UNIT-4

PART-A 1. Define the capital structure. What are the elements of a capital structure? What do you mean by an appropriate capital structure? What are the features of an appropriate capital structure? A. Capital structure refers to the mix of long term sources of funds, such as debentures, long term debt, preference share capital and equity share capital including reserves and surpluses. The appropriate capital structure maximizes the long term market price per share, also keeping in view the financial requirements of a company. A sound or appropriate capital structure should have the following features: 1. It should generate maximum returns to the shareholders. 2. There should not be the use of excessive debt to maintain long term solvency. 3. The capital structure should be flexible, to provide funds to finance its profitable activities in future. 4. The capital structure should involve minimum risk of loss of control of the company. 2. What is EBIT-`EPS analysis? The EBIT-EPS approach analyzes the impact of debt on EPS. The use of fixed cost sources of finance, such as debt and preference share capital to finance the assets of the company, is known as financial leverage. If the assets financed with the use of debt yield a return greater than the cost of debt, the earnings per share also increases without an increase in the owners interest. The firm with high level of the EBIT can make profitable use of the high degree of leverage to increase return on the shareholders equity. The EBIT-EPS analysis does not reflect the debtservicing ability of the firm. This approach does not consider operating and business risk also. 3. what is meant by optimum capital structure? The capital structure should be examined from the viewpoint of its impact on the value of the firm. It can be ultimately expected that if the capital structure decision affects the total value of the firm, a firm should select such a shareholders financing-mix as will maximise the shareholders wealth. Such a capital structure is referred to as the optimum capital structure. The optimum capital structure may be defined as the capital structure or combination of debt and equity that leads to the maximum value of the firm. 4. what are the assumptions in capital structure? Assumptions 1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares. 2. There are no corporate taxes. This assumption is removed later. 3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to the shareholders and there are no retained earnings. 4. The total assets are given and do not change. The investment decisions are, in other words, assumed to be constant. 5. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debt and reduce the equity capital. 6. The operating profits (EBIT) are not expected to grow.

7. All investors are assumed to have the same subjective probability distribution of the future expected EBIT for a given firm. 8. Business risk is constant over time and is assumed to be independent of its capital structure and financial risk. 9. Perpetual life of the firm. PART-B 1. Net Income Approach According to the Net Income (NI) Approach, suggested by the Durand, the capital structure decision is relevant to the valuation of the firm. In other words, a changing the financial leverage will lead to a corresponding change in the cost of capital as well as the total value of the firm. If, therefore, the degree of financial leverage as measured by the ratio of debt to equity is increased, the weighted average cost of capital will decline, while the value of firm as well as the market price of ordinary shares will increase. Conversely, decrease in the leverage will cause an increase in the overall cost of capital and a decline both in the value of the firm as well as the market price of equity shares. The NI Approach to valuation is based on three assumptions: First, there are no taxes; Second, that the cost of debt is less than the equity capitalisation rate or the cost of equity; Third, that the use of debt does not change the risk perception of investors. That the financial risk perception of the investors does not change with the introduction of debt or change in leverage implies that due to change in leverage, there is no change in either the cost of debt or the cost of equity. The implication of the three assumptions underlying the NI Approach is that as the degree of leverage increases, the proportion of a cheaper source of funds, that is, debt in the capital structure increases. As a result, the weighted average of capital tends to decline, leading to an increase in the total value of the firm. Thus, with the cost of debt and cost of equity being constant, the increased use of debt (increase in leverage), will magnify the shareholders earnings and, thereby, the market value of the ordinary shares. The financial leverage is, according to the NI Approach, an important variable to the capital structure of a firm. With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure which will be the one at which value of the firm is the highest and the over a cost of capital the lowest. At that structure, the market price per share would be maximum. If the firm uses no debt or if the financial leverage is zero, the overall cost of capital will be equal to the equity-capitalisation rate. The weighted average cost of capital will decline and will approach the cost of debt as the degree of average reaches one.

