Capital Structure & Capitalisation

What Does Capital Structure Mean?

A mix of a company's long-term debt, common equity and preferred equity. The capital
structure is how a firm finances its overall operations and growth by using different
sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is
classified as common stock, preferred stock or retained earnings.

Definition
The permanent long-term financing of a company, including long-term debt, common
stock and preferred stock, and retained earnings. It differs from financial structure, which
includes short-term debt and accounts payable.

Investopedia explains Capital Structure

A company's proportion of debt is considered when analyzing capital structure. When
people refer to capital structure they are most likely referring to a firm's debt-to-equity
ratio, which provides insight into how risky a company is. Usually a company more
heavily financed by debt poses greater risk, as this firm is relatively highly levered.

In finance, capital structure refers to the way a corporation finances its assets through
some combination of equity, debt, or hybrid securities. A firm's capital structure is then
the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in
equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed.
The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's
leverage. In reality, capital structure may be highly complex and include tens of sources.
Gearing Ratio is the proportion of the capital employed of the firm which come from
outside of the business finance, e.g. by taking a long term loan etc.

The Modigliani-Miller (MM) theorem, proposed by Franco Modigliani and Merton

Miller, forms the basis for modern thinking on capital structure, though it is
generally viewed as a purely theoretical result since it assumes away many
important factors in the capital structure decision. The theorem states that, in a
perfect market, how a firm is financed is irrelevant to its value.

Let us look at an example.

Company A & B are identical in all respects except the capital structure. Both have
capital employed of Rs 100 lacs and earn Rs 15 lacs (i.e. 15% on capital
employed). Company A has all equity and equity holders earn the same 15% return.
Company B has Rs 50 lacs of equity and Rs 50 lacs of 10% debentures. After
paying Rs 5 lacs interest to debentures and the world of no taxes, equity holders of
Company B make Rs 10 lacs on their investment of Rs 50 lacs ( i.e. 20% return
through ‘Trading on Equity’).

According to MM, an individual can achieve the same gearing what a company can do.
E.g. An individual who has Rs 1000 can buy 100 shares @ Rs 10 in B and earn Rs
200 as explained above. Alternatively, he can borrow Rs 1000 @ 10% (MM
assumption that the borrowing rate for an individual is the same as Company’s
borrowing rate!) and buy 200 shares of Company A for Rs 2000. He will earn
 return @ 15% of Rs 300 from which he will pay interest of Rs 100, retaining Rs
200. The same return had he invested in Company B without any borrowing.
According to MM, the arbitrage (like the one explained in this para) in the perfect
market will ensure that cost of capital for both companies is the same.

This result provides the base with which to examine real world reasons why capital
structure is relevant, that is, a company's value is affected by the capital structure it
employs. These other reasons include bankruptcy costs, agency costs, taxes,
information asymmetry, to name some. This analysis can then be extended to
look at whether there is in fact an optimal capital structure: the one which
maximizes the value of the firm.

Other theories of capital structure are Net Income Approach (debt is cheaper and risk
profile is not changed by use of debt) and Traditional Approach which advocates
optimum capital structure.

Capital structure in a perfect market

Assume a perfect capital market (no transaction or bankruptcy costs; perfect

information); firms and individuals can borrow at the same interest rate; no taxes; and
investment decisions aren't affected by financing decisions. Modigliani and Miller made
two findings under these conditions. Their first 'proposition' was that the value of a
company is independent of its capital structure. Their second 'proposition' stated that the
cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm,
plus an added premium for financial risk. That is, as leverage increases, while the burden
of individual risks is shifted between different investor classes, total risk is conserved and
hence no extra value created.

Their analysis was extended to include the effect of taxes and risky debt. Under a
classical tax system, the tax deductibility of interest makes debt financing valuable; that
is, the cost of capital decreases as the proportion of debt in the capital structure increases.
The optimal structure, then would be to have virtually no equity at all.

Capital structure in the real world

If capital structure is irrelevant in a perfect market, then imperfections which exist in the
real world must be the cause of its relevance. The theories below try to address some of
these imperfections, by relaxing assumptions made in the M&M model.

Trade-off theory

Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to
financing with debt (namely, the tax benefit of debts) and that there is a cost of financing
with debt (the bankruptcy costs of debt). The marginal benefit of further increases in debt
declines as debt increases, while the marginal cost increases, so that a firm that is
optimizing its overall value will focus on this trade-off when choosing how much debt
and equity to use for financing. Empirically, this theory may explain differences in D/E
ratios between industries, but it doesn't explain differences within the same industry.

