Post on 09-Apr-2018
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CAPITAL STRUCTURE
MeaningCapital structure of a company
prefers to the makeup of its capitalization
company procure funds by issuing
various types securities that is preferenceshares ordinary shares bonds and
debentures before issuing any of the
securities .a company decide about the
kinds of the securities to be issued .what propositions will the various kinds of
securities to be issued should also be
consider.
Capital structurerefers to mix of sources from where the
long term funds required in a business
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may be raised including loans, bonds,
share issues, reserves etc and the
components of the total capital.
Factors determining capital structure:
yNature of industryyRisk, cost and control considerationsyGestation period
yQuantum of return on investmentyLending policy of financial
institutions
yCertainty with which profits willaccrue
yMonetary and fiscal policies of thegovernment
OPTIMUM CAPITAL
STRUTURE:
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One of
the basic objectives of financial
management is to maximize the value
of wealth of firm. the capital structureism optimum when the firm has
combination of equity and debt so that
the wealth of the firm is maximum .at
this level cost of capital is minimumand market price per share is
maximum
In theory one can speak of anoptimum capital structure but in
practice appropriate capital structure
is more realistic term then the former
FEATURES OF APPROPRIATE
CAPITAL STRUCTURE
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PROFITABILITY :- minimizethe cost of financing and maximize
earnings per share FLEXIBILITY :- capital
structure should be such that
company can raise funds whenever
needed CONTROL :- minimum
risk of loss or dilution of control of
the company .
SOLVECY :- capitalstructure should be such that thefirm does not run the risk of
becoming insolvent
LEGAL REQUIREMENT
S: -
the applicable legal provisions
should be borne in mind while
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deciding about the capital structure
some provisions relate to
maximum limit of borrowings by
company approvals required forforeign direct investment.etc.
MARKETIBILITY :-themodes of obtaining finance
depends on the marketability of thecompany shares or debt
instruments (debentures/bonds) in
case of restrictions in marketability
it is difficult to obtain publicsubscription hence company has to
consider its ability to market
corporate securities
MANEUVERABILITY: - is
required to have as many
alternatives as possible at the time
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of expanding or contracting the
requirements of funds it enables
use of proper type of funds
available at a given time & alsoenhance the bargaining power
when dealing with prospective
supplier of funds .
FLEXIBILITY :- DENOTEScapacity of business and its
management to adjust to expected
and unexpected changes in the
business environment the capitalstructure should provide maximum
freedom to change at all times .
FACT
ORS A
FFECTING
CAPITAL STRUCTURE:
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TRADING ON EQUITY: when
the return on total capital
employed is more than the rate of
interest or borrowed funds or rateof dividend or preference shares,
financial leverage can be used
favorably to maximize EPS.in
such a case, the company is said to be TRADING ON EQUITY.
loans or preference shares may be
preferred in such situations the
affect of financing decision onEPS and roe should be analyzed.
Corporate taxation:
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Interest on
borrowed capital Is a tax
deductable expense but dividend is
not also the cost of raising financethrough borrowing is deductable in
the year in which it incurred due to
tax saving advantage debt has a
cheaper effective cost than preference or equity capital. The
impact of taxation should be c
carefully analyzed.
Government policies:
Raising
finance by way of borrowing or
issue of equity 9is subject to policies of the govt and its
regulatory bodies like
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RBI,SEBIetc.the monetary lending
and fiscal policy as well as rules
and regulations stipulated from
time to time by these bodies
PERIOD OF FINANCE:
Fundsrequired for medium & long-term
periods say 8-10 years. May be
raised by way of borrowings. But
if the funds are for permanentrequirement, it will be appropriate
to raise than by the issue of equity
shares.
NATURE OF INVESTORS:
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Enterprises
which enjoy stable earnings and
dividend with the proven track
record may go for borrowings or preference shares, since they are
having adequate profit to pay
interest/fixed changes. but
companies , which do not haveassured income, should preferably
relay on internal resources to large
extent since it may be difficult to
invest ors towards the issue.
Requirement of investors
Different types of securities are
issued to different class of
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investors according to their
requirement sometimes the
investor may be motivated by the
option and advantages availablewith the example double option,
convertibility, security of principle
of interest etc.
TIMING:
Proper timing of a
security of issue often brings
substantial savings because of thedynamic nature of the capital
market. Hence, the issue should be
made at the right time so as to
minimize effective cost of capital.the management should constantly
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study the trend in the capital
market & time. it issue carefully
PURPOSE OF FINANCEING:
Funds required for long term
productive purposes like
manufacturing setting up new
plant etc.. may be raised through
long term sources but if the funds
are required for non productive
purpose like welfare facilities to
employees such as schools
hospital etc. internal financing
may have to be resort to.
