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CAPITAL STRUCTURE

Capital Structure Defined  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 firm’s capital expenditure. 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

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

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.  Miller’s hypothesis with corporate and personal taxes.  Trade-off theory: costs and benefits of leverage. 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.  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%. Net Income (NI) Approach  According to NI approach  both the cost of debt and the cost of equity are independent of the capital structure; they remain 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.

C ost ke ko kd D ebt . value of the company is the same.  In the absence of taxes. This approach has no basis in reality. ke. an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore. ko ke kd ko kd D ebt Net Operating Income (NOI) Approach  According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm’s capital structure. the optimum capital C ost structure would be 100 per cent debt financing under NI approach.

convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. regardless of the amount of debt employed. the overall cost of capital must remain constant. . then the capital-structure arbitrageur will bet that it will converge. A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. for example. from a levered firm and an unlevered firm. under contracted-for conditions. Consider. shareholders can receive exactly the same return. Thus. This implies that the cost of equity must rise as financial risk increases. they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. If the spread (the difference between the convertible and the non-convertible bonds) grows excessively. The value of the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. For financial leverage to be irrelevant. With personal leverage.MM Approach Without Tax: Proposition I  MM’s Proposition I states that the firm’s value is independent of its capital structure. MM’s Proposition II  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 firm’s debt-equity ratio. with the same risk. traditional bonds and convertible bonds. The latter are bonds that are. This is called arbitrage.

 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. whereas dividend payments and retained earnings are not. debt has an important advantage over equity: interest payments on debt are tax deductible. .MM Hypothesis With Corporate Tax  Under current laws in most countries. 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). Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest.

while the marginal cost increases. Often agency costs are also included in the balance. etc). The theories below try to address some of these imperfections. bondholder/stockholder infighting. . the tax benefits of debt and there is a cost of financing with debt. suppliers demanding disadvantageous payment terms. by relaxing assumptions made in the M&M model. the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e. staff leaving. Trade-Off Theory of Capital Structure The Trade-Off Theory of Capital Structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. then imperfections which exist in the real world must be the cause of its relevance. It states that there is an advantage to financing with debt. This theory is often set up as a competitor theory to the Pecking Order Theory of Capital Structure An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. The marginal benefit of further increases in debt declines as debt increases.Capital structure in the real world If capital structure is irrelevant in a perfect market.g. so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

g. • Asset substitution effect: As D/E increases. preferring to raise equity as a financing means of last resort. This is because if the project is successful. Myers and Nicolas Majluf in 1984. whereas if it is unsuccessful. there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. internal funds are used first. the gain from the project will accrue to debtholders rather than shareholders. share holders get all the upside. or of least resistance. management have an incentive to reject positive NPV projects. the Pecking Order Theory or Pecking Order Model was developed by Stewart C. If the projects are undertaken. Hence.Pecking Order Theory In the theory of firm's capital structure and financing decisions. Free cash flow: unless free cash flow is given back to investors. Increasing leverage imposes financial discipline on management. • • . It states that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of least effort. Underinvestment problem: If debt is risky (e. Thus. equity is issued. even though they have the potential to increase firm value. Agency Costs There are three types of agency costs which can help explain the relevance of capital structure. in a growth company).. debt holders get all the downside. and when it is not sensible to issue any more debt. debt is issued. management has an increased incentive to undertake risky (even negative NPV) projects. management has an incentive to destroy firm value through empire building and perks etc. and when that is depleted.

For this purpose we will consider different variables that will help us in establish the basis for the study. For the purpose of undertaking our study we have considered three important sectors of economy which reflect the dynamics of the economy to a certain extent.for that we have considered real time ex-post financial data of three sectors and 3 different companies with in each sector as to determine if capital structure differs from one industry to another and within the industry if there are any trends that differentiate one company from another in their capital build up resources. The variables that we consider to analyse the impact and relevance of different aspects in capital structure decision are WD= weight of Debt WE= weight of owners capital(equity+ Reserves & Surplus) RE= cost of Equity RD= Cost of Raising Debt . These sectors are Automobile Industry Telecom Industry Infrastructure Industry With in these three sectors we have taken 3 different companies operating in the same environment and try to analyse the capital made up of these companies within the sector first and then make conclusions for the respective sectors and make comparisons with different sectors there after.Objective The objective of this project is to understand the relevance and the applicability of the importance of capital structure in real economic environment .

Rf= Risk free rate of return BETA= Systematic Risk of a security WACC=Total cost of capital Tax Shield Free Cash Flows Dividend Payout .

