CHAPTER - IV

Theoretical Framework

4.1 Capital Structure

The term capital structure refers to the percentage of capital (money) at work in a business
by type. Broadly speaking, there are two forms of capital: equity capital and debt capital.
Each has its own benefits and drawbacks and a substantial part of wise corporate
stewardship and management is attempting to find the perfect capital structure in terms of
risk / reward payoff for shareholders.
4.1.1 Equity Capital
This refers to money put up and owned by the shareholders (owners). Typically, equity
capital consists of two types: 1.) contributed capital, which is the money that was originally
invested in the business in exchange for shares of stock or ownership and 2.) retained
earnings, which represents profits from past years that have been kept by the company and
used to strengthen the balance sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a company can utilize
because its "cost" is the return the firm must earn to attract investment.
4.1.2 Debt Capital
Debt capital is the capital that a business raises by taking out a loan. It is a loan made to a
company that is normally repaid at some future date. Debt capital differs from equity
or share capital because subscribers to debt capital do not become part owners of the
business, but are merely creditors, and the suppliers of debt capital usually receive a
contractually fixed annual percentage return on their loan, and this is known as the coupon
rate. Debt capital ranks higher than equity capital for the repayment of annual returns. This
means that legally, the interest on debt capital must be repaid in full before any dividends are
paid to any suppliers of equity.
4.1.3 Other Forms of Capital
There are actually other forms of capital, such as vendor financing where a company lends
money to be used by the borrower to buy the vendor's products or property. Vendor finance
is usually in the form of deferred loans from, or shares subscribed by, the vendor. The

vendor often takes shares in the borrowing company. This category of finance is generally
used where the vendor's expectation of the value of the business is higher than that of the
borrower's bankers, and usually at a higher interest rate than would be offered elsewhere.
Vendor finance bridges the valuation gap due to the time value of money. If the buyer of a
business doesn't have to repay the vendor for the vendor loan for a few years, then the value
of that portion of the purchase price is worth less. In some cases, there is an interest charge
on vendor loan, but in other cases, it is simply a deferred payment.
4.2 Capital structure theory
4.2.1 Trade-off theory
Trade-off theory allows bankruptcy cost to exist. It states that there is an advantage to
financing with debt (the tax benefits of debt) and that there is a cost of financing with debt
(the bankruptcy costs and the financial distress costs of debt). The marginal benefit of
further increases in debt declines as debt increases, while the marginal cost increases, so that
a firm that is optimizing its overall value will focus on this trade-off when choosing how
much debt and equity to use for financing. Empirically, this theory may explain differences
in Debt/Equity ratios between industries, but it doesn't explain differences within the same
industry.
4.2.2 Pecking Order Theory
The pecking order model is another important model in the study of capital structure. This
model is constructed from the asymmetric information theory. This theory was developed by
Myers and Majluf (1984). They argued that the capital structure choice is designed to limit
inefficiencies caused by informational asymmetries. Asymmetric information states that firm
managers or insiders posses private information about the firms operations and its
investment opportunities which are not known by outsider investors. If the firm finance new
project by issuing equity, under-pricing may be severe such that the new investors would
capture more than the NPV of the new project. This will lead to net loss to the existing
shareholders, who rejects the project knowing the NPV of the project is positive. The other
issue arises from asymmetric information would be adverse selection problem. A potential
adverse selection problem arises as firms with lower value opportunities have incentive to

issue securities that imitate firms with higher value opportunities. This behaviour results in a
situation where securities of the former firms to be overvalued while the latter firms
undervalued.
To avoid the underinvestment and adverse selection problem, firms prefer to use internal
funds because they avoid informational problems entirely as it is of low risk, less sensitive
to mispricing and valuation errors. When internal funds are insufficient to meet financing
needs, firms turn first to risk-free debt, then risky debt, and finally equity, which is at the top
of the pecking order. Thus, the pecking order hypothesis implies the existence of a financing
hierarchy: internal funds first, debt second, and equity last. In other words, firms do not
target any debt ratio but the debt ratio is merely the outcome of cumulative result of
hierarchical financing over time. The reason for this ranking is that internal funds are
regarded as cheap and not subject to any outside interference. External debt is ranked next
as it is seen cheaper and having fewer restrictions than issuing equity. The issuance of
external equity is seen the most expensive and dangerous as it can lead to potential loss of
control of the enterprise by the original owner and manager and hence, was ranked the last
resort.

