IDBI federal Life Insurance Co. Ltd.

THE STUDY ON CAPITAL STRUCTURE AT

IDBI FEDERAL LIFE INSURANCE CO. LTD.
(A summer training project report submitted in partial fulfillment of
the requirement of Post-Graduation Diploma in Management)
(Session 2013-2015)

Under the guidance of:

Submitted By:

Ms. Piyushi Verma

(MANAGER DISTRIBUTION)
IDBI FEDERAL LIFE INSURANCE
Co. LTD.

P.NITHIN REDDY
PGDM 2ND YEAR
Roll No.-:22024

Siva Sivani Institute of Management

(kompally, Secundrabad, 500014 )

INTERNSHIP CERTIFICATE

ACKNOWLEDGEMENT
I express my sincere gratitude to my company guide Ms. Piyushi verma,
Manager Distribution, IDBI FEDERAL LIFE INSURANCE COMPANY Ltd.,
for entrusting me and providing me valuable inputs for my project STUDY ON
CAPITAL STRUCTURE AT IDBI FEDERAL LIFE INSURANCE Co Ltd
also my company coordinator, Mr. Chandu Sudheer Kumar for encouragement,
support and valuable guidance throughout the project duration. In spite of being
fraught with unending engagements in office, he kept me motivating to try best at
all times the project field work was entirely unknown to me. I would like to
express my gratitude to him, for constantly elucidating upon my repetitive queries
and without whom the whole field work would not have been possible.
I would also like to thank my faculty guide, Mrs. L. Krishna Veni for providing
me with her constant support and guidance all through the IIP.
A special thanks to all the IDBI FEDERAL HYDERABAD branch employees who
made the IIP a memorable learning experience.
I would like to thank SSIM and IDBI FEDERAL LIFE INSURANCE
COMPANY LTD. for providing me an opportunity to gain hands-on experience by
working in a corporate environment. Lastly, I would like to thank my parents,
friends and well-wishers who encouraged me to do this research work and all the
dealers and retailers who contributed directly or indirectly in completing this
project to whom I am obligated to even though anonymously.
P.NITHIN REDDY
22024
SIVA SIVANI INSTITUTE OF MANAGEMENT, Hyderabad

PREFACE
Life insurance business is booming in India. The business of life insurance is
related to the protection of the economic value of human life and this project is just
offered to draw the attention of individuals, who are interested in life insurance
business running by insurance regulatory Development Authority (IRDA).
Insurance industry has Ombudsmen in 12 cities. Each Ombudsman is
empowered to redress customer grievances in respect of insurance contracts on
personal lines where the insured amount is less than Rs. 20 lakh, in accordance
with the Ombudsman Scheme. Addresses can be obtained from the offices of LIC
and other insurers.
This project is like just an extract of my rigorous work in Life Insurance
Companies, and I hope the beneficiaries decision regarding recruitment of advice;
or, all information and data. This responsibility really in hence my effective
communication and convincing power and such quality will help me in near future
for having decision making.

TABLE OF CONTENTS
Contents
1.

EXECUTIVE SUMMERY........................................................................................... 1

2. INTRODUCTION........................................................................................................ 3
2.1 BACKGROUND OF THE TOPIC................................................................................3
2.2 NEED OF THE STUDY............................................................................................ 5
2.3 OBJECTIVES OF THE PROJECT............................................................................... 5
2.4 SCOPE OF THE STUDY........................................................................................... 5
2.5 LIMITATIONS TO THE PROJECT.............................................................................. 5
3.

COMPANY ANALYSIS.............................................................................................. 6
3.1 INDIAN INSURANCE INDUSTRY AT PRESENT:........................................................7
3.2 VISION, MISSION AND VALUES.............................................................................. 8

3.3 COMPETITORS OF IDBI FEDERAL LIFE INSURANCE CO. LTD.......................................9

3.4 ORGANIZATION STRUCTURE............................................................................... 10
3.5 PRODUCTS OF IDBI FEDERAL..............................................................................10
3.6 SWOT ANALYSIS OF IDBI FEDERAL LIFE..............................................................14
3.7 COMPETITOR ANALYSIS:.................................................................................... 15
4. ECONOMIC INDUSTRY ANALYSIS............................................................................. 19
4.1. INTRODUCTION TO INSURANCE INDUSTRY:........................................................19
4.2TYPES OF INSURANCE:........................................................................................ 19
4.3 INSURANCE SECTOR IN INDIA:............................................................................20
4.4 INDIAN INSURANCE INDUSTRY AT PRESENT:.......................................................21
4.5 REGULATORY ISSUES:........................................................................................ 21
4.6 CRITICAL SUCCESS FACTORS:............................................................................. 22
4.7 DOMESTIC ECONOMIC CONDITIONS:...................................................................24
4.8 GLOBAL ECONOMIC ENVIRONMENT:...................................................................25
4.9 DEMAND DRIVERS:............................................................................................ 25
5 LITERATURE REVIEW.............................................................................................. 27
5.1 LITERATURE...................................................................................................... 27
5.2 THEORIES OF CAPITAL STRUCTURE....................................................................31
5.2.1 INTRODUCTION:........................................................................................... 31

5.3 DIFFERENT THEORIES OF CAPITAL STRUCTURE...................................................39

5.3.1 NET INCOME APPROACH...............................................................................39
5.3.2 NET OPERATING INCOME (NOI) APPROACH:....................................................42
5.3.3 TRADITIONAL APPROACH:............................................................................44
5.3.4 MODIGLIANI MILLER (MM) HYPOTHESIS.....................................................45
5.4 ARBITRAGE PROCESS......................................................................................... 46
5.5 CRITICISM OF MM HYPOTHESIS..........................................................................48
5.6 M-M HYPOTHESIS CORPORATE TAXES.................................................................49
5.7 AGENCY COSTS.................................................................................................. 49
5.8 PECKING ORDER THEORY................................................................................... 50

