Capital Edited)

8/3/2019 Capital Edited)

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Capital Structure

&Sources of Finance

Presented by:

Aaron Harrison

Ankit Jain

Jayant Kindo


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Contents Introduction to Capital Structure

Trading on Equity

Advantages

Forms and patterns of Capital Structure

Financial B.E.P

E.B.I.T-E.P.S

Points of indifference

Optimal Capital Structure

Essentials of sound Capital Structure

Basic Ration

Factors affecting Capital Structure

Theories of Capital Structure

Net Income (NI) Theory

Net Operating Income (NOI) Theory

Traditional Theory

Modigliani-Miller (M-M) Theory


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Introduction

In finance, capital structure refers to the way a corporation financesits assets through some combination of equity, debt, or hybrid securities.

For example, a firm that sells $30 billion in equity and $70 billion in debt issaid to be 30% equity-financed and 70% debt-financed.

Capital Structure refers to the combination or mix of debt and equity which acompany uses to finance its long term operations.

Debt comes in the form of bond/debentures issues or long-term notes payable,while equity is classified as equity share , preference share or retained earning.


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Contd.

In broader sense, Financial Structure and Capital Structure aresame but, In a narrowsense:

Financial structure = Long term + Short term liabilities

Capital structure = Long term liabilities


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Financial Leverage or Trading on Equity

The use of sources of funds with fixed cost, such as debt andpreference share capital along with owners equity capital in the

structure is known as financial leverage.

Financial Leverage employed by the company will depend on theamount of the risk the company will like to pay.

Forexample, a firm that has $40 billion in equity and $60 billionin debt is said to be 40% equity-financed and 60% debt-financed. Inthis example, 60% is referred to as the firm's financial leverage


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Advantage

The rate of return on investment is more then the rate of interest ondebt and rate of dividend on preference capital and hence the

difference is distributed to share capital.

The interest paid on debt is tax deductible and hence there is taxsaving.


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Forms and Patterns of Capital Structure

Equity Shares only

Equity and Preference Shares

Equity shares and Debentures

Equity Share, Preference share and Debenture


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Financial Break Even Point

Financial BEP may be defined as that level of EBIT which is just

equal to pay the financial charges i.e. interest and preference

dividend. At this point or level of EBIT, EPS (EPS = 0).

It is a critical point in planning the capital structure of the firm. If

EBIT is less then Financial BEP, EPS shall be ve and hence fix

interest bearing debt for preference share capital should be reduced.

Forever in case the level of EBIT exceed the financial BEP, more of

such fixed cost funds may be introduced in the capital structure.


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Point of Indifference(EBIT-EPSAnalysis)

It refers to that EBIT level at which EPS remains the same

irrespective of different alternatives of debt equity mix.

At this level of EBIT, the rate of return on capital employed is equalto the cost of debt and this is also known as break-even level of EBITfor alternative financial plans.


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Point of Indifference of indifference Ascertainment

Point ofIndifference:

(X- I1) (1-T) - PD = (X-I2) (1-T) - PDS1 S2

Where,X = EBIT at Indifference Point

I1 = Interest in Alternative 1I2 = Interest in Alternative 2T = Tax RatePD = Preference DividendS1 = No. or amount of Equity Shares in Alternative 1S

2

= No. or amount of Equity Shares in Alternative


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Optimal Capital Structure

The optimal or the best capital structure implies the most

economical and safe ratio between various types of securities. It is that mix of debt and equity which maximizes the value of the

company and minimizes the cost of capital.

The relationship of debt and equity which maximizes the value of

the firms share in the stock exchange.


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Essentials of a Sound or Optimal Capital Structure

Minimum Cost of Capital

Minimum Risk

Maximum Return

Maximum Control

Safety

Simplicity

Flexibility Attractive Rules

Commensurate to Legal Requirements


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Basic RatioSoundor Optimal CapitalStructurerequires (An

Approximation):

Debt Equity Ratio: 1:1 Earning Interest Ratio: 2:1

During Depression: one and a half time of interest.

Total Debt Capital should not exceed 50 % of the depreciated value ofassets.

Total Long Term Loans should not be more than net working capitalduring normal conditions.

Current Ratio 2:1 and Liquid Ratio 1:1 be maintained.


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Factors Influencing Capital StructureInternal

Size ofBusiness

Nature ofBusiness

AssetsStructure

Trading on

Equity

Age of theFirm

Period andPurpose of

Financing

External

Capital MarketConditions

StatutoryRequirements

Nature ofInvestors

Cost of

Financing

TaxationPolicy

Economic

Fluctuations


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Theories of Capital Structure

Net Income (NI) Theory

Net Operating Income (NOI) Theory

Traditional Theory

Modigliani-Miller (M-M) Theory


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NET INCOME APPROACH

Suggested by DAVIDDURAND

Value of the firm dependson its capital structure

decision High debt content in the CS= high FL

V = E + D E= EBIT-I / Ke D= I/Kd

In the light of the graph it isclear that as D/E enhances .Kw decreases because theproportion of debt enhancesin the CS

High debt

content

ReductionOverallCost ofcapital

EnhanceValue of

FIRM


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Net operating income approach

Advocated by David Durand

Value of a firm depends on its NOI and business risk Change in the degree of leverage a firm cannot change its NOI and

Business risk

It brings variation in the distribution of income and risk between

debt and equity without affecting the total income and risk whichinfluences the market value of the firm.

