INTRODUCTION

MEANING AND CONCEPT

In order to run and manage a company, funds are needed, right from the promotional stage up to end; finances play an important role in the companys life. If funds are inadequate, the business suffers and if the funds are not properly managed, the entire organization suffers. It is therefore, necessary that correct estimate of the current and future need of capital be made to have the optimum capital structure which shall help the organization to run its work smoothly and without any stress. Estimation of capital requirement is necessary, but formation of capital structure is important. The term capital structure refers to the composition and extent of various securities in the net worth of the firm, these securities may be equity shares, preference shares, debentures as well as long term bank loans. In the present era it is not only the business which aims at wealth maximization but investors are also interested in maximization of the market value of the stock held by them. While deciding the optimum capital mix firm has to analysis that cost of capital must be minimum and firm should be in a position to repay the interest to debenture holders and other borrowers, no doubt every business prefers to rise debt in capital structure but the accessibility of debt further depends upon the performance of the equity, so we can say that it is must to take equity as a base

while selecting capital structure as nobody will be interested in giving loan to business if performance of owners capital is not reasonable

Capital Structure, Leverage, Leverage Effects, and the Return/Risk Relationship

Definitions: 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. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said to be unlevered. Capital structure can be viewed as the permanent financing the firm represented primarily by long-term debt, preferred stock, and common equity but excluding all short term credit. Debt because: Lenders require a lower rate of return than ordinary shareholders. Debt financial securities present a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation. In addition security is often provided and covenants imposed. 1. A profitable business effectively pays less for debt capital than equity for another reason: the debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid. 3 Vs Equity Financing

Financing a business through borrowing is cheaper than using equity. This is

2. Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares. There are some valuable benefits from financing a firm with debt. So why do firms tend to avoid very high gearing levels? One reason is financial distress risk. This could be induced by the requirement to pay interest regardless of the cash flow of the business. If the firm hits a rough patch in its business activities it may have trouble paying its bondholders, bankers and other creditors their entitlement. Relationship between Expected return (Earnings per share) and the level of gearing can be represented below.

THEORY OF CAPITAL STRUCTURE

Determination of an optimal capital structure has frustrated theoreticians for decades. The early work made numerous assumptions in order to simplify the problem and assumed that both the cost of debt and the cost of equity were independent of capital structure and that the relevant figure for consideration was the net income of the firm. Under these assumptions, the average cost of capital decreased with the use of leverage and the value of the firm (the value of the debt and equity combined) increased while the value of the equity remained constant.

COST Ks Ka Kd

Debt/Equity

Modigliani and Miller showed that this could not be the case. Their contention was that two identical firms, differing only in their capital structure, must have identical total values. If they did not, individuals would engage in arbitrage and create the market forces that would drive the two values to be equal.

Their proof of this proposition was based upon several assumptions (many of which have subsequently been relaxed without changing the results):

All investors have complete knowledge of what future returns will be All firms within an industry have the same risk regardless of capital structure No taxes (we will relax this assumption subsequently) No transactions costs Individuals can borrow as easily and at the same rate of interest as the corporation All earnings are paid out as dividends (thus, earnings are constant and there is no growth) The average cost of capital is constant

Since no taxes has been assumed, the operating income (EBIT) is equivalent to the net income which is all paid out as dividends. Thus, the value of the firm is equal to

V =

EBIT ka

Since the value of the firm is equal to the sum of the value of the debt and equity,

V = D+ E then k aV = k a ( D + E ) and E D ka = k s ( ) + kd ( ) D+ E D+ E

Substituting the last equation into the preceding equation and solving for Ks

k s = ka + ( ka kd )

D E

Thus, ks must go up as debt is added to the capital structure

Ks

COST

Ka

Kd

Debt/Equity

To prove their point, they assumed two identical firms, an unlevered firm (all equity) and a levered firm with $4 million of debt carrying an interest rate of 7.5%, both firms generating an operating income (EBIT) of $900,000 annually. They adopted the assumption that stockholders of both firms would have the same 9

required rate of return of 10% which, as previously mentioned, was the standard assumption at the time (that the cost of equity was constant regardless of capital structure).

Unlevered Firm EBIT -Interest Income $ 900,000 0 $ 900,000

Levered Firm $ 900,000 300,000 $ 600,000

Since the required rate of return of shareholders is 10% in both cases

Unlevered Firm Value of Equity = Value of Debt = Total Value of Firm =

$900, 000 = $9 , 000, 000 .10

Levered Firm
$600,000 = $ 6,000,000 .10

$ $9,000,000

$ 4,000,000 $10,000,000

10

If this were true, then someone who owns 10% of the levered firm would have income of $60,000 ($600,000 * 10%) and could sell it for $600,000 ($6 million * 10%). With this $600,000 the individual could borrow another $300,000 at 7.5% and buy 10% of the unlevered firm for $900,000 ($9 million * 10%). What would this individuals income be now?

EBIT -Interest Income

$ 90,000 22,500 $ 67,500

($900,000 * 10%) ($300,000 * 7.5%)

Thus, the income would be greater by buying the unlevered firms stock and borrowing money to finance the purchase. As other individuals see this opportunity, they also will sell the stock of the levered firm (driving its price down) and buy the stock of the unlevered firm (using some borrowed money) and thereby driving the value of the unlevered firms stock up. As the price of the unlevered firm is bid up, the value of the unlevered firm increases above $9 million dollars, while the selling of the levered firms stock drives the equity value below $6 million (which decreases the total firm value, including the $4 million of debt, below $10 million) until the two firms values, in equilibrium, are equal and no opportunity to arbitrage the difference exists. Consequently, if the total value of the two firms is equal, then the average cost of capital must be equal. And if the average cost of capital is equal, then it must be true that the cost of equity rises in 11

such a manner as to exactly offset the increased use of cheaper debt financing (and we end up with the previous graph showing this).

