Transcript
8/19/2019 Ch 20 Designing Capital Structure
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Designing Capital
Structure
Presenter:
Prof. Isha Dave
N.R. Institute of Business Management
GLS Institute of Computer echnolog!"MB#
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# host of factors$ %oth &uantitative an' &ualitative$ inclu'ing
su%(ective (u'gment of )nancial managers$ have a %earing on
the 'etermination of an optional capital structure of a )rm.
he! are not onl! highl! comple* %ut also con+icting in nature
an'$ therefore$ cannot )t entirel! into a theoretical frame,or-.
Moreover$ the ,eights assigne' to various factors also var!
,i'el!$ accor'ing to con'itions in the econom!$ the in'ustr!
an' the compan! itself.
herefore$ a corporate shoul' attempt to evolve an
appropriate capital structure ,here cost of capital is minimum$
given the facts of a particular case.
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he -e! factors relevant to 'esigning an appropriate capital
structure are:
/ Pro)ta%ilit!
0/ Li&ui'it!
1/ Control
2/ Leverage ratios in in'ustr!3/ Nature of in'ustr!
4/ Consultation ,ith investment %an-s5len'ers
6/ Commercial strateg!
7/ iming
8/ Compan! characteristics
9/ a* planning
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/ arnings Before Interest an' a* ;BI/ < arnings per Share
;PS/ #nal!sis
=%(ective of )nancial management is to ma*imi>e the
sharehol'ers ,ealth$ a corporate shoul' carr! out pro)ta%ilit!
anal!sis in terms of 'etermining the amount of BI
;in'i?erence point/ at ,hich its PS 5 MPS is i'entical un'er t,o
propose' )nancial plans.
In general$ the higher the level of BI than the in'i?erence
point an' the lo,er the pro%a%ilit! of its 'o,n,ar' +uctuation$
the greater is the amount of 'e%t that can %e emplo!e' %! a
corporate.
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0/ Interest Coverage Ratio
Interest Coverage ratio ;BI5I/ can also %e use' to (u'ge the
a'e&uac! of BI to meet the )rm@s o%ligations to pa! )nancial
charges$ interest on loan.
# higher ratio implies that the )rm can go for larger
proportion of 'e%t in its capital structure.
he ratio measures the si>e of the interest pa!ments relative
to the BI.
he reciprocal of this Income gearing ratio ;I5BI/ measures
the proportion of BI 'evote' to interest pa!ments.
. Pro)ta%ilit
! #spect
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Cash Alo, #nal!sis
Li&ui'it! position of a )rm is anal!>e' %! cash +o, anal!sis.
=ne measure relates the ratio of )*e' )nancial charges to net
cash in+o,s. # )rm can a?or' higher 'e%t if the ratio is high.
#nother measure to 'etermine the a'e&uac! of cash +o,s to
meet the )*e' o%ligations is Cash %u'get.
# cash %u'get shoul' %e prepare' for a range of possi%le cash
in+o,s ,ith a pro%a%ilit! attache' to each of them.
he )rm can 'etermine the level of 'e%t it can emplo! an'
still remain ,ithin an insolvenc! limit tolera%le to the
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Len'ers have no 'irect voice in the management of a compan!.
he! ma!$ place certain restrictions in the loan agreement on the
management@s activities.
So long as there is no 'efault in the pa!ment of interest or the
repa!ment of the principal$ there is little that the! can 'o legall!
against the compan!.
he! have ver! little sa! in the polic!"'ecisions of the compan!
or in the selection of the %oar' of 'irectors.
Preference sharehol'ers 'o not have the right to vote for the
appointment of the %oar' of 'irectors.
1. Control
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o,ever$ if the compan! 'oes not pa! 'ivi'en's on
preference shares for a certain num%er of !ears ;0"!ear perio'
in In'ia/$ the! are given the right to atten' the meetings an'
participate in the voting.
In most of the cases$ the!$ li-e the cre'itors$ 'o not have an!
sa! in the selection of the management. he po,er to choose
the management in most cases rests ,ith the e&uit!"hol'ers.
#ccor'ingl!$ if the main o%(ect of the management is to
maintain control$ the! ,ill li-e to have a greater ,eightage for
'e%t an' preference shares in a''itional capital re&uirements$
1. Control
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Compare ,ith the 'e%t"e&uit! ratios of companies %elonging to the
same in'ustr!$ having a similar %usiness ris-.
In'ustr! stan'ar's provi'e a useful %enchmar-.
his 'oes not necessaril! impl! that the )rm@s capital structure
planning is inappropriate. It ma! ,ell %e possi%le that other )rms ma!
not %e using appropriate 'e%t"e&uit! ratios.
he! ma! %e more conservative or more aggressive ris-"ta-ers than
'esire'.
o,ever$ comparison is helpful as it acts as a re' signal to the
management that there ma! %e something ,rong ,ith the 'e%t"
e&uit! mi* of the compan!.
2. Leverage Ratios of =ther
Airms In he In'ustr!
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he nature of in'ustr! is one of the most important elements in
'etermining the 'egree of )nancial leverage a )rm can carr!
safel! ,ithout an! ris- of %an-ruptc!.
If an in'ustr!@s sales are su%(ect to ,i'e +uctuations$ over a
%usiness c!cle$ the )rm shoul' have a lo, 'egree of )nancial
leverage.
