A PROJECT REPORT ON

CAPITAL STRUCTURE

SUBMITTED BY MS. MANINI SHAH FOR THE DEGREE OF

THE BACHELOR OF MANAGEMENT STUDIES

UNDER THE GUIDANCE OF MISS _____________

HR COLLEGE OF COMMERCE AND ECONOMICS _________ ( E ) , MUMBAI 4000____ ACADEMIC YEAR 2010 - 2011

DECLARATION I, MANINI SHAH OF THE HR COLLEGE OF COMMERCE AND ECONOMICS, ___________( E ) , HEREBY DECLARE THAT I HAVE COMPLETED THE PROJECT ENTITLED CAPITAL STRUCTURE PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE THIRD YEAR OF THE BACHELOR OF MANAGEMENT STUDIES COURSE FOR THE ACADEMIC YEAR 2010-2011

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WHAT IS CAPITAL STRUCTURE A firm needs capital to grow and acquire additional assets. Firms usually finance the purchase of long-term assets with long-term capital. Retained earnings are one source of long-term capital. But when capital requirements exceed the firms ability to generate cash internally, it must raise funds externally. The firms mix of different securities is known as its capital structure. In other terms, capital structure refers to the firms proportion of debt financing, its leverage ratio. Capital structure is the mixture of sources of funds a firm uses (debt, preferred stock, common stock). The amount of debt that a firm uses to finance its assets is called leverage. PHILIP MORRIS produces food, drink, and tobacco including such wellknown products such as Marlboro cigarettes, Maxwell House coffee, and Millers beer. In 200 the company generated $11 billion in cash. From this it paid $4.5 bn as dividends and repurchased shares for $3.6 bn. The balance of $2.9 bn was reinvested in the business but this sum was too short for further expansion and modernization so, to make up the shortfall, the company borrowed $10.9 bn and issued $100 mn of common stocks.

In considering how to finance its investments, Philip Morris s managers faced two basic decisions. One was the dividend decision. For example, the company could have paid a larger dividend the cash for this would have had to come from buying back fewer shares or selling more stock. The second decision was whether to raise cash by debt or equity. A companys mix of debt and equity is termed its capital structure. Capital structure is by definition the cumulative outcome of past financing decisions. Past financing decisions are known to depend on past market valuations. An appropriate capital structure is a critical decision for any business organization. The decision is important not only because of the need to maximize returns to various organizational constituencies, but also because of the impact such a decision has on an organizations ability to deal with its competitive environment.

COMPONENTS OF CAPITAL STRUCTURE

The above stated definition gives two broad options for financing the organizations investments- Equity and Debt

However, within the broad categories of debt and equity there exists a variety of financing instruments and vehicles that firm can use. Fir instance, The Home Depot raised debt by issuing convertible bonds, while Boeing used a combination of secured and unsecured debt, with varying maturities. The choices are narrower for private businesses, but they do exist. InfoSoft raised equity to fund its operations from both the current owners of the business and venture capitalists. EQUITY 1. Ownership interest in a corporation in the form of common stock or preferred stock. It is the risk-bearing part of the company's capital and contrasts with debt capital, which is usually secured and has priority over shareholders if the company becomes insolvent and its assets are distributed. 2. Total assets minus total liabilities; here also called shareholder's equity or net worth or book value. It is also known as common stock or simply stock. Large firms generally raise the bulk of new common equity internally- that is, by retaining a portion of earnings. But smaller or rapidly growing firms usually also issue new common stock to raise funds. Even large firms sometimes issue new common equity through sizable public offerings. In

addition, many firms have instituted dividend reinvestment or employee stock purchase plans that generate additional common equity on a continuing basis. DEBT No doubt we all have (mostly) borrowed money before. Like having a credit card, we borrow money each time we use it. The card issuer pays the merchant, and we must repay the card issuer. If we always pay the first time we are billed, the loans are interest-free. We simply repay the amount we have borrowed; no interest is charged. If we do not pay right away, however, we begin to owe interest. Here we are referring only long-term (10 or more years) debt or loan. 1. A liability or obligation in the form of bonds, loan notes, or mortgages, owed to another person or persons and required to be paid by a specified date (maturity). 2. A debt instrument is a contract between the issuer and investor or holder, which provides for the periodic payments to the holder in exchange to the, money lent to the issuer. In other words, there is a creditor-debtor relationship between the investor and issuer. The issuer makes a promise to pay (the holder) interest periodically and repay principal at the end of a certain period

of time. The issuer could be a body corporate or government. Corporate debt instruments are called debentures or bonds.

Bond A bond is a type of loan. A certificate of debt that is issued by a government or corporation in order to raise money with a promise to pay a specified sum of money at a fixed time in the future and carrying interest at a fixed rate. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). The main types of bonds are corporate bond, municipal bond, Treasury bond, Treasury note, Treasury bill, and zero-coupon bond. It is a tradable debt instrument that might be sold at above or below par (the amount paid out at maturity), and are rated by bond rating services such as Standard & Poor's and Moody's Investors Service, to specify likelihood of default. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. It is relatively more secured than equity and has priority over shareholders if the company becomes insolvent and its assets are distributed.