4.3 Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt to
total equity. The debt to equity ratio shows the percentage of company financing that comes
from creditors and investors. Each industry has different debt to equity ratio benchmarks, as
some industries tend to use more debt financing than others. A debt ratio of .5 means that
there are half as many liabilities as there is equity. A debt to equity ratio of 1 would mean
that investors and creditors have an equal stake in the business assets. A higher debt to
equity ratio indicates that more creditor financing (bank loans) is used than investor
financing (shareholders). Companies with a higher debt to equity ratio are considered more
risky to creditors and investors than companies with a lower ratio. A lower debt to equity
ratio usually implies a more financially stable business. The formula for calculating the debt
to equity ratio as follows.

Debt to Equity Ratio=

T o tal Debt
Total equity

Total Liabilities
Total Equity

4.4 Capital Adequacy Ratio

Capital adequacy ratio (CAR) is a specialized ratio used by banks to determine the adequacy
of their capital keeping in view their risk exposures. Banking regulators require a minimum
capital adequacy ratio so as to provide the banks with a cushion to absorb losses before they
become insolvent. This improves stability in financial markets and protects deposit-holders.
Basel Committee on Banking Supervision of the Bank of International Settlements develops
rules related to capital adequacy which member countries are expected to follow.

Capital Adequacy Ratio =

Tier 1 Capital + Tier 2 Capital

Risk-weighted Exposures

Tier 1 Capital = Common Equity Tier 1 + Additional Tier 1

Total Capital = Tier 1 Capital + Tier 2 Capital
Risk-weighted exposures include weighted sum of the banks credit exposures (including
those appearing on the bank's balance sheet and those not appearing). The weights are
determined in accordance with the Basel Committee guidance for assets of each credit rating
slab.
4.5 Earnings per share (EPS)
Earnings per share, also called net income per share, is a market prospect ratio that measures
the amount of net income earned per share of stock outstanding. In other words, this is the
amount of money each share of stock would receive if all of the profits were distributed to
the outstanding shares at the end of the year. Earnings per share are also a calculation that
shows how profitable a company is on a shareholder basis. So a larger company's profits per
share can be compared to smaller company's profits per share. Obviously, this calculation is
heavily influenced on how many shares are outstanding. Thus, a larger company will have to
split its earning amongst many more shares of stock compared to a smaller company. Most
of the time earning per share is calculated for year-end financial statements. Since

companies often issue new stock and buy back treasury stock throughout the year, the
weighted average common shares are used in the calculation. The weighted average
common shares outstanding is can be simplified by adding the beginning and ending
outstanding shares and dividing by two.
EPS=

Net Income
Weighted Average Outstanding Shares

There are some basic rules for calculating basic and fully diluted ESP in a complex capital
structure. The basic ESP is calculated in the same fashion as it is in a simple capital
structure.
Basic and fully diluted EPS are calculated for each component of income: income from
continuing operations, income before extraordinary items or changes in accounting
principle, and net income.
To calculate fully diluted EPS:
Diluted EPS =

Net incomePreferred dividend

(Weighted average number of shares outstandingImpact of convertible securities Impact of options , wa
4.6 Return on Equity Ratio (ROE)
The return on equity ratio is a profitability ratio that measures the ability of a firm to
generate profits from its shareholders investments in the company. So, it shows how much
profit each taka of common stockholders' equity generates.
Return on equity ratio equals to one means that every taka of common stockholders' equity
generates 1 taka of net income. This is an important measurement for potential investors
because they want to see how efficiently a company will use their money to generate net
income. ROE is also an indicator of how effective management is at using equity financing
to fund operations and grow the company. Most of the time, ROE is computed for common
shareholders. In this case, preferred dividends are not included in the calculation because
these profits are not available to common stockholders. Preferred dividends are then taken

out of net income for the calculation. The formula for calculating the Return on Equity ratio
as follows..

ROE =

Annual Net Income

Average Stockholders' Equity

4.7 Return on Asset Ratio (ROA)

Return on assets (ROA) is a financial ratio that shows the percentage of profit a company
earns in relation to its overall resources. It is commonly defined as net income divided by
total assets. Net income is derived from the income statement of the company and is the
profit after taxes. The assets are read from the balance sheet and include cash and cashequivalent items such as receivables, inventories, land, capital equipment as depreciated, and
the value of intellectual property such as patents. Companies that have been acquired may
also have a category called "good will" representing the extra money paid for the company
over and above its actual book value at the time of acquisition. Because assets will tend to
have swings over time, an average of assets over the period to be measured should be used.
Thus the ROA for a quarter should be based on net income for the quarter divided by
average assets in that quarter. ROA is a ratio but usually presented as a percentage. The
formula for calculating the Return on Asset ratio as follows.