Such )rms ,ill alrea'! have a high operating leverage.
=n the other han'$ in'ustries 'ealing ,ith non"'ura%le consumer
goo's ;foo'/ or ,ith ine*pensive items ;paper clips$ match %o*es/
or ,ith items in ha%itual use ;cigarettes/ or all those pro'ucts
3. Nature of In'ustr!
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Such in'ustries can a?or' to have higher 'e%t proportions in
capital structure as in lean !ears the! 'o not run the ris- of %eing
una%le to meet their commitments.
It ma! %e inferre' that those in'ustries ,hich have -een
competition among themselves shoul' have a relativel! greater
proportion of e&uit! than 'e%t.
Aor e*ample$ in the garment in'ustr! much of the competition is
%ase' on st!le. he st!les %eing unpre'icta%le an' transitor! thepro)ts also +uctuate accor'ingl!.
#t the other e*treme$ there are pu%lic utilit! un'erta-ings
involve' in the pro'uction of electricit!$ gas$ ,ater$ transportation
services or telephone services$ ,hich are relativel! free fromintra"in'ustr com etition.
3. Nature of In'ustr!
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#nother useful approach is to see- the opinion of investment
anal!sts$ institutional investors$ investment %an-ers an'
len'ers. hese anal!sts$ having %een in %usiness for a consi'era%le
perio' of time$ ac&uire e*pertise an' have access to
information regar'ing securities of a large num%er of
companies an' -no, ho, the mar-et evaluates them.
he! are$ therefore$ in a %etter position to assess a particular
)nancial plan.
4. Consultation ith
Investment Ban-ers Len'ers
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Ale*i%ilit! refers to a )rm@s a%ilit! to a'(ust its sources of fun's
in either 'irection–increase or 'ecrease–in response to changes
in the nee' for fun's. hat is$ the )nance manager must -eep himself in a situation
,here he can change positions.
herefore$ ,hile 'esigning the capital structure$ he shoul' not
lose sight of the future impact on the present )nancial plan.
6. Maintaining Ale*i%ilit! Aor
Commercial Strateg!
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Are&uentl! ver! su%stantial savings ma! %e o%taine' %!
proper timing of securit! issues.
hus$ the timing of the pu%lic o?erings is also an important
consi'eration in capital structure 'ecisions of a )rm.
Pu%lic o?ering shoul' %e ma'e at a time ,hen the state of
the econom! as ,ell as the capital mar-et is i'eal to provi'e
the fun's.
he monetar! an' )scal policies that are pursue' %! the
government are also important in this regar'. The
government follows a cheap money policy to boost theeconom durin a recession and a dear mone olic durin
7. iming =f Issue
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igh 'e%entures !iel's are associate' ,ith relative scarcit!
of 'e%t mone! an' lo, P5 ratios on shares are an in'ication
of the relative scarcit! of e&uit! fun's.
Are&uentl!$ therefore$ the compan! has to 'eci'e ,hether
to )nance initiall! ,ith an e&uit! issue an' later ,ith a 'e%t
issue$ or vice-versa.
7. iming =f Issue
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he characteristics of a compan! in terms of si>e an' cre'it
stan'ing$ among others$ also pla! a vital role in 'etermining the
share of 'e%t an' e&uit! in its capital structure.
Airms en(o!ing a high cre'it stan'ing among investors5len'ers
in the capital mar-et are in a %etter position to get fun's from
the sources of their choice.
If the cre'it stan'ing is poor$ the )rm@s choice of o%taining
fun's is rather limite'.
8. Characteristics =f he Compan
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he choice of an appropriate 'e%t polic! involves a tra'e"o?
%et,een ta* %ene)ts an' the cost of )nancial 'istress.
Moreover$ the management shoul' consi'er the implicit cost ofthe ta* su%si'! in using 'e%t.
9. a* Planning
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C#PI#L SRECER PR#CICS IN
INDI#In'ian corporate emplo! su%stantial amount of 'e%t in their
capital structure in terms of the 'e%t"e&uit! ratio as ,ell as total'e%t to total assets ratio.
Nonetheless$ the foreign controlle' companies in In'ia use less
'e%t than the 'omestic companies. he 'epen'ence of the In'ian
corporate sector on 'e%t as a source of )nance has over the
!ears 'ecline' particularl! since the mi'"nineties.
he corporate enterprises in In'ia seem to prefer long"term
%orro,ings over short"term %orro,ings. =ver the !ears$ the!
seem to have su%stitute' short"term 'e%t for lon "term 'e%t. he
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#s a result of 'e%t"'ominate' capital structure$ the In'ian
corporates are e*pose' to a ver! high 'egree of total ris- as
re+ecte' in high 'egree of operating leverage an' )nancial
leverage an'$ conse&uentl!$ are su%(ect to a high cost of
)nancial 'istress ,hich inclu'es a %roa' spectrum of
pro%lems ranging from relativel! minor li&ui'it! shortages to
e*treme cases of %an-ruptc!. he foreign controlle'
companies$ ho,ever$ are e*pose' to lo,er overall ris- as ,ell
as )nancial ris-.
he 'e%t service capacit! of the a si>ea%le segment of the
corporate %orro,er as measure' %! ;i/ interest coverage ratio
C#PI#L SRECER PR#CICS ININDI#
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han- Fou
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