CAPITAL STRUCTURE

Dr. S. Hari Babu

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At the end of the session
You will be able to
Understand the concept of capital
structure.
Identify the pattern of capital
structure of companies.
Interpret the importance of
Capital structure decisions on
EPS.

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Concept of Capital structure
Composition of debt
and equity.
It refers to
permanent financing.

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 Self test Question
The firm's capital structure refers to:
a. the way a firm invests its assets.
b. the amount of capital in the firm.
c. the amount of dividends a firm pays.
d. the mix of debt and equity used to finance the firm's
assets.
e. how much cash the firm holds.

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Patterns of Capital structure
The capital structure of a company may consist of any of
the following forms.
Equity shares only
Equity and preference shares
Equity shares and debentures.
Equity shares, preference shares and debentures.
Equity shares, preference shares, reserves, debentures and
long term loans.

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Example
Bandhan Financial Services, the Bengal-
based microfinance institution (MFI), has
entered into a securitisation deal with Kotak Chandra Shekhar Ghosh,
Mahindra Bank, to sell a loan portfolio CMD, Bandhan Financial
worth Rs 500 crore. Services

Other Sources
International Financial Corporation Rs 1700 Crore Equity (11%
and Singapore's sovereign wealth Stake)
fund, GIC.
Financial Inclusion Trust North Eastern Financial
Inclusion Trust
Bandhan Employees Welfare Trust Small Industries Development
Bank of India
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 Self Test Questions
What are the sources of fund for Bandhan Bank?
What are the differences in sources of fund for Bandhan
Bank and Reliance Industries Ltd?
Being a new start up in the banking industry, is it possible
for Bandhan Bank to define optimum capital structure?

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Capital structure criteria
Structure that minimizes overall cost of financing.
WACC.
Structure that maximizes the value of firm.
Relevant Question: What is the effect of change
in the financing mix on firm value? Is there any
optimal capital structure?

8 Capital Structure Decisions 10/7/20 05:37:52 AM

Importance of capital structure
ABC company has currently an all equity capital
structure consisting of 15,000 equity shares of Rs 100
each. The management is planning to raise another Rs 25
lakhs to finance a major programme of expansion and is
considering three alternative methods of financing.
To issue 25,000 equity shares of Rs 100 each.
To issue 25,000, 8% debentures of Rs 100 each.
To issue 25,000, 8% preference shares of Rs 100 each.
The company’s expected earnings before interest and taxes will be
Rs 8 lakhs. Assuming a corporate tax rate of 50 per cent,
determine the Earnings Per share in each alternative and Which
alternative is best and why?
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 Self test Question
A general rule for managers to follow is to set the firm's
capital structure such that:
a. the firm's value is minimized.
b. the firm's value is maximized.
c. the firm's bondholders are made well off.
d. the firms suppliers of raw materials are satisfied.
e. the firms dividend payout is maximized.

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Learning Objectives of the session
At the end of the session, you would be able to
Analyze the factors that should be considered while
designing an optimal capital structure.

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DESIGNING TARGET/OPTIMAL CAPITAL
STRUCTURE
The objective of designing an optimum capital structure is to
maximize the wealth of shareholders.
Factors that should be considered while designing the capital
structure of a company.
Size of the firm. (Positive Relation)
Growth in sales.
Profitability (EBIT- EPS Analysis)
Business Risk. (Negative Relation)
Debt Service Capacity.
Operating Leverage.
Stability in cash flows.
Nature of Industry.
Asset Structure.
Lenders attitude.
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Profitability (EBIT- EPS Analysis)
What is the objective of optimum capital structure?
How the profitability can be enhanced (only in financial
terms)
Trading on Equity.
Conditions apply while using EBIT- EPS analysis:
Financial leverage (If ROI > Fixed cost of funds, the
company should prefer to raise the fixed cost of funds.)
Financial Risk (Avoid undue financial risk attached
with the use of increased debt financing).
Avoid Financial Distress

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Self Test
What conditions that must satisfy while applying
EBIT- EPS analysis?

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Control
Balance between Debt and Equity.
Kinds of Debt that affect control
Convertible debentures
Convertible preference shares.
Strategic considerations to be taken
During Hostile take over bids.
Mergers and Acquisitions
The legal environment in India prescribes two share holding
patterns : 26% and 51%

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Self - test
What are the causes that influence the share holding
pattern during mergers and acquisitions?

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Flexibility and Investment Policy
Investments are opportunities or challenges?
What influence the investment environments?
Ability to expand
Change its debt and equity according to the requirements.
Whether debt or equity is accessible to raise during
volatile investment environment?

