Forms / patterns of capital structre

The capital structure of new company may consist of any of the following forms:

A) Equity shares only

B) Equity and prefeerence shares

C) Equit and debentures

D) Equity shares, Preference shares and debentures.

IMPORTANCE OF CAPITAL STRUCTURE

‘The term capital ‘ refers to the relationship between the various long term forms of

financing such as debenture, preference shares capital and equity share capital.

Financing the firm’s assets is a very crucial problem in every business and as a general

rule there should be a proper mix of debt and equity capital in financing in the firm’s

assets . The use of long term fixed interest bearing debt and preference share capital

along with equity shares is called Financing leaverage or trading on equity . the long

term fixed interest bearing debt is employed by a firm to earn more from the use of

these source than their cost so as to increse the return on owners equity. It is true that

capital struture can not affect the total earning of the firm but it can affect of share of

eaning available for equity share shareholders. Say for exampale, A company has an

equity capital of 1,000 shares of Rs. 100 each fully paid and earns an average profits of

Rs. 30,000. Now the company want to make an expansion and needs another Rs.

10000 the option with the copmany are eithers to isseu new shares or raise loans @
10% p.a. Assuming that the company would earn the same rate of profit. It is advisable

to raise loan as by doing so earning per share magnifying. The company shall pay only

Rs. 10,000 as interest and profit expected shall be Rs. 60,000 (before payment of

interest) After the payment of interest the profit left for equity shareholders shall be Rs.

50,000 (ignoring tax) it is 50% return on equity capital against 30%return otherwise

however, leaverege can operate adversaly also if the rate the interest on long-terms

loans is more than the expected rate of earning of the firm.

ESSENTIAL FEATURES OF SOUND/OPTIMAL CAPITAL MIX

A sound or an appropriate capital structure should have the following essential

features :

I. Maximum possible use of leverage.

II. The capital structure should be fllexible so that it can be easily altered.

III. To avoid undue Financial business risk will increase of debt.

IV. The use of debt should be within the capacity of a firm. The firm should be in

position to meet its obligationsin paying the loan and interest charges as and

when due.

V. It should involve minimum possible risk or loss of cantrol.

VI. It must avoid undue restrictions in arregement of debd.

VII. It should be easy to understand and simple to operate to the extent possible.
VIII. It should minimise the cost of financing and maximise earnings per shares.

FACTORS DETERMINING THE CAPITSL STRUCTURE

I. Financial leverage or trading on equity.

II. Growth and stability of sales.

III. Cost of capital

IV. Risk

V. Cash flow Ability to service debt.

VI. Nature and size ofa firm.

VII. Cantrol.

VIII. Flexibility.

IX. Requirement of Investors.

X. Capital market condition

XI. Asset structure

XII. Purpose of financing

XIII. Period of finance

 XIV. Cost of flotation

XV. Personal consideration

XVI. Corporate tax rate

XVII. Legal requirements

SIGNIFICANCE OF CAPITAL GEARING

The problem of capital gearing is very important in acompany. It has a direct bearing on

the divisable on the divisible profits of a company and hence a proper capital gearing is

a very imporatant for the smooth running of an enterpriese, In in case of a low geared

company, the fixed capital by way of fixed divident on preference share and interest and

interest on debentures is low and the equity shareholders may get ahigher leaving

lesser divisible profits for the equity shareholders.

The capital gearing in the financial structure of a business has been rightly

completed with gears of an automobiles. The gears used to maintain the desired speed

and cantrol. Initially, an automobile starts with a low gears, but as soon as it gets

momentum, the low gwars is changed to high gear to get better speed.similarly, a

company may be started with high equity started with high eqity state. That is low gear

but after momentum, it may be changed to high gearby mixing more of fixed interest

bearing securities such as preference shares and debentures. It may also be noted that

capital gearing affects not only the shareholders but the debentureholders, creditors,
financial institutions, the financial maneger and others also concerned with the capital

gearing.

CAPITAL GEARING AND TRADE CYCLES

The tecniques of capital gearing can be sucsessfuly employed by a company

during various phases of trade cycle, ie. During the conditions of inflation and deflation,

to increase the rate of return to its owners ( Equity shareholders ) and thereby

increasing the value of thair investments. The effect of capital gearing during various

phases of trade cycle is discussed below :

1) During inflation or boom period :- A company should follow the policy of high

gear during inflation or boom period as the profit of the company are higher and it

can easily pay fixed costs of debentures and preference shares. Furthers during

boom period,the rate of earing of the company is usualy higher than the fixed

rate of interested/dividend prevailing on debentures and preference shares. By

adopting the policy of high gear, a company can increases its earning per share

and thereby a higher rate of dividend.