1. EXECUTIVE SUMMERY
The Indian insurance industry has undergone transformational changes since
2000 when the industry was liberalized. With a one-player market to 24 in 13
years, the industry has witnessed phases of rapid growth along with extent of
growth moderation and intensifying competition.
There have also been a number of product and operational innovations
necessitated by consumer need and increased competition among the players.
Changes in the regulatory environment also had a path-breaking impact on the
development of the industry. While the insurance industry still struggles to move
out of the shadows cast by the challenges posed by economic uncertainties of the
last few years, the strong fundamentals of the industry augur well for a roadmap to
be drawn for sustainable long-term growth.
The decade 2001-10 was characterized by a period of high growth
(compound annual growth rate of 31 percent in new business premium) and a flat
growth (CAGR of around two percent in new business premium between 2010-12)
There was exponential growth in the first decade of insurance industry
liberalization. Backed by innovative products and aggressive expansion of
distribution, the life insurance industry grew at jet speed.
Regulatory changes were introduced during the past two years and life
insurance companies adopted many new customer-centric practices in this period.
Product-related changes, first in ULIPs (Unit Linked Insurance Plans) in
September 2011 and now in traditional products, will have the biggest impact on
the industry
This project is done on CAPTIAL STRUCTURE on IDBI Federal Life
Insurance Company Limited with comparison to leading private companies in
India. The project is all about study of comparative analysis of IDBI FEDERAL
LIFE INSURANCE Co. Ltd with different private companies and LIC. The
objective of the project was to check the awareness level of Insurance, position of
company in term of size, Growth, Productivity, Grievance handling in market place
and attitude of the people towards insurance in the current market.
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The project relates to the study of the financial analysis and the current
performance of the company and how effective the assets of the company are
managed. Financial analysis is done using ratio analysis and the trend projection
graph provides the fluctuations that have occurred. The study shows how effective
the company is able to make use of its funds and revenues generated. Future
growth of the firm is also estimated in the analysis.

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2. INTRODUCTION
2.1 BACKGROUND OF THE TOPIC
The term capital structure refers to the percentage of capital (money) at work
in a business by type. There are two forms of capital: equity capital and debt
capital. Debt includes loans and other types of credit that must be repaid in the
future, usually with interest. Equity involves selling a partial interest in the
company to investors, usually in the form of stock. In contrast to debt financing,
equity financing does not involve a direct obligation to repay the funds. Instead,
equity investors become part-owners and partners in the business, and thus earn a
return on their investment as well as exercising some degree of control over how
the business is run. Each has its own benefits and drawbacks.
A company's proportion of short and long-term 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.
It is the composition of long-term liabilities, specific short-term liabilities
like bank notes, common equity, and preferred equity which make up the funds
with which a business firm finances its operations and its growth. The capital
structure of a business firm is essentially the right side of its balance sheet.
Companies and small business owners trying to determine how much of their
startup money should come from a bank loan without endangering the business.
There is a saying that If capital structure is irrelevant in a perfect market, then
imperfections which exist in the real world must be the cause of its relevance.
There are few theories backing this statement (trade-off theory and pecking order
theory).
Merits of Equity Finance
(1) Permanent source of capital.
(2) No payment of interest.
(3) Improved ability to face business recession.
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(4) Freedom from financial worries of borrowing.

(5) Earnings remain with the firm.
(6) Liquidation of assets. (In case a business is liquidated the assets of the
business remain with the owners.)
(7) Repayment of funds.
(8) Financial base. (The funds supplied by owners provide a financial base to
the capital structure of a business.)
(9) Ability to borrow. (If a business is financed well with equity capital, its
ability to obtain borrowed capital in improved).
Demerits of Equity Financing
(1) Idle cash balances.
(2) Over capitalization.
(3) Weak control
(4) No advantage of borrowed capital.
(5) Investor expectations
Merits of Debt Finance
(1) Tax shield
(2) Positive influence on R&D activities
(3) More control
(4) Easy to administer
(5) Increases the EPS
(6) Lower interest rate
Demerits of Debt Finance
(1) High risk
(2) Insolvency
(3) Bankruptcy
(4) Regular payment of interest
(5) Reduction in cash flows
(6) Failure to make payments
(7) Impacts your credit rating (the more you borrow, the higher the risk to the
lender, and the higher interest rate youll pay.)
(8) It works against the company if earning from investments does not exceed
the interest payments
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2.2 NEED OF THE STUDY

To know whether there is a balance between debt and equity
To know the equation of capital structure in IDBI Federal Life Insurance Co
Ltd
To know the variations in debt and equity when compared to previous years
To know the capital structures impact on operating cash flows and cost of
capital
To know various factors affecting the capital structure such as taxes, industry
standards etc.
To understand the financial risk business risk and tradeoff between them
2.3 OBJECTIVES OF THE PROJECT
To understand the capital structure of IDBI Federal Life Insurance Co Ltd
To find debt ratio, debt-equity ratio and interest coverage ratio of the
company
EBIT-EPS Analysis to find the right capital mix
To know the stability of IDBI Federal Life Insurance Co Ltd capital
structure when compared to its competitors SBI LIFE, LIC, ICICI securities
To understand the value of the firm with variations in capital structure
2.4 SCOPE OF THE STUDY
A study of the capital structure involves an examination of long term as well as
short term sources that a company taps in order to meet its requirements of finance.
2.5 LIMITATIONS TO THE PROJECT
Time duration
IDBI Federal Life Insurance Co Ltd is no listed
Industry dynamics
People perceptions towards insurance