As we previously uncovered when we looked at financial leverage, this is not a surprising result. As a firm increases its use of debt, the risk to the stockholder increases and, as a consequence, the stockholders required rate of return will increase. Modigliani and Miller simply defined how the stockholders required rate of return should increase with increased financial leverage. The lesson that is intended by this is that value cannot be created by simply substituting one form of financing for another. Subsequent to this analysis, it was pointed out that corporate taxes have an impact on the valuation. Without going through the mathematics (which is in your textbook), suffice it to say that the result was that the value of the firm increased with increased leverage. Specifically,
VL = VU + t * D

The fact that the government is a partner in the business results in a subsidy when debt financing is used and a deductible expense (unlike equity payments). When corporate taxes were taken into account, the average cost of capital was found to decrease with increased leverage:

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% COST Ka before-tax

KS

Ka after tax Kd before-tax Kd after-tax Debt/Equity

This implies that a firm should use as much debt as possible. Yet, we do not see companies using 100% debt. It might be pointed out that during the late 1980s there was a considerable amount of substitution of debt for equity among firms, particularly in the case of leveraged buyouts. However, many of those firms subsequently failed (for example, Unocal) and the typical debt/equity ratio today is similar to earlier levels. So why do we not see more debt employed by companies? The answer to this question has been sought by many and two primary proposals have been put forth. First, bankruptcy costs were invoked as a factor. That is, the more debt a firm uses, the higher the probability that the firm would default and go into bankruptcy. 13

Therefore, the present value of bankruptcy costs had to be deducted from the value of the firm. A second factor was that of agency costs, such as the necessity of reporting regularly to lenders (audited financial statements, bank monitoring fees, trustees for debt payments, etc.) that accompany the use of debt. Both of these costs increase in present value of expected costs terms as the proportion of debt increases. Another way of viewing these costs is that the risk of receiving full interest and principal payments increases and thus the required rate of return of lenders increases. (For example, junk bonds often yield higher rates of interest than the required rate of return on equity for companies with very little debt.) Consequently, the cost of debt increases and the average cost of capital will ultimately increase. Ks

COST

Ka after-tax Kd after-tax

Debt/Equity

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As can be observed from the graph, a minimum average cost of capital exists, but exactly where it should be has yet to be determined within a theoretical framework. So what are the insights that we can gain from this theorectical view of capital structure? First, we should note that, while debt financing is cheap in the sense that required rates of return on equity will always be higher than the interest rate on debt, there is a hidden cost in that the cost of equity rises as we utilize more debt financing. This is one reason that using the average cost of capital in valuing a project or company is more appropriate, even if we intend to borrow all of the money to finance it. While we may use cheap debt to finance a project, the increased risk to shareholders from increasing our financial leverage results in an increase in the cost of equity. The average cost of capital reflects both the cost of debt as well as the cost of equity and thus will reflect the increased cost of equity associated with the use of more debt financing. The second important concept is that tax-deductible debt financing results in a tax subsidy by the government. This subsidy adds value to the firm. For example, what is the advantage of being a home owner with a mortgage rather than leasing a home? It is the taxes that you will save. The reason that Congress eliminated the deductibility of credit card interest is that it did not want to encourage, through a tax subsidy, the financing of purchases purely for consumption. On the other hand, the purchase of a home (which is still tax-deductible) is an investment, not to mention the political consequences of voting to end the subsidy of the American Dream of home ownership. 15

FACTORS INFLUNCING CAPITAL STRUCTURE DECISIONS

1. BUSINESS RISK : Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2. COMPANYS TAX EXPOSURE:

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Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

3. FINANCIAL FLEXIBILITY: This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.

The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top.

4. MANAGEMENT STYLE:

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Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).

5. GROWTH RATE: Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.

6. MARKET CONDITIONS: Market conditions can have a significant impact on a company's capitalstructure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a 18

company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.

7.EARNING VOLATILITY
Earnings volatility associates negatively with leverage due to many reasons. Investors prevent themselves to invest firms with volatile earnings because it amplifies the chances of negative earnings surprises and default. Smoothness in earning depicts stable financial picture and make easier for firms to borrow. According to Pecking order theory smooth earning reduces the informational advantage of informed investors over uninformed investors. There is strong correlation between earning volatility and creditor rights. In their cross countries analysis, they show that credits are not much feared about earning volatility in countries having strong creditors rights because firms tend to maintain low debt level. Nevertheless, as a whole creditor rights are negatively linked with earning volatility.

8. CASH HOLDING Internal funds available for future investments are called firms cash holding. As Pecking order theory rotates around internal and external funds and shows that firm having access to internal funds should not go for external funds (leverage). Thats mean cash holding is negatively associates with leverage.

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9.NATURE AND SIZE OF THE FIRM

Nature and size of a firm also influence its capital structure. All public utility concern has different capital structure as compared to any manufacturing concern. Public utility concerns may apply more of debt because of stability and regularity of their earnings. On the other hand, a concern which cannot provide stable earnings due to the nature of its business will have to rely mainly on equity capital, similarly small companies have to depend mainly upon owned capital as it is very difficult for them to raise long-term loans on reasonable terms and also cannot issue equity and preference shares at ease to the public

10.

