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Chapter

CAPITAL STRUCTURE THEORY

CAPITAL STRUCTURE AND LEVERAGE

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Capital Structure Defined

CAPITAL STRUCTURE THEORY

 The term capital structure is used to represent the proportionate relationship between debt and equity.  The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firms capital expenditure.

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 How should the investment project be financed?

CAPITAL STRUCTURE THEORY

Questions while Making the Financing Decision

 Does the way in which the investment projects are financed matter?  How does financing affect the shareholders risk, return and value?  Does there exist an optimum financing mix in terms of the maximum value to the firms shareholders?  Can the optimum financing mix be determined in practice for a company?  What factors in practice should a company consider in designing its financing policy?

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CAPITAL STRUCTURE THEORY

Features of An Appropriate Capital Structure

 capital structure is that capital structure at that level of debt equity proportion where the market value per share is maximum and the cost of capital is minimum. Appropriate capital structure should have the following features  Profitability / Return  Solvency / Risk  Flexibility  Conservation / Capacity  Control

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Determinants of Capital Structure
 Seasonal Variations  Tax benefit of Debt  Flexibility  Control  Industry Leverage Ratios  Agency Costs  Industry Life Cycle  Degree of Competition  Company Characteristics  Requirements of Investors  Timing of Public Issue  Legal Requirements

CAPITAL STRUCTURE THEORY

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Patterns / Forms of Capital Structure
Following are the forms of capital structure:     Complete equity share capital;

CAPITAL STRUCTURE THEORY

Different proportions of equity and preference share capital; Different proportions of equity and debenture (debt) capital and Different proportions of equity, preference and debenture (debt) capital.

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Problems on Capital structure

CAPITAL STRUCTURE THEORY

Fitwell company is now capitalized with Rs. 50,00,000 consisting of 10,000 ordinary shares of Rs. 500 each. Additional finance of Rs. 50,00,000 is required for a major expansion programme launched by the company. Four possible financing plane are under consideration. These are: 1. Entirely through additional share capital, issuing 10,000 shares of Rs. 500 each. 2. Rs. 25 lakhs through ordinary shares and Rs. 25lakhs through 12% debt. 3. Entirely through 13% debt. 4. Rs. 25 lakhs through equity and Rs. 25lakhs through 10% preference shares of Rs. 500 each. The companys EBIT presently is Rs. 6lakhs. By virtue of the increase in capitalization, the EBIT is expected to double the present level. Examine the impact of financial leverage of these four plans and calculate the EPS for the shareholders, assuming the tax rate to be 50%.
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Problems on Capital structure

CAPITAL STRUCTURE THEORY

A company needs Rs. 12,00,000 for the installation of a new factory, which would yield an annual EBIT of Rs. 200,000. the company has the objective of maximizing the EPS. It is considering the possibility of issuing equity shares plus raising a debt of Rs. 200,000, Rs. 600,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is expected to drop to Rs. 25 per share if the market borrowings were to exceed t 750,000. Cost of borrowings are indicated as under: 1. Up to Rs. 250,000 10%p.a 2. Between Rs. 250,001 and Rs. 625000 14%p.a 3. Between Rs. 625,001 and Rs. 10,00,000 16%p.a Assuming tax rate to be 50% work out EPS in each case and suggest the best option.
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Meaning of Financial Leverage

CAPITAL STRUCTURE THEORY

 The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners equity in the capital structure, is described as financial leverage or gearing or trading on equity.  The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity. The rate of return on the owners equity is levered above or below the rate of return on total assets.

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Measures of Financial Leverage
 Debt ratio  Debtequity ratio  Interest coverage

CAPITAL STRUCTURE THEORY

 The first two measures of financial leverage can be expressed either in terms of book values or market values. These two measures are also known as measures of capital gearing.  The third measure of financial leverage, commonly known as coverage ratio. The reciprocal of interest coverage is a measure of the firms income gearing.