2) During deflation or Depression period :- During depression the rate of

earinigs of the company is lower than the rate of interest/dividend on fixed

interest bearing securities and hence it can not meet the fixed costs without
 lowring the divisible profits and rate of dividents, it is therefore, better for a

company to remain in low gear and not to fixed interest bearing securities as

source of finance during such period.

Theories of capital structure

Different kinds of theories have been propounded by different authers to explain the

relationship between capital structure, cost of capital and value of the firm. The main

contributors to the theories are Dorand, Ezra, Solomon, Modiglini and Milleer.

The important theories are discussed below :

1) Net Income Approch.

2) Net Operating Income Approch.

3) The Tradational Approch.

4) Modigliani and Miller Approch

1) Net Income Approch : Accoding to this approch, a firm can minimise the

waighted average cost of capital and increase the value of the firm as well as

market price of equity shares by using debt financing to the maximum possible

extent. The theories propound that a copany can increase its value and decrease

the overall cost of capital by increasing the proportion of debt in its capital

structure. This approch is based upon The following assumption :

 I. The cost of debtis less than the cost of equity.

II. There are no taxes.

III. The risk pareception of investors is not changed by the use of debt

The line of argument in favour of net net income approch is that as the praportion of

debt financing in capital structure increase, praportion of a less expensive source of

funds increases. This results in the decreases in overall ( Waighted average cost of

capital leading to an increases in the value of the firm. The reason for assuming cost of

debt to be less than the cost of equity are that interast rate are usually lower than

dividend rates due to element of risk and the benefit of tax as the interest is a

deductable exenses.

On the other hand, If the praportion of debt financing in the capital of the firm in

the increases and the totle value of the firm will decreses . the net income

approch showing the effect of leverage on overall cost of capital has been

presented in the following figure

V = S+D

Where : V= Totale market valu of a firm

S = Market value of equity

 = Earning Available to Equity Sharehlders (NI)

Equity capitalisation rate

D = Market value of debt.

And overall cost of capital or Weighted average cost of capital can be calculated

as:

EBIT

Ko = --------------------

2) Net operating Income Approch : This theory as suggested by Durunt

is another extreme of the effect of the leverage on the value of the firm. It is

dimetrically opposite to the net income approch. According to this approch

 change in the capital structure of the company does not affect of the market

value of the firm and the overall cost of capital remain constant irrespective of the

methode of financinng it implies that the overall cost of capital remains the same

wether the debt.-equity mix is 50:50 or 20:80 or 0:100, thus, there is nothing as

an optimal capital structure and every capital structure is the optimal capital

structure. This theory presumes that:

I. The market capitalises the value of the firm is whole ;

II. The business risk remains constant at every level of debt. equity mix;

III. There are no corporate taxe.

The reasons propounded for such assumption are that increased us of debt increses

the financial risk of the equity shareholders and hence the cost of equity is raised on

the other hand, the cost of debt remain constant with the increasing praportion of debt

as the financial risk of the lenders is not affectthus, the advantage using the cheapper

sources of funds that debt is exactaly offset by increased cost of equity.

According to the net operating income ( NOI) Approch the following mix is

relevent and it does not affect the value of the firm the NOI approchshowing the

effect of leverage on the overall cost of capital has been presented in the

following figure.

EBIT
V= ------

Ko

Where, V= value of the firm

EBIT= net operating income and earining before interest and tax

Ko= overall cost of capital

THE MARKET VALUE OF EQUIT,

According to this approch is the ressidual valued which is determined by

deducting the market value of debenture from the totle market value of the firm.

Where, S = V-D

S = market valueof equity shares

V= totle market value of a firm

 D = market value of debt

The cost of equity or equity capitalisation rate can be calculated as below

Cost of equityor equity capitalisation rate (Ke) =

Earning after interest and before tax

= ---------------------------------------------------

V-D

3) THE TRADITIONAL APPROACH.

