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CAPITAL STRUCTURE

Definition of Capital Structure


A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

Meaning of Capital Structure


Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisionsi. ii. Type of securities to be issued are equity shares, preference shares and long term borrowings (Debentures). Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into twoi. ii. Highly geared companies - Those companies whose proportion of equity capitalization is small. Low geared companies - Those companies whose equity capital dominates total capitalization.

Factors Determining Capital Structure


1. Trading on Equity- The word equity denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of companys earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high.

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2. Degree of control- In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the companys management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares. 3. Flexibility of financial plan- In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans. 4. Choice of investors- The companys policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. 5. Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the companys capital structure generally consists of debentures and loans. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. 6. Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures. 7. Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits. 8. Stability of sales- An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases. 9. Sizes of a company- Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

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Assumption for Capital Structure


1. There are only two sources of funds, i.e., the equity and the debt, having a fixed interest. 2. The total assets of the firm are given and there would be no change in the investment decisions of the firm. 3. EBIT (Earnings Before Interest & Tax)/NOP (Net Operating Profits) of the firm are given and is expected to remain constant. 4. Retention Ratio is NIL, i.e., total profits are distributed as dividends. [100% dividend pay-out ratio] 5. The firm has a given business risk which is not affected by the financing wise. 6. There is no corporate or personal taxes. 7. The investors have the same subjective probability distribution of expected operating profits of the firm.

8. The capital structure can be altered without incurring transaction costs.


In discussing the theories of Capital Structure, we will consider the following notations: E = Market Value of the Equity D = Market Value of the Debt V = Market Value of the Firm = E + D I = Total Interest Payments T = Tax Rate EBIT / NOP = Earnings Before Interest and Tax OR Net Operating Profit PAT = Profit After Tax D0 = Dividend at time 0 ( i.e. now ) D1 = Expected dividend at the end of Year 1. P0 = Current Market Price Per Share P1 = Expected Market Price per share at the end of Year 1.
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Kd = Cost of Debt after Tax [ I ( 1 T ) / D ] Ke = Cost of Equity [ D1 / P0 ] K0 = Overall cost of Capital i.e., WACC = Kd [ D / D + E ] + Ke [ E / D + E ] = Kd [ D / V ] + Ke [ E / V ] = [ Kd D / V ] + [ Ke E / V ] = Kd D + Ke E / V = EBIT / V

Theories of Capital Structure


Net Income ( NI ) Approach Net Operating Income ( NOI ) Approach Traditional Approach Modigliani Miller Model

1. Net Income Approach


As suggested by David Durand, this theory states that there is a relationship between the Capital Structure and the value of the firm. The Net Income Approach assumes that Cost of Equity ( Ke ) and Cost of Debt ( Kd ) are independent of the Capital Structure. As per this approach overall Cost of Capital ( Ko ) decline and Value of the Firm ( V ) increases with the employment of Debt Capital and Vice Versa. The essence of Net Income Approach is that the firm can increase its value or decrease the overall cost of capital by increasing the proportion of the debt in the capital structure.

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Assumption
Total Capital requirement of the firm are given and remain constant Kd < Ke Kd and Ke are constant Ko decreases with the increase in leverage.

Format EBIT / NOI XXX

Less:

Interest on Debt

XXX

Net Income ( NI ) Divide: Ke

XXX

XXX

E ( Value of Equity Share ) Plus:

XXX

D ( Value of Debt )

XXX

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Formula
Ko = EBIT / V OR Ko = Ke [ E / V ] + Kd [ D / V ]

2. Net Operating Income ( NOI ) Approach


According to David Durand, under NOI approach, the total value of the firm will not be affected by the composition of capital structure. Any change in Leverage will not change the value of firm ( V ) and the market price of share as Ko is independent of degree of leverage. As per these approach the overall Cost of Capital and Cost of Debt remains Constant for all degree of Leverage ( + Deb )

Assumption Ko and Kd is Constant. Ke will change with the degree of Leverage. There is no Tax.