REQUIREMENTS OF INVESTORS

The requirements of investors is the another factor that influence the capital structure of the firm. It is necessary to meet the requirements of both institutional as well as private investors while debt financing is used. Investors are generally under three kinds i.e. bold investors, cautious investors, and less cautious investors. Bold investors are willing to take all type of risk, are entreprising in nature, and prefer capital gains and control and hence equity capital is best suited to them

11. ASSET STRUCTURE 20

The liquidity and nature of assets should also be kept in mind while Selecting the capital structure. If fixed assets constitute a major portion in total assets of the company, it may be possible for the company to raise more long term debt.

12.

PPREIOD OF FINANCE

The period for which the finances are required is also an important factor to be kept in mindwhile selectin the appropriate capital mix. If finances are required for limited period say seven years, debentures will be preferred to shares. Redeemable preference shares may also be used for a limited period finance, if found suitable otherwise. However if funds are needed for permanent basis, equity share capital is more appropriate.

CHANGES IN CAPITAL STRUCTURE

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Changes in capitalization may be sought as a means of easing tension and giving corporation opportunity to pursue its purpose. Adjustment in capital structure may also be necessitated to facilitate expansion, growth, revision, re-capitalization and re-organization etc. these changes may be compulsory or voluntary and may be implemented in form of recapitalization and readjustment in capital structure

The following are the main reasons behind change in capitalization: 1. To restore balance in the financial plan. If the financial structure of the company has become heavy with fixed cost bearing securities resulting into great strain on the financial position of the company may readjust its capital structure by redeeming its preference shares or debentures out of the proceeds of the new issue of equity shares.

2. To simplify the capital structure. When a company has issued variety of securities at different points of time to raise funds at difficult terms, it may need to consolidate such securities to simplify the financial plan as and when the market conditions are favourable.

3. To suit investors needs. 22

A company may have to change capital structure to suit the needs of the investors. The companies oftenly resort to split up its shares to make it more effective especially when the market activity in the companys shares is limited due to high face value and wide fluctuations in its market prices.

4. To fund current liabilities. Sometimes company feels that they need working capital on permanent basis. In such circumstances, the companies would prefer to convert short-term obligations into long term by taking advantages of favourable market conditions.

5. To write off the deficit In case a company has not doing well and book value of its assets is over- valued as compared to their real worth or when there are accumulated losses, it is better for the company to reorganize its capital by reducing book value of its liabilities and assets to their real values, such reorganization is also necessitated, because otherwise the company legally pay dividends to its shareholders even in future when it makes profit without writing off the losses. 6. To capitalize retained earnings

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Changes in capitalization may take place due to capitalisation of retained earnings by issue of bonus shares. To avoid over- capitalization, maintain balance between preference shares and equity shares, and debentures, a company may prefer to issue bonus shares out of its accumulated profits and resources without affecting their liquidity.

7. To clear defaults on fixed cost securities. When a company is not in a position to pay interest on debentures or repay the debentures on their maturity, it may be forced to offer them certain securities to clear the defaults into change in the capitalization of the company.

8. To facilitate merger and expansion. In the same manner, to facilitate merger and expansion, the intending companies may be required to readjust capital structure. Such a change is generally required to equate shares of different companies.

Adopt an optimal capital structure to improve

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shareholder value

A capital restructuring involves raising debt to finance the return of capital to shareholders accompanied by a new dividend policy that maintains the desired level of financial leverage. Re capitalization depends upon: The market value of the business. The financial flexibility needed to meet on-going capital requirements, unplanned investment opportunities and to weather unforeseen adverse trading conditions. The impact of capital structure change on the business cost of capital. Externally imposed constraints that limit the shareholder policies towards providing new equity business ability to achieve capital).

maximum value (e.g., if it is a government-owned entity it may be constrained by

The desired form of capital return, e.g., special dividend or share repurchase. The optimal borrowing structure. This includes borrowing sources, the mix of fixed rate and floating rate debt, maturity structure, covenants and banking relationships.

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Optimal capital structure

Capital structure is part of a companys package of financial policies, which include dividend policy and the type and amount of debt and equity claims issued. Assessment of the optimal capital structure has the following main elements: Financial flexibility assessment. Weighted average cost of capital. Optimal debt arrangements.

Financial flexibility assessment

Financial flexibility can be defined as the ability to fund expenditures at short notice and at reasonable cost under a range of economic and financial market conditions. It refers to the internal funding and borrowing capacity of a business since these are the only funding sources that are always available. Over a more extended time frame, businesses have a Much wider range of funding options including raising more equity. Equity raising may not be available or may be limited to cases of actual financial distress in the case of government-owned entities. Benefits of financial flexibility include the ability to accommodate unanticipated deviations from the business plan without disrupting operations or undermining market position. Such benefits also include the ability to fund profitable investment

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Opportunities as they arise. The need for financial flexibility varies among businesses depending on a number of factors that will be unique to that business, and may change over time. Such factors include market stability and business environment, availability of new investment opportunities, importance of new technology and the strength of competitors or regulation change