The tradational approch are also known as intermediate approch is a

comprise between two the two extremes of net income approch and net

operating income approch according to this theory, the value of the firm can be

increased intionaly or the cost of capital can be decreased by using more debt as

the debt is a cheaper source of the funds than equity. Thus optimum capital

structure can be reached by a proper debt equity mix. Beyond a particullar point,

the cost of capital increased because increased debt increase the financial risk

of the equity shareholders the advantage of the cheaper debt at this point of the
 capital can not be afset by the advantage of low cost debt thus overall cost of

capital, according to this theory decrease upto certain point, remains more or

less unchanged for modarate increased in debt thereafter ; and increase or

raised beyond a certain point. Even the cost of debt may increased in this stage

due to increased financial risk. Theory has been explained

4) MODIGLIANI AND MILLER APPROACH .

M & M Hypothesis is identical with the net operating income approch if taxes is

ignored. However, when corporate taxesare assumed to exist, their hypothesis is

similar to the net income approch.

a) In the absence of taxes. (Theory of Irrelevance) : the theory proves that the

cost of capital is not affected by changes in the capital structure or say that

the debt-equity mix is irrelevant in the determination of the totle value of the

firm. The reason argued is that through debt is cheaper to equity, with

increased use of debt as a source of finance the cost of equity increse. This

increses in cost of equity offsets that advantage of the low cost of debt. thus,

although the financial leverageaffects the cost of equity,the overall cost of

capital remain constant. Theory emphasis the fact that a firm’s operating

income is a determinant of its total value. The theory further propounds that

beyond acertain limit of debt, the cost of debt increases due to increases

financial risk but the cost of equity falls thereby again balancing the to cost of

debt increase ( due to increases financial risk ) but the cost of equity falls
 thereby again balancing the to cost. In the opinion of Modiglini & Miller, to

identical firms firms in all respects except their capital structure can not have

different market values or cost of capital because of arbitrage process . In

case to identical firms except for thair capital structure have differunt market

values or cost of capital, arbitrage will take place and the investor s will

engage in ‘in parcenal leverage’ as against the ‘corporate leverage’ ; and this will again

render the two firms to havrthe same total value.

The M&M approch is based upon the following assumption :

I. There are no corporate taxes.

II. There is a perfect market.

III. Investor act rationally.

IV. The expected earnings of all the firms have identical risk

characteristics.

V. The cut-of point of investment in a firm is capitalisaton rate.

VI. Risk to investor depends upon the random fluctuations of expected

earnings and the possiblity that the actual value of the variable may

turn out to be different from their best estimets .

 VII. All earings are distributed amongs the shareholders.

b) When corporate taxxes are assumed to exist. Theory of Relevance) Modiglini

and Miller, in their article of 1963 have recognised that the value of the firm

will increased or the best of capital will decreased with structure can be

achived by maximising the debt mix in the equity of a firm.

RISK RETURN TRADE OFF

Thus a firm has a reach a balance (trade-of) between the financial riskof non

employement of debt to capital increase its market value.

 Capital structure
decisions

Debt- equity
mix

Non employement of debt

Financial risk
capital risk ( NEDC)

Risk- return trade off

Market- value of the firm

(Risk return trde off )

Financial distress

Debt provides tax benefits to the firm, but it also puts pressure on the firm, since interest

and principal payments are obligations, according to the trade-off model. The closer the

firm is to bankruptcy, the larger is the cost of financial distress. The ultimate financial

distress is bankruptcy, where ownership of the firm’s assets is legally transferred from

the stockholders to the bondholders (Haugen & Senbet, 1978). Bankruptcy costs are
made up of two parts, direct and indirect costs. Direct costs can be seen as out-of-

pocket cash expenses, which are directly related to the filing of bankruptcy and the

action of bankruptcy. Examples of direct costs are fees for lawyers, investment bankers,

administrative fees and value of managerial time spent in administering the bankruptcy

(Haugen & Senbet, 1978). In 1990, Weiss estimated the direct cost of bankruptcy for 37

New York and American Stock Exchange firms to be 3.1% of the firm value. Warner

(1977) found that direct costs of bankruptcy decrease when the size of the firm

increases which implies that for large companies bankruptcy costs are less important

when determiningcapital structure than it is for smaller firms. Indirect bankruptcy costs

are expenses or economic losses that result from bankruptcy but are not cash expenses

on the process itself. Examples of such costs caused by bankruptcy are sales that are

lost during and after bankruptcy, diversion of management time while bankruptcy is

underway, and loss of key employees after the firm becomes bankrupt. Sales can

frequently be lost because of fear of impaired service and loss of trust (Titman, 1984).