The degree of leverage (B/V) is plotted along the X-axis, while the percentage rates of k1 ke and kO are on the Y-axis. This graph is based on Example 10.1. Due to the assumptions that ke and k} remain unchanged as the degree, of leverage changes, we find that both the curves are parallel to the X-axis. But as the degree of leverage increases, k0 decreases and approaches the cost of debt when leverage is 1.0, that is, (k0 = k). It will obviously be so owing to the fact that there is no equity capital in the capital structure. At this point, the firms overall cost of capital would be minimum. The significant conclusion, therefore, of the NI Approach is that the firm can employ almost 100 per cent debt to maximise its value. 2. Net Operating Income (Noi) Approach Another theory of capital structure, suggested by Durand, is the Net Operating Income (NOI) Approach. This Approach is diametrically opposite to the NI Approach. The essence of this Approach is that the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any-change in the total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage. The NOI Approach is based on the following propositions. 1.Overall Cost of Capital/Capitalisation Rate (k0) is Constant The NOI Approach to valuation argues that the overall capitalisation rate of the firm remains constant, for all degrees of leverage. The value of the firm, given the level of EBIT, is V =EBIT/Ko In other words, the market evaluates the firm as a whole. The split of the capitalisation between debt and equity is, therefore, not significant. 2. Residual Value of Equity The value of equity is a residual value which is determined by deducting the total value of debt (S) from the total value of the firm (V). Symbolically, Total market value of equity capital (S) = V - B. 3 Changes in Cost of Equity Capital The equity capitalisation rate cost of equity capital (ke), increases with the degree of leverage. The increase in the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial risk to the ordinary shareholders. To compensate for the increased risk, the shareholders would expect a higher rate to return on their investments. The increase in the equity capitalisation rate (or the lowering of the price-earnings ratio, that is, P/E ratio) would match in the increase in the debt equity ratio. 4 Cost of Debt The cost of debt (Ki) has two parts: (a) Explicit cost which is represented by the

rate of interest. Irrespective of the degree of leverage, the firm is assumed to be able to borrow at a given rate of interest. This implies that the increasing proportion of debt in the financial structure does not affect the financial risk of the lenders and they do not penalise the firm by charging higher interest; (b) Implicit or hidden cost. As shown in the assumption relating to the changes in ke, increase in the degree of leverage or the proportion of debt to equity causes an increase in the cost of equity capital. This increase in Ke, being attributable to the increase in debt, is the implicit part of Ki. Thus, the advantage associated with the use of debt, supposed to be a cheaper source of funds in terms of the explicit cost, is exactly neutralised by the implicit cost represented by the increase in Ke; As a result, the real cost of debt and the real cost of equity, according to the NOI Approach, are the same and equal Ko. Optimum Capital Structure The total value of the firm is unaffected by its capital structure. No matter what the degree of leverage is, the total value of the firm will remain constant. The market price of shares will also not change with the change in the debt-equity ratio. There is nothing such as an optimum capital structure. Any capital structure is optimum according to the NOI Approach.

Modigliani-Miller (Mm) Approach The Modigliani-Miller Thesis relating to the relationship between the capital structure, cost of capital and valuation is akin to the NOI Approach. The NOI Approach, as explained above, is definitional or conceptual and lacks behavioral significance. The NOI. Approach, in other words, does not provide operational justification for the irrelevance of the capital structure. The MM proposition supports the NOI Approach relating to the independence of the cost of capital and the degree of leverage at any level of debt-equity ratio. The significance of their hypothesis lies in the fact that it provides behavioral justification for constant overall cost of capital and, therefore, total value of the firm. In other words, the MM Approach maintains that the weighted average (overall) cost of capital does not change, with a change in the proportion of debt to equity in the capital structure (or degree of leverage). They offer operational justification for this and are not content with merely stating the proposition. 1 Basic Propositions There are three basic propositions of the MM Approach: I The overall cost of capital (k0) and the value of the firm (V) are independent of its capital structure. The kQ and V are constant for all degrees of leverage. The total value is given by capitalising the expected stream of operating earnings at a discount

rate appropriate for its risk class. II The second proposition of the MM Approach is that the ke is equal to the capitalisation rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity-capitalisation rate (Ke) and Ki times the ratio of debt to equity. In other words, ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt. III The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. We are interested mainly in exploring the relationship between leverage and valuation. Our focus, therefore, is on proposition (I). 2Assumptions The proposition that the weighted average cost of capital is constant irrespective of the type of capital structure is based on the following assumptions: a) Perfect capital markets: The implication of a perfect capital market is that (i) securities are infinitely divisible; (ii) investors are free to buy/sell securities; (iii) investors can borrow without restrictions on the same terms and conditions as firms can T(iv) There are no transaction costs; (v) information is perfect, that is, each investor has the same information which is readily available to him without cost; and (vi) investors are rational and behave accordingly. b) Given the assumption of perfect information and rationality, all investors have the same expectation of firms net operating income (EBIT) with which to evaluate the value of a firm. c) Business risk is equal among all firms within similar operating environment. That means, all firms can be divided into equivalent risk class or homogeneous risk class. The term equivalent homogeneous risk class means that the expected earnings have identical risk characteristics. Firms within an industry are assumed to have the same risk characteristics. The categorisation of firms into equivalent risk class is on the basis of the industry group to which the firm belongs. (a) The dividend pay out ratio is 100 per cent. (b) There are no taxes. This assumption is removed later. Proposition I The basic premise of the MM Approach (proposition I) is that, given the above assumptions, the total value of a firm must be constant irrespective of the degree of leverage (debt-equity ratio). Similarly, the cost of capital as well as the market price of shares must be the same regardless of the financing-mix. The operational justification for the MM hypothesis is the arbitrage process. The term arbitrage refers to an act of buying an asset/security in one market (at lower prices) and selling it in another (at higher price). As a result, equilibrium is restored in the market price of a security in different in markets. The essence of the arbitrage process is the purchase of securities assets whose prices are lower (undervalued securities) and, sale of securities whose prices are higher, in related markets which are temporarily out of equilibrium. The arbitrage process is essentially a balancing operation. It implies that a security cannot sell at different prices. The MM Approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly similar in all respects except leverage so that one of them has debt in its capital structure while the other does not. Such homogeneous firms are, according to Modigliani and Miller, perfect substitutes. The total value of the