Cost of capital
The weighted average cost of capital (WACC) is defined as the average cost of equity and debt weighted in proportion to their contribution to the total capital of the company. A number of general points should be noted: Debt is less expensive than equity capital. Shareholders bear more risk of loss in the event of financial distress than do lenders and seek a higher return to compensate for that higher risk. However as the proportion of debt funding increases the cost of equity capital and debt funding both tend to rise. While in theory WACC is unaffected by changes in capital structure, in practice there are a number of reasons why capital structure changes affect WACC. These reasons include: - Taxation. Dividend imputation was supposed to remove the tax Induced preference for higher debt funding levels, but where shareholders cannot use imputation credits the preference remains. Impact on the cost of debt of credit worthiness assessment guidelines By 27

credit rating agencies and bank debt covenant criteria. Typical borrowers and debt

issuers are rated in bands. For example, spreads paid by BBB rated borrowers in New Zealand are typically 2 to 3 times the spreads charged to A-rated borrowers (the next highest rating band). - Investor preferences. For example many institutions are unable to invest in unlisted, unrated or lowly-rated issues or have strong preferences for certain maturity dates that match their liabilities. - The costs associated with financial distress. At high levels of gearing WACC typically begins to rise sharply as the risk and cost of financial distress becomes an important factor for capital providers. Measuring a companys WACC involves building a picture of the way that Increasing levels of gearing affect: - Credit rating and cost of debt. This is done by simulating the credit rating Process undertaken by rating agencies and banks for the type of business. - The leveraged cost of equity capital. This requires an assessment of the companys asset beta and un-leveraged cost of equity capital. These measurements are made on a market basis, not accounting or book value basis since WACC is a market variable

Assessing the impact of debt on shareholder value

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Developing a debt policy requires a review of the way in which different borrowing arrangements can affect shareholder value. The key debt policy issues include: Level of total borrowing. This is a function of the optimal capital structureand the level and timing of desired capital return to shareholders. Maturity profile, term and coupon structure. Arrangements with lenders. Financial and currency risk management policies. Source and type of debt offerings available from different markets. The likely size of borrowing requirements will determine whether it is economic to contemplate a public securities issue, private placement with institutions or bank borrowing. The most significant ways in which debt claims can affect shareholder value are the following: Changes in nominal interest rates (which can be separated into real and Inflation expectations components) affect the present value of outstanding debt and operating cash flows. For example, the present value of expected operating cash flows may be affected by changes in the real and inflation expectations component of nominal interestrates according to the extent to which: - Revenues and costs are linked to inflation. - Changes in real interest rates reflect in changes in the market cost of capital. 29

- Product demand is interest rate sensitive. Through the impact of debt maturity and refinancing on financial flexibility. Through their impact on the expected costs of financial distress. Nominal interest rates and future inflation expectations tend to be closely linked. For this reason the extent to which operating cash flows are linked to inflation is perhaps the major issue in the choice of fixed or floating rate debt. The criterion for selecting the appropriate mix of fixed and floating rate debt should be based upon minimizing the variation in shareholder value arising from nominal interest rate changes. Policy decisions include: Floating or fixed rate borrowing. Short, medium or long term maturities for fixed rate debt. Covenants. It is important when negotiating with lenders that the client has a good understanding of the value trade off between more restrictive covenants and lower on-going interest cost. Management issues. Generally, because of the complexities of compelling reasons managing

Derivative instruments, simpler approaches are favoured unless there are

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REVIEW OF LITERATURE

Corporate finance theory bases on the Modigliani and Miller (1958) propositions that specify certain conditions under which various corporate financing decisions are irrelevant. The MM propositions provide a base for analyzing how financing decisions can create and destroy the value for a corporation. Theory of irrelevancy was presented in an era when research was 31

dominated by assumption that there is no interaction between the firms investment and financial decisions of the firm. MM proposition-1 [2] states that in a perfect competitive market the value of a firm depends on its operating income and level of business risk. Simply, value of firm does not relate to its capital structure. Financing and risk management choices will not affect firms value if the capital market is perfect. A perfect market has following traits: All investors are price takes. All market participants can borrow and lend at the risk free rate. There are no costs of bankruptcy. Firms issues two types of claims: risk free debt and risky equity. Homogenous risk free classification of firms. Neutral taxes Managers always maximize shareholders wealth. Information symmetry Taxes are neutral means tax system is unbiased. Same tax rate for each tax payers and for all income sources. But in general it is assumed that tax rate is zero. Modigliani and Miller grouped every firm to a certain risk class and a risk class is described as an array of firms each of which has a matching pattern of earnings payoffs. Further, No transaction costs and no institutional restrictions create frictionless capital markets in which every investor can undertake the same financial transactions as firms. Firms financial choices do not give any signals to investors about firms financial position. If, on the contrary, leverage can signal the 32

firms profitability by altering investors beliefs about the firms payoffs, then its choice would affect investors decisions and the firms market value. That contradicts with MM proposition-1. In perfect market assumption, investors can form a portfolio with any desired cash flow pattern so there is no need for corporations to design their capital structures in ways that tailor their securities to satisfy these desires. In start, MM propositions were considered as, for firms debt equity choices. But applications of propositions have since expended to debt maturity, risk management, mergers and spin-offs. MM proposition-2 states that: A firms cost of equity is a linear function of the firm's debt to equity ratio. A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. This proposition also holds the assumption of perfect market. MM proposition-3 focuses on dividend payments and value of firm. It states that: Under certain conditions, the value of a firm is independent of its dividend policy. Expressed more loosely: two identical firms that belong to same risk class will have equal market value, even they have different dividend policies. Several researches has been done and shown evidence of certain regularities that exist between capital structure and other variables. For showing the reliance between investment and financial decision, Kraus and Litzenberger [14] in 1976, present the bankruptcy model of capital structure in which they discuss the significance of tax shelter. Tax reduction attracts firms to issue more debt, but high 33

level of debt offsets the tax reduction advantage. Subsequently, optimal capital structure balance these paybacks and costs of tax shelter. In order to understand the vast work on the question of capital structure, we classify the literature in three categories. Agency theories that are focused on diminishing the interest conflict between shareholder and managers. Static trade-off theory, that focuses on bankruptcy cost and tax shelter.The asymmetric information theories and their variations.