3. COMPANY ANALYSIS

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IDBI Federal Life Insurance Co Ltd is a joint-venture of IDBI Bank, Indias

premier development and commercial bank, Federal Bank, one of Indias leading
private sector banks and Ageas, a multinational insurance giant based out of
Purpose. In this venture, IDBI Bank owns 48% equity while Federal Bank and
Ageas own 26% equity each. . Having started in March 2008, in just five months
of inception, IDBI Federal became one of the fastest growing new insurance
companies to garner Rs 100 Cr in premiums. Through a continuous process of
innovation in product and service delivery IDBI Federal aims to deliver worldclass wealth management, protection and retirement solutions that provide value
and convenience to the Indian customer. The company offers its services through a
vast nationwide network of 2137 partner bank branches of IDBI Bank and Federal
Bank in addition to a sizeable network of advisors and partners. As on 28th
February 2013, the company has issued over 8.65 lakh policies with a sum assured
of over Rs. 26,591Cr.
IDBI Federal today is recognized as a customer-centric brand, with
an array of awards to their credit. They have been awarded the PMAA Awards
(2009) for best Dealer/Sales force Activity, EFFIE Award (2011) for effective
advertising, and conferred with the status of Master Brand 2012-13 by the CMO
Council USA and CMO Asia.
Federal Bank Ltd is engaged in the banking business. The Bank operates in four
segments: treasury operations, wholesale banking, retail banking and other banking
operations.
Ageas is an international insurance group with a heritage spanning more than 180
years. Ranked among the top 20 insurance companies in Europe, Ageas has chosen
to concentrate its business activities in Europe and Asia, which together make up
the largest share of the global insurance market.
3.1 INDIAN INSURANCE INDUSTRY AT PRESENT:
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Life Insurance Corporation (LIC) had the monopoly over the market till the late
90s when the insurance sector in India was opened for private players. Before that
there were only two state insurer, one was LIC (Life Insurance Corporation of
India) and GIC (General Insurance corporation of India).
Indian insurance sector at present has undergone many structural changes in 2000.
The Government of India has liberalized the insurance sector in 2000 with IRDA
(Insurance Regulatory and development authority) lifting all entry restriction of
foreign players with a specific limit on direct foreign ownership. Under the current
guideline 26% of equity cap is there for foreign players in an insurance company
and proposal is being given to increase this limit to 49%. Post liberalization
insurance industry in India have come a long way and today it stands as one of the
most competitive, challenging and exploring industry in India. Increased use of
new distribution channels are in limelight today due to entry of private players. In
the long run the use of these distribution channels and modern IT tools has
increased scope of the insurance industry. Also the changing economics patterns,
changing political scenario, modern IT tools will eventually help in reshaping
future of Indian financial market and Life Insurance business in the country.

Milestones

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March 2008

IDBI Federal starts operations

Homesurance & Wealthsurance.

with

two

products

August 2008

IDBI Federal becomes one of the fastest growing new life

insurers to collect premiums worth Rs 100 crores.

October 2008 IDBI Federal launches Bondsurance

January 2009 IDBI Wealthsurance Cup 2009 India v/s Sri Lanka held in Sri
Lanka.
March 2009

November
2009

collected premium of over 328 corers and 87,000 policies and

a Sum assured of Rs 2825 crores since inception
Launches Retirements & Termsurance Grameen Suraksha
IDBI Federal launches Incomesurance

March 2010

Launches Incomesurance Endowment & Money Back Plan,

Termsurance Protection Plan & Termsurance Grameen Bachat
Yojana

September
2010

Launches Loansurance Group Life Plan & Healthsurance

Hospitalization and Surgical Plan

March 2011

Launches Retirements Guaranteed Pension plan

Launches TV Campaigns for Wealthsurance jinse bhi suna,
khaeed liya, Incomesurance guaranteed income ki
bhavishyavani and Retiresurance Monthly pension, zindgi
bhar

3.2 VISION, MISSION AND VALUES

Vision
To be the leading provider of wealth management, protection and retirement
solutions that meets the needs of our customers and adds value to their lives.

Mission
To continually strive to enhance customer experience through innovative product
offerings, dedicated relationship management and superior service delivery while
striving to interact with our customers in the most convenient and cost effective
manner.
To be transparent in the way we deal with our customers and to act with integrity.
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To invest in and build quality human capital in order to achieve our mission.

Values
Transparency: Crystal Clear communication to our partners and stakeholders
Value to Customers: A product and service offering in which
customers perceive value

Rock Solid and Delivery on Promise: This translates into being financially
strong, operationally robust and having clarity in claims

Customer-friendly: Advice and support in working with customers and

partners

Profit to Stakeholders: Balance the interests of customers, partners,

employees, shareholders and the community at large
3.3 COMPETITORS OF IDBI FEDERAL LIFE INSURANCE CO. LTD

1. AEGON Religare Life Insurance

2. Aviva India
3. Shriram Life Insurance
4. Bajaj Allianz Life Insurance
5. Bharti AXA Life Insurance Co Ltd
6. Birla Sun Life Insurance
7. Canara HSBC Oriental Bank of Commerce Life Insurance
8. Star Union Dai-ichi Life Insurance
9. DLF Pramerica Life Insurance
10.

Edelweiss Tokio Life Insurance Co. Ltd

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11.

Future Generali Life Insurance Co Ltd

12.

HDFC Standard Life Insurance Company Limited

13.

ICICI Prudential

14.

IDBI Federal Life Insurance

15.

IndiaFirst Life Insurance Company

16.

ING Vysya Life Insurance

17.

Kotak Life Insurance

18.

Max Life Insurance

19.

PNB MetLife India Life Insurance

20.

Reliance Life Insurance Company Limited

21.

Sahara Life Insurance

22.

SBI Life Insurance Company Limited

23.

TATA AIA Life Insurance

24.

Oriental insurance company

25.

L&T general insurance company

26.

Universal sampo general insurance company

27.

National insurance company limited

28.

Apollo Munich health insurance company

29.

United India insurance company limited

30.

Export credit and guarantee corporation of India Limited.

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3.4 ORGANIZATION STRUCTURE

CEO
VIGNESH SHAHANE

Marketing
&
Promotion

Under
writing

Finance

North
Zonal
Support
Manager
South
Zonal
Support
Manager

Human
Resourc
e

Product

East Zonal
Support
Manager

West
Zonal
Support
Manager

3.5 PRODUCTS OF IDBI FEDERAL

At IDBI Federal, its our constant endeavor to create innovations that create value
for our customers. These innovations are brought to life through our wide array of
products that fit the varying financial and investment needs at different stages of
life.
LIFESURANCE
CHILDSURANCE
INCOMESURANCE
TERMSURANCE
WEALTHSURANCE
LOANSURANCE
MICROSURANCE
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LIFESURANCE:
Often, the first step towards a long and arduous journey is the toughest. However,
once you have taken that first stride, the rest of the journey seems easier and more
enjoyable. With your investments, it is the same approach that will ensure you
build the right corpus to fulfil your dreams for yourself and your family start
small, save big!