homogeneous firms which differ only in respect of leverage cannot be different because of the operation of arbitrage. The investors of the firm whose value is higher will sell their shares and instead buy the shares-of-the firm whose value is lower. Investors will be able to earn the same return at lower outlay with the same perceived risk or lower risk. They would, therefore, be better off. The behaviour of the investors will have the effect of (i) increasing the share prices (value) of the firm whose shares are being purchased; and (ii) lowering the share prices (value) of the firm whose shares are being sold. This will continue till the market prices of the two identical firms become identical. Thus, the switching operation (arbitrage) drives the total value of two homogeneous firms in all respects, except the debt-equity ratio, together. The arbitrage process, as already indicated, ensures to the investor the same return at lower outlay as he was getting by investing in the firm whose total value was higher and yet, his risk is not increased. This is so because the investors would borrow in the proportion of the degree of leverage present in the firm. The use of debt by the investor for arbitrage is called as home-made or personal leverage. The essence of the arbitrage argument of Modigliani and Miller is that the investors (arbitragers) are able to substitute personal leverage or home-made leverage for corporate leverage, that is, the use of debt by the firm itself.

Proposition II Financial leverage causes two opposing effects: it increases the shareholders return but it also increases their financial risk. Shareholders will increase the required rate of return (i.e., the cost of equity) on their investment to compensate for the financial risk. The higher the financial risk, the higher the shareholders required rate of return or the cost of equity. The cost of equity for a levered firm should be higher than the opportunity cost of capital, ka; that is, the levered firms ke > ka. It should be equal to constant ka, plus a financial risk premium.

RELEVANCE OF CAPITAL STRUCTURE: THE MM HYPOTHESIS UNDER CORPORATE TAXES MM show that the value of the firm will increase with debt due to the deductibility of interest charges for tax computation, and the value of the levered firm will be higher than of the unlevered firm.

Traditional Approach The preceding discussions clearly show that the Net Income Approach (NI) as well as Net Operating Income Approach (NOI) represent two extremes as regards the theoretical relationship between financing decisions as determined by the capital structure, the weighted average cost of capital and total value of the firm. While the NI Approach takes the position that the use of debt in the capital structure will always affect the overall cost of capital and the total valuation, the NOI Approach argues that capital structure is totally irrelevant. The MM Approach supports the NOI Approach. But the assumptions of MM hypothesis are of doubtful validity. The Traditional Approach is midway between the NI and NOI Approaches. It partakes of some features of both these Approaches. It is also known as the intermediate Approach. It resembles the NI Approach in arguing that cost of capital firm are not independent of the capital structure. But it does not subscribe to the view (of NI Approach) that value of a firm will necessarily increase of average. In one respect it shares a feature with the NOI Approach that beyond a certain degree of leverage, the overall cost increases leading to a decrease in the total value of the firm. But it differs from the NOI Approach in that it does not argue that the weighted average cost of capital is constant for all degrees of leverage. In one respect it shares a feature with the NOI approach that beyond a certain degree of leverage, the over all cost increases leading to a decrease in the total value of the firm. But it differs from the NOI approach in that it does not argue that the weighted average cost of capital is constant for all degrees of leverage.