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Financial Leverage of Ten Largest Indian Companies, 2006
Company Debt ratio 1. Indian Oil 2. HPCL 3. BPCL 4. SAIL 5. ONGC 6. TELCO 7. TISCO 8. BHEL 9. Reliance 10. L&T 11. HLL 12. Infosys 13. Voltas 0.556 0.350 0.490 0.858 0.106 0.484 0.577 0.132 0.430 0.522 0.027 0.000 0.430 Capital Gearing Debtequity ratio 1.25:1 0.54:1 0.96:1 6.00:1 0.12:1 0.94:1 1.37:1 0.15:1 0.75:1 1.09:1 0.03:1 0.00:1 0.72:1 Interest coverage 4.00 5.15 5.38 - ve 53.49 0.99 1.62 8.36 3.46 2.31 264.92 NA* 2.64

CAPITAL STRUCTURE THEORY

Income Gearing Interest to EBIT ratio 0.250 0.194 0.186 - ve 0.019 1.007 0.616 0.120 0.289 0.433 0.004 NA* 0.378
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Financial Leverage

CAPITAL STRUCTURE THEORY

 financial leverage is the ability of the firm to use fixed financial charges to magnify the effects of changes in EBIT on the firms earnings per share.  In other words, financial leverage may be defined as the payment of fixed rate of interest for the use of fixed interest bearing securities to magnify the rate of return as equity shares

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Financial Leverage and the Shareholders Return

CAPITAL STRUCTURE THEORY

 The primary motive of a company in using financial leverage is to magnify the shareholders return under favourable economic conditions. The role of financial leverage in magnifying the return of the shareholders is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and banks or debentures) can be obtained at a cost lower than the firms rate of return on net assets (RONA or ROI).  EPS, ROE and ROI are the important figures for analysing the impact of financial leveraged

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Effect of Leverage on ROE and EPS
 Favourable ROI > I  Unfavourable ROI < I  Neutral ROI = i

CAPITAL STRUCTURE THEORY

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Debt-equity Mix and the Value of the Firm
 Capital structure theories:  Net operating income (NOI) approach.  Traditional approach and Net income (NI) approach.  MM hypothesis with and without corporate tax.  Millers hypothesis with corporate and personal taxes.  Trade-off theory: costs and benefits of leverage.

CAPITAL STRUCTURE THEORY

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Assumption of Capital Structure Theories
There are only two sources of funds i.e.: debt and equity.  The total assets of the company are given and do no change.

CAPITAL STRUCTURE THEORY

 The total financing remains constant. The firm can change the degree of leverage either by selling the shares and retiring debt or by issuing debt and redeeming equity.  Operating profits (EBIT) are not expected to grow.  All the investors are assumed to have the same expectation about the future profits.  Business risk is constant over time and assumed to be independent of its capital structure and financial risk.  Corporate tax does not exit.  The company has infinite life.  Dividend payout ratio = 100%.
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Net Income (NI) Approach
 According to NI approach both
Cost

CAPITAL STRUCTURE THEORY

the cost of debt and the cost of equity are independent of the capital structure; they remain
ke, ko ke

constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt.  This approach has no basis in reality; the optimum capital
Debt kd ko kd

structure would be 100 per cent debt financing under NI approach.

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Net Operating Income (NOI) Approach
 According to NOI approach the value of the firm and the weighted average structure.  In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the cost of capital are
Cost

CAPITAL STRUCTURE THEORY

independent of the firms capital

ke

ko kd

Debt

capital structure and therefore, value of same.

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the company is the

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MM Approach Without Tax: Proposition I

CAPITAL STRUCTURE THEORY

 MMs Proposition I states that the firms value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

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MMs Proposition II

CAPITAL STRUCTURE THEORY

 The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firms debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases.

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MM Hypothesis With Corporate Tax


CAPITAL STRUCTURE THEORY

Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the allequity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

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        Profitability Solvency Return Risk Flexibility Capacity Control Conservatism

CAPITAL STRUCTURE THEORY

Features of an Appropriate Capital Structure

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