There is no legal distinction between a debenture and a bond except that a debenture could be either secured or unsecured, whereas a bond is

secured. The term bond is usually applied to public sector debt offerings. These terms are used interchangeably in this project.

When a firm decides to issue debt securities, it must decide several things. Should the debt have a fixed or a variable interest rate? When should it mature? Should it include a sinking fund, which will retire it in installments? Should the firm retain a call option so that it can call in the debt and refund it if interest rates drop?

Market research shows that the volume of debt issues tends to vary with the level of long term interest rates. During periods of rising long-term interest rates such as 1977-1981, firms tend to favor short-term borrowing in the hope that long-term interest rates will fall. When long-term interest rates do fall, as they did from 1981 to 1986 and from 1990 to 1993, firms begin to replace this short-term debt.

Features of a bond A bond is a marketable debt instrument. The length of time before it matures is called term to maturity, usually greater than a year. Those with term to maturity of less than a year are called money market instruments,

and those with term greater than one year are called capital market instruments. The issuer generally pays a fixed rate of interest on the principal (face value). The rate of interest is called coupon rate, and the amount itself is called coupon. The coupon can be paid annually or semi-annually. Long-term debt instruments share several common features.
1. Stated maturity: This is the date by which the borrower must repay

the money it borrowed.

2. Stated principal amount: This is the amount the borrower must repay. 3. Stated coupon rate of interest: The interest rate may be a fixed rate,

or it may be a variable rate that is adjusted according to a specified formula.

4. Mandatory redemption (or sinking fund) schedule:

Some bonds

contain a sinking fund, whereas others are repaid in a single sum at maturity. A sinking fund involves a sequence of principal repayments prior to the maturity date. Bonds are redeemed in cash at their face amount or else through capital market purchases.
5. Optional redemption provision: The issuer has the right to call the

issue (or some portion of it) for early redemption. A schedule of

optional redemption prices is specified at the time of issue. Callable bonds usually provide for a grace period immediately following issuance. Bonds are noncallable during this period. Many long-term issues contain a weaker provision. The bonds are only

nonrefundable. During the nonrefundable period, the issuer cannot use the proceeds from a new debt issue that ranks senior to, or on a par with, the outstanding debt to refund it.
6. Protective

Covenants: Covenants impose restrictions on the

borrower. They are designed to protect the bondholders. Types of long term debt There are four main classes of long-term corporate debt instruments: Secured debt, Unsecured debt, Tax-exempt debt, and Convertible debt. Secured debt: Secured debt is backed by specific assets. This backing reduces both the lenders risk and the interest rate they require. Mortgage bonds, collateral trust bonds, equipment trust certificates, and conditional sales contracts are the most common types of secured debt. Mortgage Bonds: Mortgage bonds are secured by a lien on specific assets of the issuer. If the issuer defaults-fails to make a required payment of principal or interest-or fails to perform some other provision of the loan contract, lenders can seize the assets that secure the mortgage bonds and

sell them to pay off the debt obligation. The extra protection that the mortgage provides lowers the risk. In return, that lowers the required return. But the issuer sacrifices flexibility in selling assets. Mortgaged assets can be sold only with the mortgaged bondholders permission or if the borrower provides suitable replacement collateral. Collateral Trust Bonds: Collateral trust bonds are similar to mortgage bonds except that the lien is against securities, such as common shares of one of the issuers subsidiaries, rather than against real property such as plant and equipment. Equipment Trust Certificates And Conditional Sales Contracts: Equipment certificates and conditional sales contracts are frequently issued to finance the purchase of aircraft or railroad rolling stock. Equipment trust certificates are usually issued to finance a leveraged lease. The trust that issues them owns the assets during the tem of the lease. Conditional sales contracts are agreements that manufacturers use to finance customer purchases of their goods. They are long-term receivables. The two financing mechanisms are similar: The borrower obtains title to he assets only after it fully repays the debt. Unsecured Debt: Unsecured long-term debt consists of notes and debentures. Notes are unsecured debt with an original maturity of ten

years or less. Debentures are unsecured debt with an original maturity greater than ten years. Notes and debentures are issued on the strength of the issuers general credit. A financial contract (the bond indenture) specifies their terms; they are not secured by specific property. If the issuer goes bankrupt, note holders and debentures holders are classified as general creditors. Tax-Exempt Corporate Debt: Firms can issue tax-exempt bonds for specified purposes. Convertible Debt: A convertible bond is a bond that can be converted into a predetermined number of shares of the common stock, at the discretion of the bondholder. Although it generally does not pay to convert at the time of the bond issue, conversion becomes a more attractive option as stock prices increases. Advantages of debt: 1. It provides a tax benefit because interest expenses are tax deductible. 2. For some firms, it can force managers to now more disciplined in their investment choices. Disadvantages of Debt:

1. Debt increases the risk that a firm will be unable to meet its fixed payments and go bankrupt. 2. As firms borrow money, they increase the potential for conflicts between lenders and equity investors. 3. Firms that borrow money lose some flexibility with regard to future financing.