So devising a proper capital structure policy and sources of funds become very critical to the overall cost of capital for the company. Mahindra & Mahindra Hero Honda We have considered the past data of the past 3 financial years of each of these companies and calculated their WACC. Three companies that we have considered in the automobile sector represent the passenger vehicle .A) AUTOMOBILE SECTOR Automobile industry is a very capital intensive and heavy capital investment industry. commercial vehicles and two wheeler segments of the automobile industry. Ltd. All the above mentioned variables will help us in establishing if at all they affect the existing capital structure of the company depending upon their future requirements. Free Cash Flows and Tax Shield and overviewed some essential Ratios year on year to come some conclusion that justifies the relevance of Capital Structure theory in the practical world of Finance. . These three companies are Maruti Suzuki Ind.

7011/0.15753 0.280 6 Market Return 0. .4743/0.109305 -0.030 3 2009-10 0.6932/0.Table 1 Beta and Security Return Company\Year Maruti Suzuki 2007-08 beta/ Return 0.064 8 2008-09 0.266 5 M&M 0.25295 From the above table we can interpret that for Maruti Suzuki and Hero Honda the beta is less than that of Mahindra and Mahindra.054 8 0. In case of Maruti and HH who are in the maturity stage of their Business Life Cycle have initially lower return in the year 200708 but during recession 2008-09 have given positive return where as the market gave negative returns on index and have given above the benchmark return in the Year 2009-10.3324/0.6310/0.198 5 0.7353/0.9587/0. M&M stock returns over the 3 year period are almost similar to that of the market.016 5 0.1331 1.0486/0.6719/0.255 7 Hero Honda 0.

0695/0.2613 Rd=0.1661 Re=0.0648/0.563 4 2009-10 0.0338 Re=0.0692 Rd= 0.4365/0.0983 Rd=0.0966/0.102 2008-09 Re=0.903 3 0.0936 Rd=0.1998 Rd=0.930 4 0.1687 Table 3 Debt and Equity (By Weight) Company\Year Maruti Suzuki 2007-08(D/E) 0.0662 Re=0.Table 2 Cost of Equity and Debt Company\Year Maruti Suzuki 2007-08 Re=0.0692 Rd=0.1014 Rd=0.033 Re=0.730 8 M&M .935 1 0.8653 2008-09 0.0431 M&M Re=0.0729 2009-10 Re=0.2691/0.0692 Rd=0.1346/0.1891 Rd=0.0544 Hero Honda Re=0.

18881323 0.MS and HH are almost equity funded with very little exposure to Debt.Hero Honda 0.9576 0.188012157 From Table 2 and Table 3 we can see that during the Year 2007-08 Both HH and MS have been able to provide Greater rate of return to their investors as compared to M&M where the CoC is almost equal to the RF rate of return and the D/E weights are very high as compared to that of MS and HH.9797 0.068101883 0. .092519863 2008-09 0.050934117 0.070490572 2009-10 0.093181279 0.981 3 Table 4 WACC From the Period 2007 till 2010 Company\Year Maruti Suzuki M&M Hero Honda 2007-08 0. Coming out of the recession period both MS and HH have been able to keep their CoC at similar levels of around 18% where as M&M have a higher CoC primarily due to its high Cost of Equity but as they have a major Debt component M&M have been able to drag the overall CoC to lower levels.0187/0.023/0.042/0.201695586 0.072977889 0.

906784 2009-10 10.989.4855 42.45 596.531008 .30 -487.11372 22.10 Table 6 Tax Shield Company\Year Maruti Suzuki M&M Hero Honda 2007-08 19.568.40 997.2391 4.159.98817 3.544.55 2008-09 1.60 318.645803 2008-09 13.80 2009-10 1.For MS and HH the overall CoC is almost equal to the Cost of Equity as the weight of Debt to the over all source of capital is significantly low and they have not been able to lower the over cost of capital coz the debt is raised at high Cost which nullifies any chances of the lowering the CoC due to introduction of Debt to the capital Structure.90 2.7598 22.20 -452. Table 5 Free Cash Flows Company\Year Maruti Suzuki M&M Hero Honda 2007-08 -1.39656 2.

have not exposed themselves to the advantage of Financial Leverage. . From the above interpreted data it can be concluded that of the three companies operating in the automobile sector the two companies who have been able to optimize their production and resource utilization . Also considering that all these companies have been paying Dividends regularly to its share holders and have a consistent payout ratios and in case of M&M the tax shield provide a large cushion for the shareholders as against the case of MS and HH shareholders as they are not able to take much benefit out of the Tax Shield. Whereas in case of M&M have resorted to infusing Debt in order to meet its Capital requirement and also bringing the overall CoC lower as its Cost of Equity is quite High as compared to its industry contemporaries.Table 5 and Table 6 also highlight the fact that MS and HH have been able to meet its capex requirements from its internal resources but have raised very little Debt to meet their capital requirements even if it comes at a higher cost. Which actually defies the premises of the bringing the Total Cost of Capital by introducing Debt with the acceptable levels of Debt into the capital Structure.