The crux of the traditional view relating to leverage and valuation is the through judicious use of debt equity proposition, a firm can increase its total value and thereby reduced its overall cost of capital. The rational behind this view is that debt is relatively cheaper source of funds as compared to ordinary shares. With a change the leverage, that is, using more debt in place of equity, a relatively cheaper source of funds replaces a source of funds which involves a relatively higher cost. This obviously causes a decline in the overall cost of capital. If the debt-equity ratio is raised further, the firm would become financially more risky to the investors who would penalise the firm by demanding a higher equity capitalisation rate (ke). But the increase in ke may not be so high as to neutralise the benefit of using cheaper debt. In other words, the advantages arising out of the use of debt is so large that, even after allowing for higher ke the benefit of use of the cheaper source of funds is still available. If, however, the amount of debt is increased further, two things are likely to happen: (i) owing to increased financial risk, ke will record a substantial rise; (ii) the firm would become very risky to the creditors who also would like to the compensated by a higher return such that ki will rise. The use of debt beyond the certain point will, therefore, have the effect of raising the weighted average cost of capital and conversely the total value of the firm. Thus, up to a point/degree of leverage, the use of debt will favourably affect the value of a firm; beyond the point, use of debt will adversely affect it. At the level of debt-equity ratio, the capital structure is an optimal capital structure. Optimum capital structure, the marginal real cost of debt, define to include both implicit and explicit, will be equal to the real cost of equity. For a debt; equity ratio before that level the marginal real cost of debt would be less than that of equity capital, while beyond that level leverage, the marginal real cost of debt would exceed that of equity. There are, of course, variations to the traditional approach. According to one of these, the equity capitalisation rate (ke) rises only after a certain level of leverage and not before, so that the use of debt does not necessarily increase the ke. This happens only after a certain degree of leverage. The implication is that a firm can reduce its cost of capital significantly with the initial use of leverage. Another of the variant of the Traditional Approach suggests that there is no one single capital structure, but, there is a range of capital structures in which the cost of capital (k0) is the minimum and the value of the firm is the maximum. In this range, changes in leverage have very little effect on the value of the firm.
Cost ke

ko

kd

Debt

TRADE-OFF THEORY Financial distress arises when a firm is not able to meet its obligations to debtholders.

For a given level of debt, financial distress occurs because of the business (operating) risk . with higher business risk, the probability of financial distress becomes greater. Determinants of business risk are: Operating leverage (fixed and variable costs) Cyclical variations Intensity of competition Price fluctuations Firm size and diversification Stages in the industry life cycle Financial distress may ultimately force a company to insolvency. Direct costs of financial distress include costs of insolvency. Financial distress, with or without insolvency, also has many indirect costs. These costs relate to the actions of employees, managers, customers, suppliers and shareholders.

With more and more debt, the costs of financial distress increases and therefore, the tax benefit shrinks. The optimum point is reached when the marginal present values of the tax benefit and the financial distress cost are equal. The value of the firm is maximum at this point. Agency costs: In practice, there may exist a conflict of interest among shareholders, debt holders and management. These conflicts give rise to agency problems, which involve agency costs. Agency costs have their influence on a firms capital structure. ShareholdersDebt-holders conflict ShareholdersManagers conflict Monitoring and agency costs PECKING ORDER THEORY The pecking order theory is based on the assertion that managers have more information about their firms than investors. This disparity of information is referred to as asymmetric information. The manner in which managers raise capital gives a signal of their belief in their firms prospects to investors. This also implies that firms always use internal finance when available, and choose debt over new issue of equity when external financing is required. The pecking order theory is able to explain the negative inverse relationship between profitability and debt ratio within an industry. However, it does not fully explain the capital structure differences between industries. IMPLICATIONS: Internal equity may be better than external equity. Financial slack is valuable. If external capital is required, debt is better.