THEORIES OF CAPITAL STRUCTURE

In practice it is difficult to specify an optional capital structure-indeed, managers even feels uncomfortable about specifying an optional capital structure range. Thus, financial managers worry primarily about whether their firms are using too little or too much debt, not about the precise optimal amount of debt. Even if a firms actual capital structure varies widely from the theoretical optimum, this capital structure decisions are secondary in importance to operating decisions, especially those relating to capital budgeting and the strategic direction of the firm. In general, financial managers focus more on identifying a prudent level of debt than on setting a precise optimal level. A prudent level is defined as one that captures most of the benefits of debt yet (1) keeps financial risk at a manageable level, (2) ensures future financing flexibility, and (3) allows the firm to maintain the desirable credit rating. Thus, a prudent level of debt will protect the company against financial and capital markets under conditions Establishing the right capital structure is an imprecise process at best, and it should be based on both informed judgment and quantitative analyses.

Basic Assumptions in Capital Structure theories: The study of the following basic assumption is necessary before studying the capital structure theories under traditional and modern views: The company distributes all its earnings as dividends to its shareholders and no consideration of dividend and retention policies. The taxation and its effect on cost of capital are ignored. Business risk is treated constant at different capital structure of a company. There are no transaction costs and a company can alter its capital structure without any transaction costs. The continuous and perpetual earning of profits to the expectations of the stockholders. Traditional View (Weighted average Cost of Capital) The cost of capital is interdependent on the degree of leverage. The lowest component in the cost of capital relates to the fixed interest bearing investments. Traditionally, optimal capital structure is assumed at a point where weighted average cost of capital (WACC) is minimum. For a project evaluation, this WACC is considered as the minimum rate of return

required from project to pay-off the expected return of the investors and as such WACC is generally referred to as the required rate of return. WACC is defined as the weighted average of the cost of various sources of finance. Weights being the market value of each source of finance outstanding, cost of various sources of finance refers to the return expected by the respective investors. The debt component should be raised up to the level where the WACC of the firm is at the lowest which is called optimum cost of capital. Till the optimum level reaches a firm can rise its debt component to minimize WACC and for increasing returns to the equity holders. After the optimum level, any further increase in debt increases the risk to the equity holders.

Cost Of Equity

Cost Of Capital (Rs.)

WACC Cost of Equity

Optimum Point Degree of Leverage

The above figure shows that the cost of debt lower than cost of equity. Firms can borrow at low rate of interest in the beginning. With the increase

in leverage, lenders being to worry about the repayment of interest and principal and security available to them. The interest rate will be higher on additional loans. Therefore, average cost of debts begins to rise. Simultaneously, when the equity holders will not much bother when the debt levels of the company are lower. But which increasing leverage, the equity holders are much concerned about the level of interest payments affecting the volatility of cash flow for equity. Then the equity holders demand for more rates of return for taking an additional risk. Thus, a combination of both the sources of finance, with the increase in leverage, the overall cost of capital will also start raising after the optimum level of gearing. WACC is undoubtedly an important tool in determining optimal capital structure. To minimize the value of the firm as well as the market value of the stock, the firm should strive to minimize WACC. Thus, considerable weight is placed on WACC for achieving the ultimate objective of increasing the stockholders worth by choosing an appropriate capital mix. Other conditions, like cash flow, ability of the firm to meet fixed charges, degree of leverage, fluctuations of EBIT and its likely impact on EPS for alternative methods of financing etc. should also be taken into consideration with due weight age for the purpose.

Value of firm Market value

Value of equity

Value of debt Optimal level of capital Degree of leverage

The above figure shows the impact of leverage on value of the firm. The value of the firm is maximum where the level of gearing for each firm at which the cost per unit of capital is at its lowest point. Therefore, a firm should identify and maintain capital structure at this optimum level.

Net Income Approach This is approach is given by Durant David. According to this approach, the capital structure decision is relevant to the valuation of the firm. As such a change in the capital structure causes an overall change in he cost of capital and also in the total value of the firm. A higher debt content in the capital structure means high financial leverage and this results in decline in the overall or weighted average cost of capital. This result in increases in the value of the firm and also increases in the value of the equity shares. In

an opposite situation, the reverse conditions prevail. There are usually three basically assumptions of this approach: Corporate taxes do not exist. Debt content does not change the risk perception of the investors. Cost of debt is less than cost of equity i.e., debt capitalization rate is less than the equity capitalization rate. According to net income approach, the value of the firm and the value of equity are determined as given below:

Value of Firm (v)

Where,

V = S+B

S = Market value of Equity B = Market value of Debt

Net operating Income Approach: According to net operating income approach (NOI) value of the firm is independent on its capital structure. It assumes that the weighted average cost of capital is unchanged irrespective of the level of gearing. The underlying assumption behind this approach is that the increase in the employment of debt capital increases the expected rate of return by the

stockholders and the benefit of using relatively cheaper debt funds is offset by the loss arising out of the increase in cost of equity. A change in proportion of various sources of finance cannot alter the weighted average cost of capital and as such, the value of firm remains unaltered for all degrees of leverage. Under this approach optimal capital structure does not exist, as average cost of capital remains constant for varied types of financing mix. NOI approach is opposite to NI approach. According to this approach, the market value of the firm depends upon the net operating profit or EBIT and the overall cost of capital, weighed average cost of capital (WACC). The financing mix or the capital structure is irrelevant and does not affect the value of the firm. The NOI approach is based on certain assumptions: The investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole.

