Capital structure

Form of Capital:

Capital Structure

Capitalization

Capital Structure

Financial Structure

Terminologies

Total amount of

(in )

issued by a company

Current Liabilities Current Assets

Debt

Preference Shares

Fixed Assets

Equity Shares

Retained Earnings

Capitalization Balance Sheet

Balance Sheet


Debt

Preference Shares

Fixed Assets

Equity Shares

Retained Earnings

CapitalStructure( % mix)

Balance Sheet


Debt

Preference Shares

Fixed Assets

Equity Shares

Retained Earnings

FinancialStructure ( % mix )

What does it

Conclude !!

Capital Structure = Financial CurrentStructure liabilities

Kinds of Capital Structure

Equity Share Capital

+ Retained Earnings Debt + Preference Share Debt

Foun

dati

on

Exp

an

si

on

Horizontal

Vertical

Pyramid Shaped

Inverted

Pyramid

Shaped

Importance of Capital Structure:

Indicator

of risk

profile of

the firm

Acts as a

managem

ent tool

Reflects the

firm’s strateg

y

Level of EBIT which is just equal to pay the total financial charges.

At this point EPS = 0.

Critical point in planning capital structure of firm.

If EBIT < financial break even point, then debt and preference share capital

should be reduced in capitalization.

If EBIT> financial break even point more of fixed cost may be inducted in

capital structure.

Financial Break-Even Point

When capital structure consists of debt and equity share capital and

no preference share capital

• Financial Break Even Point = Fixed Interest Charges

When capital structure consists

of equity share capital,

preference share capital and debt

• Financial break even point= I+ Dp

• (1-t)• here, I = fixed interest charges• Dp = preference dividend • t = tax rate

Point of Indifference/ Range of Earnings

It is EBIT level at which

EPS remains the same ;

irrespective of different alternatives of debt-equity mix.

At this level of EBIT,

rate of return on capital employed = cost of debt.

Calculation of Point of Indifference (algebraically): (X-I1) (1-T) – PD = (X-I2) (1-T)- PD S1 S2

WHERE, X = point of indifference,

I1 = interest under alternative financial plan 1,


T= tax rate,

S1 = no of equity shares under financial plan1,

S2 = no of equity shared under financial plan 2,

PD= preference dividend.

A project under consideration by your company

requires a capital investment of 60 lakhs. Interest on

loan 10 % p.a and tax rate 50%. Calculate point of

indifference for the project, if debt equity ratio is 2:1.

As debt equity ratio is 2:1. So, Company has two alternatives :(i) Raising entire amount by issue of share capital and no debt.(ii) Raising 40 lakh by way of debt and 20 lakh by issue of equity

share capital.Calculation of point of indifference:

(X-I1) (1-T) – PD = (X-I2) (1-T)- PD S 1 S2

I1 = 0 , I2 = 40* 10% = 4 , tax rate = 50 % or .5 , S1= 60, S2 = 20 now substitute the values, (X-0) (1-0.5) – 0 = (X-4) (1-0.5) – 0 60 2020 (.5X) = 60 (.5X-2)10X = 30X-120

X=6Thus, EBIT at point of indifference is 6 lakhs.

Graphically :

1 2 3 4 5 6 7 8 9 100

2

4

6

8

10

12

Plan 1Plan 2

EPS (

Rs.

)

EBIT (Rs. In lakhs)

Indifference point

Debt

Equity

Point of indifference and uncommitted earnings per share

Equivalency point for uncommitted EPS can be calculated as below:(X-I1) (1-T) –PD-SF = (X-I2) (1-T)- PD- SF

S1 S2

where, X = Equivalency point or point of indifference



T= tax rate,

S1 = no of equity shares under financial plan1,

S2 = no of equity shared under financial plan 2,

PD= preference dividend.

SF= sinking fund obligations

Optimal Capital StructureCapital structure or combination of debt and equity that leads

to maximum value of firm.

Maximises value of company and wealth of owners.

Minimises the company’s cost of capital.

Considerations to be kept in mind while

maximising value of firm:Company should make maximum possible use of leverage to increase EPS and market value of firm.

Company should take advantage of tax leverage

Capital structure should be flexible.

Firm should avoid undue financial risk attached with use of increased debt financing.

Risk-Return Trade Off

Capital mix involves two types of

risks:

1. Financial Risk

2. Non-Employment of Debt

Capital

Risk (NEDC)

Financial Risk

• Debt causes financial

risk !

• The use of debt

financing is referred to

as financial leverage.

• Financial leverage

measures Financial

risk.