Idea was earlier Birla Tatan At&T and was taken over by Aditya Birla Group .1. it started the consolidation phase in the Telecom sector where as Rcom entered the Indian Mobile Service with CDMA technology with cheap fares and then diversified into GSM operator and also has a subsidiary in the form of Tower business.B)Telecom Telecom sector in India is in the growth phase of its Business life cycle and has a huge potential to tap further growth opportunities.2 lakh crore to Govt. And with the 3G services being launched in INDIA. of India for the spectrum which has put pressure on its profits and existing capital structure. Major capital expenditure areas for telecom industry have been in setting up Network Coverage Areas and acquiring Spectrum from the Govt. Telecom Mojors paid around RS. . We will see what sort of capital structure policies these companies believe in order to meet their Capital requirements The companies we have considered in this sector are Airtel Idea RCOM These three companies encompass the different stages of growth in the telecom sector. While Airtel is the first Mobile service Provider in India.

141 1 0.0563 2009-10 Re=0.0598 2008-09 Re=0.25295 Market Return Table 2 Cost of Equity and Debt Company\Year Airtel 2007-08 Re=0.8044/0.039 8 0.0956/0.1023 Rd=0.0598 Rd=0.8765/0.7930/0.2104 Rd=0.081 6 2008-09 0.4156/0.2010/0.1654 Idea RCOM 0.0511 2009-10 0.2108 1.0451 .109305 1.15753 1.3320/0.Table 1 Beta and Security Return Company\Year Airtel 2007-08 beta/ Return 0.161 8 1.085 6 1.3167 -0.0120/0.7545/0.

352 5 0.2182/0.06922 Rd=0.1206/0.598 4 0.3742/0.245/0.Idea Re=0.879 4 0.1034 Rd=0.115280 584 Rd=0.078 18 0.1505 RCOM Re=0.1068 Re=0.269497 094 Rd=0.7549 0.3247/0.3104 Rd=0.550 5 2008-09 0.1592 Re=0.675 3 RCOM Table 4 .0512 Table 3 Debt and Equity (By Weight) Company\Year Airtel Idea 2007-08(D/E) 0.4016/0.0429 Re=0.625 8 2009-10 0.6475/0.0373 Rd=0.3629/0.06922 Re=0.4495/0.637 1 0.

100662742 0. Both RCom and Airtel have been able to raise their Debt at very competitive rates which has not been the case with Idea and that has contributed to a high Cost of Capital .017285972 0.190217758 0.0499031 2009-10 0. it has used internal sources of fund as against Airtel and Idea as both of them have diluted their equity to raise new capital.9% in the Financial Yr 200910.219682612 0. where RCOM is being competitive in bringing its Total Cost of Capital to around 12. Rcom has been bringing its Debt to Equity Ratio to more conventional numbers as any further introduction of Debt can raise issue of insolvency . . One important thing that must be observed that while keeping ist over all cost of capital at reasonal levels.123173651 From the above 4 tables we can interpret that though Rcom has a very high Cost of Equity but the overall CoC for Rcom is very reasonable and it can be inferred from the fact that Rcom has a good mix of Debt and Equity in their Capital Structure .090645278 0.3% as compared to Airtlel’s 19% and Idea’s 21. the same situation can be inferred for Idea as well but the cost of Raising Debt for Idea is on a higher side than that of RCOM.WACC From the Period 2007 till 2010 Company\Year Airtel Idea RCOM 2007-08 0.099326924 0. Also where RCOM has gained advantage is that for new projects and capex .075039805 2008-09 0.

672 2008-09 14.635.071.883.776. .34 -7.50094 113.7588 609.808 From the above two tables we can infer that Rcom has been able to put the advantage of raising Debt and its Tax shield to provide its share holders with an increasing Dividends over the period under study .2682 7773.97593 50.51 Table 6 Tax Shield Company\Year Airtel Idea RCOM 2007-08 34.Table 5 Free Cash Flows Company\Year Airtel Idea RCOM 2007-08 -700.06 -3.1414 2009-10 15.64 2008-09 13.24 -1.92427 119.19 -702.757.89 2.305.03162 347.135.24 4.32 2009-10 9.

C) Infrastructure Industry Infrastructure sector has been identified as the emerging sector in the economy where the progress has been very slow and the scope of growth is the way forward for the economy. road highways and airport infrastructure is growing and the Govt. The demand for basic infrastructure in the rail transportation . has undertaken various Mega Projects to build nation’s infrastructure on war footing and this policy provides a Golden opportunity for the Companies in the Infrastructure sphere to ride on and be the leaders in the industry The companies which we have considered for studying the Capital structure are GMR GVK Reliance Infrastructure Ltd. .