ELEMENTS OF CAPITAL STRUCTURE A company formulating its long-term financial policy should, first of all, analyse its current financial structure. The following are the important elements of the companys financial structure that need proper scrutiny and analysis. 1 .Capital Mix Firms have to decide about the mix of debt and equity capital. Debt capital can be mobilised from a variety of sources. How heavily does the company depend on debt? What is the mix of debt instruments? Given the companys risks, is the reliance on the level and instruments of debt reasonable? Does the firms debt policy allow it flexibility to undertake strategic investments in adverse financial conditions? The firms and analysts use debt ratios, debt-service coverage ratios, and the funds flow statement to analyse the capital mix. 2. Maturity and Priority The maturity of securities used in the capital mix may differ. Equity is the most permanent capital. Within debt, commercial paper has the shortest maturity and public debt longest. Similarly, the priorities of securities also differ. Capitalised debt like lease or hire purchase finance is quite safe from the lenders point of view and the value of assets backing the debt provides the protection to the lender. Collateralised or secured debts are relatively safe and have priority over unsecured debt in the event of insolvency. Do maturities of the firms assets and liabilities match? If not, what trade-off is the firm making? A firm may obtain a risk-neutral position by matching the maturity of assets and liabilities; that is, it may use current liabilities to finance current assets and short-medium and long-term debt for financing the fixed assets in that order of maturities. In practice, firms do not perfectly match the sources and uses of funds. They may show preference for retained earnings. Within debt, they may use long-term funds to finance current assets and assets with shorter life. Some firms are more aggressive, and they use short-term funds to finance long-term assets. 3.Terms and Conditions Firms have choices with regard to the basis of interest payments. They may obtain loans either at fixed or floating rates of interest. In case of equity, the firm may like to return income either in the form of large dividends or large capital gains. What is the firms preference with regard to the basis of payments of interest and dividend? How do the firms interest and dividend payments match with its earnings and operating cash flows? The firms choice of the basis of payments indicates the managements assessment about the future interest rates and the firms earnings. Does the firm have protection against interest rates fluctuations? The financial manager can protect the firm against interest rates fluctuations through the interest rates derivatives. There are other important terms and conditions that the firm should consider. Most loan agreements include what the firm can do and what it cant do. They may also state the schemes of payments, pre-payments, renegotiations etc. What are the lending criteria used by the suppliers of capital? How do negative and positive conditions affect the operations of the firm? Do they constraint and compromise the firms operating strategy? Do they limit or enhance the firms competitive position? Is the company level to comply with the terms and conditions in good time and bad time? 4. Currency Firms in a number of countries have the choice of raising funds from the overseas markets. Overseas financial markets provide opportunities to raise large amounts of funds.

Accessing capital internationally also helps company to globalise its operations fast. Because international financial markets may not be perfect and may not be fully integrated, firms may be able to issue capital overseas at lower costs than in the domestic markets. The exchange rates fluctuations can create risk for the firm in servicing it foreign debt and equity. The financial manager will have to ensure a system of risk hedging. Does the firm borrow from the overseas markets? At what terms and conditions? How has firm benefited - operationally and or financially in raising funds overseas? Is there a consistency between the firms foreign currency obligations and operating inflows? 5 Financial innovations Firms may raise capital either through the issues of simple securities or through the issues innovative securities. Financial innovations are intended to make the security issue attractive to investors and reduce cost of capital. For example, a company may issue convertible debentures at a lower interest rate rather than non-convertible debentures at a relatively higher interest rate. A further innovation could be that the company may offer higher simple interest rate on debentures and offer to convert interest amount into equity. The company will be able to conserve cash outflows. A firm can issue varieties of optionlinked securities; it can also issue tailor-made securities to large suppliers of capital. The financial manager will have to continuously design innovative securities to be able to reduce the cost. An innovation introduced once does not attract investors any more. What is the firms history in terms of issuing innovative securities? What were the motivations in issuing innovative securities and did the company achieve intended benefits? 6 Financial market segments There are several segments of financial markets from where the firm can tap capital. For example, a firm can tap the private or the public debt market for raising long-term debt. The firm can raise short-term debt either from banks or by issuing commercial papers or certificate deposits in the money market. The firm also has the alternative of raising short-term funds by public deposits. What segments of financial markets have the firm tapped for raising funds and why? How did the firm tap and approach these segments? FRAMEWORK FOR CAPITAL STRUCTURE: THE FRICT ANALYSIS A financial structure may be evaluated from various perspectives. From the owners point of view return, risk and value are important considerations. From the strategic point of view, flexibility is an important concern. Issues of control, flexibility and feasibility assume great significance. A sound capital structure will be achieved by balancing all these considerations: Flexibility The capital structure should be determined within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors fixed charges and principal sum and leave some excess cash to meet future contingency. The capital structure should be flexible. It should be possible for a company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. Risk The risk depends on the variability in the firms operations. It may be caused by the macroeconomic factors and industry and firm specific factors. The excessive