Pecking order theory

Pecking Order theory tries to capture the costs of asymmetric information. It states that
companies prioritize their sources of financing (from internal financing to equity)
according to the law of least effort, or of least resistance, preferring to raise equity as a
financing means “of last resort”. Hence: internal debt is used first; when that is depleted,
then debt is issued; and when it is no longer sensible to issue any more debt, equity is
issued. This theory maintains that businesses adhere to a hierarchy of financing sources
and prefer internal financing when available, and debt is preferred over equity if external
financing is required. Thus, the form of debt a firm chooses can act as a signal of its need
for external finance. The pecking order theory is popularized by Myers (1984) when he
argues that equity is a less preferred means to raise capital because when managers (who
are assumed to know better about true condition of the firm than investors) issue new
equity, investors believe that managers think that the firm is overvalued and managers are
taking advantage of this over-valuation. As a result, investors will place a lower value to
the new equity issuance.

Agency Costs

There are three types of agency costs which can help explain the relevance of capital
structure.

• Asset substitution effect: As D/E increases, management has an increased

incentive to undertake risky (even negative NPV) projects. This is because if the
project is successful, share holders get all the upside, whereas if it is unsuccessful,
debt holders get all the downside. If the projects are undertaken, there is a chance
of firm value decreasing and a wealth transfer from debt holders to share holders.
• Underinvestment problem: If debt is risky (eg in a growth company), the gain
from the project will accrue to debt holders rather than shareholders. Thus,
management has an incentive to reject positive NPV projects, even though they
have the potential to increase firm value.
• Free cash flow: unless free cash flow is given back to investors, management has
an incentive to destroy firm value through empire building and perks etc.
Increasing leverage imposes financial discipline on management.

Arbitrage

Similar questions are also the concern of a variety of speculator known as a capital-
structure arbitrageur.

A capital-structure arbitrageur seeks opportunities created by differential pricing of

various instruments issued by one corporation. Consider, for example, traditional bonds
and convertible bonds. The latter are bonds that are, under contracted-for conditions,
convertible into shares of equity. The stock-option component of a convertible bond has a
calculable value in itself. The value of the whole instrument should be the value of the
traditional bonds plus the extra value of the option feature. If the spread, the difference
between the convertible and the non-convertible bonds grows excessively, then the
capital-structure arbitrageur will bet that it will converge.

Capital Gearing

It is the relationship between equity funds (including retained earnings) and long term
debt. Preference shares are normally clubbed with debt for this purpose as it affects return
on equity. Americans call it leverage or financial leverage. The resultant effect is Trading
on Equity as illustrated below :

Capital employed Rs 250 lacs financed by 10% debentures to the extent of Rs 1.25 crore,
8% Preference shares of Rs 50 lacs and balance by equity.

Expected Return @ 18% Rs 45 lacs. (EBIT)

Less: Debenture Interest Rs12.5 lacs

Earning Before Tax (EBT) Rs 32.5 lacs

Less: Income-tax @ 30% Rs 9.75 lacs

Rs 22.75 lacs

Less: Preference Dividend Rs 4 lacs

Balance available for Equity Rs 18.75 lacs or 25% on equity capital of Rs 75 lacs.

Thus, 18% pre-tax (12.6% post tax) overall return fetches 25% on equity by ‘Trading on
Equity’. Calculate similarly if expected return is 8% to see how this double edged sword
works.

Capitalisation

Capital plays an important role in any business. Capitalisation refers to the long term
indebtedness and includes both the ownership capital and the borrowed capital. Capital
and Capitalisation are two different terms. The term 'capitalisation' is used only in
relation to companies and not in respect of partnership firms or sole proprietorships. It is
distinguished from capital which represents total investment or resources of a company.
It thus represents total wealth of the company. It should be distinguished from share
capital which refers only to the paid up value of the shares issued by the company and
definitely excludes bonds, debentures, loans and other form of borrowings. Capitalisation
means the total par value of all the securities, i.e. shares and debentures issued by a
company and reserves, surplus and value of all other long term obligations. The term thus
includes the value of ordinary and preference shares, the value of all surplus – earned and
capital, the value of bonds and securities still not redeemed and the value of long term
loans. Capitalisation is thus the sum total of all long term funds available to the firm
along with the free reserves. According to E.T. Lincoln capitalisation is "a word
ordinarily used to refer to the sum of outstanding stocks and funded obligations which
may represent fictitious values". According to Gerstenbug, capitalisation is that which
"comprises of a company's ownership capital which includes capital stock and surplus in
whatever form it may appear and borrowed capital which consists of bonds or similar
evidences of long-term debt".

