Chapter-9 , Capital Structure

8/10/2019 Chapter-9 , Capital Structure

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Chapter

Capital Structure &

theories of CapitalStructure


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Meaning & Definition

Capital Structure of a company refers to the composition or make- up of its capitalisation & it

includes all long term capital resources viz: loans, Reserves, Shares & bonds.

Capital Structure is made up of debt & equity securities & refers to permanent financing of a firm.

It is composed of long-term debt, preference share capital & shareholders funds.


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Capitalisation, Capital Structure & Financial

Structure

Capitalisation is quantitative aspect of financial planning of an enterprise, capital structure is

concerned with the qualitative aspect. Thus Capitalisation refers to the total amount of

securities issued by a company while capital structure refers to the kind of securities & the

proportionate amounts that make up capitalisation.

Financial Structure means the entire liabilties side of Balance Sheet.


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Forms/Patterns of Capital Structure

EquityShares

Only

Equity &preference

Shares

Equity

Shares &Debentures

EquityShares,

PreferenceShares &

Debentures


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Importance Of Capital Structure

Financing the firms assets is a very crucial problem in every business & as a

general rule there should be a proper mix of debt & equity capital in financing

firms assets. The use of long term fixed interest bearing debt & preference share

capital along with equity shares is called financial leverage or trading on equity.


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Practical Problem 1

XYZ company has currently an all equity capital structure consisting of

15,000 equity shares of Rs. 100 each. The management is planning to raise

further Rs. 25 laks to finance a major programme of expansion & 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 expected earnings before interest & taxes will be Rs. 8 laks.

Assuming a corporate tax rate of 50% determine EPS in each alternative &

comment which alternative is best & why?


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Practical Problem 2

X Ltd. Company has equity share capital of Rs. 5,00 000 divided into shares of Rs.

100 each. It wishes to raise further Rs. 3,00,000 for expansion. The company plans

the following schemes:

All Common stock

Rs. One lak in common stock & Rs. Two Lak in debt @10% p.a.

All debt @10%p.a.

Rs. One lak in common stock & Rs. Two lak in preference capital with the rate of

dividend @ 8%.

The company existing earning before interest & tax Rs. 1,50,000.The corporate rate

of tax is 50%. Determine the EPS in each plan & comment.


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Optimal capital Structure

The Capital Structure or combination of debt & equity that leads to the maximum

value of the firm, is known as optimal capital structure. Thus Optimal capital

structure maximises the value of the company & hence the wealth of its owners &

minimises the company cost of capital. The following consideration should be kept

in mind while maximising the value of the firm in achieving the goal of optimum

capital structure: If the return on investment is higher than the fixed cost of funds, the company

should prefer to raise fund having fixed cost, it will increaser EPS & market value of

the firm.

Company must take the advantage of tax leverage as interest is allowed as a

deductible expense in computation of tax.

Capital structure should be flexible


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DETERMINANTS OF OCS

A SOUND OR AN APPROPRIATE CAPITAL STRUCTURE SHOULD HAVE THE FOLLOWING

ESSENTIAL FEATURES:

Maximum possible use of leverage

Capital Structure should be flexible

Avoidance of undue financial/business risk with the increase use of debt

Use of debt should be within the capacity of a firm.

It should involve minimum possible risk of loss of control

It must avoid undue restrictions in agreement of debt

Growth & stability of sales

Cost of capital

Nature & size of a firm

Capital market conditions Period of finance

Personal considerations

Corporate tax rate & legal requirement


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Theories of CS

Net IncomeApproach

NetOperating

IncomeApproach

The

TraditionalApproach

Modigliani &

MillerApproach


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Net Income Approach

As per this approach, a firm can minimize the weighted average cost of capital

&increase the value of the firm as well as market price of equity shares by using

debt financing to the maximum possible extent. This approach is based upon the

following assumptions:

Cost of debt is less than the cost of equity

No taxes

1. No change in risk perception of the investors.

2. The total market value of the firm on the basis of this approach is:

3. V=S+D Where V=Total market value of a firm

1. S=Market value of equity share (Earnings available to

equity share holders/Equity Capitalisation rate)

2. D=Market value of debt

& Over all cost of capital is = K=EBIT/V


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Practical problem

A company expects a net income of Rs. 80,000. It has Rs.

2,00,000, 8% debentures. The equity capitalisation rate of the

company is 10%. Calculate the value of the firm & over all cost

of capital as net income approach

If the debenture debt is increased to Rs. 3,00,000, what shall

be the value of the firm & over all capitalisation rate?


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Net Operating Income approach

This theory as suggested by Durand is another extreme of the effect of the

leverage on the value of the firm. It is diametrically opposite to the net income

approach. As per this, change in the capital structure of a company doesnt affect

the market value of the firm & over all cost of capital remains constant irrespective

of the method of financing. It implies that over all cost of capital remains the

same, thus there Is nothing like optimal capital structure & every capital structureis the optimum capital structure. This theory presumes:

Market capitalises the value of the firm as a whole

Business risk remains constant at every level of debt equity mix

No taxes


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Cont..