The overall cost of capital, Ko, of the firm is constant and depends upon the business risk, which also is assumed to be unchanged.

The cost of debt, Kd, is also constant.

There is no tax.

The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increase in the cost of equity capital i.e., Ke.

The NOI approach believes that the market value of the firm as a whole for a given risk complexion. Thus, for a given value of EBIT the value of the firm remains the same irrespective of the capital composition and instead depends on the overall cost of the capital. Ascertainment of value of firm and value of equity V = EBIT Ko Value of Firm (V) Where, EBIT = Earnings before interest and tax Ko = Overall cost of capital S = V-B Value of Equity (S) Where, V = Value of Firm B = Value of debt Thus, financing mix is irrelevant and does not affect the value of the firm. The value remains same for all types of debt-equity mix. Since there will be

the change in the risk of the shareholders due to change in debt-equity mix therefore, Ke, will be changing linearly with change in debt proportion.
Cost of Equity Cost of capital Level of gearing WACC Cost of Debt

The NOI approach can be illustrated with the help of the above diagram. The diagram shows that the cost of the debts and the overall cost of capital are constant for all level of leverage. As the debt proportion or the financial leverage increases the risk of the shareholders also increases and thus, the cost of the equity capital also increases. However, the increase in the cost of the equity capital does not affect he overall value off the firm and it remains same. It is to be noted that an all- equity firm the cost of equity capital is just equal to WACC as the debt proportion is increased, the cost of the equity also increases. However, the overall cost of the capital remains constant. Because increase in cost of equity is just sufficient to offset the benefit of cheaper debt financing. The NOI approach believes that leverage has no effect on the WACC and value of the firm. Hence, every capital structure is optional.

The MM approach is quite similar to NOI approach in many respects. But still NOI approach is only conceptual in the sense and it fails to give operational justification to the fact that the capital structure is not important for the valuation of the firm. MM approach also supports the NOI approach but it provides justification for the independence of the total valuation and cost of capital from the capital structure. Modigliani and Miller Theory (Modern View) The traditional view of capital structure as explained in Weighted average cost of capital is rejected by the proponents Modigliani and Miller (MM) (1958). According to them cost of capital is independent of capital structure and, therefore, there is no optimal value. According to them, under competitive conditions and perfect markets, the choice between equity financing and borrowing does not affect a firms market value because the individual investor can alter investments to any mix of debt and equity the investor desires. Assumptions of MM theory: The MM theory is based on the following assumptions: Perfect capital markets exist where individuals and companies can borrow unlimited amounts at the same rate of interest. There are no taxes or transaction costs.

 The firms investment schedules and cash flows are assumed constant and perpetual. The stock markets are perfectly competitive. Investors are rational and expect other investors to behave rationally.

Cost of capital

Cost of Equity Average cost of capital Cost of debt

Level of Leverage

It means according to MM approach the weighted average cost of capital does not change with change in debt-equity mix i.e., change in capital structure. Whenever the debt equity ratio changes, the expectations of the equity shareholders also change. Result is that the overall cost of capital of the enterprise remains unaffected. This is exactly what MM approach says.
MM Theory: No Taxation

The debt is less expensive than equity. An increase in debt will increase the required rate of return on equity. With the increase in the levels of debt, there will be higher level of interest payments affecting the cash flow of the company. Then equity shareholders will demand for more returns. The

increase in cost of equity is just enough to offset the benefit of low cost debt, and consequently average cost of capital is constant for all levels of leverage as shown in the above figure. In MM theory the following symbols will be used: Vu = Market value of ungeared company i.e., company with 100% equity financing. Vg = Market value of a geared company i.e., the capital structure of the company includes both debt and equity capital. D = Market value of debt in a geared company. Veg = Market value of equity in a geared company and then Vg = Veg + D Ku = Cost of equity in an ungeared company. Kg = Cost of equity in geared company. Kd = Cost of debt. PROPOSITION The market value of nay firm is independent of its capital structure, changing the gearing ratio cannot have nay effect on the companys annual cash flow. It is determined by the assets in which the company has invested and not how those assets are financed. The value of the Geared Company is as follows:

Vg = Vu Vg = Profit before interest WACC Vu = Vg = Earnings in ungeared company Ku WACC is independent of the debt/equity ratio and equal to the cost of capital, which the firm would have with no gearing in its capital structure. PROPOSITION The rate of return required by shareholders increases linearly as the debt/equity ratio is increased i.e., the cost of equity rises exactly in line with any increase in gearing to precisely offset any benefits conferred by the use of apparently cheap debt. MM went on arguing that the expected return on equity of a geared company is equal to the return on a pure equity stream plus a risk premium dependent on the level of capital structure. The premium for financial risk can be calculated as debt/equity ratio multiplied by the difference between the cost of equity for an ungeared company and the risk free cost of debt. The cost of equity of a geared company is calculated as follows: Kg = Ku +

[ (Ku Kd) x D ]
Veg

By introducing debt in capital structure, the cost of equity raises linearly to offset the lower cost of debt directly given a constant weighted average of capital irrespective of the level of gearing. PROPOSITION MM theories third proposition asserts that the cut off rate for new investments will in all cases be average cost of capital and will be unaffected by the type of security used to finance the investment.