2. Pecking Order Theory

In the theory of firm's capital structure and financing decisions, the Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers and Nicolas Majluf in 1984. It states that companies prioritize their sources of financing (from 34

internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when
available, and debt is preferred over equity if external financing is required.

Evidence Tests of the Pecking Order Theory have not been able to show that it is of firstorder importance in determining a firm's capital structure. However, several authors have found that there are instances where it is a good approximation of reality. On the one hand, Fama and French[1], and also Myers and Shyam-Sunder[2] find that some features of the data are better explained by the Pecking Order than by the Trade-Off Theory. Goyal and Frank show, among other things, that Pecking Order theory fails where it should hold, namely for small firms where information asymmetry is presumably an important problem. [3]

Profitability and debt ratios The Pecking Order Theory explains the inverse relationship between profitability and debt ratios: 1. Firms prefer internal financing.

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2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus unpredictable fluctuations in profits and investment opportunities, mean that internally generated cash flow is sometimes more than capital expenditures and at other times less. If it is more, the firm pays off the debt or invests in marketable securities. If it is less, the firm first draws down its cash balance or sells its marketable securities, rather than reduce dividends. 4. If external financing is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In addition, issue costs are least for internal funds, low for debt and highest for equity. There is also the negative signaling to the stock market associated with issuing equity, positive signaling associated with debt

3.Trade-Off Theory of Capital Structure

The Trade-Off Theory of Capital Structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger[1] who considered a balance between the dead-weight costs of 36

bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the Pecking Order Theory of Capital Structure. A review of the literature is provided by Frank and Goyal.[2] An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc). 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. The empirical relevance of the Trade-Off Theory has often been questioned. Miller[3] for example compared this balancing as akin to the balance between horse and rabbit content in a stew of one horse and one rabbit. Taxes are large and they are sure, while bankruptcy is rare and, according to Miller, it has low dead-weight costs. Accordingly he suggested that if the Trade-Off Theory were true, then firms ought to have much higher debt levels than we observe in reality. Myers[4] was a particularly fierce critic in his Presidential address to the American Finance Association meetings in which he proposed what he called "The Pecking Order Theory". Fama and French [5] criticized both the Trade-Off Theory and the Pecking Order Theory in different ways. Welch has argued that firms do not undo the impact of stock price shocks as they should under the basic Trade-Off Theory and

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so the mechanical change in asset prices that makes up for most of the variation in capital structure.[6] Despite such criticisms, the Trade-Off Theory remains the dominant theory of corporate capital structure as taught in the main corporate finance textbooks. Dynamic version of the model generally seem to offer enough flexibility in matching the data so, contrary to Miller's[3] verbal argument, dynamic trade-off models are very hard to reject empirically.

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RESEARCH METHODOLOGY

39

OBJECTIVES

There are two major objectives behind conducting this study: 1. To know the composition of capital structure of Tata Motors & Maruti Suzuki. 2. To analyze these capital structures using some financial parameters.

RESEARCH METHODOLOGY

RESEARCH DESIGN

40

A number of facts could be explored by means of this research in regards to the Capital structure of two major banking companies TATA MOTORS & MARUTI SUZUKI.

DATA SOURCES The task of data collection begins after a research problem has been defined and a research design has been chalked out. While deciding about the method of data collection, the researcher should keep in mind two types of data viz., primary and secondary. The primary data are those, which are collected a fresh and for the first time and thus happen to be original in character. The secondary data are those that have already been collected by someone else and which have already been passed through the statistical process. The methods of collecting primary data are to be originally collected, while in case of secondary data the nature of data collection work is merely that of compilation.

This research mainly involves the Secondary sources of collecting the data.

The data was gathered from the authorized corporate websites available on the internet The financial results of Tata Motors & Maruti Suzuki as on 31 of the April 2008 are taken as the base for this research. 41

RESEARCH APPROACH The approaches mainly opted by the researcher to get the results about the various capital mixes preferred by the corporate include behavioral, survey, focus group, observational, experimental approaches etc.. STATISTICAL TOOLS Classification and Tabulation transforms the raw data collected through corporate websites into useful information by testing the data with reference to some statistical tools and accounting standards such as financial ratios. Following applications of statistics are used to organize and analyze the data:

Simple tabulation of data using tally marks. Calculating the accuracy of capital structure by applying certain ratios like, debt- equity ratio, leverage ratio, capital gearing ratio, Earning per share etc. Graphical analysis by means of pie charts and bar graphs etc

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DATA ANALYSIS AND INTERPRETATION

1. Composition of capital structure

The following table shows the availability of different securities in the capital structure of both the companies.

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Particulars

Availability TATA SUZUKI

Equity share capital Preference share capital Reserves &surplus Debentures Long term loans

Yes No Yes No Yes

Yes No Yes No Yes

INTERPRETATION: As the table above is showing that both the banks are having equity share capital, reserves & surplus, and long term borrowings. Both have not issued debentures.

