Corporate Finance

Project Report
On

Capital Structure Trends

Group Details

Nikhil Kumar Pathak 21BM63024

Shubham Maniklal Divate 21BM63028
Mohit S 21BM63040
Bala Sai Tarun Chinnamuthavi 21BM63130

Companies under consideration

Bharti Airtel
ITI Ltd.
Vodafone Idea Ltd.
Hero MotoCorp Ltd.
Mahindra and Mahindra Ltd.
Maruti Suzuki India Ltd.
Adani Green Energy Ltd.
JSW Energy Ltd.
Power Grid Corp. of India Ltd.
Tata Power Co. Ltd.
Index
1. Introduction
2. Literature review
3. Data sources
4. Analysis
A. Analysis of capital structure of firms
B. Factors affecting capital structure of firms
C. Optimal capital structure
5. Results
6. Conclusion
7. References
Introduction:
What is Capital Structure?
A company's use of debt and equity to fund operations and purchase assets is referred to as capital
structure. A company's capital structure can help us understand its current financial health, risk
profile, and suitability for certain investments or acquisitions. Understanding the dynamics and
interplay between debt and equity and their roles in different companies' capital structures is an
essential component of any investor's toolset for assessing the feasibility of a potential investment
or target and its growth potential.

What ratios are used to understand capital structure?

Analysts typically use three ratios to evaluate the capitalization structure of a company.

• Debt Ratio (total debt to total assets): More liabilities equal less equity in the debt ratio,
indicating a more leveraged situation. The difficulty with this metric is that it has an overly
broad reach and assigns operational and debt responsibilities equal weight.

• Debt-to-Equity (D/E) ratio (total debt to total shareholders' equity): The debt-to-equity ratio
faces the same problem. Current and non-current operational liabilities, particularly the
latter, indicate long-term commitments to the company. In addition, unlike debt,
operational liabilities do not have set principal or interest payments.

• Capitalization Ratio (long-term debt divided by (long-term debt + shareholders' equity)): The
capitalization ratio, on the other hand, compares the debt component of a company's
capital structure to the equity component, giving a more accurate picture. A low value
expressed as a percentage implies a solid equity cushion, always preferable to a high debt-
to-equity ratio.
A debt ratio and D/E ratio are two widespread measurements because of their ease of calculation.

When it comes to financial analysis, why does the source of funding matter?
It's critical to understand a company's funding sources because different debt or equity sources will
have varied effects on the cost of capital, influencing enterprise value. The types of debt a firm has
and the interest rates associated with that debt will affect the price a potential acquirer is willing to
pay and signal potential dangers associated with investing in or acquiring that company. As a result,
it's critical to examine capital structure data to determine if a company's capital structure is more
skewed toward debt or equity and to identify those that best meet the optimal capital structure of
various investing styles or financial services.
Literature review:
Bader Eid Aljamaan. "Capital structure: definitions, determinants, theories and link with
performance literature review" European Journal of Accounting, Auditing and Finance Research
Vol.6, No.2, pp.49-72, February 2018
The notion of capital structure and its theories and links to company performance will be discussed
in this paper. Since the Modigliani and Miller theory (MM) (1958), the relationship between capital
structure and a firm's value and performance has been a puzzle in corporate finance and
accounting literature. They argue that under the perfect capital market condition, which assumes
that the firm's value is independent of capital structure if there are no bankruptcy costs and capital
markets are frictionless if there are no taxes. If there is no asymmetric information, the firm's value
is independent of capital structure. According to MM theory, the only factor determining a firm's
value is its future earnings potential (anticipated cash flow). Hence the capital structure decision is
meaningless. Several theories have been created after that to describe a firm's capital structure,
including the Pecking Order Theory, Trade-off Theory, and Agency Cost Theory.
Anshu Handoo and Kapil Sharma. "A study on determinants of capital structure in India." IIMB
Management Review (2014), http://dx.doi.org/10.1016/j.iimb.2014.07.009
The report analyses the most critical factors of capital structure for 870 listed Indian corporations,
including both private and government firms from the period 2001 to 2010. Regression analysis was
used to assess ten independent variables and three dependent variables. Profitability, growth, asset
tangibility, size, cost of debt, tax rate, and debt serving capability have all substantially impacted
the leverage structure selected by Indian businesses.
Arulvel K. and Ajanthan A. "Capital structure and financial performance." South Asian Academic
Research Journals, Volume 3, Issue 6 (June, 2013) ISSN 2249-7137
A company's capital structure is a critical decision. It is critical not only from the standpoint of profit
maximization but also because this decision significantly impacts a company's capacity to compete
successfully. The ability of organizations to meet the needs of their stakeholders is inextricably
linked to their financial structure. As a result, this derivation is a crucial point that we must not
overlook. In financial terms, capital structure refers to how a company finances its assets through a
combination of stock, debt, and hybrid securities (Saad, 2010). From the period 2007 to 2011, this
study examines the relationship between capital structure and financial performance of trading
companies registered on the CSE (Colombo Stock Exchange). All financial performance measures
[Gross Profit (GP); Net Profit (NP); Return on Equity (ROE); and Earnings Per Share (EPS)] are
inversely connected with debt ratio, according to the research. Similarly, all financial performance
metrics except GP are inversely correlated with the debt-equity ratio (D/E), and only (D/E) ratio has
a meaningful association with NP. The debt/equity and debt ratios explain 36.6%, 91.6%, 36%, and
11.2% of the observed variability in financial performance, respectively, according to R2
(Regression) values.