MM Theory: Arbitrage The cost of equity will rise by an amount just sufficient to offset any possible saving or loss. The supply of debt is determined by the lenders. The optimal level is simply the maximum amount of debt which lenders are prepared to subscribe in any given circumstances. For example, level of inflation, rate of economic growth, level of profits etc. The investors will exercise their own leverage by mixing their own portfolio with debt and equity. They call this the Arbitrage process. Under these conditions of investments the average cost of capital is constant. If two different firms which same level of business risks but with levels of gearing sold for different values, then shareholders would move from

overvalued firm to the undervalued firm and adjust their level of borrowings through the market to maintain financial risk at the same level. The shareholders would increase their income through this method. While maintaining their net investment and risk at the same level. This process of arbitrage would dive the twice of the two firms to a common equilibrium total value. The word arbitrage is a technical term referring to a situation where two identical commodities are selling in the same market for different prices, then the market will reach equilibrium by the dealers start buy at a lower price and sell at the higher price, thereby making profits. The increase in demand will force up the prices of a lower priced goods and increase in supply will force down the high priced commodities. The arbitrage in the MM theory show that the investors will move quickly to take advantage and will make profits in an equilibrium capital market, then this would represent an arbitrage opportunity. MM Theory: Corporate Taxation In our previous discussion, MM theory has ignored the tax relief on debt interest. MM has further modified their theory by considering tax relief available to a geared company when the debt component is existing in the capital structure. The tax burden on the company will lessen to the extent

of relief available on interest payable on the debt, which makes the cost of debt cheaper, which reduces the weighted average capital of the firm to the lower where capital structure of a company has debt component. This MM theory adjusted to taxation is shown in the following figure.
Cost of capital Cost of Equity WACC Cost of debt (after tax)

Level of gearing

Weighted average cost of a geared firm Kg = (Cost of equity x % of equity) + (1-T) (Cost of debt x % of debt) Under the assumption of tax relief being available on debt interest, the total market value of the company is increasing function of the level of gearing. where T = corporate tax rate Kd = Pretax cost of debt MM theory assumes that the value of the geared company will always be greater than an ungeared company with similar business risk but only by the amount of debt-associated tax saving of the geared company. Value of geared company Vg = Vu + DT When corporate taxation is introduced, the tax deductibility of debt interest creates value for shareholders via the tax shield, but this is a wealth Kg = Ku + (1-T)(Ku - Kd) x D

transfer from taxpayers. The value of a geared company equals the value of an equivalent ungeared company plus the tax saving. A further effect of corporate taxation is to lower WACC, which will fall continuously as gearing increases. MM Theory: Personal Taxation: Miller (1977) argued that the existence of tax relief on debt interest but not on equity dividends, would make debt capital more attractive than equity capital to companies. When the company offers an after personal tax return on debt at least as equal to the after personal tax return on equity, the equity supply will switch over to supply debt to the company. Suppliers of funds would be prepared to take up debt provided that they were compensated by a high return so that the after tax return on debt was at least equal to the after tax return on equity. MM Theory: In Real World: Under the modern view of capital structure decisions, the favorable tax implications of borrowing will help reduce of average cost of capital even the levels of leverage increases. It is based on the assumption that interest payments on debt are allowed as a tax deduction whereas dividends on equity capital are not allowed for tax deduction.

Demand for debt Interest rate %

Supply for debt

Optimum point

Total Corporation debt

Financial Distress and Capital Structure The assumption is that when firm has very level of borrowing they are more likely to run into the costs of financial distress and cost of bankruptcy as it is very likely that at some stage it will not be able to make annual interest payments and loan repayments.

Pecking Order Theory

There is a theory, which explains the inverse relationship between profitability and debt ratios. It goes like this, Firms prefer internal finance They adapt their target dividend payout ratios to their investment opportunities while trying to avoid sudden changes in dividends Sticky dividend policies, plus unpredictable fluctuations in profitability and investment opportunities, mean that internal generated cash flow is sometimes more than capital expenditures and at other times less. Is it is

less, the firm first draws down its cash balance or sells its marketable securities If external finance is required, firms issue the safest security first. I.e., they start with debt, they possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. The pecking order explains why the most profitable firms generally borrow lessnot because they have low target debt ratios, but because they dont need outside money. Less profitable firms issue debt because they do not have internal funds sufficient for their capital investment program, and because debt financial is first on the pecking order of external financing. The pecking order theory rests on 1. Sticky dividend policy 2. The preference for internal funds 3. An aversion to issuing equity