Sales

Operating (–) Variable costs

Leverage Contribution

(–) Fixed costs

EBIT / Profit

(–) Interest expense

Financial EBT

Leverage (–) Taxes

EAT

(-) Preference dividend Earnings available

for equity Shareholders

Non-Employment of Debt Capital

(NEDC) Risk

No advantage of Financial leverage.

Loss of control by issue of more and more

Equity.

Higher Floatation Cost.

Strike a balance (trade off) between

the financial risk

and

Risk of non-employment of debt

capital

to increase

Firm’s Market Value.

Theories of Capital Structure

1. Net Income Approach

2. Net Operating Income Approach

3. The Traditional Approach

4. Modigliani and Miller Approach

PURPOSE OF STUDY

CAPITAL STRUCTURE

VALUE OF FIRMCOST OF CAPITAL

1. NET INCOME APPROACH

ASSUMPTIONS:

1. COST OF DEBT < COST OF EQUITY

2. NO TAXES

3. RISK NOT INFLUENCED BY DEBT’S USAGE

IMPLICATIONSINCREASE IN

FIRMS’ VALUE

PROPORTION OF CHEAP SOURCE OF FUNDS INCREASE

PROPORTION

OF DEBT INCREASES

CONT…DECREASE IN

FIRMS’VALUE

FINANCIAL LEVERAGE IS REDUCED

PROPORTION OF DEBT FINANCING DECREASES

Calculation of THE TOTAL MARKET VALUE OF A FIRM

V = S + DWhere, V= Total market value of a firm

S= Market value of equity shares

Earnings available to equity shareholders (NI)

Equity Capitalization Rate

D = market value of debt

And, Overall Cost of Capital (Weighted Average Cost of Capital)

K0 = EBIT

V

A company expects a net income of Rs. 80,000. It

has Rs. 2,00,000, 8% debentures. The equity

capitalization rate of the company is 10%.

Calculate:

(a)the value of the firm & overall capitalization rate.

(b) If the debenture debt is increased to Rs

3,00,000, what shall be the value of the firm &

overall capitalization rate?

Solution

Particulars

Net income

Less interest on 8% debentures of

Rs .2,00,000/3,00,000

Earnings available to equity shareholders

Equity capitalization rate

Market value of equity(s)

Market value of debentures(D)

Value of the firm (S+D)

Overall cost of capital

Rs

80,000

(16000)

6400010%

6,40,000

2,00,000

8,40,000

(80,000/8,40,000)X100

=9.52%.

Rs

80,000

(24000)

56,00010%

5,60,000

3,00,000

8,60,000

(80,000/8,60,000)X100

=9.30%

2. NET OPERATING INCOME APPROACH

ASSUMPTIONS:

1. MARKET CAPITALISES VALUE OF FIRM AS A WHOLE

2. BUSINESS RISK REMAINS CONSTANT AT EVERY LEVEL OF DEBT EQUITY MIX

3. NO CORPORATE TAXES

IMPLICATIONS

INCREASED USE OF DEBT

INCREASES FINANCIAL RISK OF THE EQUITY

SHAREHOLDERS.

COST OF EQUITY

INCREASES.

ADVANTAGE OF USING CHEAP

SOURCE OF FUND i.e., DEBT IS

EXACTLY OFFSET BY INCREASED

COST OF EQUITY.

OVERALL COST OF CAPITAL

REMAINS THE SAME.

Ascertainment of value of firm

V= EBIT/KO

V= Value of the firm EBIT= Net operating income or earnings before interest & tax KO= Overall cost of capital S= V-D S= Market value of equity shares V= total market value of a firm D= market value of debt

A company expects a net operating income of

Rs.1,00,000. It has Rs 5,00,000 6% debentures.

The overall capitalization rate is 10%. Calculate

the value of the firm & cost of equity according to

net operating income approach. If the debenture

debt is increased to Rs 7,50,000. What will be the

effect on the value of the firm % the equity

capitalization rate?

Solution

PARTICULARS

Net operating income

Overall cost of capital (Ko)

Market value of the firm= EBIT/Ko (100000x100/10)

Market value of the firm(v)Less market value of debentures (D)Total market value of equity

Cost of equity= (EBIT-I) x 100 (V-D)

RS

1,00,000

10%

10,00,000

10,00,000(5,00,000)

5,00,000

(1,00,000-30,000) x 10010,00,000-5,00,000

=14%.

RS

1,00,000

10%

10,00,000

10,00,000(7,50,000)

2,50,000

(1,00,000-45000) x 10010,00,000-7,50,000

=22%

3. Traditional approach

USE OF DEBT INITIALLY

VALUE OF FIRM

INCREASESCOST OF CAPITAL

DECREASES

BUT..