Data Sources: ProwessIQ

Analysis:
A. Analysis of capital structure of firms

1. Adani Green Power

Adani Green Power was founded in 2015. The data above shows that the beta value is higher than
"1", which means that the returns were high and the risk is high compared to industry standards.
The company's ICR is increasing over the years, which means that the company has more borrowed
fund securities. The power sector is a highly capital-intensive industry; hence, most power sector
industries have a D/E ratio of more than 1-2. DSCR refers to the ability of the company to repay its
debt. Since the DSCR is very low here, the company should avoid any more debts. Since the debt is
very high, the company hardly pays any tax, and also green energy sector gets subsidized tax rates.
The EPS of the company is good. The EV/PBDITA value of a company in 2020 was very high and
reached 570.14, which means the company has an excellent valuation; typically, EV/PBDITA value
of 10 is considered to be healthy.
 2. JSW Energy

JSW Energy was founded in 1994 and was listed on BSE at 2010. The beta value of JSW Energy is
very high, reaching up to 2.04 in 2016; investing in JSW would be riskier, but it has had good
returns. Due to covid, we can see a sharp decline in EPS; however, soon, it recovered as an
aftereffect. The company holds less debt; hence its debt-to-equity ratio is also low. Since this
company is also capital intensive, its DSCR is usually below "1"; however, JSW has maintained a
DSCR value and is capable of paying out all of its outstanding debts quickly. The EV/PBDITA value
of a company in 2021 was very high and reached 47.39, which means the company has an excellent
valuation. Since tax to income ratio is high, companies can get more debt.
 3. Power Grid

Power Grid Corporation of India was 1989 and was listed in BSE in 2007. The company's beta value
is consistently below 1, which indicates that a stock's price is less volatile than the overall market.
The company's debt-to-equity ratio is also above "2", which is also concerning since it has high
debt. However, the company's DSCR value is mostly above "1", which indicates the ability of a
company to repay its debt. Also, the power grid's total taxes to income ratio are very high; hence it
can borrow more money. The power grid's EV/PBDITA value is very low; typically, values above
ten are considered healthy, but recently after 2016, its EV/ PBDITA value is consistently decreasing
while competitors from private players have been increasing. This shows that the company's
overall valuation within the segment is falling.
 4. Tata Power