APPLICATION OF CAPITAL STRUCTURE THEORY

These following concepts will be helpful in designing capital structure in real life situations. Operating and financial leverage The concept of fixed and variable costs was introduced under break-even analysis. Fixed operating costs do not change with volume changes in the short run. Fixed costs include depreciation on plant and equipment, buildings, etc., insurance, and managerial remuneration. Variable costs, on the other hand, vary directly with the level of output. These include raw materials; direct labor costs and certain administrative expenses. Example Consider two firms that have the following cost structure: (In Rs cr.) Firm A Sales Variable cost Fixed cost 2047 1642 144 Firm B 7736 6186 1089

Depreciation

55

164

EBIT

206

297

If sales were to increase by 30 percent

Sales Variable costs Fixed costs Depreciation

2660 2134 144 55

10056 8041 1089 164

EBIT

327

762

Percentage change in EBIT

58.9%

157

For the same percentage change in sales, percent change in EBIT for firm A is much lower than that for firm B. this is due to the different cost structures. Firm B has substantial fixed costs. The percentage change in EBIT for a given percentage change in sales is called operating leverage.

The impact of operating leverage is that there is more than proportional change in profits when sales change, in either direction. The degree of sensitivity of a firms operating profit to changes in sales is called the degree of operating leverage (DOL).

DOL = Percentage change in EBIT Percentage change in sales

The operating leverage employed by some of the prominent companies is given below:

Company

%age change in sales %age change in profits O.L.

ITC CMC Ltd. Wipro tube Investment Grasim

15.7 18.4 31.2 9.5 -12.8

15.9 24.8 133.0 30.3 -13.5

1.01 1.34 1.26 3.19 1.05

L&T Videocon

18.0 15.6

6.0 70.9

0.33 4.54

The operating leverage should be measured over a period of time rather than on the basis of 1-year data. DOL changes from year to year. An average of DOL for the recent past may be taken. Many executives tend to believe that operating leverage is same as business risk. They are not same. The volatility in sales and expenses gives rise to business risk. Other things remaining same, the higher the degrees of operating leverage, the higher the business risks. Financial leverage Just the presence of fixed operating costs can boost earnings above the break-even point, the presence of fixed cost financing can boost per share and return on equity. Consider two firms A and B. A is all equity financed, whereas firm B has 40 per cent debt. Both employ Rs 500000. Both generate earnings before interest and tax of Rs. 150000. The interest rate on debt is 14 percent.

Firm A

Firm B

Equity Debt EBIT Interest Tax @ 35% 42700 Profit after tax 79300 No. of shares 30000 Outstanding EPS

500000 -150000 -52500

300000 200000 150000 28000

97500

50000

1.95

2.64

The above example illustrates the effect of leverage on EPS. As expected, EPS increases when debt is injected to the capital structure. This is because firm B has issued lesser number of shares. Extending the

example further, it can be verified that the volatility of EPS increases when firms resort to debt financing due to the presence of fixed interest cost. When earnings are high, debt financing boosts EPS; and when earnings are low, debt financing depress EPS. The level of EBIT at which EPS is zero is called break-even EBIT. It is to be understood that the increase in EPS may not be cost free. The investors may expect higher returns as risk have gone up. The degree of sensitivity of a firms EPS to changes in operating profit is called the degree of financial leverage (DFL).

DFL = Percentage change in EPS Percentage change in EBIT

Other things remaining constant, the higher the degree of financial leverage, the higher the financial risk. Total leverage The product of degree of operating leverage and degree of financial leverage is called degree of total leverage (DTL). It is the ration of percentage change in EPS and percentage change in sales that causes the change.

DTL = Percentage change in EPS Percentage change in sales

DEBT CAPACITY Interest on debt is a fixed obligation that should be met regardless of the firms profitability at the time of payment. A default can lead to, in an extreme case, bankruptcy. Normally only debt is considered a fixed obligation. To stay competitive, a firm may have to maintain R&D expenditure, invest in working capital and fixed assets and these investments are largely determined by product market conditions. In this sense, investment in fixed assets and working capital can also be considered as fixed obligation. The debt level a firm can maintain is the level at which the cash flow from operation is adequate to service debt and maintain investment in fixed assets, working capital, R&D, etc. that is,(eq. 1)

NOPAT + Depreciation + Borrowing = After tax interest payment + Capital expenditure + Increases in working capital + Principal repayment

The interpretation in the above equation is fairly simple. The cash flow from operations coupled with external borrowing is used to pay interest, invest in fixed assets and working capital. Extending this logic, external equity can be included as well.

NOPAT + Depreciation + Borrowing + Equity = Interest payments + Capital expenditure + working capital

It has been seen that in real life that firms hate to cut dividends. Theyd prefer to maintain or increase dividends. So dividend payment can also be considered a fixed payment.