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Risk
Financial Risk
Business Risk
Greater the fixed costs of a firm, ________ the risk of
business.
If debt is high, ___________________ will be high.
Value of firm = Value of Debt + Value of Equity.
If 100% equity, Value of firm =
If 50 % equity, Value of Firm =

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Financial Distress
When a firm finds it difficult to honor its commitments to
its debtors, it is called financial distress.
What are the affects of financial distress on the
organization?
Relationship between liquidity and financial distress.
Indicator to find financial distress:
Interest coverage Ratio

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Self Test
How the risk factors influence the financial distress of
a company?

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Liquidity (Cash flow analysis)
What is cash flow analysis?
How the cash flows are analyzed?
Why the cash flows analysis is required?
Projects the issue of liquidity.
Able to determine the debt capacity of a firm and avoid
financial distress.

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Nature of Industry
Industry with high volatility in sales.
Industry which are conservative.
Industry with long credit cycles.
Life cycle of the industry.

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Tax Planning
Tax on Borrowings.
Tax on Dividends. (Since April 2003, dividends are
subject to an excess of 10% under section 115)

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Theories of Capital structure
Net Income Approach
Net Operating Income Approach
Traditional Approach
Modigliani- Miller Approach.

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Assumptions of Capital Structure theories
There are only two kinds of funds- Debt and Equity
There are no corporate taxes.
D/P ratio is 100%.
Firms assets do not change as investments are constant.
Firms financing is constant.
EBIT is given and it is not expected to grow.
All investors have same expectation.
Business risk is constant.
Firm has perpetual life.

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NI Approach
• The capital structure decision of a firm is relevant to the
valuation of the firm.
 According to this approach, a firm can minimize the weighted
average cost of capital and increase the value of the firm as well
as market price of equity shares by using debt financing to
maximum possible extent.
 Assumptions
Cost of debt is less than cost of equity
There are no taxes.
The risk perception of investors is not changed by use of debt.
A change in the financial leverage will lead to a corresponding
change in the overall cost of capital as well as the total value of
the firm.
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NI Approach
 The total market value of a firm on the basis of Net Income
Approach is
V=S+D
V = Total market value of a firm
S = Market value of equity shares
Earnings available to equity share holders
_______________________________________
Equity capitalisation rate
D = Market value of debt

And overall Cost of capital or Weighted average cost of capital

= Ko = EBIT / V

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Format for calculating value of the firm on the basis of
NI approach.

Net operating income (EBIT) XXX

Less: interest on debenture XXX
Earnings available to equity holder XXX
(NI)
Equity capitalization rate (Ke) XXX
Market value of equity (S) XXX
Market value of debt (D) XXX
Total value of the firm (S+B) XXX
Overall cost of capital = Ko = XXX
EBIT/V(%)

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Example
Earnings before Interest 100000
Tax (EBIT)
Bonds (Debt part) 300000
Cost of Bonds issued 10%
(Debt)
Cost of Equity 14%
Calculate the value of Firm and Overall cost of Capital.
Determine the value of firm if the debt increased from Rs
300000 to Rs 400000, every thing else remain same.

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NI Approach: Numerical
a) A company expects a net income of Rs 80,000. It has Rs
2,00,000, 8% Debentures. The equity capitalization rate of the
company is 10%. Calculate the value of the firm and overall cost
of capitalisation rate according to Net Income Approach.
(Ignoring income tax).
b) If the debenture debt is increased to Rs 3,00,000, what shall
be the value of the firm and overall capitalisation rate.
c) If the debenture debt is reduced to Rs 2,00,000, what shall be
the value of the firm and overall capitalization rate.

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NI Approach
X Ltd is expecting an annual EBIT of Rs 1 lakh. The
company has Rs 4 lakhs in 10% debentures. The cost
of equity capital or capitalization rate is 12.5%.
Calculate the total value of the firm according to NI
approach.

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Net Operating Income Approach
 It is diagrammatically opposite to NI approach.
According to the theory, change in capital structure does
not affect the market value of firm and WACC remains
constant irrespective of mode of financing.
It means there is nothing as an optimum capital structure
and every capital structure is the optimum capital structure
Assumptions:
The market capitalizes the value of the firm
The business risk remains constant at every level of debt and
equity mix
There are no corporate taxes.