The value of the firm on the basis of Net Operating Income Approach:

V=EBIT/K

Where V=Value of a firm

EBIT=Earnings before interest & tax

K=Over all cost of capital

The market value of equity as per 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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Practical Problem

A company expects a net operating income of Rs. 1,00,000. It has Rs.5,00,000, 6%

debentures. The over all capitalisation rate is 10%. Calculate the value of the firm

& the equity capitalisation rate according to net operating income approach.

If the debenture debt is increased to Rs. 7,50,000. what will be the effect on the

value of the firm & equity capitalisation rate.


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Traditional Approach

The traditional approach also known as intermediate approach, is a compromise between the

two extremes of earlier two approaches. According to this theory, the value of the firm can

be increased initially or the cost of the capital can be decreased by using more debt as the

debt is a cheaper source of funds than equity. Thus, optimum capital structure can be

reached by a proper debt-equity mix. Beyond a particular point, the cost of equity increases

because increased debt increases the financial risk of the equity shareholders. The advantage

of cheaper debt at this point of capital structure is offset by increased cost of equity. Afterthis there comes a stage when the increased cost of equity cannot be off set by the

advantage of low-cost debt. Thus, over all cost of capital according to this theory decreases

up to a certain point, remains more or less unchanged for moderate increase in debt

thereafter & increases or rises beyond a certain point. Even the cost of debt may increase at

this stage due to increased financial risk.


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Practical problem

Compute the market value of the firm, value of shares & the average cost of

capital from the following information:

Net Operating Income Rs. 2,00,000

Total Investment Rs. 10,00,000

Equity capitalisation rate

If the firm uses no debt 10%

If the firm uses Rs. 4,00,000 Debenture 11%

If the firm uses Rs. 6,00,000 debentures 13%

Assume that Rs. 4,00,000 debentures can be raised @ 5% of interest where as Rs.

6,00,000 debentures can be raised @6% rate of interest.


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MODIGLIANI & MILLER APPROACH

In the absence of taxes (Theory of irrelevance): The theory proves that the cost of capital isnot affected by changes in the capital structure or that the debt-equity mix is irrelevant in thedetermination of the total value of a firm. The reason argued is that though debt is cheaperto equity, with increased use of debt as a source of finance, the cost of equity increases. Thisincrease in cost of equity offsets the advantage of the low cost of debt. Thus, although thefinancial leverage affects the cost of equity, the over all cost of capital remains constant.

When corporate taxes are assumed to exist. (Theory of relevance): Modigliani & Miller, haverecognised that the value of a firm will increase or the cost of capital will decrease with theuse of debt on account of deductibility of interest charges for tax purposes. Thus theoptimum capital structure can be achieved by maximising the debt mix in the equity of afirm.

According to this approach, the value of a unlevered & levered firm can be calculated as:

Vu = Earnings before interest & tax/overall cost of capital Vl = Vu + tD

Where Vu is the value of unlevered firm & tD is the discounted present value of the taxsavings resulting from the tax deductibility of the interest charges, t is the rate of tax & D isthe quantum of debt used in the mix.


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LEVERAGE

Leverage allows us to accomplish certain things which are otherwise not possible, viz; lifting

of heavy objects with the help of leverage. This concept of leverage is valid in business also.

In financial management, the term leverage is used to describe the firms ability to use fixed

cost assets or funds to increase the returns to its owners i.e. equity share holders.

There are basically two types of leverages:

Financial leverage or trading on equity

Operating Leverage


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OPERATING LEVERAGE

Operating leverage results from the presence of fixed cost that help in magnifying net

operating income fluctuations flowing from small variations in revenue. The change in sales

are related to change in revenue. The fixed cost do not change with the change in sales. Any

increase in sales, fixed cost remaining the same, will magnify the operating revenue. The

operating leverage occurs when a firm has fixed costs, which must be recovered irrespective

of sales volume. The fixed cost remaining the same, the percentage change in operating

revenue will be more than the percentage change in sales. The occurrence is known asoperating leverage. Thus, the degree of operating leverage depends upon the amount of

fixed elements in the cost structure.

Operating Leverage = Contribution/Operating profit

Contribution = SalesVariable Cost

Operating profit = SalesVariable costFixed cost


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Practical problem & solution

Following is the cost information of a firm:

Fixed Cost = Rs. 50,000 ; Variable Cost = 70% of sales; Sales = Rs.2,00,000 in previous year &

Rs. 2,50,000 in current year.

Solution:

1) PY CY %age change

Sales 2,00,000 2,50,000 25 Less: Variable cost(70%) 1,40,000 1,75,000 25

Profit from operations 60,000 75,000 25

2)

Sales 2,00,000 2,50,000 25

Less: Variable Cost(70%) 1,40,000 1,75,000 25

Contribution 60,000 75,000 25

Less: FC 50,000 50,000

Profit from operations 10,000 25,000 150

Chapter-9 , Capital Structure

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