Conservation :
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The debt contact should not
exceed the maximum which company
bear .
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TYPE OF
FUND
RISK COST C
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EQUITY
CAPITAL
Low risk
no question
of re
payment of
capital
except when
the
company is
under
liquidation
MOST
expensive
dividend
expectation of
share holder
are higher
than interest
rate also
dividend are
not
deductible
D
c
t
b
e
n
h
a
PREFERENCE
CAPITAL
Slightly
higher risk
when
compared to
equity
capital.
Slightly
cheaper cost
than equity
but higher
than interest
rates on loan
N
c
v
r
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funds.
LOAN
FUNDS
High risk
capital
should
repaid as
per
agreement.
interest
should be
paidirrespective
of
performance
or profit
Comparatively
cheaper
prevail
interest rates
are
considered
after tax
impact
N
c
f
in
n
r
b
d
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Capital structure:
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The objective of a firm should be
directed towards the maximization of the
value of the firm, the capital structure, or
leverage decision should be examinedfrom the point of view of its impact on
the value of the firm. If the value of the
firm can be affected by capital structure
or financing decision, a firm would liketo have a capital structure which
maximizes the market value of the firm.
There are broadly four
approaches in this regard. These are:
1. Net Income Approach ( N.R.approach)
2. Net Operating IncomeApproach ( N.O.I. approach)
3. Traditional Theory
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4. Modigliani and MillarApproach
These approaches analysesrelationship between the leverage, cost
of capital and the value of the firm in
different ways. However, the following
assumptions are made to understand thisrelationship.
1. These are only two sources offunds viz., debt and equity.
2. The total assets off firm are given.The degree of leverage can be
changed by selling
debt repurchases shares or sellingshares to retire debt
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3. There are no retained earnings. Itimplies that entire profits are
distributed among
shareholders.4. The operating profit of firm is
given and expected to grow.
5. The business risk is assumed to beconstant and is not affected by thefinancing mix decision.
6. There are no corporate or personaltaxes.
7. The investors have the samesubjective probability distribution ofexpected earnings.
Net Income
Approach (NI-approach)
This
approach has been suggested by Durand.
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According to this approach a firm can
increase its value or lower the overall
cost of capital by increasing the
proportion of debt in the capital structure.In other words, if the degree of financial
leverage increases the weighted average
cost of capital will decline with every
increase in the debt content in total fundsemployed, while the value of firm will
increase. Reverse will happen in a
converse situation.
Net income
approach is based on the following three
assumptions :
(i)There are no corporate taxes(ii)The cost of debt is less than cost
of equity capitilisation rate.
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(iii)The use of debt content doesnot change the risk perception of
investors as a result both the Kd
(debt capitalization rate) remainsconstant.
The value of the firm
on the basis ofNet Income Approach can
be ascertained as follows:
V =S+D
Where V = Value of the firm.
S = Market value of equity.D = Market value of debt.
Market value of equity (S
) = NI/keWhere. NI = Earnings available for
equity shareholders.
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Ke = Equity Capitalisation
rate
Under, NI approach, the value of
the firm will be maximum at a point
where weighted average cost of capital is
minimum. Thus, the theory suggests total
of maximum possible debt financing for
minimizing the cost of capital. The N.I.
Approach can be illustrated with help of
the following example.
The overall cost of capital under
this approach is :
Overall cost of
capital=E.B.I.T/Value of the firm
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1. Net operating Income (NOI)Approach :
This approach has been
suggested by Durand. According tothis approach, the market value of the
firm is not affected by the capital
structure changes. The market value
of the firm is ascertained bycapitalising the net operating income
at the overall cost of capital which is
constant.
The market value of the firm isdetermined as follows:
Market value of the
firm (V) = Earnings before interestand tax/Overall cost of capital
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The value of equity can be determined
by the following equation
Value of equity(S) = V (Market value
of firm) D (Market value of debt)
And the cost of equity = Earnings
afterInterestandbeforetax/Market
value of firm(V) Market value ofdebt(D)
The Net Operating Income
Approach is based on the
following assumptions :(i) The overall cost of capital remains
constant for all degree of debt
equity mix.
(ii)The market capitalises the value offirm as a whole. Thus the split
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between debt and equity is not
important.
(iii) The use of less costly debtfunds increases the risk ofshareholders. This causes the
equity capitilisation rate to
increase. Thus, the advantage of
debt is set off exactly by increasein equity capitalisation rate.
