Capital Structure Planning

Definition
Capital structure of a company refers to the make-up of its capitalization and it includes all long-term capital resources, viz., shares, loans, reserves and bonds. - Gerstenberg

Capital Structure consists of:

1. Owned Funds: It belongs to the proprietors It includes share capital, free reserves and surplus. 2. Borrowed Funds: It consists of long-term borrowings from outside sources. It consists of debentures, bonds and long-term loans provided by banks and term lending institutions.

Equity share capital

Risk bearing capital of the company Shares which do not enjoy special rights in respect of payment of dividend and repayment of capital. Rate of dividend fluctuates depending upon the availability of profits

Advantages
1. It represents a permanent source of finance 2. It does not carry any fixed burden 3. It enhances the creditworthiness of the firm

Disadvantages
1. Its cost is very high 2. Issue of equity to outsiders causes dilution of control
5

Preference Shares
Shares which enjoy priorities in the payment of dividend as well as in the repayment of capital Preference shareholders are entitled to receive a fixed rate of dividend Preference shareholder is paid back the capital before any payment is made to the equity shareholders.
6

Types of preference shares

1. Participating: shareholders are entitled to participate in surplus profits

Non-participating: shareholders are entitled to receive only a fixed rate of dividend

2. Redeemable: returnable either at the discretion of the company or at the end of a certain period Irredeemable: non-returnable 3. Cumulative: the dividend payable in a year of loss gets carried over to the next year Non-cumulative: dividend paid if sufficient profits are available or else it lapses.
7

4. Convertible: can be converted into equity shares of the company at a certain conversion ratio decided by the company Non-convertible: cannot be converted into ordinary shares

Advantages
Preferential rights Arrears of Unpaid dividend payable Gives flexibility to the company Redeemable and Convertible Shares

Disadvantages
Fixed dividend No control
9

Debentures
Money received by the issue of debentures is a loan Debenture is a security issued by a company against the debt. Debenture holders are the creditors of the company Interest on debentures has to be paid even if the company makes losses Debenture holders have no voting rights No dilution of control Less risky for shareholders

10

Advantages
Regular fixed income Safety and security of investment Liquidity- easy sale in stock exchange Conversion into shares

Disadvantages
No control Fixed returns
11

Term Loans
Meaning 3 categories based on Pay back period: Short term Loans Medium term Loans Long term Loans

12

Advantages
Cost lower than share capital No dilution of control Backed by security

Disadvantages
No voting rights Repayment is obligatory
13

Comparison of Long-term Sources of Finance

Sources of Finance Equity Capital Preference Capital Debenture Capital Term Loans Cost High High Low Low Dilution of control Yes No No No Risk High Negligible Nil Nil

14

Essentials of an optimum capital structure

1. Flexibility: the capital structure should facilitate further financing for expansion, replacement, etc.
2. Economy: the capital structure must ensure the maximum use of leverage at minimum cost 3. Solvency: the capital structure must provide a balance between different securities so that there is neither excess of debt nor lack of benefits of using the debt.
15

4. Efficiency: the capital structure must ensure intensive utilization of available resources.
5. Simplicity: the capital structure must be made easy to understand by avoiding doubts and complexities. 6. Safety: the capital structure should ensure safety in the business by maintaining adequate cash ratio (liquidity) in the business. 7. Control: While designing the capital structure it should be kept in mind that the controlling position of present shareholders remains undisturbed.
16

Indifference Point
EPS Plan 1 = EPS Plan 2 (EBIT - I1) (1-t) - PD1 = (EBIT - I2) (1-t) - PD2 E1 E2
Where, EBIT = Earnings Before Interest and Tax I1 = Interest charges in plan 1 I2 = Interest charges in plan 2 T = Rate of tax PD1 = Preference dividend in plan 1 PD2 = Preference dividend in plan 2 E1 = Number of equity shares in plan 1 E2 = Number of equity shares in plan 2
17

Indifference Analysis:
When 2 mutually exclusive financial plans do generate the level of EBIT where the EPS is the same such a situation is referred to as indifferent point level.
Debt

EPS (Rs.)
Indifference Point Equity

EBIT (Rs.)

18

Financial Break-even:
The minimum level of EBIT required to satisfy all fixed financial charges At financial break-even level of EBIT the firms EPS = 0 If EBIT > financial break-even point, then EPS will be positive

19

Patterns in Capital Structure

1. Capital structure with equity shares only 2. Capital structure with both equity and preference shares 3. Capital structure with equity shares and debentures 4. Capital structure with equity shares, preference shares and debentures.

20

Determinants of Capital Structure

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Nature of business Stability of earnings Amount of initial capital required Growth rate Nature of investors Financial leverage Return on Investment Dilution of control Trends in capital market Government regulations Flexibility Lenders attitude
21

Format of Evaluation of Alternative Capital Plans

Particulars EBIT Less: Interest on Borrowed Funds EBT Less: Tax @ ______% EAT Less: Preference Dividend Amount Available to Shareholders
PLANS

Option 1 xxxx xx xxxx xx xxxx xx xxxx

Option 2 xxxx xx xxxx xx xxxx xx xxxx

Option 3 xxxx xx xxxx xx xxxx xx xxxx

22

Basis of Selection of Capital Plans

EPS = Amount available to Equity Shareholders Number of Equity Shares Shows capacity of the company to pay dividend to Equity Shareholders i.e., earnings available per equity share Price Earning (P/E) Ratio = MPS EPS Indicates the number of times market price is higher or lower than EPS i.e., whether the shares are under- valued or over- valued.
23

 Dividend Payout (D/P) Ratio = DPS EPS Indicates the percentage of earnings actually distributed as Equity dividend i.e., portion of earnings used for payment of dividend and portion of earnings retained.

24

Thank you

25