Table 1 Beta and Security Return Company\Year GMR 2007-08 beta/ Return 1.2256 -0.1679/0.2294 1.2894/0.015 .069 8 2008-09 1.305 4 0.0697/0.1190 Rd=0.15753 1.3982/0.0719 2009-10 1.2820 Rd=0.9598/0.109305 1.486 3 0.0566 2009-10 Re=0.6817/0.3295/0.0692 Rd=0 Re=0.0659 1.6808/0.315 7 Reliance Infra 1.0557 GVK 0.Profiling these companies brings out the fact that these are the few companies who have undertaken major public infrastructure projects .0275 GVK Re=0.25295 Market Return Table 2 Cost of Equity and Debt Company\Year GMR 2007-08 Re=0.0692 Rd=0.0529 2008-09 Re=0.1081 Rd=0 Re=0.0744/0.3030 Rd=0.

404/0.0427 Re=0.921 2 0/1 0.306/0.113691797 0.203467828 0.108113282 2008-09 0.0451 Table 3 Debt and Equity (By Weight) Company\Year GMR GVK Reliance Infra 2007-08(D/E) 0.039/0.3931/0.6939 0.3218 Rd=0.931 3 0/1 0.Reliance Infra Re=0.06922 2009-10 0.606 8 Table 4 WACC Company\Year GMR GVK 2007-08 0.312/0.0787/0.9609 0.0692 Rd=0.291616824 .0616 Re=0.0686/0.5959 2008-09 0.6879 2009-10 0.06810778 0.1295 Rd=0.

571. Raising Equity come at a high cost for the industry but the Debt can be raised at a very competitive cost and a good mix of Debt and Equity eventually brings down the overall Cost of Capital for the Companies.185. Table 5 Free Cash Flows Company\Year GMR GVK Reliance Infra 2007-08 -4.130.Reliance Infra 0.36 -275.74 -5. Debt forms a 40 % of the total capital at the present stage and that is adding to the projects viability .74 -2.84 -8.812. The reason for a high cost of equity in the industry can be attributed to the past performance of the industry and the regular delays in the implementation and execution of the proposed projects and bottlenecks that the industry faces in the form of regulations and restrictions.737. It is where both GMR and Relaince infra score in framing theri capital structure.63 -855. Also the debt can be collateralised again the property so it come as a much cheaper rates.64 475.077.210329321 The first 4 tables which give out the basic information about the Capital structure of the three companies in the Infrastructure sector and the inference can be made that the where GMR and Reliance Infra score over GVK is the substantial Debt component in their Capital structure.091441467 0.37 .062695822 0.08 2009-10 -2.60 2008-09 1.

On the other hand GVK has restrained itself from introducing any substantial debt into their Capital Structure .5004 Table 5 and 6 gives us insight into the free cash flow position of the companies and we can deduct from the balance sheet and ratio analysis of the 3 companies that Reliance Infra has actually bought back some shares signalling a positive trend for its future prospects and have raised new loans to meet the requirements and have passed on the benefit of the Tax Shield to the share holders by regularly declaring Dividends.53065 2008-09 1.5069 2009-10 1. .Table 6 Tax Shield Company\Year GMR GVK Reliance Infra 2007-08 1.467843 0. where as GMR has issues equity and borrowed funds for its future projects .123891 0.575014 43.123891 0.044436 66.4032 50. With no dividend policy as of now both GMR and GVK consider themselves as growth Firms and would like to reward its shareholders by maximizing their wealth in the long run rather than pass on any free cash until they have resources and projects for positive NPV projects.

.Conclusion By comparing the companies within their sector we can infer that there is no particular trend that I being followed by any particular industry when it comes to raising capital and deciding upon the Capital Structure. Companies within the industry also have their own unique policy to raise capital with no co relation to what the other counterpart is doing but the only reason to alter the capital structure is the cost of individual source of capital.

org/wiki/Capital_structure Corporate Finance Ross Westerfield Jaffe 7th edition Chapter 15 and 16. they will most likely to depend on internal sources of financing rather than going for Debt inclusion and that doesn’t mean that these companies are not competent .com/markets/ http://en.indiatimes. While mature companies who are able to meet their capex requirements from their internal sources have not resorted to much of debt into their capital structure and along with Positive Project executions have been following a regular dividend policy as in case of Maruti Suzuki and Hero Honda in the Auto industry. companies who require major capital expenditure and for other expenses resort to debt financing in order to bring down with Total Cost of capital. Bibliography http://economictimes.wikipedia. but in fact they are the market leaders of their respective industries like in case of Maruti Suzuki and Hero Honda. Finally concluding that though an optimum level of Debt will always help to bring the Cost of Capital for firms to set realistic targets but in case the companies are sure about their future cash flows . . It is the policy of some companies to make sure that along with their future project funding requirement they distribute some amount to their shareholders as dividends and don’t alter their existing dividend policy as in the case of Reliance ADA group companies operating in two different sectors namely RCOM in Telecom and Reliance Infra in Infrastructure industry.Equity being costly than Debt.