Capital Structure & Sources of Finance

Presented by: Aaron Harrison Ankit Jain Jayant Kindo

Contents
Introduction to Capital Structure Trading on Equity Advantages Forms and patterns of Capital Structure Financial B.E.P E.B.I.T-E.P.S Points of indifference Optimal Capital Structure Essentials of sound Capital Structure Basic Ration Factors affecting Capital Structure Theories of Capital Structure Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory Modigliani-Miller (M-M) Theory

Introduction
 In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.  For example, a firm that sells $30 billion in equity and $70 billion in debt is said to be 30% equity-financed and 70% debt-financed.  Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.  Debt comes in the form of bond/debentures issues or long-term notes payable, while equity is classified as equity share , preference share or retained earning.

Contd.

In broader sense , Financial Structure and Capital Structure are same but, In a narrow sense: Financial structure = Long term + Short term liabilities Capital structure = Long term liabilities

Financial Leverage or Trading on Equity

The use of sources of funds with fixed cost, such as debt and preference share capital along with owners equity capital in the structure is known as financial leverage. Financial Leverage employed by the company will depend on the amount of the risk the company will like to pay. For example, a firm that has $40 billion in equity and $60 billion in debt is said to be 40% equity-financed and 60% debt-financed. In this example, 60% is referred to as the firm's financial leverage

Advantage
The rate of return on investment is more then the rate of interest on debt and rate of dividend on preference capital and hence the difference is distributed to share capital. The interest paid on debt is tax deductible and hence there is tax saving.

Forms and Patterns of Capital Structure

Equity Shares only Equity and Preference Shares Equity shares and Debentures Equity Share, Preference share and Debenture

Financial Break Even Point

Financial BEP may be defined as that level of EBIT which is just equal to pay the financial charges i.e. interest and preference dividend. At this point or level of EBIT, EPS (EPS = 0).

It is a critical point in planning the capital structure of the firm. If EBIT is less then Financial BEP, EPS shall be ve and hence fix interest bearing debt for preference share capital should be reduced. Forever in case the level of EBIT exceed the financial BEP, more of such fixed cost funds may be introduced in the capital structure.

Point of Indifference (EBIT-EPS Analysis)

It refers to that EBIT level at which EPS remains the same irrespective of different alternatives of debt equity mix. At this level of EBIT, the rate of return on capital employed is equal to the cost of debt and this is also known as break-even level of EBIT for alternative financial plans.

Point of Indifference of indifference Ascertainment

Point of Indifference : (X- I1) (1-T) - PD S1 = (X-I2) (1-T) - PD S2

Where, X = EBIT at Indifference Point I1 = Interest in Alternative 1 I2 = Interest in Alternative 2 T = Tax Rate PD = Preference Dividend S1 = No. or amount of Equity Shares in Alternative 1 S2 = No. or amount of Equity Shares in Alternative

Optimal Capital Structure

The optimal or the best capital structure implies the most economical and safe ratio between various types of securities. It is that mix of debt and equity which maximizes the value of the company and minimizes the cost of capital. The relationship of debt and equity which maximizes the value of the firms share in the stock exchange.

Essentials of a Sound or Optimal Capital Structure

Minimum Cost of Capital Minimum Risk Maximum Return Maximum Control Safety Simplicity Flexibility Attractive Rules Commensurate to Legal Requirements

Basic Ratio
Sound or Optimal Capital Structure requires (An Approximation):
Debt Equity Ratio: 1:1 Earning Interest Ratio: 2:1
During Depression: one and a half time of interest.

Total Debt Capital should not exceed 50 % of the depreciated value of assets. Total Long Term Loans should not be more than net working capital during normal conditions. Current Ratio 2:1 and Liquid Ratio 1:1 be maintained.

Factors Influencing Capital Structure

Internal
Size of Business

External
Capital Market Conditions

Nature of Business

Statutory Requirements

Assets Structure

Nature of Investors

Trading on Equity

Cost of Financing

Age of the Firm

Taxation Policy

Period and Purpose of Financing

Economic Fluctuations

Theories of Capital Structure

Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory Modigliani-Miller (M-M) Theory

NET INCOME APPROACH

Enhance Value of FIRM Suggested by DAVID DURAND Value of the firm depends on its capital structure decision High debt content in the CS = high FL V=E+D E= EBIT-I / Ke D= I/Kd In the light of the graph it is clear that as D/E enhances . Kw decreases because the proportion of debt enhances in the CS

High debt content

Reduction Overall Cost of capital

Net operating income approach

Advocated by David Durand Value of a firm depends on its NOI and business risk Change in the degree of leverage a firm cannot change its NOI and Business risk It brings variation in the distribution of income and risk between debt and equity without affecting the total income and risk which influences the market value of the firm. Optimum CS When there is 100% debt content

Assumptions
Kw is constant for all degree of leverage NOI is capitalized at an overall capitalization rate to find out the total market value of the firm. Thus the split between D & E is irrelevant.