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Format NOI / EBIT Divide: Ko V ( Value of Firm ) Less: D ( Value of Debt ) E ( Value of Equity shareholder ) XXX XXX XXX XXX XXX

Formula
Ke = NOI Interest / E 3. Traditional Approach It takes a mid-way between the NI approach and the NOI approach. According to this view, the value of the firm can be increased or the cost of capital can be reduced by a mix of debt and equity capital. This Approach implies that the cost of capital decrease within the reasonable limit of debt and then increases with Leverage. An optimum Capital Structure does exist in Traditional Approach. According to the Traditional Approach, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three stages as under:

First Stage ( Increasing Value Stage ) In the first stage, the cost of equity Ke, remain constant or rises slightly with debt. But when it increases, it does not increases fast to offset the advantage of low-cost debt. As a result, the value of firm ( V ) increases or the overall cost of capital ( Ko ) falls with increasing leverage.

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Second Stage ( Optimum Value Stage ) Once the firm has reached a certain degree of leverage, increase in leverage have a very less effect on the value, or the cost of capital. This is so because the increase in the cost of equity due to the added financial risk offsets the advantages of low-cost debt. Third Stage ( Decreasing Value Stage ) Beyond the acceptable limit of leverage, the value of the firm decrease with leverage of the cost of the capital increase with the leverage. This happens because investors perceive a high degree of financial risk and demand higher cost on equity which offsets the advantage of low cost debt and cost of debt is also increases with risk.

Assumption
The value of the firm increases with the increase in financial leverage, upto a certain limit only. Kd is assumed to be less than Ke.

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4. Modigliani Miller ( MM ) Approach


Modigliani Miller Approach is identical with the NOI Approach. They have concluded that, in the absence of corporate taxes, a firms market value ( V ) and overall cost of capital ( Ko ) remains constant to the changes in capital structure. In other words, an optimum capital structure does not exist. Capital structure decisions are irrelevant and value of the firm is independent of debt equity mix. Basic Propositions:Proposition I The overall cost of capital (KO) and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. Value of unlevered firm = value of levered firm Proposition II The financial risk increases with more debt content in the capital structure. As a result cost of equity (Ke) increases in a manner to offset exactly the low cost advantage of debt. Hence, overall cost of capital remains the same. The expected Yield on equity, Ke is equal to Ko Plus a premium. This premium is equal to debt equity ratio times the difference between Ko and the yield on debt, Kd. Ke = Ko + ( Ko Kd ) D / E Proposition III The cutoff rate for investment decision making for a firm in a given risk class is not affected by the manner in which the investment is financed.

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Assumption
There is a perfect Capital Market. Capital Markets are perfect when: a. b. c. d. e. Investors are free to buy and sell securities, They can borrow funds without restriction at the same terms as the firms do, They behave rationally They are well informed There are no transaction costs.

Homogeneous risk classes: Business risk is equal among all firms within similar operating environment. All investors have the same expectation of a firms net operating income (EBIT). The dividend payout ratio is 100%, which means there are no retained earnings. There are no corporate taxes. This assumption has been removed later.

Optimum Capital Structure


Optimum Capital Structure means combination of Debt and Equity in such a way that Value of the Firm ( V ) is highest and overall cost of Capital ( Ko ) is lowest. In NI Approach optimum Capital Structure is not exist because it is achieved at a point when company has 100% Debt in its Capital Structure. Which is not possible. In NOI Approach, there is nothing such as Optimum Capital Structure. Any Capital Structure is optimum, according to the NOI Approach. In Traditional Approach Optimum Capital Structure is achieved in Second Stage.
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Difference Between Business Risk and Financial Risk


Business Risk
It is the volatility in revenues and profit of particular company due to its market conditions product mix, competition etc. It may arise due to External reasons ( Govt. Policies specific to that kind of industry ) or Internal Reasons ( Labour efficiency, management etc. )

Financial Risk
These are risks that are associated with the Capital Structure of a company. A company with no debt financing has no financial risk. Higher the financial leverage , higher the financial risk. These may also arise due to short term liquidity problems, shortage in working capital receivable, etc.

