Capital Structure Definedy The term capital structure is used to represent the

proportionate relationship between debt and equity. y The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firm s capital expenditure.

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Features of An Appropriate Capital Structure capital structure is that capital structure at that level of debt equity proportion where

the market value per share is maximum and the cost of capital is minimum. Appropriate capital structure should have the following features Profitability / Return Solvency / Risk Flexibility Conservation / Capacity Control

Determinants of Capital Structure Seasonal Variations Tax benefit of Debt Flexibility Control Industry Leverage Ratios Agency Costs Industry Life Cycle Degree of Competition Company Characteristics Requirements of Investors Timing of Public Issue Legal Requirements

Patterns / Forms of Capital StructureFollowing are the forms of capital structure:

Complete equity share capital; Different proportions of equity and preference share capital; Different proportions of equity and debenture (debt) capital and Different proportions of equity, preference and debenture (debt) capital.

Debt-equity Mix and the Value of the Firm Capital structure theories: Net operating income (NOI) approach. Traditional approach and Net income (NI) approach. MM hypothesis with and without corporate tax. Miller s hypothesis with corporate and personal taxes. Trade-off theory: costs and benefits of leverage.

Assumption of Capital Structure TheoriesThere are only two sources of funds i.e.: debt and equity. The total assets of the company are given and do no change. The total financing remains constant. The firm can change the degree of leverage either

by selling the shares and retiring debt or by issuing debt and redeeming equity. Operating profits (EBIT) are not expected to grow. All the investors are assumed to have the same expectation about the future profits. Business risk is constant over time and assumed to be independent of its capital

structure and financial risk. Corporate tax does not exist. The company has infinite life. Dividend payout ratio = 100%.

Net Income (NI) ApproachThis theory is propounded by David Durand. According to thisapproach capital structure decisions regarding leverage or dept-equity mix exercise an important impact on the value of the firm. An increase in the degree of leverage or debt in the capital structure will bring down the overall cost of capital (Ko) and will increase the total market value of the firm, resulting in raising the market price of equity shares and vice versa. The inter-relationship between financial leverage , cost of capital and value of the firm holds certain assumptions: There are no taxes. The rate of interest on dept (Ki) is lower than rate of return on equity shareholder. The investors perceive no change in financial risk.

Net Income (NI) Approach According to NI approach both theCost

cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality;kd ko kd ke, ko ke

the optimum capital structure would be 100 per cent debt financing under NI approach.

Debt

Net Operating Income (NOI)ApproachThis theory is also propounded by David Durand. According to this approach the overall cost of capitalization (Ko) remains constant . It has no relation with capital structure which means that overall capitalization rate is independent of changes in capital structure through variations in debt- equity mix. Investors determine the total value of the firm on the basis of Ko.

Cont..As contrary to NI approach ( in which Ke was considered to be constant ) but the rate of return to equity shareholders Ke is not constant under NOI approach and will increase with every increase in financial leverage, because of increased financial risk for equity holders, it does not compensate the existing shareholders for enhanced risk and this will increase the rate of return on their equity capital, this raise the cost of equity share capital (Ke). In case the firm does not increases rate of return due to increase in leverage then the shareholders may start selling their shares and this will bring down market value of shares.

Net Operating Income (NOI) Approach According to NOI approach the

value of the firm and the weighted average structure. In

cost

of

capital

are

Cost ke

independent of the firm s capital

the

absence

of

taxes,

an

ko kd

individual holding all the debt and equity securities will receive the same cash flows regardless of theDebt

capital structure and

therefore,

value of the company is the same.

Traditional TheoryThe traditional theory of capital structure is an intermediary approach which reconciles NI and NOI approaches. This theory assumes that : There is relevance of capital structure and through proper increase in leverage or debt- equity mix a firm can have a optimum capital structure in which the total market value(v) of the firm will be maximum and overall cost of capital minimum. The overall cost of capital is affected by capital structure decisions. Beyond a particular point increase in leverage causes rise in equity capitalization rate(Ke) at a rapid rate

MM Approach Without Tax: Proposition I MM s Proposition I states that the firm s value is

independent of its capital structure. With

personal

leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the overpriced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

ContThis approach closely resembles NOI approach so far as the theme of irrelevance of capital structure in determining V and Ko are concerned. Both the approaches contend that Ko is independent of the degree of leverage in capital structure and hence the value of the firm in not affected by financing decisions. MM approach, provides rational explanation ( which is ignored in NOI approach) that there is no inter-relationship between cost of capital and debt- equity ratio. The assumptions of MM approach are as follow: The capital markets are perfect. There are no transaction costs. All the firms can be classified into equivalent risk or group or homogeneous risk category. 100% dividend payout ratio

y y y y

Cont..It may be pointed that the entire MM theme is built up on the process known as arbitrage. Meaning of arbitrage:- Simultaneous purchase and sale of the same or equivalent security in order to profit from price discrepancies. The process of arbitrage balances the discrepancies and restores an equilibrium in V and Ko of the two firms.(belonging to same risk class), In case the V of a levered firm is higher and Ko is lower as compared to unlevered firm , the rational investor will start selling their proportionate shares in the levered firm and purchase equivalent share in equity of the unlevered firm. By doing so the rational investors will be having the benefit of the same return after arbitrage.

