of two related actions or steps simultaneously in order to derive some benefit e.g. buying by a speculator in one market & selling the same at the same time in some other market or selling one type of investment & investing the proceed in some other investment. The profit or benefit from the arbitrage may be in any form: increased income from the same level of investment or same income from lesser investment.
  29. Company L (Levered) has 10% debt of Rs 300000 in its capital structure. Company U (Unlevered) has only equity. Cost of equity 20%. EBIT -Interest Net Profit Equity Capitalization rate,ke 200/0 Value of Equity Value of Debt Total Value, V WACC, ko = EBIT/V 15.38%
  30. Arbitrage Strategy 2. 3. 4. 5. 6. 7. An investor has a holding of 10% equity in L i.e. Rs Income to the investor = Rs of 350000) He disposes of this share & receives Rs 350000. He wants to buy 10% of U i.e. Rs 500000. He borrows 10% of L's debt @ 10% interest i.e. Rs 300000. He invests Rs 500000 & is left with Rs 150000. By investing Rs 500000 his income is . Rs 100000 (20% of Rs 500000) Less: Interest Rs 30000 70000 His total income will be greater than Rs 70000 as he will also invest remaining Rs 150000.
  31. Arbitrage in reverse direction L's Capital Structure = Rs 450000 UL's Capital Structure = Rs 500000 2. 3. 4. An investor has 10% of UL's share ie. Rs 500000. Sell Rs 500000 Buy 10% of equity of L i.e. Rs 150000 & 10% debt Rs 300000. Income on above securities: 10% of 700000 =70000 1 of 300000= 30000 100000 Investment of Rs 450000 led to an income of Rs 100000 whereas in L also he was earning Rs 100000 at an investment of Rs 500000.
  32. Critical evaluation of MM model Non substitutability of personal and corporate leverages Risk Perception Convenience Cost Institutional Restrictions Transaction Costs Taxes
  33. Chapter-IO Optimum Capital Structure
  34. Capital Structure: It refers to the mix of long-term sources of funds, such as debentures, long-term debt, preference share capital & equity share capital including reserves & surpluses. The financial manager should plan an optimum capital structure of his company. There are significant variations among industries & among individual companies within an industry in terms of capital structure. Number of factors determine the capital structure.
  35. A sound or appropriate capital should have the following features: Profitability Solvency Flexibility Capacity Control
  36. Optimum Capital Structure Models: 2. 3. Operating & Financial Leverage Model Cost of capital & valuation model for determining the impact of debt on the shareholders value. Cash flow models governing the capital structure decisions
  37. Limitations of EPS as a financing decision: EPS is one of the most widely used measures of the company's performance. Too much emphasis is given EPS. EPS does not consider risk. Ignores the variability about the expected value of EPS. Investors in valuing the shares of the company consider both expected value & variability.
  38. EPS Variability a) b) The EPS variability resulting from the use of financial leverage is called financial risk. Financial risk is added with the use of debt as : Increased Variability in the Shareholders Earnings. The threat of insolvency. A firm can avoid risk altogether if it does not employ debt in the capital structure. But EPS wont be maximized. Due to increase in debt, the expected EPS will continue to increase, but the value of the company will fall due to increase in financial distress.
  39. EPS does not consider the long-term perspectives of financing decisions. It fails to deal with the risk-return trade-off. A long-term view of the effects of financing decisions will lead to a criterion of wealth maximization rather than EPS maximization. EPS should be used as performance criterion rather than decision criterion. Long term view of the effect of the alternative financial plans on the value of the shares should be taken.
  40. Operating Conditions: Variability of EPS depends on the growth & stable of sales. Magnitude of the EPS variability with sales will depend on the degrees of operating & financial leverages employed by the company. High growth firms can afford to have high degree of leverage as they can meet fixed commitments easily.
  41. Cost of Capital & Valuation Model The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. Debt is the cheapest source of the finance & equity the most expensive. Pecking-Order Hypothesis:
  42. The profitable firms have lower debt ratios because they have lower targets & they use internal sources of finance as it is cheaper than equity. An equity issue indicates that the share price is overvalued. The management avoids signaling adverse information about their companies.
  43. Trade-off Theory This theory studies the following costs: Costs of Financial Distress: Financial Distress arise when a firm is not able to meet its obligations to debt holders. When the higher business risk & higher debt, the probability of financial distress becomes greater. Costs of Financial Distress are of two types: Direct Costs of financial distress include Costs of Insolvency. Indirect Costs: Employees Customers Suppliers Investors Shareholders Managers
  44. Agency Costs: There may exist a conflict of interest among shareholders, debt- holders & management. These conflicts give rise to agency problems, which involve agency costs. Agency costs have their influence on a firm's capital structure. Shareholders-Debt holders conflict Shareholders-Managers conflict Monitoring & agency costs
  45. Cash Flow Model Components of Cash Flows: 2. 3. Operating Cash Flows: Operations of the firm Non-Operating Cash Flows: Capital Expenditure & Working Capital changes Financial Flows: Interests, Dividends,etc

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