TRADITIONAL APPROACH
Cost of capital is dependent on the capital structure. The main propositions of this approach are:Cost of debt capital remains constant up to a certain degree of leverage and there after rises Cost of equity capital remains constant more or less or rise gradually up to a certain degree of leverage and thereafter increases rapidly. The average cost of capital reduces up to a certain point and remains more or less unchanged for moderate increase in leverage and there after rises after attaining a certain point.

Contd.

It accepts that capital structure of a firm affects the COC and its valuation. It does not subscribe to the concept that the value of the firm will necessarily enhance with all levels of leverage.

MODIGLIANI MILLER APPROACH

Total market value of the firm and cost of capital are independent of the capital structure WACC does not make any change with a proportionate change in debt equity mix in the total capital structure of the firm It provides operational justification for irrelevance of the capital structure in the valuation of the firm.

Propositions
COC and market value of the firm are independent of its capital structure. Cost of capital = capitalization rate of equity Total market value of the firm is determined by capitalizing the expected NOI by the rate appropriate for the risk class. Ke Kd = premium for financial risk Increased Ke is offset by the use of cheaper debt The cut off rate for investment is always independent of the way in which an investment is financed.

Criticism of MM hypothesis
Different rates of interest Corporate taxes

Contd.

The use of low cost debt enhances the risk of equity share holders, enhancing the equity capitalization rate. Thus the benefit of DEBT is nullified by the increase in the EQUITY CAPITALIZATION RATE. V = EBIT / Kw An increase in the use of debt funds is offset by an increase in the equity capitalization rate. This occurs because the equity investors seek more compensation as they are exposed to higher risk arising from increase in the degree of leverage

Sources of fund

Table of content
Introduction to sources of funds Finance types Equity shares Advantages Disadvantages Preference shares Types Features Advantages Disadvantages

Deffered Shares Sweat equity Debentures

Types of debentures Advantages Disadvantages

Retained Earnings

Advantages of retained earnings Disadvantages Loan Financing Bridge Financing Lease Financing

Introduction
In our present day economy, finance is defined as the provision of money at the time when it is required. In fact, finances today is rightly said as the life blood of an enterprise. Capital required for a business can be classified under two main categories :Fixed Capital Working Capital

According to period

Short term Medium term Long term

According to ownership

Owned Borrowed

According to the source of finance

Internal External

According to the mode of financing

Security financing or External financing Internal financing Loan financing through raising of long-term and short-term loans

EQUITY SHARES
Equity shares, also known as ordinary shares or common shares, represent the owners capital in a company. Real owners of the company. Equity shareholders are paid dividend after paying it to the preference shareholders. Cannot be redeemed

CHARACTERISTICS OF EQUITY SHARES

Maturity Claims / Rights to Income Claim on Assets Right to Control or Voting Rights

ADVANTAGES OF EQUITY SHARES

Equity shares do not create any obligation to pay a fixed rate dividend. Equity shares can be issued without creating any charge over the assets of the company. It is a permanent source of capital and the company has not to repay it except under liquidation.

DISADVANTAGES OF EQUITY SHARES

If only equity shares are issued, the company cannot take the advantage of trading on equity. As equity capital cannot be redeemed, there is a danger of over capitalization. Equity shareholders can put obstacles in management by manipulation and organizing themselves.

PREFERENCE SHARES
Preference for payment of dividend

Preferences

Preference for repayment of capital

TYPES OF PREFERENCE SHARES

Cumulativ e preferenc e shares

Non cumulativ e preferenc e shares

Redeemab le preferenc e shares

Irredeema ble preferenc e

Participati ng preferenc e shares

Nonparticipati ng preferenc e shares

Convertibl e preferenc e shares

Non convertible preference shares

FEATURES OF PREFERENCE SHARES

Maturity

FEATURES OF PREFERENCE SHARES

Claims on assets Claims on income

ADVANTAGES OF PREFERENCE SHARES

No legal obligation to pay dividend on preference shares. Provides a long term capital for the company. Enhances the creditworthiness of a firm

DISADVANTAGES OF PREFERENCE SHARES

Frequent delays or non payment adversely affects the creditworthiness of the firm. Cumulative preference shares becomes a permanent burden so far as the payment of dividend is concerned. Market price of preference shares fluctuate much more than that of dividend.