Altman provided a study in 1984 with a sample of 19 firms, 12 retailers, and 7 industrials

that all went bankrupt between 1970 and 1978. By Optimal Capital Structure Theoretical

Framework 24 comparing expected profits with actual profits, he found the arithmetic

indirect bankruptcy costs to be 10.5% of firm value. Altman (1984) also estimated that

both indirect and direct costs together are frequently greater than 20% of firm value.

These findings give us reason to believe that bankruptcy costs are sufficiently large to

support a theory of optimal capital structure that is based on the trade-off between gains

from the tax shield and losses that come with costs of bankruptcy.
Agency costs

Another factor that can be added to the trade-off model is the agency cost, which arises

due to conflicts of interests. There are two types of agency costs: agency costs of equity

and agency costs of debt. Agency cost of equity has its roots in the simple argument

that you will work harder if you are the owner of the company than if you were an

employee. Also, if you own a larger percentage of the company, you will work harder

than if you owned a smaller percentage of the company (Copeland & Weston, 1992). A

more detailed discussion of the agency cost of equity can be found in Appendix III.

Agency costs of debt occur because there is a conflict of interest between stockholders

and bondholders. As a firm increases the amount of debt in the capital structure,

bondholders begin taking on an increasing fraction of the firm’s business and operating

risk, but shareholders and managers still control the firm’s investment and operating

decisions. This gives managers a variety of different ways for selfish strategies, which

will increase their own wealth, on behalf of the cost of the bondholders. A more detailed

explanation can be found in Appendix I

ECONOMIC VALUE ADDED:

Stern and Stewart, a consultancy firm introduced a performance Measure called

Economic Value Added (EVA) to indicate the minimum return required by the
shareholders to invest in the company’s shares. Economic Value Added (EVA) is the
excess of actual return earned by a firm over such minimum return required by the
shareholders or investors. Here, actual return implies the Net Operating Profit After Tax
(NOPAT) and minimum return denotes cost of capital employed (WACC * CE) to earn
that profit. To put it in an equation form.
EV = NOPAT - (WACC x CE)

Where,

NOPAT = Net Operating Profit After Tax

WACC = Weighted Average Cost of Capital

CE = Capital Employed

NOPAT is calculated from net profit tax as appeared in the Profit and Loss
Account by adding back interest payments and subtracting and adding non-operating
income and non-operating expenses respectively. But in actual practice some other
adjustments are made with the net profit to calculate NOPAT to convert accounting
profit to economic profit. Stern-Stewart have mentioned 164 types of such adjustment
that are kept out of purview of this article for time and constraints.

WACC is the weighted average of the cost of all types of own capital and borrowed
capital such as equity share capital preference share capital, debentures, secured and
unsecured loans etc. with weights equivalent to the proportion of each element in the
total capital of the company. Capital employed denotes all finds belonging to the equity
shareholders and all interest bearing loan capital.

MARKET VALUE ADDED:

 Market Value Added is used as a supplementary to Economic Value Added to
evaluate the performance of a company in the stakeholder’s value creation. It measures
the market value of the company over the value of the investor’s capital. In case of EVA
economic profit is taken into consideration, which is the value added by the company
over given period, the MVA is a measure of the investors perception of value added.
It may be considered as cumulative measure of corporate performance.

MVA = Current market value of debt and equity - Economic book value, where
Economic book value = Share capital + Reserve + debt.

TOTAL SHAREHOLDERS RETURN:

Total Shareholders Return (TSR) is a composite indicator which takes into

account total shareholders’ fund and the dividend declared / proposed by the company.
It represents the change in the capital value of a company over a period of one year,
plus dividends, expressed as a percentage of gain or loss on the beginning capital
value. Capital value implies capital employed excluding debt capital. The exclusive, of
debt capital provides more accuracy in measuring the Total Shareholders’ Return
(TSR).

TSR = (Closing capital value – Beginning capital value + Dividend) / (Beginning

Capital Value x 100).

Weighted Average Cost Of Capital - WACC

What Does Weighted Average Cost Of Capital - WACC Mean?

A calculation of a firm's cost of capital in which each category of capital is
proportionately weighted. All capital sources - common stock, preferred stock, bonds
and any other long-term debt - are included in a WACC calculation. All else help equal,
the WACC of a firm increases as the beta and rate of return on equity increases, as an
increase in WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value
(NPV) of a project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.