use of debt magnifies the variability of shareholders earnings, and threatens the solvency of the company. Income The capital structure of the company should be most advantageous to the owners (shareholders) of the firm. It should create value; subject to other considerations, it should generate maximum returns to the shareholders with minimum additional cost. Control The capital structure should involve minimum risk of loss of control of the company. The owners of closely held companies are particularly concerned about dilution of control. Timing The capital structure should be feasible to implement given the current and future conditions of the capital market. The sequencing of sources of financing is important. The current decision influences the future options of raising capital. The FRICT (flexibility, risk, income, control and timing) analysis provides the general framework for evaluating a firms capital structure. The particular characteristics of a company may reflect some additional specific features. Further, the emphasis given to each of these features will differ from company to company. For example, a company may give more importance to flexibility than control, while another company may be more concerned about solvency than any other requirement. Furthermore, the relative importance of these requirements may change with shifting conditions. The companys capital structure should, therefore, be easily adaptable. PRACTICAL CONSIDERATIONS IN DETERMINING CAPITAL STRUCTURE The determination of capital structure in practice involves additional considerations in addition to the concerns about EPS, value and cash flow. A firm may have enough debt servicing ability but it may not have assets to offer as collateral. Attitudes of firms with regard to financing decisions may also be quite often influenced by their desire of not losing control, maintaining operating flexibility and have convenient timing and cheaper means of raising funds. Some of the most important considerations are discussed below. 1 .Assets The forms of assets held by a company are important determinants of its capital structure. Tangible fixed assets serve as collateral to debt. In the event of financial distress, the lenders can access these assets and liquidate them to realise funds lent by them. Companies with higher tangible fixed assets will have less expected costs of financial distress and hence, higher debt ratios. On the other hand, those companies, whose primary assets are intangible assets, will not have much to offer by way of collateral and will have higher costs of financial distress. Companies have intangible assets in the form of human capital, relations with stakeholders, brands, reputation etc., and their values start eroding as the firm faces financial difficulties and its financial risk increases. 2. Growth Opportunities The nature of growth opportunities has an important influence on a firms financial leverage. Firms with high market-to-book value ratios have high growth opportunities. A substantial part of the value for these companies comes from organisational or intangible assets. These firms have a lot of investment opportunities. There is also higher threat of bankruptcy and high costs of financial distress associated with high growth firms once they start facing financial problems. These firms employ lower debt ratios to avoid the problem

of under-investment and costs of financial distress. But bankruptcy is not the only time when debt-financed high-growth firms let go of the valuable investment opportunities. When faced with the possibility of interest default, managers tend to be risk averse and either put off major capital projects or cut down on R&D expenses or both. Therefore, firms with growth opportunities will probably find debt financing quite expensive in terms of high interest to be paid due to lack of good collateral and investment opportunities to be lost. High growth firms would prefer to take debts with lower maturities to keep interest rates down and to retain the financial flexibility since their performance can change unexpectedly any time. They would also prefer unsecured debt to have operating flexibility. Mature firms with low market-to-book value ratio and limited growth opportunities face the risk of managers spending free cash flow either in unprofitable maturing business or diversifying into risky businesses. Both these decisions are undesirable. This behaviour managers can be controlled by high leverage that makes them more careful in utilising surplus cash. Mature firms have tangible assets and stable profits. They have low costs of financial distress. Hence these firms would raise debt with longer maturities as the interest rates will not be high for them and they have a lesser need of financial flexibility since their fortunes are not expected to shift suddenly. They can avail high interest tax shields by having high leverage ratios. 3 Debt- and Non-debt Tax Shields We know that debt, due to interest deductibility, reduces the tax liability and increases the firms after-tax free cash flows. In the absence of personal taxes, the interest tax shields increase the value of the firm. Generally, investors pay taxes on interest income but not on equity income. Hence, personal taxes reduce the tax advantage of debt over equity. The tax advantage of debt implies that firms will employ more debt to reduce tax liabilities and increase value. In practice, this is not always true as is evidenced from many empirical studies. Firms also have non-debt tax shields available to them. For example, firms can use depreciation, carry forward losses etc. to shield taxes. This implies that those firms that have larger non-debt tax shields would employ low debt, as they may not have sufficient taxable profit available to have the benefit of interest deductibility. However, there is a link between the non-debt tax shields and the debt tax shields since companies with higher depreciation would tend to have higher fixed assets, which serve as collateral against debt. 4. Financial Flexibility and Operating Strategy A cash flow analysis might indicate that a firm could carry high level of debt without much threat of insolvency. But in practice, the firm may still make conservative use of debt since the future is uncertain and it is difficult to be able to consider all possible scenarios of adversity. It is, therefore, prudent to maintain financial flexibility that enables the firm to adjust to any change in the future events or forecasting error. As discussed earlier, financial flexibility is a serious consideration in setting up the capital structure policy. Financial flexibility means a companys ability to adapt its capital structure to the needs of the changing conditions. The company should be able to raise funds, without undue delay and cost, whenever needed, to finance the profitable investments. It should also be in a position to redeem its debt whenever warranted by the future conditions. The financial plan of the company should be flexible enough to change the