Tata Power was founded in 1911. The beta value of Tata power from 2015 to 2021 has consistently
been above "1", which indicates that a stock's price is more volatile than the overall market and
riskier. The D/E ratio is almost 1, which means that both creditors and shareholders contribute
equally to the business's assets and, according to the industry standard, they can take more debt.
The DSCR is also acting exactly ideal when compared with the D/E ratio. Typically, DSCR is inversely
proportional to D/E, and here, DSCR is low, which indicates the ability of a company to repay its
debt is tough. The EV/PBDITA is not as high as Adani green and JSW Energy but is also not as low as
Power Grid, and it has a healthy EV/PBDITA ratio.
 5. Bharti Airtel

Bharti Airtel was founded in 1995 and was listed in 2002. The company's beta value is around 0.8
from 2015 to 2021; however, through the debt-to-equity ratio, it is visible that the company's debt
is constantly increasing. The debt service coverage ratio (DSCR) is almost 1.2 on average, which
shows that the company is capable of paying back its debt quickly and is also eligible to take more
debt. After the launch of Jio, this sector was disrupted entirely, and its impact is visible throughout
the variables. EV/ PBDITA value fell to as low as 3.96 in 2015. However, Airtel made a comeback,
and it has a good hold on the market as of last year. Similarly, the total return went negative and
debt increased 400 times due to such tough competition. ICR (Interest coverage ratio) kept falling
due to huge loans taken by the company during the tenure.
 6. ITI Ltd

ITI Ltd is a government-owned company founded in 1948. The beta value is above "1.6"
throughout the tenure, showing that the shares are highly volatile and riskier. Its debt-to-equity
ratio is less than "1" which means that its debt is too low. However, their DSCR is also significantly
less and almost tending towards "0", which is alarming, and they need to work towards improvising
it immediately. Since the beta value is so volatile, its effect is seen both in EPS and total returns,
where the returns have been negative. The EV/ PBIDTA value is slightly increasing, which shows
that its market valuation is holding a good grip. This is primarily because of the external factors like
recent announcements in Govt. the budget, the Make in India movement, etc.
 7. Vodafone Idea

(The values from 2015-2018 are of "Idea" and then it's "Vodafone idea")

Vodafone and idea were merged in 2018 and were listed in the same year. Previously they were
two different companies having a perfect hold on the market. However, as Jio entered the market,
it disrupted all the players and Vodafone and Idea had to join hands to compete in the space.
The beta value during 2015 had reached very low; however, it has been slowly recovering during
this period. And during the merger, it had to burn more cash, due to which the debt-to-equity
ratio skyrocketed to as great as "15.8", while its low DSCR ratio shows that the company will face
difficulty in repaying its debt. Due to such a high D/E ratio, it impacted all other variables and its
valuation in the market which is calculated using the EV/ PBDITA ratio, also became "0". Again,
due to high debt company faces a high-interest amount to be paid and hence significantly less tax
is paid and is almost "0". Its earnings per share (EPS) is also negative since 2017.
 8. Hero MotoCorp

Hero MotoCorp Ltd was founded in 1985. The company's beta value is in and around "1" and
fluctuating, which shows that the share price of this company mostly follows the BSE index itself.
Moreover, Hero MotoCorp is an almost debt-free company due to which its debt-to-equity ratio is
mostly "0"; hence its DSCR is very high, and it can pay all of its debts in significantly less time. The
EV/ PBDITA ratio shows that the company is a healthy player in the industry. Its total taxes to total
income ratio is high again since interest on debt of the company is very low. A company can take
more debt to have an efficient capital structure. Its total returns are volatile since it fluctuates
between profits and losses. The EPS is also very high, which is beneficial for the investors.
 9. Mahindra & Mahindra