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Example
1. There are two company X and Y. X Company has 10% Debenture of 600000. Y Company has 10% Debenture of 700000 the operating profit of Company is 100000 with the Equity Capitalization rate being 12%. Find out value of the firm and overall cost of Capital of two enterprise. 2. From the following information find out value of the firm and overall cost of Capital under Net Income approach. i. ii. iii. iv. v. vi. Total asset of the company X and Y are Rs. 1500000. EBIT is 20% of Investment. X Ltd. Is leverage firm with 900000 Debt Y Ltd. Is unleveraged firm ( without Debt ) Rate of Interest on Debt 10% Equity Capitalization rate is 15%

3. The Net operating Income of a Company is Rs. 200000 its Capital Structure include 8% debt of Rs. 500000 while overall cost of capital is 10%. Find out cost of equity capital using NOI Approach. If company change the capital structure and increase the debt upto Rs. 800000 What will be the answer and also check NOI Approach. 4. A firm has an EBIT of Rs. 5,00,000 and belongs to a risk class of 10%. What is the cost of Equity if it employs 8% debt to the extent of 30%, 40% or 50% of the total capital fund of Rs. 20,00,000? 5. XYZ Ltd. Has EBIT of Rs. 400000. The firm currently has outstanding debts of Rs. 1500000 at an average cost, Kd of 10%. Its cost of equity capital Ke is estimated to be 16%. i. ii. iii. Determine the current value of the firm using the traditional approach. Determine the firms overall capitalization rate. Ko. The firm is considering to issue capital of Rs. 500000 in order to redeem Rs. 500000 debt. The cost of debt is expected to be unaffected. However, the firms cost of equity capital is to be reduce to 14% as a result of decrease in leverage. Would you recommend the proposed action?

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6. A Ltd. Has EBIT Ra. 300000; Recommend Capital Structure from following Information:

Capital Structure I

Debt ( Rs. )

Kd %

Ke %

300000

10

12

II

400000

10

12.5

III

500000

11

13.5

IV

600000

12

15

700000

14

18

7. Aparna Steel Ltd. Has employed 15% Debt of Rs. 1200000 in its capital structure. The net income of the firm is Rs. 320000 and has an equity capitalization rate is 16%. Assuming that there is no tax. Find out the value of the firm under NI Approach.

8. The Net operating profit of the firm is 2100000 and the total market value of its 12% debt is Rs. 300000. The equity capitalization rate of an unlevered firm of the same risk class is 16%. Find out the value of Levered firm given that the tax rate is 30% for both the firms.

[ Hint: Value of Unlevered Firm = EBIT ( 1 t ) / Ke Value of Levered Firm = Value of Unlevered Firm + Debt ( t ) ]

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9. The following estimates of the cost of debt and equity capital have been made at various level of the Debt-Equity mix for ABC Ltd.

% of Debt 0

Cost of Debt %

Cost of Equity %

12

10

12

20

12.5

30

5.5

13

40

14

50

6.5

16

60

20

Assume no tax, determine the optimum debt equity ratio for the company on the basis of the overall cost of capital ( WACOC )

10. The following information is available for X Ltd. And Y Ltd. In respect of their present position. Compute the equilibrium value ( V ) and equity capitalization rate of the two companies, assume that i. ii. There is no income tax; The overall capitalization for such companies in the market is 12.5%

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Particulars EBIT / NOI Less: Interest@ 5% Net Income for Equity holders Divide: Equity Capitalization Rate Market Value of Equity Plus: Market Value of Debt Total Market Value Cost of Capital, Ko ( EBIT / Market Value )

X Ltd. 150000 20000 130000 0.13 1000000 400000 1400000 10.71%

Y Ltd. 150000 150000 0.12 1250000 1250000 12%

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