(iv) There are no corporate taxes.(v)The cost of debt is constant.
Under NOI approach sinceoverall cost of capital is constant,
therefore there is no optimal
capital structure rather every
capital structure is as good as anyother and so every capital structure
is optimal one.
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3. Traditional Approach :
The traditional approach is also
called an intermediate approach as it
takes midway between NI approach
(that the value of the firm can beincreased by increasing financial
leverage) and NOI approach(that the
value of firm constant irrespective of
the degree of financial leverage).According to this approach the firm
should strive to reach the optimal
capital structure and its total valuation
through a judicious use of the both
debt and equity in capital structure. At
the optimal capital structure the
overall cost of capital will be
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minimum and the value of the firm is
maximum. It further states that the
value of the firm increases with
financial leverage upto a certain point.Beyond this point the increases in
financial leverage will increase its
overall cost of capital and hence the
value of firm will decline. This is because the benefits of use of debt
may be so large that even after off
setting the effect of increases beyond
an acceptable limit the risk of debtinvestor may also increase,
consequently cost of debt also starts
increasing. The increasing cost of
equity owing to increased financialrisk and increasing cost of debt makes
the overall cost of capital to increase.
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Thus as per the traditional
approach the cost of capital is a
function of financial leverage and thevalue of firm can be affected by the
judicious mix of debt and equity in
capital structure. The increase of
financial leverage upto a pointfavourably affects the value of firm.
At this point the capital structure is
optimal and the overall cost of capital
will be the least.
Modigliani and Miller Approach
(MM Approach)
According to this approach the
total cost of capital of particular firm
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is independent of its methods and
level of financing. Modigliani and
Miller argued that the weighted
average cost of capital of a firmcompletely independent of its capital
structure. In other words, a change in
the debt equity mix does not affect the
cost of capital. They gave a simpleargument in support of their approach.
They argued that according to the
traditional approach, cost of capital is
the weighted average of cost of debtand cost of equity, etc. The cost of
equity, they argued, is determined
from the level of shareholder`s
expectations. Now, if shareholdersexpect 16% from a particular
company, they do take into account
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the debt-equity ratio and they expect
16% merely because they find t%
covers the particular risk which this
Company entails. Suppose, furtherthat the debt Content in the Capital
Structure of this company increases :
this means that in the eyes of
shareholders, the risk of the companyincreases, since debt if a more risky
mode of finance. Hence, each change
in the debt equity mix is automatically
offset by a change in the expectationsof the shareholders from the equity
share capital. This is because a change
in the debt equity ratio changes the
risk element of the company, which inturn changes the expectations of the
shareholders from the particular
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shares of the company. Modigliani
and Miller, therefore, argued that
financial leverage has nothing to do
with the overall cost of capital acompany is equal to the capitalisation
rate of pure equity stream of its class
of risk. Hence, financial leverage has
no impact on share market neither onshare market prices nor on the cost of
capital.
Assumptions
1.
The capital markets are assumed tobe perfect. This means that investors
are free to buy and sell securities.
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They are well informed about the
risk-return on all type of securities.
There are no transaction costs. The
investors behave rationally. Theycan borrow without restrictions on
the same terms as the firms do.
2. The firms can be classified into`homogenous risk class. They
belong to this class if their expected
earnings is having identical risk
characteristics.
3. All investors have the sameexpectations from a firm`s netoperating income (EBIT) which are
necessary to evolute the value of a
firm.
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4. The dividend payment ratio is100%. In other words, there are no
retained earnings.
5. There are no corporate taxes.However this assumption has been
removed later.
Modigliani and Miller agree that
while companies in differentindustries face different risks which
will result in their earnings being
captalised at differntrates, it is not
possible for these companies toaffect their market value, and
therefore their overall capitilisation
rate by use of leverage. That is, for a
company in a particular risk class,the total market value must be same
irrespective of proportion of debt in
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company`s capital structure. The
support for this hypothesis lies in the
presence of arbitrage in the capital
market. That contend that arbitragewill substitute personal leverage for
corporate leverage. This is
illustrated below:
Suppose there are twocompanies A&B in the same risk
class. Company A is financed by
equity and company B has a capital
structure which includes debt. Ifmarket price of share for company
B is higher than company A, market
participants would take advantage of
difference by selling equity sharesof company B, borrowing money to
equate there personal leverage to the
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degree of corporate leverage in
company B, and use these funds to
invest in Company A. The sale of
Company B share will bring downits price until the market value of
company B debt and equity equals
the market value of the company
financed only by equity capital.