composition of the capital structure as warranted by the companys operating strategy and needs. It should also be able to substitute one form of financing for another to economise the use of funds. Flexibility depends on loan covenants, option to early retirement of loans and the financial slack, viz., excess resources at the command of the firm. 5.Loan Covenants Restrictive covenants are commonly included in the long-term loan agreements and debentures. These restrictions curtail the companys freedom in dealing with the financial matters and put it in an inflexible position. Covenants in loan agreements may include restrictions to distribute cash dividends, to incur capital expenditure, to raise additional external finances or to maintain working capital at a particular level. The types of covenants restricting the firms investment, financing and dividend policies vary depending on the source of debt. While private debt contains both affirmative and negative covenants, public debt has a lot of negative covenants and commercial paper does not entail much restrictions. Loan covenants may look quite reasonable from the lenders point of view as they are meant to protect their interests, but they reduce the flexibility of the borrowing company to operate freely and it may become burdensome if conditions change. Growth firms prefer to take private rather than public debt since it is much easier to renegotiate terms in time of crisis with few private lenders than several debenture-holders. Generally, a company while issuing debentures or accepting other forms of debt should ensure to have minimum of restrictive clauses that circumscribe its financial actions in the future in debt agreements. This is a tough task for the financial manager. A highly levered firm is subject to many constraints under debt covenants that restrict its choice of decisions, policies and programmes. Violation of covenants can have serious adverse consequences. The firms ability to respond quickly to changing conditions also reduces. The operating inflexibility could prove to be very costly for the firms that are operating in unstable environment. These companies are likely to have low debt ratios and maintain high financial flexibility to remain competitive and not allow compromising their competitive posture. Thus, financial flexibility is essential to maintain the operating flexibility and face unanticipated contingencies. 6. Financial Slack The financial flexibility of a firm depends on the financial slack it maintains. The financial slack includes unused debt capacity, excess liquid assets, unutilised lines of credit and access to various untapped sources of funds. The financial flexibility depends a lot on the companys debt capacity and unused debt capacity. The higher is the debt capacity of a firm and the higher is the unused debt capacity; the higher will be the degree of flexibility enjoyed by the firm. If a company borrows to the limit of its debt capacity, it will not be in a position to borrow additional funds to finance unforeseen and unpredictable demands except at restrictive and unfavourable terms. Therefore, a company should not borrow to the limit of its capacity, but keep available some unused capacity to raise funds in the future to meet some sudden demand for finances. 7. Early repayment A considerable degree of flexibility will be introduced if a company has the discretion of early repaying its debt. This will enable management to retire or replace cheaper source of finance for the expensive one whenever warranted by the circumstances. When a company has excess cash and does not have profitable investment opportunities, it becomes desirable to retire debt. Similarly, a company can take advantage of declining rates of interest if it has

a right to repay debt at its option. Suppose that funds are available at 12 per cent rate of interest presently. The company has outstanding debt at 16 per cent rate o f interest. It can save in terms of interest cost if it can retire the old debt and replace it by the new debt. 8. Limits of financial flexibility Financial flexibility is useful, but the firm must understand its limit. It can help a profitable firm to seize opportunities, and it can provide temporary help in adverse situation, but it cannot save a firm, which is basically unhealthy. No doubt that financial flexibility is desirable, but the firm should have basic financial strength. Also, it is achieved at a cost. A company trying to obtain loans on easy terms will have to pay interest at a higher rate. Also, to obtain the right of refunding, it may have to compensate lenders by paying a higher interest or may have to allow them to participate in the equity. Therefore, the company should compare the benefits and costs of attaining the desired degree of flexibility and balance them properly. 9. Sustainability and Feasibility The financing policy of a firm should be sustainable and feasible in the long run. Most firms want to maintain the sustainability of their financing policy over a long period of time. The sustainable growth model helps to analyse the sustainability and the feasibility of the long-term financial plans in achieving growth. This model is based on the assumption that the firm uses the internal financing and debt, consistent with the target debt-equity ratio and payout ratio and does not issue shares during the planning horizon. Given the firms financing and payout policies and operating efficiency, this model implies that its assets and sales will grow in tandem with growth in equity (internal). Thus, the sustainable growth depends on return on equity (ROE) and retention ratio. 10.Control In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. This is particularly so in the case of the firms promoted by entrepreneurs. The existing management team not only wants control and ownership but also to manage the company, without any outside interference. 11 Widely held companies The ordinary shareholders elect the directors of the company. If the company issues new shares, there is risk of dilution of control. The company can issue rights shares to avoid dilution of ownership. But the existing shareholders may not be willing to fully subscribe to the issue. Dilution is not a very important consideration in the case of widely held companies. Most shareholders are not interested in taking active part in a companys management. Nor do they have time and money to attend the meetings. They are interested in dividends and capital gains. If they are not satisfied, they will sell their shares. Thus, the best way to ensure control and to have the confidence of the shareholders is to manage the company most efficiently and compensate shareholders in the form of dividends and capital gains. The risk of loss of control can be reduced by distribution of shares widely and in small lots. 12 Closely held companies The consideration of maintaining control may be significant in case of closely held and small companies. A shareholder or a group of shareholders can purchase all or most of the new shares of a small or closely held company and control it. Even if the owner-managers hold the majority shares, their freedom to manage the company will be curtailed when they go for initial public offerings (IPOs). Fear of sharing control and being interfered by others often delays the decision of the closely held small companies to go public. To avoid the risk