NOPAT + Depreciation + Borrowing + Equity = Interest payments + Capital expenditure + change in working capital + Dividends

This equation holds good if the firm has access to unlimited external financing. Whenever cash flow falls short of I + CE + WC + D, the firm can sell securities to bridge the gap. But unlimited external finance is not a realistic assumption. If cash flow cannot cover even interest payments. Further, if debt or equity is not available, the company will be in financial distress. So assessing, debt capacity involves assessing the risk of default

given the fact that product market condition and competitive market conditions determine cash flow and capital market condition determine availability of external financing. The third equation is useful to, Establish the relationship between earnings and debt level; Arrive at the earnings level that the firm should maintain in order to service the debt and maintain a certain level of investment.

RATIO ANALYSIS The amount of debt a project can support depends on the amount of cash flow the project can generate to service debt- interest and principal, credit support available to the project and the lenders coverage requirements. Two ratios are widely used to measure a projects ability to service debt; interest coverage ratio and debt service coverage ratio. Interest coverage ratio = EBIT Interest

It measures the adequacy of operating profits to cover interest charges. A ratio less than one indicate that earnings are not adequate to meet interest charges and hence cannot support that level of borrowing. Lenders may typically insist that interest coverage ratio never fall below 1.25. DSCR = EBIT Interest expense + Principal repayment 1 Tax rate While interest coverage ratio conveys how comfortable a company is in making interest payments, the firms ability to make principal repayment is ignored. DSCR considers both. The higher the DSCR, the better.

CREDIT RATING CONSTRAINTS Whenever a company sells debt, it should get its issue rated by a credit rating agency such as CRISIL, CARE or ICRA. The issue approaches the agency to rate its issue and update the rating throughout the life of the issue. For this service, the agency is paid a fee. The credit rating is an attempt to judge the probability of default. The highest rating of AAA is given to those companies, which have negligible default risk. A debt rating is not an evaluation of the issuing company but is security specific.

ADJUSTING FOR BANKRUPTCY COSTS Bankruptcy cost is the cost associated with going bankrupt. It includes direct, deadweight costs such as administrative and legal expenses and indirect costs such as lost sales, lost investment opportunities, interest paid on emergency loan (if any), higher salary for chief executive (due to increased riskiness of leverage), etc. there is no surefire formula to estimate bankruptcy cost. It is to be noted that it is the expected bankruptcy cost (i.e., present value at the time of borrowing) that we are interested in and not the actual expenses incurred in the year of going bankrupt.

PV of expected bankruptcy costs = Probability of going bankrupt x PV of bankruptcy costs

COST OF UNUSED DEBT CAPACITY Unused debt capacity is like excess cash or inventory (financial inventory). Just as a purchase manager should know the cost of holding raw material inventory, a finance manager should know the cost of holding financial reserves. The decision not to use Rs 1 million of debt capacity is equivalent to holding Rs 1 million more equity than needed. Using equity instead of debt has an implicit cost. If the cost of new equity is 18% and after tax cost

of debt is 8.45 %, the cost of not borrowing is (18 8.450 9.55%. in rupee terms this works out to (9.55% of 1 million) Rs 95500.

MANAGEMENT INCENTIVES AND DEBT CAPACITY It is generally difficult to convince managers that debt is something beneficial and that free cash flow needs to be returned to shareholders when debt is available and/or the company is under-leveraged.

Bringing them all together

Operating leverage constraint

Credit rating constraint

Debt policy

Cost of disruption

Choice of securities Cost of capital and firm value

ISSUES IN CAPITAL STRUCTURE

For listed companies higher the level of debt it seems to send a signal to the stock market and the stock prices go up. Conversely, reducing the level of debt is associated with the more severe decline in stock price. Two possible explanations for this effect are, 1. Managers borrow more when business looks less risky. Investors recognize this and buy more shares on the expectation of better or less risky returns. Managers reduce their debt when business looks more risky, causing investors to react negatively. 2. Managers only issue new shares when they think the market is overvaluing their company. By doing so, they gain extra money fro their company. If they think that their stock price is undervalued they will choose to borro2w money rather than sell equity. Investors know that managers have better information about their companys prospects and respond to the debt/ equity choice. Debt ratios vary widely across different industries. Businesses based on valuable fixed assets such as construction, hotels, metals and paper tend to be highly leveraged while businesses relying on intangible knowledge

based assets such as pharmaceuticals, IT, and biotechnology tend to have little debt

MAKING A CHANGE IN CAPITAL STRUCTURE

Hat should a firm do when it finds that its desired capital structure differs significantly from its current capital structure? There are two basic choices: change its capital structure slowly or change it more quickly. A firm can alter its capital structure slowly by adjusting its future financing mix appropriately. Fir example, suppose a firms target capital structure consists of 35% longterm debt and 65% common equity, and its current capital structure consists 25% long-term debt and 75% common equity. The firm could cure the underleveraged condition by using long-term debt for all new external financing until the long-term debt ratio reached 35%. However, this means that the firms capital structure would continue to be suboptimal while the firm changed it over time. Alternatively, the firm could change its capital structure quickly through an exchange offer, recapitalization offer, debt or share repurchase, or stockfor-debt swap. Of course, such a quick change is not without cost either. The firm will incur transaction costs, and there will be signaling effects associated with he change.

