Capital structure b.v.raghunandan

Capital Structure-B.V.Raghunandan

Post-Graduate Department of Commerce,

Government First Grade College, Hebri

April 6, 2014

Capital Structure

• It is the mixture or combination of debt and equity used by a corporate in financing its long-term operations

• As debt and equity have different cost of servicing, the composition has an effect on the profitability and ultimately on the valuation of a corporate

Leverage

• Leverage: Having debt in the capital structure of a company

• In 1950s and 60s, it was considered to be a magical act through comparison of leveraged company and a non-leveraged company

• Effect was considered for profitable companies and non-profitable companies were ignored

Theories of Capital Structure

• Theories of capital structure dealt with the presence of debt in the long-term capital structure of a firm and its impact on cost of capital, profitability and valuation of the firm wit the objective determining the optimum capital structure

• Theories are:

1) Net Income Approach-David Duran

2) Net Operating Income Approach-David Duran

3) Traditional Approach-Ezra Solomon

4) Modigliani-Miller Theories

I Net Income Approach

• Propounded by David Durand in 1952

• The presence of debt and its increase reduces the weighted average cost of capital of the firm as cost of debt is less than cost of equity

• Thus, an increase in debt component of the capital structure leads to better valuation of the firm

• There is a direct relation between degree of financial leverage and the valuation of the firm

II Net Operating Income Approach

• Also propounded by David Durand

• Directly opposite to Net Income Approach

• Increase in debt increases debt-equity ration forcing the lenders to charge a higher rate of interest

• Thus, cost of debt will be equal to cost of debt which is equal to weighted average cost of capital

• Thus, change in financial leverage does not change the cost of capital or valuation of the firm

• Known as Irrelevance Theory

III Traditional Approach

• Asserted by Ezra Solomon

• Resolves the contradiction between NI and NOI

• Upto a certain level, increase in debt will increase the benefit of financial leverage leading to weighted average cost of capital and higher valuation of the firm

• After that, a higher debt-equity ratio will result in a higher rates of interest neutralising the benefit of leverage

Prof. Ezra Solomon

Franco Modigliani

• Italian Economist

• Naturalised American

• Professor at Graduate School of Industrial Administration of Carnegie Mellon University in 1958

• Joined Merton Miller in advocating Modigliani-Miller Theorem on Corporate Finance

Merton Miller

• Graduate from Harvard School

• Joined as Asst.Professor at London School of Economics

• A ground-breaking work called,”MertonMiller on Derivatives”

• Nobel Laureate

IV Modigliani-Miller Theory

• they compiled a paper on ‘The Cost of Capital, Corporate Finance and the Theory of Investment’,

• They based their theory on NOI Approach

• They objected to the traditional view of finding an optimal capital structure

• The weighted cost of capital does not change with increase in debt

• Hence, no change in leverage or valuation of firm

Rationale for Acceptance

• High corporate taxes caused reduced tax incidence as interest on debt was a business expense

• Promoters’ Control was not diluted as debt did not carry voting rights

• Equity form of finance like venture capital emerged later

• The concept of risk management also emerged later

Reality Check

• During a long gestation period of heavy industries and infrastructure projects, it becomes toxic

• For the industry having a huge capital cost and huge running expenses like civil aviation, it is devastating

• When unexpected risks exist, the tables will turn very quickly

• Prolonged trade cycles like mining and metal industries

Warning

• Sharia held debt to be a sin• Shakespeare maintained, "never a lender nor a borrower be”

and also depicted the cruelest aspect through the character of Shylock in Merchant of Venice

• Financial Management considered both equity and debt to be the components of capital structure

• Never considered the repayment programme, cautions, warning signals etc as an important exercise

A Carefree World

• Corporates did not learn the lesson leading to the development of art and science of bankruptcy

• Individuals and families were encouraged to overborrow like housing finance, consumer finance, finance for hospital bills, student loans

• Questionable methods employed for recovery including foreclosure

• Credit card booms• Empty houses and homeless

population

Revival of Equity Culture

• A more mature and developed primary market and stock market• Reduced corporate tax rates• Emergence of venture capital and private equity fund• Contribution of HNI and Angel Investors• A Systematic Risk Management and Popularity of debt-free capital structure• Basel Norms for Banks

Rationale for Equity Shares• No need to pay dividend in the absence

of profit• Even in the presence of profit, a growth

oriented company does not declare dividend

• No need to pay dividend during gestation period

• Large body of investors to share the losses

• Equity shares are the cheapest source of finance

• Shareholder Loyalty for other projects and group companies

• Huge funds can be raised through IPOs and FPOs

• Share Premium as another cheap source of finance

• Listed companies having access to cheaper foreign funds

The Fallen Empire-DLF Limited

• 1946-Chaudhry RagvendraSingh promoted

• Developer of residential and other complexes in Delhi until 1957

• 1957-Delhi Development Authority banned private developers

• It went out to Gurgaon in Haryana to develop a city

IPO Details of DLF Ltd.

• 2007-IPO made• 17.5 crore shares of Rs.2 through book-building• Cut-off Price Rs.525• Face Value of Shares: Rs.35 crore• Share Premium: Rs.9,152.5 crore• Share Price went upto Rs.1000 in 2008

Falling Down from Grace

• Forays into Capital Intensive expansion

• Hospitality Industry

• Wind and other power business

• Extensive Borrowings

• Debt: Rs.19000 crores

• Questionable Trade Practices

Correlation between Interest and Profit of DLF Ltd.(Figures in Rs.Crore)

Year Sales Interest Profit

2007-08 14433 310 7,847

2008-09 10,035 555 4,497

2009-10 7,423 1,110 1,709

2010-11 9,560 1,706 1,638

2011-12 9,629 2,246 1,169

2012-13 7,773 2,314 663

2013-14 8,298 2,463 582

Alternative

• FPO at the cut-off price of IPO could have brought in a huge amount of cost-free funds

• It would have saved the interest

• More meaningful diversification

• Taking care of quality of building in Gurgaonand maintaining the customer relation

THANK YOU