HOW IT WORKS

CHILDSURANCE:
Whether your child wants to be a doctor, an engineer, an MBA, a sportsman, a
performing artist, or dreams of being an entrepreneur, the IDBI Federal
Childsurance Dream builder Insurance Plan will keep you future-ready against
both, changing dreams and lifes twists. It allows you to create build and manage
wealth by providing several choices and great flexibility so that your plan meets
your specific needs. However, what makes Childsurance a must-have for any
parent who is looking to make their childs future shock-proof is its powerful
insurance benefits. Childsurance allows you to protect your child plan with triple
insurance benefits so that your wealth-building efforts remain unaffected by

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unforeseen events and your childs future goals can be achieved without any
hindrance.

HOW IT WORKS
This second illustration below explains how the product works for a limited premium policy with
a policy term of 20 years

INCOMESURANCE:
IDBI Federal Incomesurance Endowment and Money Back Plan is loaded with lots
of benefits which ensure that you get Guaranteed Annual Payout along with
insurance protection which will help you to reach you goals with full confidence.
Incomesurance Plan is very flexible and allows you to customise your Plan as per
your individual and familys future requirements. Moreover it also allows you to
choose Premium Payment Period, Payout Period, Payout Options and more.

HOW IT WORKS
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Age

Payout

Age

Payout

18-30

138%

47

131%

31-36

137%

48

131%

37-39

136%

49

130%

40

135%

50

130%

41

135%

51

130%

42

134%

52

128%

43

134%

53

128%

44

133%

54

127%

45

133%

55

126%

46

132%

3.6 SWOT ANALYSIS OF IDBI FEDERAL LIFE

SWOT analysis of IDBI Federal Life Insurance represents analyzing strength,
weakness, opportunities, and threat of the company which are as follows:STRENGTH:-

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 The major strength of IDBI Federal Life is its sponsor companies which are
IDBI bank, Federal bank and Fortis. Because of its innovative ideas it is the
first insurance company to collect 100cr within five months of its
commencement of business. One major strength of IDBI Federal is its
combined network of more than 1600 branches of IDBI bank and Federal
bank.
Superior customer service with huge network and innovative products
High level of customer (both internal & external) satisfaction because of its
management policy.
Large pool of technically skilled workforce with deep knowledge of
insurance market.
WEAKNESS: The major weakness of IDBI Federal is the constraint sectorial growth due
to low unemployment level.
Low confidence of people in private insurance company.
The corporate clients under group schemes and salary savings schemes are
captured by other major players.
OPPORTUNITIES: Only 10% of Indian population is covered by insurance policy out of 30%
insurable population.
Due to liberalization it can operate globally.
Fast track carrier development opportunities on an industrial wide basis.
After liberalization it is expected that insurance business is roughly 400
billion rupees per year now which shows big opportunities and market for
IDBI Federal Life Insurance.
The existing LIC and GIC, have created a large group of dissatisfied
customers due to the poor quality of service. Hence there will be shift of
large number of customers for other players.
THREATS: Big public insurance companies like LIC, National Insurance Companies
Limited, Oriental Life Insurance etc are the biggest threats to IDBI Federal
Life Insurance.
Large potential market attracts new rivals.
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Latest market share of all insurance companies as of march 2013:

3.7 COMPETITOR ANALYSIS:

Competitor analysis in marketing and strategic management is a judgment of
strength and weakness of the competitors. Companies generally do this analysis to
understand the strength and weakness of their current and potential competitors.
This analysis provides both offensive and defensive strategy to identify both
opportunity and threats. IDBI federal Life Insurance is one of emerging insurance
company. It is one of the few companies that have shown rapid growth since the
day of its inception. In order to gain higher market Share Company has to
understand its competitors that is their strength and weakness .Competitor analysis
will help IDBI to understand strength and weakness of their competitors. This
analysis will help IDBI to come up with offensive or defensive strategy to identify
both opportunity and threats.
Some of the main competitors of IDBI federal are:
1. Life Insurance Corporation of India (LIC)
2. ICICI prudential
3. SBI Life
4. HDFC standard Life
5. Bajaj Alliance
1. Life Insurance Corporation of India ( LIC):
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LIC was founded in 1956 with the merger of 243 insurance company and
provident societies. It is the largest insurance and investment company in
India. It is a state owned with 100% stake owned by government of India.
Products offered by LIC are:
1. Jeevan Arogya plan:
Jeevan arogya plan is a unique non-linked health insurance plan which
provides health insurance against certain specified health risk. LICs
jeevan arogya plan is a direct competition to IDBIs Healthsurance plan.
2. Bima Account plan:
Under this plan the premiums payed by the customer after deduction of
all charges, will be credited to the policyholders account maintained
separately for each policyholder. If all premiums are paid the amount
held in policyholders account will earn an annual interest rate of 6% p.a
3. Endowment plan:
Its a unit linked endowment plan which offers investment cum insurance
cover during the term of the policy.
4. Children Plans
5. Plan for Handicapped Dependents
6. Endowment assurance plans
7. Plans for high worth Individual
8. Money Back Plans
9. Special Money Back Plan for Women
10.Whole Life Plans
11.Term assurance plans
12. Joint Life Plan
1.1 SWOT Analysis of LIC:
SWOT Analysis is a strategic planning method used to analyze strength,
weakness, opportunity and threat involved in a business or a project.
1. Strength:
LIC is Indias largest state-owned company and also Indias
largest investors
LIC has over 2000 branches all across India and more than 1,
00,000 agents.
LIC is the largest investor in India with largest fund base.
LIC has over 1, 15,000 employees across India.
LIC is the 8th most trusted brand of India.
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 LIC has subsidiaries like LIC card services Ltd, LIC Housing
finance Ltd, LIC Nomura mutual fund.
2. Weakness:
It lacks imagination since it has an image of a government
company
Red tape, bureaucracy causes the problem since it is a government
company.
During the economic crises managing a he workforce is a lot of
burden.
2. ICICI Prudential:
ICICI prudential Life Insurance Company is the joint venture of ICICI bank
and Prudential Plc, one of the leading financial service groups in UK.
Products offered by ICICI prudential:
1. ICICI pru care:
It is an insurance plan that protects familys future and ensures they lead
their life comfortably.
2. Save n Protect
3. Cash back
4. Home Assure
5. Life Guard
6. ICICI pru iprotect
7. Smartkid Regular premium
8. ICICI pru Elite Life
9. Group term insurance plan
10.Group Gratuity plan
11.Annuity solution
12. ICICI pru life link pension SP
13.Forever Life
14.Immediate annuity
15.ICICI pru heath saver
16.ICICI pru Hospital care
17.ICICI pru crisis cover
18.ICICI pru Mediassure
SWOT Analysis of ICICI prudential:

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STRENGTHS:
1.Strong tie up
2.Brand Equity
3.Strong network
4.Huge customer database
5.Strong financial base

Weaknesses:
1.Low customer awareness
2.Less promotion
3.Untouched Rural Population

OPPORTUNITIES:
1.Untouched Rural market
2.Large Uninsured population
3.Network Building

Threats:
1.Competitors
2.Customer beliefs in LIC
3.Fast turnover of employees

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4. ECONOMIC INDUSTRY ANALYSIS

4.1. INTRODUCTION TO INSURANCE INDUSTRY:
Insurance is a form of risk management that shields insured from the risk of any
uncertain of unfortunate events. In simple terms insurance can be defined as
transfer of risk from one entity to another in exchange of the payment. The
transaction consists of insured assuming a guaranteed small loss in the form of
payment to the insurer in exchange of the promise to compensate insured in case of
any kind of financial loss to insured. In a laymans term, insurance is a guard
against monetary loss arising on the happening of an unforeseen event. In
developing countries like India insurance sector still holds lot of potential which
need to be tapped.
4.2TYPES OF INSURANCE:
Insurance can be classified into three categories:
1. Life Insurance:
Life Insurance is a concord between the insurer and the policyholder, where
insurer promises to pay beneficiary designated sum of money upon death of
the insured person. Life Insurance covers number of contingencies like
Death, Disability, and Disease.
2. General Insurance:
General Insurance is a non-life insurance policy including automobile and
homeowner policy. General insurance specifically consist of non- life
insurance. It includes property insurance, liability insurance and other forms
of insurance. Fire and Marine insurance are called property insurance.
3. Social Insurance:
Social insurance is another type of insurance for weaker section of the
society. It provides protection to weaker section of the society who are unable
to pay premium. Industrial Insurance, sickness insurance, pension plan,
disability benefits, unemployment benefits are some the type of social
insurance.

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4.3 INSURANCE SECTOR IN INDIA:

Indian insurance sector has gone through different phases of competition, from
being an open competitive market to a nationalized market and then again getting
back to liberalized market. Indian insurance sector has witnessed complete
dynamism in past few centuries.
Insurance sector in India has a deep- rooted history. Its mention has been found in
writings of Manu (Manusmriti), Yagnavalkya (dharmashastra) and Kautilya
(Arthshastra). Ancient Indian history has preserved traces of insurance in the form
of marine trade loans and carrier contracts.
Insurance industry in India is governed by Insurance Act of 1938, Life Insurance
Corporation Act of 1956 and General Insurance business Act, 1972, Insurance
Regulatory and Development Authority (IRDA) Act of 1999 and other related acts.
Insurance industry in India is considered as an industry with big potential market.
One of the reason that India is seen as huge potential market is because of its huge
population and untapped market area of this population. In terms of population
India has an immense potential expanding their life insurance cover. Majority of
people in India are unaware of the functions and benefits of Insurance because of
which insurance sector has a bright future in India. But it is relevant to consider
factors like different varieties of social structure, urban and rural composition other
than very important factors like age, sex, income level, literacy level. Making
assessment of Life Insurance potential of India is very difficult task due to wide
variance in every aspect of Indian circumstances and without a refined analysis any
estimate
would
be
meaningless.

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4.4 INDIAN INSURANCE INDUSTRY AT PRESENT:

Life Insurance Corporation (LIC) had the monopoly over the market till the late
90s when the insurance sector in India was opened for private players. Before that
there were only two state insurer, one was LIC (Life Insurance Corporation of
India) and GIC (General Insurance corporation of India).
Indian insurance sector at present has undergone many structural changes in 2000.
The Government of India has liberalized the insurance sector in 2000 with IRDA
(Insurance Regulatory and development authority) lifting all entry restriction of
foreign players with a specific limit on direct foreign ownership. Under the current
guideline 26% of equity cap is there for foreign players in an insurance company
and proposal is being given to increase this limit to 49%. Post liberalization
insurance industry in India have come a long way and today it stands as one of the
most competitive, challenging and exploring industry in India. Increased use of
new distribution channels are in limelight today due to entry of private players. In
the long run the use of these distribution channels and modern IT tools has
increased scope of the insurance industry. Also the changing economics patterns,
changing political scenario, modern IT tools will eventually help in reshaping
future of Indian financial market and Life Insurance business in the country.

4.5 REGULATORY ISSUES:

Insurance Regulatory and Development Authority (IRDA) is a national agency of
government of India. It was formed by an act of Indian Parliament known as
IRDA Act 1999 which was amended in 2002 to incorporate some upcoming
requirement. It is responsible for protecting the interest of policy holders, to
regulate and promote orderly growth of Insurance Industry in India. To achieve
this objective IRDA has taken following steps:
1. IRDA has notified protection of policyholders Interest Regulation 2001 to
provide for: policy proposal document is in easily understandable language;
claims procedure in both life and non-life; setting up grievance redress
machinery; speedy settlement of claims and policy holders servicing. The
regulation also provides for payment of interest by insurer for delay in
settlement of claims.