MM Hypothesis With Corporate Tax

Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

Features of an Appropriate Capital Structure

Profitability Solvency Return Risk Flexibility Capacity Control Conservatism

CONCEPT OF LEVERAGEThe leverage may be defined as the % change in one variable divided by the % change in some other variable or variables. The term leverage in general, refers to a relationship between two interrelated variables, with reference to business firm. These variables may be costs, sales revenue, EBIT, earning per share etc. In the leverage analysis, the emphasis is on the measurement of the relationship of these variables rather then on measuring these variables.

TYPES OF LEVERAGEOperating Leverage 2. Financial Leverage 3. Combined Leverage1.

OPERATING LEVERAGEWhen a firm operates with heavy fixed costs in relation to its total operating cost. If a high percentage of a firm s total costs are fixed costs, then the firm is said to have a high degree of operating leverage. Use of high fixed operating costs does magnify a change in profits relative to a give change in sales. In other words, it can be said that when operating leverage is high , a slight favourable or unfavourable change in sales will cause a more favourable or unfavourable change in operating profits or EBIT of the firm

Meaning of Financial LeverageThe use of the fixed-charges sources of funds, such as debt and preference capital along with the owners equity in the capital structure, is described as financial leverage or gearing or trading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity. The rate of return on the owners equity is levered above or below the rate of return on total assets.

FINANCIAL LEVERAGEFinancial leverage indicates the impact of debt financing on the earnings ( profit before tax ) of the firm. High financial leverage represents a higher proportion of borrowed funds in the total capitalization of the company . Capital structure with a high degree of financial leverage creates a heavy fixed burden on the profits which can be sustained till sales earnings are adequate

COMPUTATION OF FINANCIAL LEVERAGE

FL= Financial leverage EBIT= Earnings before interest and tax INT= Interest on borrowed capital PBT= Profit before tax

Financial Leverage and the Shareholders ReturnThe primary motive of a company in using financial leverage is to magnify the shareholders return under favourable economic conditions. The role of financial leverage in magnifying the return of the shareholders is based on the assumptions that the fixedcharges funds (such as the loan from financial institutions and banks or debentures) can be obtained at a cost lower than the firm s rate of return on net assets (RONA or ROI). EPS, ROE and ROI are the important figures for analysing the

impact of financial leveraged

Effect of Leverage on ROE and EPSFavourable ROI > I Unfavourable ROI < I Neutral ROI = I

COMBINED LEVERAGEThe OL explains the business risk complexion of the firm where as the FL deals with the financial risk of the firm. Both these leverage exercise a combined impact on the earnings of a firm. Operating leverage exercise a considerable or decelerating impact on the rate of return on overall investment in relation to change in the size of the sales which involves business risk.

OR

EPS and ROE Calculations

Earnings per share =

Profit after tax Number of shares ( EBIT INT)(1 T ) PAT EPS = ! N N

Return

on equity

=

ROE =

Profit after tax Value of equity (EBIT INT)(1 S

T)

y For calculating ROE either the book value or the

market value equity may be used.

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Effect of Financial Plan on EPS and ROE: Constant EBITy The firm is considering two alternative financial plans:(i) either to raise the entire funds by issuing 50,000 ordinary shares at Rs 10 per share, or y (ii) to raise Rs 250,000 by issuing 25,000 ordinary shares at Rs 10 per share and borrow Rs 250,000 at 15 per cent rate of interest.y

Financial Plan DebtEquity Earning before 120000 interest & tax (EBIT) Less:- Interest Earning before tax PBT=EBT-INT Less:- Taxes Profit after tax(PAT) Total earnings of investor (PAT+INT) 37500 82500 41250 41250 78750 All Equity 120000 120000 60000 60000 60000

y The tax rate is 50 per cent.

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Combining Financial and Operating Leveragesy Operating leverage affects a firm s operating

profit (EBIT), while financial leverage affects profit after tax or the earnings per share. y The degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales.

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