2. Proportion of securities
The following table shows the proportion of securities in the capital structure.

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%AGE OF SECURITY PARTICULAR TATA Equity share capital 2.74 SUZUKI 1.55

Reserves and surplus

52.71

88.78

Secured loans

17.46

.01

Unsecured loans

27.09

9.66

INTERPRETATION: As the data is showing both companies are having equity share capital in very low proportion(2.74% & 1.55%) but having reserves to major extent( 52.71% & 88.78%) specially in SUZUKI where 88.78% of capital is kept as reserve, TATA motors obtained 17.46% of its funds through secured loans but in SUZUKI that is near to zero, ratio of unsecured loans in both companies are 27.09% and 9.66%.

3. Debt- equity ratio

Debt-equity ratio = long term borrowed funds / Owners equity 45

Standard debt-equity ratio is 2:1, if proportion of debt exceeds this limit it is considered as risky for the company.

Particulars Debt-equity ratio

TATA 0.80 : 1

SUZUKI 0.10 : 1

INTERPRETATION: As the above table is showing that both the companies are within the debt-equity standard, while comparing these two we can conclude that Tata Motors is using more debt(0.80 : 1) as compared to Maruti Suzuki in which the debt is just 10% of the equity.

4. Earning per share.

EPS = Profit after interest and tax / No. of equity shares issued

Particulars

TATA (Rs. ) 46

SUZUKI (Rs.)

EPS

52.63

59.91

INTERPRETATION: As far as the case of earning per share is concerned Maruti Suzuki(59.91) looks better than the Tata motors(52.63) which is having earning per share less than Maruti Suzuki by 7.28

5. Capital gearing ratio

Equity + reserves & surplus = ----------------------------------Preference capital + long-term debt. 47

Particulars

TATA

SUZUKI

CGR

1.24 : 1

9.34 : 1

INTERPRETATION A firm is said to be high geared if the proportion of preference share capital and debt is high than equity, after referring the data we can conclude that both the firms are low geared, while comparing these two we can say that capital gearing of Tata motors(1.24 : 1) is high than Maruti Suzuki.(9.34 : 1).

6. Reserves to equity capital ratio.

Reserves & surplus = ----------------------------48

Equity share capital

Particulars Reserves to equity capital ratio

TATA 19.26 : 1

SUZUKI 57.23 : 1

INTERPRETATION: Reserves show the profitability of the business, on comparing with the standards both the companies are excellent in terms of keeping reserves, while comparing with each other Maruti Suzuki seems 3 times better than Tata motors having strong ratio 57.23 against 19.26.

7. Current liabilities to shareholder funds ratio.

Current liabilities 49

---------------------------Shareholder funds

Particulars Current liabilities to shareholder fund ratio

TATA

SUZUKI

1.54 : 1

0.36 : 1

INTERPRETATION: This ratio is calculated to find out whether the company is having proper owners fund to meet up its current liabilities or not. If we compare both the companies using this ratio we can say that Maruti Suzuki (0.36 : 1)is far better than Tata motors(1.54 :1)

8. Total investment to long term liabilities ratio.

Shareholder funds + long term liabilities 50

---------------------------------------------------------Long term liabilities

Particulars

TATA

SUZUKI

Total investment to long term liabilities ratio 2.24 : 1 10.34 : 1

INTERPRETATION If this ratio is very high it is not considered as good for the financial prosperity of the business, after referring to the above statistics we can conclude that Tata motors is in sound position with ratio of just 2.24 :1 as compared to Maruti Suzuki which is having ratio of 10.34 : 1

9. Current assets to shareholder funds ratio

Current assets = ------------------------ 100 51

Shareholder funds

Particulars Current assets to shareholder funds ratio

TATA

SUZUKI

1.37 : 1

0.37 : 1

INTERPRETATION This ratio shows the participation of shareholder funds in the current assets of the firm generally major part of the shareholders funds is invested in fixed assets. On comparing the two companies on the basis of this ratio we can say that Maruti Suzuki is better than Tata motors having current assets equal to just 37% of the capital.

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FINDINGS

Following are the main findings of the study

Capital structure is very vital determinant from the financial prospective of any company. 53

 While deciding the capital structure company should consider some important factors like cost of capital, objective of the business, risk bearing capacity of the business along with competitive structure of the company

Market conditions are not always stable so to cope up with the changes every company must make necessary amendments in its capital structure and if necessary it must reorganize the capital structure.

Primary objective of every company is to maximize the value of its share in the market in order to boost the growth for this purpose it may have a need of borrowed capital but further the accessibility of debt depends on the performance of the equity so, while selecting the optimum capital mix every company should take equity as the base.

Besides these findings we conducted a comparative study of the capital structure of two major auto car manufacturing companies Tata Motors and Maruti Suzuki following are the abstracts of the research:

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 Both the companies are very similar in terms of constituents of the capital structure

Both

companies

are

having

equity

share

capital

in

very

low

proportion(2.74% & 1.55%) but having reserves to major extent( 52.71% & 88.78%) specially in SUZUKI where 88.78% of capital is kept as reserve, TATA motors obtained 17.46% of its funds through secured loans but in SUZUKI that is near to zero, ratio of unsecured loans in both companies are 27.09% and 9.66%.

Study is showing that both the companies are within the debt-equity standard, while comparing these two we can conclude that Tata Motors is using more debt(0.80 : 1) as compared to Maruti Suzuki in which the debt is just 10% of the equity

Both the firms are low geared, while comparing these two we can say that capital gearing of Tata motors(1.24 : 1) is high than Maruti Suzuki.(9.34 : 1).