Optimum CS

When there is 100% debt content


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Assumptions

Kw is constant for all degree of leverage

NOI is capitalized at an overall capitalization rate to find out thetotal market value of the firm. Thus the split between D & E isirrelevant.


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TRADITIONAL APPROACH Cost of capital is dependent on the capital structure.

The main propositions of this approach are:-

Cost of debt capital remains constant up to a certain degree ofleverage and there after rises

Cost of equity capital remains constant more or less or risegradually up to a certain degree of leverage and thereafter

increases rapidly. The average cost of capital reduces up to a certain point and

remains more or less unchanged for moderate increase inleverage and there after rises after attaining a certain point.


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Contd.

It accepts that capital structure of a firm affects the COC and itsvaluation.

It does not subscribe to the concept that the value of the firm willnecessarily enhance with all levels of leverage.


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MODIGLIANIMILLERAPPROACH

Total market value of the firm and cost of capital are independentof the capital structure

WACC does not make any change with a proportionate change indebt equity mix in the total capital structure of the firm

It provides operational justification for irrelevance of the capital

structure in the valuation of the firm.


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Propositions

COC and market value of the firm are independent of its capitalstructure.

Cost of capital = capitalization rate of equity

Total market value of the firm is determined by capitalizing theexpected NOI by the rate appropriate for the risk class.

Ke Kd = premium for financial risk

Increased Ke is offset by the use of cheaper debt The cut off rate for investment is always independent of the way in

which an investment is financed.


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Criticism of MM hypothesis

Different rates of interest

Corporate taxes


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Contd.

The use of low cost debt enhances the risk of equity share holders,enhancing the equity capitalization rate. Thus the benefit of DEBT

is nullified by the increase in the EQUITY CAPITALIZATION RATE.

V = EBIT / Kw

An increase in the use of debt funds is offset by an increase in the

equity capitalization rate. This occurs because the equity investorsseek more compensation as they are exposed to higher risk arisingfrom increase in the degree of leverage


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Sources of fund


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Table of content Introduction to sources of funds

Finance types

Equity shares

Advantages

Disadvantages

Preference shares Types

Features

Advantages

Disadvantages

Deffered Shares

Sweat equity Debentures

Types of debentures

Advantages

Disadvantages

Retained Earnings


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Advantages of retained earnings

Disadvantages

Loan Financing

Bridge Financing

Lease Financing


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Introduction

In our present day economy, finance is defined as the provision ofmoney at the time when it is required. In fact, finances today is

rightly said as the life blood of an enterprise.

Capital required for a business can be classified under two maincategories :-

Fixed Capital

Working Capital


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Accordingto period

Short term Medium term Long term

Accordingto

ownership

Owned Borrowed

Accordingto the

source offinance

Internal External

Accordingto the

mode offinancing

Security financing orExternal financing

Internal financing

Loan financing throughraising of long-termand short-term loans


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EQUITY SHARES

Equity shares, also known as ordinary shares or commonshares, represent the owners capital in a company.

Real owners of the company. Equity shareholders are paid dividend after paying it to the

preference shareholders.

Cannot be redeemed


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CHARACTERISTICSOF EQUITY SHARES

Maturity

Claims / Rights to IncomeClaim on Assets

Right to Control or Voting Rights


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ADVANTAGESOF EQUITY SHARES

Equity shares do not create any obligation to pay a fixed rate

dividend.Equity shares can be issued without creating any charge over theassets of the company.

It is a permanent source of capital and the company has not torepay it except under liquidation.


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DISADVANTAGESOF EQUITY SHARES

If only equity shares are issued, the company cannot take theadvantage of trading on equity.

As equity capital cannot be redeemed, there is a danger of overcapitalization.

Equity shareholders can put obstacles in management bymanipulation and organizing themselves.


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PREFERENCE SHARES

Preferences

Preferencefor

payment ofdividend

Preferencefor

repaymentofcapital


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TYPES OFPREFERENCE

SHARES

Cumulative

preference shares

Noncumulativ

epreferenc

e shares

Redeemable

preference shares

Irredeemable

preference

Participating

preference shares

Non-participati

ngpreferenc

e shares

Convertible

preference shares

Nonconvertiblepreference

shares


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FEATURESOF PREFERENCE SHARES

FEATURESOFPREFERENCE

SHARES

Maturity

Claimson

income

Claimson assets


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ADVANTAGESOF PREFERENCE SHARES

No legal obligation to pay dividend on preference shares.

Provides a long term capital for the company.

Enhances the creditworthiness of a firm


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DISADVANTAGESOF PREFERENCE SHARES

Frequent delays or non payment adversely affects the

creditworthiness of the firm.

