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Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.
Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system of capital so that the maximum rate of return can be earned at a minimum cost. This sort of system of capital is known as capital structure.
From Debentures
Internal Factors
Size of Business Nature of Business Regularity and Certainty of Income Assets Structure Age of the Firm Desire to Retain Control Future Plans Operating Ratio Trading on Equity Period and Purpose of Financing
External Factors
Capital Market Conditions Nature of Investors Statutory Requirements Taxation Policy Policies of Financial Institutions Cost of Financing Seasonal Variations Economic Fluctuations Nature of Competition
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.
Conclusion
If the Expected EBIT is much more than the Point of Indifference Level - ? If the Expected EBIT is lower than the Point of Indifference Level - ? If the Expected EBIT is even less than the Fixed Cost - ?
Here, X = EBIT at Indifference Point R1 = Interest in Alternative 1 R2 = Interest in Alternative 2 T = Tax Rate PD = Preference Dividend N1 = No. of Equity Shares in Alternative 1 N2 = No. of Equity Shares in Alternative 2
Case
ABC Ltd. has a share capital of of Rs. 20 lacs divided into 40,000 equity shares of Rs.50 each. The company can raise additional funds of Rs.10 lacs for expansion either by issuing all equity shares or all 9% debentures. The companys present EBIT is Rs. 2,80,000. Rate of income tax is 50%. In this case: 1) What is the point of indifference? 2) Which alternative is beneficial to the company and Why?
Case
A new project under consideration by your company requires a capital investment of Rs.150 Lacs. Interest on Term Loan is 12% and tax rate is 50%. If the debt equity ratio insisted by the financing agencies is 2:1. 1) What is the point of indifference? 2) Which alternative is beneficial to the company and Why?
It is due to the fact that debt is, generally a cheaper source of funds because:
(i) Interest rates are lower than dividend rates due to element of risk, (ii) The benefit of tax as the interest is deductible expense for income tax purpose.
Assumptions of NI Theory
The Kd is cheaper than the Ke. Income tax has been ignored. The Kd and Ke remain constant.
Case
K.M.C. Ltd. Expects annual net income (EBIT) of Rs.2,00,000 and equity capitalization rate of 10%. The company has Rs.6,00,000; 8% Debentures. There is no corporate income tax. (A) Calculate the value of the firm and overall (weighted average) cost of capital according to the NI Theory. (B) What will be the effect on the value of the firm and overall cost of capital, if:
(i) the firm decides to raise the amount of debentures by Rs.4,00,000 and uses the proceeds to repurchase equity shares. (ii) the firm decides to redeem the debentures of Rs. 4,00,000 by issue of equity shares.
Case
ABC Ltd. Expects annual net operating income of Rs.4,00,000. It has Rs.10,00,000 outstanding debts, cost of debt is 10%. If the overall capitalization rate is 12.5%, (1) What would be the total value of the firm and the equity capitalization rate according to NOI Theory. (2) What will be the effect of the following on the total value of the firm and equity capitalization rate, if
The firm increases the amount of debt from Rs.10,00,000 to Rs.15,00,000 and uses the proceeds of the debt to repurchase equity shares. The firm returns debt of Rs.5,00,000 by issuing fresh equity shares of the same amount.
Traditional Theory
This theory was propounded by Ezra Solomon. According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital.
Case
Compute the total value of the firm, value of equity shares and the overall cost of capital from the following information and also give conclusion? Net Operating Income: Rs.2,00,000 Total Investment: Rs.10,00,000 Equity Capitalization Rate: (a) If the firm uses no debt: 10% (b) If the firm uses Rs.4,00,000, 5% debentures: 11% (c) If the firm uses Rs.6,00,000, 6% debentures: 13%
Modigliani-Miller Theory
This theory was propounded by Franco Modigliani and Merton Miller. They have given two approaches
In the Absence of Corporate Taxes When Corporate Taxes Exist
Computation
Value of Unlevered Firm Vu = EBIT(1 T) Ke Value of Levered Firm VL = Vu + Dt Where, Vu : Value of Unlevered Firm VL :Value of Levered Firm D : Amount of Debt t : tax rate
Case
XYZ Ltd. is planning an expansion programme which will require Rs.30 crores and can be funded through out of the following three options: (a) Issue further equity shares of Rs.100 each at par. (b) Raise loans at 15% interest. (c) Issue Preference shares at 12%. Present paid up capital is Rs.60 Crores and average annual EBIT is Rs.12 crores. Assume income tax rate at 50%. After the expansion, EBIT is expected to be Rs.15 crores p.a. (i) Calculate EPS under the three financing options indicating the alternative giving the highest return to the equity shareholders. (ii) Determine the point of indifference between equity share capital and debt i.e option (a) and (b) above.