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 Net Operating Income Approach
 The increased use of debt increases financial risk of the equity
share holders and hence the cost of equity increases.
 On the other hand, the cost of debt remains constant with the
increasing proportion of debt as the financial risk of the lenders is
not affected.
 The Value of the firm on the basis of Net Operating Income
Approach can be determined as
V = EBIT/Ko
The market value of equity, according to this approach is the
residual value which is determined by deducting the market
value of debentures from the market value of the firm.
S=V-D

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Formula to calculate Value of Firm using
NOI Approach
EBIT XXXXX
Overall capitalization Rate XXXXX
Market Value of firm (V= EBIT/K0) XXXXX
Total Value of Debt XXXXX
Market Value of equity(E= V-D) XXXXX
Equity Capitalisation Rate = Ke XXXXX
= Earnings available for equity share
holders/total market value of equity shares

Ke= (EBIT- Interest)/V- D

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Net Operating Income Approach

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Numerical
a) A company expects a net operating income of Rs 1,00,000. It
has Rs 5,00,000, 6% debentures. The overall capitalization
rate is 10%. Calculate the value of the firm and the equity
capitalization rate according to NOI approach.
b) If the debenture debt is increased to Rs 7,50,000, what will
be the effect on the value of the firm and equity
capitalization rate.

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A firm has an EBIT of Rs. 2, 00,000 and belongs to a
risk class of 10%. What is the value of equity capital if
it employees 6% debt to the extent of 30%, 40%, 50%
of the total capital fund of Rs. 10, 00,000.

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Problem
A company expects a net operating income of Rs
1,00,000. It has Rs 5,00,000 , 6% debentures. The
overall cost of capitalization rate is 10%. Calculate
the value of firm and equity capitalization rate
according to the NOI approach.

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Traditional Approach
 It is also called Intermediate approach.
 It is a compromise between NI and NOI approach.
 Value of the firm initially increases or overall cost of
capital reduces with more cheaper debt and equity.
 Optimal capital structure is reached by a proper D/E mix.
 Beyond a point, cost of equity increases because increase in
Kd lead to a financial risk for equity share holders.
 The advantage of financial leverage is offset.

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 Compute the market value of the firm, value of shares and average cost of
capital from the following information
Net operating income = Rs 2,00,000
Total Investment = Rs 10,00,000
Equity Capitalization rate
If firm uses no Debt = 10%
If firm uses Rs.4,00,000 Debentures = 11%
If firm uses Rs. 6,00,000 Debentures = 13%
Assume that Rs.4, 00,000 debentures can be raised at 5% rate of interest
whereas Rs. 6, 00,000 Debentures can be raised at 6% rate of interest.

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Formula to find Value of firm and Overall
cost of capital
Unlevered Firm Levered Firm Levered Firm
(with debt)- with increased
existing or decreased
debt
NOI ie EBIT
Total cost of debt
Net Income
Cost of Equity Ke
Market value of Share=E=
Net Income/Ke
Market Value of Debt
Total Value of Firm = V= E+
D
Average cost of capital=
Ko=EBIT/V

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Modigliani- Miller Approach
MM hypothesis is identical with the NOI approach, if
taxes are ignored. When corporate taxes are assumed
to exist, their hypothesis is similar to the NI approach.
Assumptions
 There are no corporate taxes.
 There is a perfect market.
 Investors act rationally.
 The expected earnings of all the firms have identical risk characteristics.
 The cut-off point of investment in a firm is capitalization rate.
 Risk to investors depends upon the random fluctuations of expected
earnings.
 All earnings are distributed to the shareholders.

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 Modigliani- Miller Approach
 MM Hypothesis (in the absence of taxes): Theory of irrelevance
 The cost of capital is not affected by the changes in capital structure.
 Debt-equity mix is irrelevant in the determination of total value of the firm.
 With the increased use of debt, the cost of equity increases which off-sets the
advantage of low cost of debt.
 Although financial leverage affects the cost of equity, the overall cost of capital
remains constant.
 The theory emphasizes that a firm’s operating income is a determinant of its
total value.
 The theory further propounds that beyond a certain limit of debt, the cost of debt
increases, but cost of equity falls thereby again balancing the two costs.
Firms total market value = EBIT/Ke
Firms Market value of equity = S= V-D
Firms leverage cost of equity = Cost of equity + (Cost of equity – Cost of Debt)

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Modigliani- Miller Approach
 MM Hypothesis (When Corporate taxes are assumed):
Theory of relevance
 The value of the firm will increase or the cost of the capital
will decrease with the use of debt on account of deductibility
of interest charge for tax purpose.
 The optimum capital structure can be achieved by maximizing
the debt mix in the equity of a firm.
Value of unlevered firm (Vu) = EBIT (1-t)/Ko
Value of levered firm = VL = Vu + tD
tD = discounted present value of the tax savings resulting from
the tax deductability of interest charges.
t = tax rate
D = Quantum of debt.
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Essential features of a sound/optimal capital mix
 Maximum possible use of leverage
 It should be flexible.
 Avoid undue financial/business risk.
 Use of debt should be within the capacity.
 It should involve minimum possible risk of loss of control.
 It must avoid undue restrictions in agreement of debt.
 It is easy to understand.
 It should minimize the cost of financing and maximise EPS.

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