Cumulative preference shares becomes a permanent burden so far

as the payment of dividend is concerned.

Market price of preference shares fluctuate much more than that of

dividend.


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DEFERRED SHARES

Also known as founder shares since they are issued to the foundersor promoters for services.

Rank last as far as payment of dividend and return of capital isconcerned.

According to Companies Act,1956 no public limited company orwhich is a subsidiary of public company can issue deferred shares


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SWEAT EQUITY

Equity shares issued by a company to its employees or

directors at a discount.

To induce a sense of belongingness of the employee or

director towards the company.

To ensure more loyalty and participation of the employee.

Can be issued only one year after the company is entitled to

commence business


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DEBENTURES

While Starting of a business the company needs large amount ofinvestment. The company borrow funds from banks or other

financial institutions. Debenture is a long term liability, these arethe creditors to the company & the company pay some %age ofinterest to the debenture holder. Debentures are also called BONDS.


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TYPES OF DEBENTURES

SIMPLE OR UNSECURED

DEBENTURES

REGISTEREDDEBENTURES

BEARER DEBENTURES

CONVERTIBLEDEBENTURES


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FEATURES OF DEBENTURES

MATURITY

CLAIMSONINCOME

CLAIMSON

ASSETS


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ADVANTAGES OF DEBENTURES

ADVANTAGES TO THE COMPANY:

Debentures provide long term funds

The rate of interest payable on debentures is usually lower than therate of dividend paid on shares.

ADVANTAGES TO THE INVESTORS:

Debentures provide a fixed and regular source of income to the

It is comparatively a safer investment.


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DISADVANTAGES OF DEBENTURESDISADVANTAGES FOR THE COMPANY:

The fixed rate charges and repayment of principal amount on

maturity are legal obligations of the company. These have to be paideven when there are no profits.

The use of debt financing usually increases the risk perception ofinvestors in the firm .

Cost of raising finance through debentured is also high because of

high stamp duty.


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CONTD.

DISADVANTAGES FOR THE INVESTORS:

Debentures dont carry any voting rights and hence its holders dont

have any controlling power over the management.

Interest on debentures is usually taxable.


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PLOUGHING BACK OF PROFITS

Ploughing back of profit also known as retained earnings is atechnique of financial management under which all profits of a

company are not distributed amongst the shareholders as dividend,but a part of the profit is retained or re-invested into the business.This process of retaining profits year after year and their utilizationin the business is known as PLOUGHING BACK OF PROFITS.


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MERITS OF PLOUGHING BACK OF PROFITS

ADVANTAGES TO THE COMPANY:A cushion to absorb the shocks of the company.

Economical method of financing.Flexible financial structure.

ADVANTAGES TO THE SHAREHOLDERS:Increase in the value of shares.

Safety of investment.

Enhanced earning capacity.


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DEMERITS OF PLOUGHING BACK OF PROFITS

OVERCAPITALISATION

MISUSE OFRETAINEDEARNINGS

CREATION OFMONOPOLIES


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LOANFINANCING

Important modeoffinancing

Short term loans and credits

Medium loans


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SHORT TERM LOANSAND CREDITS

Indigenous bankers

Trade credit

Installment credit Advances

Factoring or accounts receivable credit .


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CONTD

Accrued expenses

Deferred Incomes

Commercial banksx Different forms

x Loans

x Cash credits

x Overdrafts

x Purchasing and Discounting of bills

Public deposits


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LOANS

Specializedfinancialinstitutions ordevelopmental

banks

Commercialbanks

Loans


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SpecialFinancialInstitutions

Industrial finance corporation of India(IFCI)

Industrial credit and investment corporation of India(ICICI)

State financial corporations

State industrial development corporations(SIDCS)


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Other innovative source of finance Venture capital:

Financial investment in a highly risk project to earn a high returnof profit.

Provides the necessary risk capital to meet promoterscontribution

Financialagencies:

Venture capital scheme of IDBI

Venture capital scheme of ICICI Credit rating information services of India ltd.


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Seed capital:

Schemes opened by IDBI to finance the eligible entrepreneurs who

lack financial capability.

Specially designed for promoters to the company.

Operating schemes:

Special seed capital assistance schemes

Seed capital assistance schemes


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Bridge finance

To avoid delay in implementation of the project

Specifically short term loans

Higher rate of interest

Loan repaid when loan disbursements are received from thefinancial institutions.


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Lease financing

Form of renting assets but the firm need not own the assets.

Basically interested in acquiring the use of asset.

Firm considers leasing the assets rather than buying it.


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Types of Leasing

Operating or servicelease:-

Short term lease on a period to period basis.

Cancelable at short notice by the lessee

Option of renewing the lease after the expiry of lease period


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Contd.

Financiallease:

Usually for a longer period and non cancelable.

Lessee is responsible for the maintenance, insurance and Service

of the asset and so also known as net lease.


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Euro issues

Method of raising funds through foreign exchange.

Issue made abroad through instruments denominated in foreign

currency.

Any one capital market can absorb only a limited amount of

companys stock.


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