Mahindra and Mahindra was founded in 1945. The company's beta value is highly volatile, with a
recent value of "1.39", and this was also due to covid 19, which raised the overall sales of the
complete industry. Mahindra and Mahindra do have little debt; however, it's very low compared
to the industry standards due to which its DSCR is also high, which means it is easy for the
company to repay its debt. The EPS and Total returns are primarily positive, which is a good note
for investors. The total tax to income ratio is also maintained at 2.5, which is equivalent to
industry standards. The EV/ PBDITA is considered a healthy value since, according to industry
standards, "10" is a healthy value, and Mahindra is always in and around "10".
 10.Maruti Suzuki

Maruti Suzuki was founded in 1981 and was listed in 2003. The company's beta value is in and
around "1" and fluctuating, which shows that the share price of this company mostly follows the
BSE index itself. Moreover, Maruti is an almost debt-free company due to which its debt-to-equity
ratio is mostly "0"; hence its DSCR is high, and it can pay all of its debts in significantly less time.
The EV/ PBDITA ratio shows that the company is a good player in the industry and its valuation is
pretty high. Its total taxes to total income ratio are high again since interest on debt of the
company is very low. A company can take more debt to have an efficient capital structure. Its
total returns are volatile since it fluctuates between profits and losses. The EPS is also very high,
which is beneficial for the investors
 B. Factors affecting capital structure of firms
Following are the main factors which affect the capital structure decision:

External Internal
factors factors

Inflation ICR & DSCR

Corporate taxes Cash flow

Sales growth,
Government policies profitability and
stability

Cost of capital Nature of business

• External factors

▪ Cost of capital:
Every dollar invested in a business is a cost. As a result, a company must be able to repay the
money borrowed from suppliers. The cost of equity is a rate of return offered to equity
holders, and it is directly related to the level of risk they are willing to take. On the other
hand, the cost of debt refers to the interest paid on debts.
To be considered optimal, a capital structure must repay the cost of capital to its
stakeholders. A capital structure should utilize low-cost resources to fund assets, operations,
and future expansion.

▪ Government policies:
The laws and structures under which corporations' function are created by governments. The
government will update these regulations and frameworks from time to time, causing firms to
change how they operate. For example, government regulatory authorities such as the RBI
and SEBI publish regulations on the issue of debentures, shares, dividend payments, mergers
and acquisitions, and interest rates regularly. As a result, financial managers should examine
these policies when deciding on capital structure.

▪ Corporate taxes:
Changes in tax incentives considerably impact capital structure, with reduced taxes resulting
in increasing equity and lower long-term debt levels. Smaller, more lucrative businesses are
more likely to reduce their debt levels; therefore, lowering taxes reduces the incentive to
maintain debt due to lower interest rates and tax deductibility.
 ▪ Inflation:
Inflation is a significant element to consider. A company's raw material, electricity or power
usage, transportation, equipment, and machinery costs all climb due to a sudden increase in
goods and services. A slight rise in the cost of such items might negatively influence a
company's budget and output level as a result, it's clear that a company must build an optimal
capital structure to account for inflation risk.

• Internal factors

▪ Nature of business:
The type of a company's operation directly impacts its capital requirements; for example,
manufacturing businesses demand significant investments in plants, machinery, and
warehouses, among other things. On the other hand, trading companies require a smaller
investment in such assets. These assets will continue to provide revenue and profits for a long
time. Furthermore, funds that have been invested in fixed assets cannot be withdrawn and
used for other purposes.

▪ Sales growth, profitability and stability:

A company's goodwill supports a smooth business operation if it earns well in the market, has
a customer base, and continually demands its products and services. On the other hand, low
sales and growth can lead to a situation in which there is more danger and debt. The
company's debt and interest repayments are made possible through sales and development.
As a result, it's critical for deciding on capital structure.

▪ Cash flow:
The ability to create cash flow is critical to achieving the best structure. A corporation can
build a lower debt or preferential capital structure by conserving cash flow and forecasting
future requirements and shortages. As a result, cash flow predictability and variability are
important determinants of capital structure.