DEFERRED SHARES
Also known as founder shares since they are issued to the founders or promoters for services. Rank last as far as payment of dividend and return of capital is concerned. According to Companies Act,1956 no public limited company or which is a subsidiary of public company can issue deferred shares

SWEAT EQUITY
Equity shares issued by a company to its employees or directors at a discount. To induce a sense of belongingness of the employee or director towards the company. To ensure more loyalty and participation of the employee. Can be issued only one year after the company is entitled to commence business

DEBENTURES
While Starting of a business the company needs large amount of investment. The company borrow funds from banks or other financial institutions. Debenture is a long term liability, these are the creditors to the company & the company pay some %age of interest to the debenture holder. Debentures are also called BONDS.

TYPES OF DEBENTURES
SIMPLE OR UNSECURED DEBENTURES REGISTERED DEBENTURES

BEARER DEBENTURES

CONVERTIBLE DEBENTURES

FEATURES OF DEBENTURES
CLAIMS ON ASSETS

CLAIMS ON INCOME MATURITY

ADVANTAGES OF DEBENTURES
ADVANTAGES TO THE COMPANY : Debentures provide long term funds The rate of interest payable on debentures is usually lower than the rate of dividend paid on shares. ADVANTAGES TO THE INVESTORS : Debentures provide a fixed and regular source of income to the It is comparatively a safer investment.

DISADVANTAGES OF DEBENTURES
DISADVANTAGES FOR THE COMPANY :
The fixed rate charges and repayment of principal amount on maturity are legal obligations of the company. These have to be paid even when there are no profits. The use of debt financing usually increases the risk perception of investors in the firm . Cost of raising finance through debentured is also high because of high stamp duty.

CONTD.

DISADVANTAGES FOR THE INVESTORS :

Debentures dont carry any voting rights and hence its holders dont have any controlling power over the management. Interest on debentures is usually taxable.

PLOUGHING BACK OF PROFITS

Ploughing back of profit also known as retained earnings is a technique of financial management under which all profits of a company are not distributed amongst the shareholders as dividend, but a part of the profit is retained or re-invested into the business. This process of retaining profits year after year and their utilization in the business is known as PLOUGHING BACK OF PROFITS.

MERITS OF PLOUGHING BACK OF PROFITS

ADVANTAGES TO THE COMPANY :
A cushion to absorb the shocks of the company. Economical method of financing. Flexible financial structure.

ADVANTAGES TO THE SHAREHOLDERS :

Increase in the value of shares. Safety of investment. Enhanced earning capacity.

DEMERITS OF PLOUGHING BACK OF PROFITS

OVER CAPITALISATION

MISUSE OF RETAINED EARNINGS

CREATION OF MONOPOLIES

LOAN FINANCING
Important mode of financing
Short term loans and credits Medium loans

SHORT TERM LOANS AND CREDITS

Indigenous bankers Trade credit Installment credit Advances Factoring or accounts receivable credit .

CONTD

Accrued expenses Deferred Incomes Commercial banks x Different forms x Loans x Cash credits x Overdrafts x Purchasing and Discounting of bills Public deposits

LOANS
Specialized financial institutions or developmental banks

Commercial banks

Loans

Special Financial Institutions

Industrial finance corporation of India(IFCI) Industrial credit and investment corporation of India(ICICI) State financial corporations State industrial development corporations(SIDCS)

Other innovative source of finance

Venture capital: Financial investment in a highly risk project to earn a high return of profit. Provides the necessary risk capital to meet promoters contribution Financial agencies: Venture capital scheme of IDBI Venture capital scheme of ICICI Credit rating information services of India ltd.

 Seed capital:
Schemes opened by IDBI to finance the eligible entrepreneurs who lack financial capability. Specially designed for promoters to the company.

Operating schemes:
Special seed capital assistance schemes Seed capital assistance schemes

Bridge finance
To avoid delay in implementation of the project
Specifically short term loans Higher rate of interest Loan repaid when loan disbursements are received from the financial institutions.

Lease financing
Form of renting assets but the firm need not own the assets.
Basically interested in acquiring the use of asset. Firm considers leasing the assets rather than buying it.

Types of Leasing
Operating or service lease :Short term lease on a period to period basis. Cancelable at short notice by the lessee Option of renewing the lease after the expiry of lease period

Contd.

Financial lease:
Usually for a longer period and non cancelable. Lessee is responsible for the maintenance, insurance and Service of the asset and so also known as net lease.

Euro issues
Method of raising funds through foreign exchange. Issue made abroad through instruments denominated in foreign currency. Any one capital market can absorb only a limited amount of companys stock.