of loss of control, small companies may slow their rate of growth or issue preference shares or raise debt capital. If the closely held companies can ensure a wide distribution of shares, they need not worry about the loss of control so much. The holders of debt do not have voting rights. Therefore, it is suggested that a company should use debt to avoid the loss of control. However, when a company uses large amount of debt, a lot of restrictions are put by the debt-holders, specifically the financial institutions in India, since they are the major providers of loan capital to the companies. These restrictions curtail the freedom of the management to run the business. A very excessive amount of debt can also cause serious liquidity problem and ultimately render the company sick, which means a complete loss of control. 13 Marketability and Timing Marketability means the readiness of investors to purchase a security in a given period of time and to demand reasonable return. Marketability does not influence the initial capital structure, but it is an important consideration to decide about the appropriate timing of security issues. The capital markets are changing continuously. At one time, the market favours debenture issues, and, at another time, it may readily accept share issues. Due to the changing market sentiments, the company has to decide whether to raise funds with an equity issue or a debt issue. The alternative methods of financing should, therefore, be evaluated in the light of general market conditions and the internal conditions of the company. 14 Capital market conditions If the capital market is depressed, a company will not issue equity shares, but it may issue debt and wait to issue equity shares till the share market revives. During boom period in the share market, it may be advantageous for the company to issue shares at high premium. This will help to keep its debt capacity unutilised. The internal conditions of a company may also dictate the marketability of securities. For example, a highly levered company may find it difficult to raise additional debt. Similarly, when restrictive covenants in existing debt-agreements preclude payment of dividends on equity shares, convertible debt may be the only source to raise additional funds. A small company may find difficulty in issuing any security in the market merely because of its small size. The heavy indebtedness, low payout, small size, low profitability, high degree of competition etc. cause low rating of the company, which would make it difficult for the company to raise external finance at favourable terms. 15 Issue Costs Issue or flotation costs are incurred when the funds are externally raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage companies to use debt than issue equity shares. Retained earnings do not involve flotation costs. The source of debt also influences the issue costs with fixed costs being much higher for issue of commercial paper and public debt (debenture) than the private debt. This also means that economies of scale are high for the debt instruments having high fixed costs. Hence these instruments should be used when large amounts of funds are needed. Issue costs as a percentage of funds raised will decline with larger amount of funds. Large firms require large amounts of funds, and they may plan large issues of securities to economise on the issue costs. These firms are more likely than others to resort to commercial paper or public debt for raising capital. A large issue of securities can, however, curtail a companys financial flexibility. The company should raise only that much of funds, which it can employ profitably. Many other more important factors have to be considered when deciding about

the methods of financing and the size of a security issue. 16 Capacity of Raising Funds The size of a company may influence its capital and availability of funds from different sources. A small company finds great difficulties in raising long-term loans. If it is able to obtain some long-term loan, it will be available at a higher rate of interest and inconvenient terms. The highly restrictive covenants in loan agreements in case of small companies make their capital structures very inflexible and management cannot run business freely without interference. Small companies, therefore, depend on share capital and retained earnings for their long-term funds requirements. It is quite difficult for small companies to raise share capital in the capital markets. Also, the capital base of most small companies is so small that they can not be listed on the stock exchanges. For those small companies, which are able to approach the capital markets, the cost of issuing shares is generally more than the large ones. Further, resorting frequently to ordinary share issues to raise long-term funds carries a greater risk of the possible loss of control for a small company. The shares of small companies are not widely scattered and the dissident group of shareholders can be easily organised to get control of the company. The small companies, therefore, sometimes limit the growth of their business to what can easily be financed by retaining the earnings. A large company has relative flexibility in designing its capital structure. It can obtain loans on easy terms and sell ordinary shares, preference shares and debentures to the public. Because of the large size of issues, its cost of distributing a security is less than that for a small company. A large issue of ordinary shares can be widely distributed and thus, making the loss of control difficult. The size of the firm has an influence on the amount and the cost of funds, but it does not necessarily determine the pattern of financing. In practice, the debt-equity ratios of the firms do not have a definite relationship with their size.