If the difference between a firms actual capital structure and its target corresponds to one full rating category or more, some type of one time transaction to make an immediate change in capital structure is probably warranted. A leverage increase for a significantly underleveraged firm is likely to increase he firms share price. If the firm is less than one full category away from its rating objective (for example, it is a weak single- A and wants to come a strong single A), altering its retention ratio and its external financing mix is probably most cost effective.

FACTORS INFLUENCING CAPITAL STRUCTURE DECISIONS

In reality the following factors have a great practical implications for capital structure:
1.

Tax advantage of debt: The first factor is the tax advantage of debt. Interest paid on debt is deductible from income and reduces a firms tax liabilities, therefore, debt has a tax advantage over equity and by increasing the amount of debt issued, and a firm increases its earnings available to shareholders.

2.

Investors attitude to risk and return: The second factor is related to segmented market, with different sets of investors measuring risk differently or simply charging different rates on the capital that they invest. By choosing the instrument that taps the cheapest market, firms lower their cost of capital. However, the trade-off in terms of availability of funds always exists.

3.

Financing decision and firms risk exposure: The third factor is the impact of financing decisions on the riskiness of a firm. As firms pile on more and more debt, their ability to meet fixed interest payments out of current earnings diminishes. This affects the probability of bankruptcy and as a result, the cost (or risk premium) of both debt

and equity. Firms that adjust their capital structure in order to keep the riskiness of their debt and equity reasonable should have a lower cost of capital.
4.

Control of firm: When the promoters do not wish to dilute their control, the company, may rely more on debt funds than by issue of fresh shares. If the promoters are more answerable to the existing shareholders about improvement in EPS, the only mode of finance left for the company is to raise finance by way of borrowing.

5.

Flexibility: It is more important consideration with the raising of debt is flexibility. As and when the funds are required, the debt may be raised and it can be paid off and when desired. But in case of equity, once the funds raised through of issue of equity shares, it cannot ordinarily be reduced except with the permission of the court and compliance with lot of legal provisions. Hence, debt capital has got the characteristic of more flexibility than equity capital, which will influence the capital structure decisions.

6.

Timing: The time at which the capital structure decision is taken will be influenced by the boom, or recession conditions of the economy. In times of boom, it would be easier for the firm to raise equity, but in

times of recession, the equity investors will not show much of interest in investing. Then the firm is to rely in raising debt.
7.

Legal provisions: Legal provisions in raising capital will also play a significant role in planning capital structure. Raising of equity capital is more complicated than raising debt.

8.

Profitability of the company: A company with higher profitability will have low reliance on outside debt and it will meet its additional requirement through internal generation.

9.

Growing companies: The growing companies will require more funds for its expansion schemes, which will be met through raising debt.

10. Sales stability: A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company

with unstable sales. Utility companies because of their stable demand, have historically been able to use more financial leverage than industrial firms.
11.

Asset structure: Firms whose assets are suitable as security for

loans tend to use debt rather heavily. General-purpose assets that can be used by many businesses make good collateral, whereas special- purpose

assets do not. Thus real estate companies are usually highly levered, whereas companies involved in technological research are not.
12. Operating

leverage: Other things the same, a firm with less operating

leverage is better able to employ financial leverage because it will have less business risk.
13. Growth

rate: Other things the same, faster growing firms must rely

more heavily on external capital. Further, the flotation costs involved in selling common stock exceed those incurred when selling debt, which encourages rapidly growing firms to rely more heavily on debt. At the same time, however, these firms often face greater uncertainty, which tends to reduce their willingness to use debt.
14. Lender

and rating agency attitudes: Regardless of managers own

analyses of the proper leverage factors for their firms, lenders and rating agencies attitudes frequently influence financial structure decisions. In the majority cases, the corporation discusses its capital structure with lenders and rating agencies and gives much weight to their advice.
15. Market

conditions: Conditions on stock and bond markets undergo

both long- and short- term changes that can have an important bearing on an optimal capital structure.

16. The

firms internal condition: A firms own internal condition can

also have a bearing on its target capital structure. For example, suppose a firm has just successfully completed an R & D program, and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in stock price. This company would not want to issue stockit would prefer to finance with debt until the higher earnings materialized and are reflected in the stock price. Then it could sell an issue of common stock, retire the debt, and return to its target capital structure.

Putting all these thought together gives rise to the goal of maintaining financial flexibility, which, from an operational viewpoint, means an

maintaining adequate

reserve

borrowing

capacity.

Determining

adequate reserve borrowing capacity is judgmental, but it clearly depend s on the factors discussed in the chapter, including the firms forecasted need for funds, predicted capital market conditions, managements confidence in its forecasts, and the consequences of a capital shortage.

BIBLIOGRAPHY Principles of Corporate Finance - Brealey Myres (7th ed.) Corporate Finance Theory and Principles Vishwanath S. R. Financial Management Theory and Practice Brigham (10th ed.) Financial Management Ravi Kishore (5th ed.) Corporate Finance Management Emery and Finnerty Corporate Finance Aswath Damodaran http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm http://www.westga.edu/~bquest/2002/rethinking.htm http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page22.htm