INCREASED USE OF DEBT

FINANCIAL RISK OF EQUITY

SHAREHOLDERS INCREASE

COST OF EQUITY

INCREASES

OVERALL COST OF CAPIAL

INCREASES

Implications:

Compute: Market value of Firm, Value of shares, and Average cost of Capital

Particulars


Total investment

Equity capitalization rate

a. If the firm uses no debt

b. If the firm uses Rs 4,00,000

debentures

c. If the firm uses Rs 6,00,000

debentures

Rs.

2,00,000

10,00,000

10%

11%

13%

Assume that Rs. 4,00,000 debentures can be raised at 5% rate of

interest whereas Rs. 6,00,000 debentures can be raised at 6% rate of

interest.

Solution


Less int.

Earnings available to

eq. Sh.Holders

Eq. Capitalization rate

Market value of

shares

Market value of debt

Market value of firm

Average cost of

Capital =EBIT/v

(a) No debt

2,00,000

-

2,00,000

10%

20,00,000

-

20,00,000

2,00,000/20,00,000X100

=10%

(b) Rs 4,00,000 5%

debentures

2,00,000

(20,000)

1,80,000

11%

16,36,363

4,00,000

20,36,363

2,00,000/20,36,363X100

=9.8%

(c) Rs. 6,00,000 6%

debentures

2,00,000

(36,000)

1,64,000

13%

12,61,538

6,00,000

18,61,538

2,00,000/18,61,538

X100

=10.7%

4. Modigliani & Miller Approach(IN THE ABSENCE OF TAXES)ASSUMPTIONS:

THERE ARE NO CORPORATE TAXES

THERE IS A PERFECT MARKET

INVESTORS ACT RATIONALLY

THE EXPECTED EARNINGS OF ALL THE FIRMS HAVE IDENTICAL RISK CHARACTERSTICS

ALL EARNINGS ARE DISTIBUTED TO THE SHAREHOLDERS

Implications

Cost of capital not influenced by changes in

capital structure

Debt-equity mix is irrelevant in

determination of market value of firm

(B) WHEN TAXES ARE ASSUMED TO EXIST

USE OF DEBTCOST OF CAPITAL

DECREASE

ACHIEVEMENT OF OPTIMAL

CAPITAL STRUCTURE

Implication:

The mix of debt, preferred stock, and common stock the firm plans to use over the long-run to finance its operations.

Features of a Optimal Capital Mix

• Optimum capital structure is also referred as “ appropriate capital structure” and “sound capital structure”

• Capacity of a FIRM• Possible use of LEVERAGE• FLEXIBLE• Avoid Business RISK• MINIMISE the cost of Financing and MAXIMISE

earning per share

Factors determining capital structure

A company is considering 4 different plans to finance its total project cost of Rs 5,00,000

Plan I Plan II Plan III Plan IV

Equity(Rs. 10 per share)

8% Preference Shares

Debt (8% Debenture)

5,00,000

-

-

5,00,000

2,50,000

2,50,000

-

5,00,000

2,50,000

-

2,50,000

5,00,000

2,50,000

1,00,000

1,50,000

5,00,000

Plan I Plan II Plan III Plan IVEBIT 1,00,000 1,00,000 1,00,000 1,00,000

Less: Interest on DebenturesEBT

-

1,00,000

-

1,00,000

20,000

80,000

12,000

88,000

Less: Tax @50%

Earning after Interest and TaxLess: Preference Dividend

50,000

50,000

NIL

50,000

50,000

20,000

40,000

40,000

NIL

44,000

44,000

8,000

Earning available for eq.Shareholders (A)

50,000 30,000 40,000 36,000

No. of Equity Shares(B)

50,000 25,000 25,000 25,000

EPS(A/B) 50,000/50,000= Rs.1per share

30,000/25,000=Rs.1.20per share

40,000/25,000=Rs.1.60per share

36,000/25,000=Rs.1.44per share

PRINCIPLES OF CAPITAL STRUCTURE

COST PRINCIPLE

RISK PRINCIPLE

TIMING PRINCIPLE

FLEXIBILITY PRINCIPLE

CONTROL PRINCIPLE

CAPITAL GEARING• The term "capital gearing" or "leverage" normally refers to the proportion

of relationship between equity share capital including reserves and

surpluses to preference share capital and other fixed interest bearing

funds or loans.

• It is the proportion between the fixed interest or dividend bearing funds

and non fixed interest or dividend bearing funds.