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2. Solvency margins are to be maintained by the insurer so that they can be in a

position to meet their obligation towards the policyholder with respect to
payment of claims.
3. The Insurance Company has to clearly disclose the benefits, terms and
condition under the policy.
4. The advertisement issued by the insurer should not mislead the insuring
public.
5. Proper grievance redress machinery should be set up in the head office and
all the other offices by the insurer.
6. If any complaints are received by the policyholder with respect to the
services provided by the insurer under the insurance contact, then the
authority takes up with the insurer.
7. Insurer has to maintain separate account related to the fund of Policyholder.
The funds of the policyholder should be retained within the country.
8. According to the new regime, Insurance companies will have to exposure to
rural and social sector.

4.6 CRITICAL SUCCESS FACTORS:

Post Liberalization Insurance industry in India has become very competitive. With
private players entering into the India market making the market lot more
competitive. Insurance industry in India has become highly competitive with
different companies and individual agents competing against each other to gain
higher market share. In order to gain higher market share companies have to
differentiate themselves from others. Companies can differentiate themselves in the
market by using a number of critical success factors:
1. Product Quality:
One the most important factor that differentiates companies is by the quality
of product it offers. Quality of product instills a confidence in the customer
that the product offered by the company is better. Better the quality of
product, more successful is the company.

2. Developing relationships with the customer:

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Insurance Industry is a highly competitive industry. In order to gain the

market share first priority is to be given to the customer. Range of product
and services should be designed to give the customer what he desires.
3. Market Segmentation:
Greater market segmentation should be done in which target audience
should be divided into homogenous groups and products and services should
be targeted towards such market. This would tie company to their client by
customized combination of coverage, easy payment plan, risk management
advice and quick claim handling.
4. Designing new strategies:
Insurance Industry cannot be satisfied with consolidation of their existing
market, but have to achieve future growth and penetration. Companies must
focus on new distribution channels, strengthening their existing point of
services, direct contact with their ultimate customer, refresh their marketing
setup, new comers should focus on tapping the market which is left
unexploited by public sector companies.
5. Shift towards Rural market:
Rural market is India is still uncovered by this sector. Insurance penetration
can be achieved by tapping the untapped rural market of India.
6. Motivating sales force:
Sales force is one the major strength that the company has that could
differentiate them from their competitors. A good sales force can do wonders
to the future of the company, because of which a proper motivation of sales
force is very important for the company. Life Insurance Company should
constantly involve in motivating their sales force so that they can meet their
target on time.
7. Use of technology:
Technology plays a very important role in the success of the company.
Internet based Life insurance will help companies to reduce time and
transaction cost and also improves quality of services to its customer.
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4.7 DOMESTIC ECONOMIC CONDITIONS:

Domestic economic conditions play a major role in growth or downfall of an
Insurance company, No matter how financially stable an insurer is; none is
immune to the slow economic growth. In an Indian economy double digit inflation
is one the uncomfortable factor and RBI which is the central bank of India has a
huge task of controlling the inflation without hampering the economic growth.
Trade off between Interest rates and Inflation has been the core the business of the
RBI and the past one year has been very difficult for the RBI. In an attempt to
manage inflation, RBI has been constantly raising repo rate and reverse-repo rates
every quarter but it has not succeeded in moderating inflation. This simply implies
that inflation is more of a supply side issue than a monetary implication. The
implications of this relatively high interest rates and high inflation regime are
unlikely to be positive for insurance industry. It would be difficult for an
Insurance industry to manage return expectations as they are likely to be high.
While competing with a fixed income product higher assured returns are required
for high.
Interest rates in order to increase penetration. There may be some reductions in
actual growth rates, but Indians long term fundamentals remain intact as life
Insurance being an industry with long time horizon, it would be able to tide over
economic cycle.
Inflation on the other hand means lower disposal incomes in the hand of the
consumer leading to lower household savings which currently stands at 34.7%,
though significantly lower than china which is 50%.

4.8 GLOBAL ECONOMIC ENVIRONMENT:

According to the Swiss Res newly appointed Economist, Kurl Karl low interest
rates and euro debt crisis will prove to be a problem for insurance industry.
According to Kurt karl momentum of growth has been slowed down due to this
two factors, but the only bright spot according to him is the ongoing growth in the
emerging market. However Kurl is lot more optimistic looking forward to 2013
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forecasting a pick-up in investment yield and premium in a modest improvement

in economic conditions.
1. Political Development:
Political developments are the more serious threat in Europe and US. In
Europe this can lead to serious sovereign defaults and also exit from the
euro monetary union.
2. Emerging markets has been negatively impacted by faltering growth in
the developed economy. Also tighter monetary policies on the part of
several emerging economies also slowed down growth.
3. Both global in-force and new business life insurance fell in 2011, but it
again recovered. According to the economist in order to return to the precrisis profitability short- term factors like low investment returns, high
hedging cost and more onerous capital requirement. Life Insurance
industrys capitalization has improved markedly and it is in the better
shape to cope up with the future challenges.
4. Because of some Regulatory changes in China and India, coming two
years will see life insurance business in emerging market returning to its
long term trend of around 8%.

4.9 DEMAND DRIVERS:

Insurance industry in India has become lot more competitive in recent years. With
private players entering into the market, competition level has significantly
increased with more private players trying to gain more market share. Some of the
demand drivers that give change
to the smaller companies to compete against giants like Life Insurance
Corporation of India Ltd (LIC) which has 70% market share are:
1. Rural market:
According to the Mckinsey report, titled India Insurance 2012: Fortune
Favors the Bold, finds that the sector is still in a dissident with different
players in different stage of development and market presence. According
to the Mckinseys report the rural penetration is likely to increase from
about 25% at present to around 35-40% in 2012. With 65% of the Life
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insurance coming from rich urban class, smaller companies can look for
rural and low income group as potential demand driver.
2. Product Mix;
A better product mix would also drive growth of insurance companies,
with companies making a move to lower the share of single premium
products.
Life insurance product can also fill the gap that is created by growing demand for
investment products and long-term savings