ROA =

Annual Net Income

Total Asset

4.8 Share Price

A share price is the price of a single share of a number of saleable stocks of a

company, derivative or other financial asset. Companies live and die by their stock price, yet
for the most part they don't actively participate in trading their shares within the market.
Companies receive money from the securities market only when they first sell a security to
the public in the primary market, which is commonly referred to as an initial public
offering (IPO). In the subsequent trading of these shares on the secondary market (what
most refer to as "the stock market"), it is the regular investors buying and selling the stock

who benefit from any appreciation in stock price. Fluctuating prices are translated into gains
or losses for these investors as they shift stock ownership. Individual traders receive the
full capital gain or loss after transaction costs and taxes. The original company that issues
the stock does not participate in any profits or losses resulting from these transactions,
because this company has no vested monetary interest. This is what confuses many people.
The first and most obvious reason why those in management care about the stock market is
that they typically have a monetary interest in the company. It's not unusual for a public
company's founder to own a significant number of outstanding shares, and it's also not
unusual for the company's management to have salary incentives or stock options tied to the
company's stock prices. For these two reasons, managers act as stockholders and thus pay
attention to their stock price. Too often, investors forget that stock means ownership.
Management's job is to produce gains for the shareholders. Although a manager has little or
no control of share price in the short run, poor stock performance could, over the long run,
be

attributed

to

company

mismanagement.

If

the

stock

price

consistently underperforms shareholders' expectations, the shareholders will be unhappy

with management and look for changes. In extreme cases, shareholders can band together
and try to oust current management in a proxy fight. To what extent shareholders can control
management is debatable. Nevertheless, executives must always factor in shareholders'
desires since these shareholders are part owners of the company. Another main role of the
stock market is to act as a barometer for financial health. Analysts are constantly scrutinizing
companies, and this information affects the companies' traded securities. Because of
this, creditors tend to look favorably upon companies whose shares are performing strongly.
This preferential treatment is in part due to the tie between a company's earnings and its
share price. Over the long term, strong earnings are a good indication that the company will
be able to meet debt requirements.
As a result, the company will receive cheaper financing through a lower interest rate, which
in turn increases the amount of value returned from a capital project. Alternatively, favorable
market performance is useful for a company seeking additional equity financing. If there is
demand, a company can always sell more shares to the public to raise money. Essentially
this is like printing money, and it isn't bad for the company as long as it doesn't dilute its

existing share base too much, in which case issuing more shares can have horrible
consequences for existing shareholders. A company may aim to increase share simply to
increase its prestige and exposure to the public. Managers are human too, and like anybody
they are always thinking ahead to their next job. The larger a company's market
capitalization, the more analyst coverage the company will receive. Essentially, analyst
coverage is a form of free publicity and allows both senior managers and the company itself
to introduce them to a wider audience.
4.9 Optimal Capital Structure
The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes
its value. Putting it simple, the optimal capital structure for a company is the one which
proffers a balance between the idyllic debt-to-equity ranges thus minimizing the firms cost
of capital. Theoretically, debt financing usually proffers the lowest cost of capital because of
its tax deductibility. However, it is seldom the optimal structure for as debt increases, it
increases the companys risk. The short and long term debt ratio of a company should also
be considered while examining the capital structure. Capital structure is most commonly
referred as a firms debt-to-equity ratio, which gives an insight into the level of risk of a
company for the potential investors. Estimating an optimal capital is a key requirement of a
companys corporate finance department. There are numerous ways in which a companys
optimal capital structure can be estimated. One method of estimating a companys optimal
capital structure is utilizing the average or median capital structure of the principle
companies engaged in the market approach. This approach is helpful as the appraiser is well
aware about which companies are included in the analysis and the degree to which they are
related to the subject company. However, this method features a limitation that fluctuations
in market prices and the spread out nature of debt offerings and retirements might cause the
actual capital structure of a principle company to be significantly different from the target
capital structure. The other method is applied if the risk of a company did not change
because of the nature of its capital structure, and a company would wish as much debt as
possible, as the interest payments are tax deductible and debt financing is always cheaper
than equity financing. The main objective of this method is determining the debt level at

which the benefits of increased debt does not overshadow the increased risks and potential
costs associated with a economically distressed company.