Reserves show the profitability of the business, on comparing with the standards both the companies are excellent in terms of keeping reserves, while comparing with each other Maruti Suzuki seems 3 times better than Tata motors having strong ratio 57.23 against 19.26. 55

 Current liabilities to shareholders fund ratio is calculated to find out whether the company is having proper owners fund to meet up its current liabilities or not. If we compare both the companies using this ratio we can say that Maruti Suzuki (0.36 : 1)is far better than Tata motors(1.54 :1)

Current assets to shareholder fund ratio This shows the participation of shareholder funds in the current assets of the firm generally major part of the shareholders funds is invested in fixed assets. On comparing the two companies on the basis of this ratio we can say that Maruti Suzuki is better than Tata motors having current assets equal to just 37% of the capital.

If Total investment to long term liability ratio is very high it is not considered as good for the financial prosperity of the business, after referring to the above statistics we can conclude that Tata motors is in sound position with ratio of just 2.24 :1 as compared to Maruti Suzuki which is having ratio of 10.34 : 1

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57

LIMITATIONS

Limitations of the study

Following are the main limitation limitations of the study:

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 This research is based on the secondary data and the data is collected from the corporate websites believing it true and fair in case there is any manipulation in that very data our result will not be accurate.

Since latest financial data for 31 march 2009 was not available at the time of my research so, I took data for 31 march 2008. This is also possible that during this time capital structures of both the companies has been amended if this happens then the relevance of the research decreases.

Due to inadequacy of data we were unable to analyze the leverage ratios of the companies.

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CONCLUSION

CONCLUSION

60

As far as the conclusion is concerned as we have already explained that capital structure is the vital determinant is the financial growth of every organization so, while composing the capital structure various factors must be properly reviewed funds are needed, right from the promotional stage up to end, finances play an important role in the companys life. If funds are inadequate, the business suffers and if the funds are not properly managed, the entire organization suffers, we also threw a light on leverage-risk relationship, theories of capital structure and factors affecting capital structure etc. In the research part we analyzed the capital structures of two major auto car manufacturing companies Tata motors & Maruti Suzuki in the light of some ratios and techniques, after analysis we can conclude that Maruti Suzuki is having better capital structure than Tata motors

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BIBLIOGRAPHY

Websites referred

http://moneyrediff.com/companies/tatamotorsltd/100510008/balancesheet

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 http://moneyrediff.com/companies/tatamotors-ltd/100510008/profit loss account http://moneyrediff.com/companies/maruti-suzui-ndialtd/10520005/balancesheet http://moneyrediff.com/companies/maruti-suzuki-indialtd/10520005/profit & loss account http://ssrn.com/abstract=670543

&

Books referred

Pandey I M,Financial management,Vikas publication House,Edition 8th, chapter capital structure.

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ANNEXURE

Balance sheet of Maruti Suzuki Ltd.

Balance sheet

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Mar ' 08 Sources of funds Owner's fund Equity share capital Share application money Preference share capital Reserves & surplus Loan funds Secured loans Unsecured loans Total Uses of funds Fixed assets Gross block Less : revaluation reserve Less : accumulated depreciation Net block Capital work-in-progress Investments Net current assets Current assets, loans & advances Less : current liabilities & provisions Total net current assets Miscellaneous expenses not written Total Notes: Book value of unquoted investments Market value of quoted investments Contingent liabilities Number of equity sharesoutstanding (Lacs) 144.50 8,270.90 0.10 900.10 9,315.60 7,285.30 3,988.80 3,296.50 736.30 5,180.70 3,190.50 3,088.40 102.10 9,315.60 5,169.60 219.50 2,734.20 2889.10

Mar ' 07 Mar ' 06 Mar ' 05 Mar ' 04 144.50 6,709.40 63.50 567.30 7,484.70 6,146.80 3,487.10 2,659.70 238.90 3,409.20 3,956.00 2,779.10 1,176.90 7,484.70 3,398.10 270.40 2,094.60 2889.10 144.50 5,308.10 144.50 4,234.30 144.50 3,446.70 311.90 3,903.10 4,566.70 2,735.90 1,830.80 74.90 1,677.30 2,144.40 1,840.60 303.80 16.30 3,903.10 1,666.20 150.90 1,119.80 2889.10

71.70 307.60 5,524.30 4,686.40 4,954.60 3,259.40 1,695.20 92.00 2,051.20 3,870.70 2,184.80 1,685.90 5,524.30 2,040.10 289.80 1,289.70 2889.10 5,053.10 3,179.40 1,873.70 42.10 1,516.60 3,097.40 1,843.40 1,254.00 4,686.40 1,505.50 200.10 893.60 2889.10

Trading & profit and loss account of Maruti Suzuki Ltd.