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5 LITERATURE REVIEW
5.1 LITERATURE
Capital structure is defined as the specific mix of debt and equity a firm uses to
finance its operations. Four important theories are used to explain the capital
structure decisions. These are based on asymmetric information, tax benefits
associated with debt use, bankruptcy cost and agency cost. The first is rooted in the
pecking order framework, while the other three are described in terms of the static
trade-off choice. These theories are discussed in turn.
The concept of optimal capital structure is expressed by Myers (1984) and Myers
and Majluf (1984) based on the notion of asymmetric information. The existence
of information asymmetries between the firm and likely finance providers causes
the relative costs of finance to vary among different sources of finance. For
example, an internal source of finance where the funds provider is the firm will
have more information about the firm than new equity holders, thus these new
equity holders will expect a higher rate of return on their investments. This means
it will cost the firm more to issue fresh equity shares than to use internal funds.
Similarly, this argument could be provided between internal finance and new debtholders. The conclusion drawn from the asymmetric information theories is that
there is a certain pecking order or hierarchy of firm preferences with respect to the
financing of their investments (Myers and Majluf, 1984). This pecking order
theory suggests that firms will initially rely on internally generated funds, i.e.,
undistributed earnings, where there is no existence of information asymmetry; they
will then turn to debt if additional funds are needed, and finally they will issue
equity to cover any remaining capital requirements. The order of preferences
reflects the relative costs of various financing options. Clearly, firms would prefer
internal sources to costly external finance (Myers and Majluf, 1984). Thus,
according to the pecking order hypothesis, firms that are profitable and therefore
generate high earnings are expected to use less debt capital than those that do not
generate high earnings.
Capital structure of the firm can also be explained in terms of the tax benefits
associated with the use of debt. Green, Murinde and Suppakitjarak (2002) observe
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that tax policy has an important effect on the capital structure decisions of firms.
Corporate taxes allow firms to deduct interest on debt in computing taxable profits.
This suggests that tax advantages derived from debt would lead firms to be
completely financed through debt. This benefit is created, as the interest payments
associated with debt are tax deductible, while payments associated with equity,
such as dividends, are not tax deductible. Therefore, this tax effect encourages debt
use by the firm, as more debt increases the after tax proceeds to the owners
(Modigliani and Miller, 1963; Miller, 1977). It is important to note that while there
is corporate tax advantage resulting from the deductibility of interest payment on
debt, investors receive these interest payments as income. The interest income
received by the investors is also taxable on their personal account, and the personal
income tax effect is negative. Miller (1977) and Myers (2001) argue that as the
supply of debt from all corporations expands, investors with higher and higher tax
brackets have to be enticed to hold corporate debt and to receive more of their
income in the form of interest rather than capital gains. Interest rates rise as more
and more debt is issued, so corporations face rising costs of debt relative to their
costs of equity. The tax benefits arising from the issue of more corporate debt may
be offset by a high tax on interest income. It is the trade-off that ultimately
determines the net effect of taxes on debt usage (Miller, 1977; Myers, 2001).
Bankruptcy costs are the costs incurred when the perceived probability that the
firm will default on financing is greater than zero. The potential costs of
bankruptcy may be both direct and indirect. Examples of direct bankruptcy costs
are the legal and administrative costs in the bankruptcy process. Haugen and
Senbet (1978) argue that bankruptcy costs must be trivial or nonexistent if one
assumes that capital market prices are competitively determined by rational
investors. Examples of indirect bankruptcy costs are the loss in profits incurred by
the firm as a result of the unwillingness of stakeholders to do business with them.
Customer dependency on a firms goods and services and the high probability of
bankruptcy affect the solvency of firms (Titman, 1984). If a business is perceived
to be close to bankruptcy, customers may be less willing to buy its goods and
services because of the risk that the firm may not be able to meet its warranty
obligations. Also, employees might be less inclined to work for the business or
suppliers less likely to extend trade credit.
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These behaviours by the stakeholders effectively reduce the value of the firm.
Therefore, firms that have high distress cost would have incentives to decrease
outside financing so as to lower these costs. Warner (1977) maintains that such
bankruptcy costs increase with debt, thus reducing the value of the firm. According
to Modigliani and Miller (1963), it is optimal for a firm to be financed by debt in
order to benefit from the tax deductibility of debt. The value of the firm can be
increased by the use of debt since interest payments can be deducted from taxable
corporate income. But increasing debt results in an increased probability of
bankruptcy. Hence, the optimal capital structure represents a level of leverage that
balances bankruptcy costs and benefits of debt finance. The greater the probability
of bankruptcy a firm faces as the result of increases in the cost of debt, the less
debt they use in the issuance of new capital (Pettit and Singer, 1985).
The use of debt in the capital structure of the firm also leads to agency costs.
Agency costs arise as a result of the relationships between shareholders and
managers, and those between debt-holders and shareholders (Jensen and Meckling,
1976). The relationships can be characterized as principal-agent relationships.
While the firms management is the agent, both the debt-holders and the
shareholders are the principals. The agent may choose not to maximize the
principals wealth. The conflict between shareholders and managers arises because
managers hold less than 100% of the residual claim (Harris and Raviv, 1990).
Consequently, they do not capture the entire gain from their profit-enhancing
activities but they do bear the entire cost of these activities. Separation of
ownership and control may result in managers exerting insufficient work,
indulging in perquisites, and choosing inputs and outputs that suit their own
preferences. Managers may invest in projects that reduce the value of the firm but
enhance their control over its resources. For example, although it may be optimal
for the investors to liquidate the firm, managers may choose to continue operations
to enhance their position. Harris and Raviv (1990) confirm that managers have an
incentive to continue a firms current operations even if shareholders prefer
liquidation.
On the other hand, the conflict between debt-holders (creditors) and shareholders is
due to moral hazard. Agency theory suggests that information asymmetry and
moral hazard will be greater for smaller firms (Chittenden et al., 1996). Conflicts
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between shareholders and creditors may arise because they have different claims
on the firm. Equity contracts do not require firms to pay fixed returns to investors
but offer a residual claim on a firms cash flow. However, debt contracts typically
offer holders a fixed claim over a borrowing firms cash flow. When a firm
finances a project through debt, the creditors charge an interest rate that they
believe is adequate compensation for the risk they bear. Because their claim is
fixed, creditors are concerned about the extent to which firms invest in excessively
risky projects. For example, after raising funds from debt-holders, the firm may
shift investment from a lower-risk to a higher-risk project.
According to Jensen and Meckling (1976), the conflict between debt-holders and
equity-holders arises because debt contract gives equity-holders an incentive to
invest sub optimally. More specifically, in the event of an investment yielding large
returns, equity-holders receive the majority of the benefits. However, in the case of
the investment failing, because of limited liability, debt-holders bear the majority
of the consequences. In other words, if the project is successful, the creditors will
be paid a fixed amount and the firms shareholders will benefit from its improved
profitability. If the project fails, the firm will default on its debt, and shareholders
will invoke their limited liability status. In addition to the asset substitution
problem between shareholders and creditors, shareholders may choose not to invest
in profitable projects (under invest) if they believe they would have to share the
returns with creditors.
The agency costs of debt can be resolved by the entire structure of the financial
claim. Barnea et al. (1980) argue that the agency problems associated with
information asymmetry, managerial (stockholder) risk incentives and forgone
growth opportunities can be resolved by means of the maturity structure and call
provision of the debt. For example, shortening the maturity structure of the debt
and the ability to call the bond before the expiration date can help reduce the
agency costs of underinvestment and risk-shifting. Barnea et al. (1980) also
demonstrate that both features of the corporate debt serve as identical purposes in
solving agency problems.