• Equity share capital includes equity share capital and all reserves and

surpluses items that belong to shareholders. Fixed interest bearing funds

includes debentures, preference share capital and other long-term loans.

HOW TO CALCULATE

Formula of capital gearing ratio:-

[Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds]

EXAMPLE1992 1993

EQUITY SHARE CAPITAL

5,00,000 4,00,000

RESERVES AND SURPLUSES

3,00,OOO 2,00,000

LONG TERM LOANS

2,50,000 3,00,000

6% DEBENTURES

2,50,000 4,00,000

CALCULATION

Capital Gearing Ratio 1992 = (500,000 + 300,000) / (250,000 +

250,000) = 8 : 5 (Low Gear) 1993 = (400,000 + 200,000) / (300,000

+400,000) =6 : 7 (High Gear)It may be noted that gearing is an inverse ratio to

the equity share capital.Highly Geared------------Low Equity Share CapitalLow Geared---------------High Equity Share Capital

SIGNIFICANCE

Capital gearing ratio is important to the company and the prospective investors. It must be carefully planned as it affects the company's capacity to maintain a uniform dividend policy during difficult trading periods. It reveals the suitability of company's capitalization.

REASONS FOR CHANGE IN CAPITAL STRUCTURE :-

To restore balance in financial plan

To simplify the capital structure

To suit investors needs

To fund current liabilities

To write-off the debts

To capitalise retained earnings

To clear default on fixed cost structures

To fund accumulated dividends

To facilitate merger and expansion

To meet legal requirements

1.)

A company can adjust its capital structure as according to needs.

So as to maintain a balance in financial plan and ease out the tension and strain

Restoring balance in financial plan

2.) Simplify the capital structure

Whe

n

market c

onditi

ons are fav

ora

ble vari

ous sec

urities at

differe

nt

poi

nt

of ti

me ca

n

be c

ons

oli

date

d.

This will lead to simplification of financial plan

3.)To suit the need of investors

To make the investment more attractive especially when the shares are limited

due to wide fluctuations in market

the company may change capitalisation to suit the needs of investors.

4.)To fund current liabilities

There may be need of converting short term obligations into long term obligations

Or vice versa

When the market conditions are favorable

5.)To write off deficitA company may need to re-organize its capital by reducing book value of

its liabilities and assets to its real values

As when the book value of assets are over-valued

Or when there are accumulated losses

So as to make company legally payable for dividends

to its shareholders

6.)To capitalise retained earnings

To avoid over-capitalisation

Maintain a balance between preference

shares and equity shares and equity

shares and debentures

Company may capitalise retained earnings by issuing

bonus shares out of it

7.)To clear defaults on fixed cost securities:-

When the company is not in a position to pay interest on debentures

or to repay them on maturity

It may offer them certain

securities(equity shares, preference

shares or new debentures)

to clear default

8.)To fund accumulated dividend

When its time to pay fixed dividends to its preference shareholders

Or when the preference shares are due for redemption

And the company do not have sufficient funds

The company may prefer to issue new shares in lieu

9.)To facilitate merger and expansion

To facilitate merger and expansion

Companies may be required to re adjust its capital structure

10.)To meet legal requirements

To meet the legal requirements

It is necessitated to meet the changes in various legal requirements

As and when took place

Financial Distress and Capital Structure

• Financial risk increases when firm uses more debt;it may not be able to pat fixed interest and runs into bankruptcy.

• Firms using more equity don't face this problem.

• Use of debt provides tax benefit but bankruptcy costs work against the advantage.

• When firm raises debt, suppliers put restrictions in agreement resulting to less freedom of decision making by management called agency cost.

Pecking Order Theory

• This theory was suggested by DONALDSON in 1961.• It was modified by MYERS in 1984.

According to Donaldson,

o Firm has well defined order of preference for raising finance.

o When firm need funds it will rely on internally generated funds.

o This order of preference is so defined because internally generated funds have no issue costs.

Theory presump

tions

Cost of internally generated funds is lowest.

Raising of debt is

cheaper source of finance.

Raising of debt through term loan is

cheaper than issuing bonds.

Issue of new equity capital involves heavy

issue cost.

Servicing of debt capital is relatively less as compared

to equity

Proposes of pecking order theory

Dividend policy is stickily

There is preference for

internally generated funds

to external financing

If external financing is

needed, debt is preferred to

equity

Issue of new equity for raising additional funds is considered as

a last resort

According to modified pecking order theory,

o Order of preference for raising funds arises because of asymmetric information between market and firm.

o Firm may prefer internal funds and then raising of debt as compared to issue of new equity share capital.

BY Manisha Joshi

Capital structure

Education

Transcript of Capital structure