▪ ICR & DSCR:

Interest Coverage Ratio (ICR) is the percentage of time that a company's profits before
interest and taxes (EBIT) cover its interest payment obligation. Companies with a high ICR can
have more borrowed fund securities, whereas those with low ICR can have less.
Debt Service Coverage Ratio (DSCR) is one step ahead of ICR in that ICR only considers the
responsibility to repay interest on the debt. In contrast, DSCR considers both interest and
principal repayment. If the DSCR is high, the company can use more debt in its capital
structure because a high DSCR indicates its ability to repay its debt; nevertheless, if the DSCR
is low, the company must avoid debt and rely solely on equity capital.
 C. Optimal capital structure
What is optimal capital structure?
The optimum capital structure is the mix of equity
and debt that a business uses to increase wealth
and market value while lowering costs of capital. As
a result, it is calibrated to strike a balance between
the company's value and its cost. A corporation
might have an all-equity capital structure or a debt-
free capital structure.

When deciding on a capital structure, a company's goal is to find the lowest weighted average cost
of capital. The WACC is the weighted average of the company's debt and equity costs. A firm is not
obligated to take on any debt.
WACC = [D (Kd)/ (D+E)] + [D (Ke) x (1 - t)/ (D + E)]

where, D = Total debt E = Total equity Kd = Cost of debt Ke = Cost of equity t = Tax rate

It also relies on the company's industry, as typical capital structures differ depending on the
industry and whether the company is private or public. As a result, there is no one-size-fits-all
formula for determining an optimal capital structure; it is determined on a case-by-case basis.
Consequently, it must be computed separately for each organization, taking into account all of
the parameters mentioned in the previous section.

Key Points in Designing an Optimal Capital Structure

1. Ensure that the company's wealth is maximized; the net worth, wealth, and market value of a
company will all be maximized if the capital structure is ideal. The present value of future cash
flows is used to calculate the company's wealth. The WACC dismisses this claim.
2. Reduce capital costs as much as possible; the smaller the capital cost, the lower the danger of
bankruptcy. Companies in industries with unpredictable future cash flows should keep their finance
costs as low as possible—the larger the present value of future cash flows, the lower the cost of
capital.
3. Structure simplicity, it should be straightforward to structure and comprehend. A complex
capital structure adds to the confusion.
4. Remain in control; the rights and control of the owners are preserved in an optimal capital
structure. It's also flexible, allowing for future borrowing when needed without sacrificing control.
Conclusion:
To run the business successfully, it needs to have the best capital structure possible. It means
getting to a position where the two main types of finance, debt and equity, complement each
other.
Numerous things have an impact on a company's finances and cash flow. The sources of capital
have a significant effect on the firm's value. Thus, they're important to consider. Because debt is
the least expensive source of capital, it is simple for a corporation to take on debt to keep
production continuing. The cost of debt (interest) is a tax-deductible item that's also relatively
low-risk.
On the other hand, excessive borrowing raises a company's risk of insolvency and undermines its
capacity to pay dividends. Even if the company loses money, it still has to pay interest on its
obligations. As a result, the earnings available for dividend distribution is reduced. It exposes stock
shareholders to more significant risks. In this case, shareholders must be compensated for the
increased risk. As a result, the cost of equity increases, undermining the advantages of low-priced
financing.
On the one hand, it is advantageous for a corporation to acquire debt rather than equity, which is
more expensive. On the other side, a corporation must constantly search for low-cost resources
and excellent financial planning and execution to avoid taking on too much debt. As a result, the
company devises the best capital structure possible to outperform it.
Lowering the weighted average cost of capital is one of the most practical and recognized
techniques for constructing the optimal capital structure. The average cost of getting equity and
debt financing for a company is the WACC. So, if a company can reduce its WACC or raise capital by
paying a smaller dividend and paying a lower interest rate on debt, it can maximize its value. As a
result, a company's goal should be to find the best balance of debt and equity to obtain the lowest
cost of capital.
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