Profit loss account Mar ' 08 Mar ' 07 Mar ' 06 Mar ' 05 Mar ' 04

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Income: Operating income Expenses Material consumed Manufacturing expenses Personnel expenses Selling expenses Adminstrative expenses Expenses capitalized Cost of sales Operating profit Other recurring income Adjusted PBDIT Financial expenses Depreciation Other write offs Adjusted PBT Tax charges Adjusted PAT Non recurring items Other non cash adjustments Reported net profit Earnigs before appropriation Equity dividend Preference dividend Dividend tax Retained earnings

18,066.80 13,622.00 670.60 356.20 560.20 326.30 -19.80 15,515.50 2,551.30 456.10 3,007.40 59.60 568.20 2,379.60 763.30 1,616.30 37.90 76.60 1,730.80 7,368.10 144.50 24.80 7,198.80

14,806.40 11,063.70 489.80 288.40 499.90 274.50 -14.30 12,602.00 2,204.40 361.10 2,565.50 37.60 271.40 2,256.50 705.30 1,551.20 -23.00 33.40 1,561.60 5,947.10 130.00 21.90 5,795.20

12,197.90 9,223.70 359.60 228.70 356.00 170.60 -6.70 10,331.90 1,866.00 268.10 2,134.10 20.40 285.40 1,828.30 560.90 1,267.40 -83.70 5.40 1,189.10 4,631.20 101.10 14.20 4,515.90

11,046.30 8,508.50 273.80 196.00 369.90 150.20 -22.40 9,476.00 1,570.30 218.90 1,789.20 36.00 456.80 16.30 1,280.10 446.50 833.60 -31.40 51.40 853.60 3,611.00 57.80 8.20 3,545.00

9,449.50 7,033.50 219.40 177.90 666.20 112.90 -12.80 8,197.10 1,252.40 198.90 1,451.30 44.90 494.90 72.40 839.10 227.70 611.40 -151.90 82.60 542.10 2,878.00 43.30 5.60 2,829.10

Balance sheet of Tata Motors Ltd.

Balance sheet Mar ' 08 Sources of funds Owner's fund Equity share capital 385.54 Mar ' 07 385.41 Mar ' 06 382.87 Mar ' 05 Mar ' 04 361.79 353.00

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Share application money Preference share capital Reserves & surplus Loan funds Secured loans Unsecured loans Total Uses of funds Fixed assets Gross block Less : revaluation reserve Less : accumulated depreciation Net block Capital work-in-progress Investments Net current assets Current assets, loans & advances Less : current liabilities & provisions Total net current assets Miscellaneous expenses not written Total Notes: Book value of unquoted investments Market value of quoted investments Contingent liabilities Number of equity sharesoutstanding (Lacs)

7,428.45 2,461.99 3,818.53 14,094.51 10,830.83 25.51 5,443.52 5,361.80 5,064.96 4,910.27 10,781.23 12,029.80 -1,248.57 6.05 14,094.51 4,145.82 2,530.55 5,590.83 3855.04

6,458.39 2,022.04 1,987.10 10,852.94 8,775.80 25.95 4,894.54 3,855.31 2,513.32 2,477.00 10,318.42 8,321.20 1,997.22 10.09 10,852.94 2,117.86 1,323.08 5,196.07 3853.74

5,127.81 822.76 2,114.08 8,447.52 7,971.55 26.39 4,401.51 3,543.65 951.19 2,015.15 9,812.06 7,888.65 1,923.41 14.12 8,447.52 1,648.57 1,550.00 2,185.63 3828.34

3.83 3,749.60 3,236.77 489.81 942.65 2,005.61 317.12 6,606.81 4,853.37 6,611.95 3,454.28 3,157.67 538.84 2,912.06 7,248.88 7,268.80 -19.92 18.16 6,606.81 2,480.15 1,260.05 1,450.32 3617.52 5,985.40 3,023.69 2,961.71 286.09 3,056.77 3,835.78 5,309.17 -1,473.39 22.19 4,853.37 2,778.87 732.76 896.07 3529.58

Trading & profit and loss account of Tata Motors Ltd.

Profit loss account Mar ' 08 Mar ' 07 Mar ' 06 Mar ' 05 Mar ' 04

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Income: Operating income Expenses Material consumed Manufacturing expenses Personnel expenses Selling expenses Adminstrative expenses Expenses capitalized Cost of sales Operating profit Other recurring income Adjusted PBDIT Financial expenses Depreciation Other write offs Adjusted PBT Tax charges Adjusted PAT Non recurring items Other non cash adjustments Reported net profit Earnigs before appropriation Equity dividend Preference dividend Dividend tax Retained earnings

28,738.30 20,931.81 1,230.14 1,544.57 1,179.48 1,982.79 -1,131.40 25,737.39 3,000.91 389.03 3,389.94 471.56 652.31 64.35 2,201.72 547.55 1,654.17 374.75 2,028.92 3,042.75 578.43 81.25 2,383.07

26,664.25 20,088.63 19,529.88 1,200.36 1,367.83 1,068.56 1,488.16 -577.05 24,077.74 2,586.51 887.23 3,473.74 455.75 586.29 85.02 2,346.68 660.37 1,686.31 227.15 -0.07 1,913.39 2,690.15 578.07 98.25 2,013.83 14,376.11 929.82 1,143.13 759.54 1,042.52 -308.85 17,942.27 2,146.36 685.18 2,831.54 350.24 520.94 73.78 1,886.58 524.93 1,361.65 167.23 1,528.88 2,094.54 497.94 69.84 1,526.76

17,199.17 12,101.28 830.45 1,039.34 598.75 911.73 -282.43 15,199.12 2,000.05 399.94 2,399.99 234.30 450.16 67.12 1,648.41 415.50 1,232.91 4.04 -1.54 1,235.41 1,601.21 452.19 63.42 1,085.60

13,028.17 8,720.10 628.73 882.49 455.56 758.90 -144.89 11,300.89 1,727.28 235.65 1,962.93 225.96 382.60 51.64 1,302.73 482.55 820.18 -6.82 -3.02 810.34 934.05 282.11 36.14 615.80

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