Capital structure - Copy

8/7/2019 Capital structure - Copy

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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.

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Capital structure - Copy

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