Cost & Earnings Theory of Capitalisation

OVER CAPITALISATION
A company is said to be over capitalised when its earnings are not sufficient to yield a
fair return on the amount of shares or debentures. IN other words, when a company is not
in a position to pay dividends and interests on its shares and debentures at fair rates, it is
said to be over capitalised. It means that an over-capitalised company is unable to pay a
fair return on its investment. According to Hoagland, "whenever the aggregate of the par
values of stocks or bonds outstanding exceeded the true value of the fixed assets the
corporation is said to be over-capitalised". According to Gerstenberg, "a corporation is
over-capitalised when its earnings are not large enough to yield a fair return on the
amount of stocks and not large enough to yield a fair return on the amount of stocks and
bonds that have been issued or when the amount of securities outstanding exceeds the
current value of assets".
Over-capitalisation is not synonymous with excess capital. Excess of capital may be one
of the reasons for over-capitalisation. A company is over capitalised only because of its
capital and funds not being effectively and profitably deployed with the result that there
is a fall in the earning capacity of the company and in the rate of dividend to be paid to its
shareholders as well as a fall in the market value of its shares.
Causes of Over-capitalisation
Floating of excess capital
Purchasing property at an inflated price
Inflationary conditions
High cost of promotion
Borrowings at a higher than normal rate
Purchase of assets in the boom period
Incorrect capitalisation rate applied
Insufficient provision for depreciation
High rates of taxation
Liberal dividend policy
Wrong estimation of future earnings
Low production
Remedial measures to correct Over-capitalisation
Reduction of funded debts
Reduction of interest on debentures and loans
Reduction of preference shares
Reduction of face value of the shares
Reduction in the number of equity shares
Ploughing back of profits

Effects of Over-capitalisation
Loss of goodwill
Difficulty in obtaining capital
Window dressing of accounts
Decline in efficiency
Liquidation
Loss of Market
Low rate of dividend
Fall in the Market value of shares
Loss on re-organization
Small value of collateral
Speculative gambling
Reduction in quality
Cuts in wages
Competition
Misapplication of society's resources
Gambling in shares
Setback to industry
Watered Capital
'Water' is said to be present in the capital when a part of the capital is not represented by
assets. It is considered to be as worthless as water. Sometimes the services of the
promoters are valued at an unduly high price.

Similarly, the concern may pay too high a price for an asset acquired from a going
concern. The capital becomes watered to the extent of the excess price paid for an asset.
Thus, if a company pays 1,25,000 on account of goodwill, which if valued correctly is
worth Rs. 50,000 only, the capital is watered to the extent of Rs. 75,000. 'Watered capital'
must be distinguished from 'over capitalisation'. 'Water enters the capital usually in the
initial period-at the time of promotion. Over capitalisation can, however, be found out
only after the company has worked for sometime. Although watered capital can be a
cause of over capitalisation, yet it is not exactly the same thing. If the earnings are up to
the general expectation, a concern will not be over capitalized even though a part of its
capital is watered.

UNDER CAPITALISATION
Under capitalisation is just reverse of over capitalisation. The state of under-capitalisation
is where the value of assets are much more than it appears in the books of the company.
In well established companies, there is a large appreciation in assets, but such
appreciation is now shown in the books. As against over capitalisation, under
capitalisation is associated with an effective utilisation of investments, an exceptionally
high rate of dividend and enhanced prices of shares. In other words, the capital of the
company is less in proportion to its total requirements under the state of under-
capitalisation. In the words of Gerstenberg, "A corporation may be under capitalised
when the rate of profits it is making on the total capital is exceptionally high in relation to
the return enjoyed by similarly situated companies in the same industry or when it has too
little capital with which to conduct its business".
Under capitalisation is a condition where the real value of the company is more than its
book value. The assets bring profits but it would appear to be much larger than warranted
by book figures of the capital. In such cases, the dividend will naturally be high and the
market value of shares will be much higher. Under capitalisation and inadequacy of
capital are regarded as inter-changeable terms but there is a difference between these two
terms. Under-capitalisation does not mean inadequacy of capital. Profits are high in such
companies and a part of the profits are ploughed back in the business directly or
indirectly. The value of assets is shown at lower price than their real value. It means that
there are secret reserves in under-capitalised companies.

Causes of Under Capitalisation

Under estimation of capital requirements
Under estimation of future earnings
Promotion during deflation
Narrow dividend policy
Desire of control
Excessive depreciation provided
Maintenance of high efficiency
Secret reserves
Difficulty in procurement of capital
Remedies of under capitalisation
Splitting up of shares
Increasing the number of shares
Increase in the par value of shares
Issue of Bonus shares
Fresh issue of shares

Effects of under capitalization

Limited marketability of shares

Cut-throat competition
Industrial unrest
Dissatisfaction of customers
Government control
Inadequacy of capital.
Secret reserves and window dressing of accounts
High taxes
Manipulation of share values

Financial Break Even & Indifference Analysis

That level of EBIT when after meeting interest cost, tax and preference dividend, EPS on
equity is zero.
On the other hand, at indifference point under two alternate finance plans, EPS is the
same.