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5.2 THEORIES OF CAPITAL STRUCTURE

5.2.1 INTRODUCTION:
The Capital Structure or financial leverage decision should be examined from the
point of its impact on the value of the firm. If capital structure decision can affect a
firms value, then it would like to have a capital structure, which maximizes its
market value. However, there exist conflicting theories on the relationship between
capital structure and the value of a firm. The traditionalists believe that capital
structure affects the firms value while Modigliani and Miller (MM), under the
assumptions of perfect capital markets and no taxes, argue that capital markets and
no taxes, argue that capital structure decision is irrelevant. MM reverses their
position when they consider taxes. Tax savings resulting from interest paid on debt
create value for the firm. However, the tax advantage of debt is reduced by
personal taxes and financial distress. Hence, the tradeoff between costs and
benefits of debt can turn capital structure into a relevant decision. There are other
views also on the relevance of capital structure; we first discuss the traditional
theory of capital structure followed by MM theory and other views.
The capital structure of a company refers to a contamination of the long-term
finances used by the firm. The theory of capital structure is closely related to the
firms cost of capital. The decision regarding the capital structure or the financial
leverage or the financing wise is based on the objective of achieving the
maximization of shareholders wealth.
To design capital structure, we should consider the following two
propositions :
1) Wealth maximization is attained
2) Best approximation to the optimal capital structure.
What is capital Structure?
Since capital is expensive for small businesses, it is particularly important for small
business owners to determine a target capital structure for their firms. The capital
structure concerns the proportion of capital that is obtained through debt and
equity. There are tradeoffs involved: using debt capital increases the risk associated
with the firm's earnings, which tends to decrease the firm's stock prices. At the
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same time, however, debt can lead to a higher expected rate of return, which tends
to increase a firm's stock price. As Brigham explained, "The optimal capital
structure is the one that strikes a balance between risk and return and thereby
maximizes the price of the stock and simultaneously minimizes the cost of capital."
Capital structure decisions depend upon several factors. One is the firm's business
riskthe risk pertaining to the line of business in which the company is involved.
Firms in risky industries, such as high technology, have lower optimal debt levels
than other firms. Another factor in determining capital structure involves a firm's
tax position. Since the interest paid on debt is tax deductible, using debt tends to be
more advantageous for companies that are subject to a high tax rate and are not
able to shelter much of their income from taxation.
A third important factor is a firm's financial flexibility, or its ability to raise capital
under less than ideal conditions. Companies that are able to maintain a strong
balance sheet will generally be able to obtain funds under more reasonable terms
than other companies during an economic downturn. Brigham recommended that
all firms maintain a reserve borrowing capacity to protect themselves for the
future. In general, companies that tend to have stable sales levels, assets that make
good collateral for loans, and a high growth rate can use debt more heavily than
other companies. On the other hand, companies that have conservative
management, high profitability, or poor credit ratings may wish to rely on equity
capital instead.
SOURCES OF CAPITAL
DEBT CAPITAL Small businesses can obtain debt capital from a number of
different sources. These sources can be broken down into two general categories,
private and public sources. Private sources of debt financing, according to W. Keith
Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan and
Raising Venture Capital, include friends and relatives, banks, credit unions,
consumer finance companies, commercial finance companies, trade credit,
insurance companies, factor companies, and leasing companies. Public sources of
debt financing include a number of loan programs provided by the state and federal
governments to support small businesses.
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There are many types of debt financing available to small businessesincluding

private placement of bonds, convertible debentures, industrial development bonds,
and leveraged buyoutsbut by far the most common type of debt financing is a
regular loan. Loans can be classified as long-term (with a maturity longer than one
year), short-term (with a maturity shorter than two years), or a credit line (for more
immediate borrowing needs). They can be endorsed by co-signers, guaranteed by
the government, or secured by collateralsuch as real estate, accounts receivable,
inventory, savings, life insurance, stocks and bonds, or the item purchased with the
loan.
When evaluating a small business for a loan, Jennifer Lindsey wrote in her book
The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year
operating history, a stable management group, a desirable niche in the industry, a
growth in market share, a strong cash flow, and an ability to obtain short-term
financing from other sources as a supplement to the loan. Most lenders will require
a small business owner to prepare a loan proposal or complete a loan application.
The lender will then evaluate the request by considering a variety of factors. For
example, the lender will examine the small business's credit rating and look for
evidence of its ability to repay the loan, in the form of past earnings or income
projections. The lender will also inquire into the amount of equity in the business,
as well as whether management has sufficient experience and competence to run
the business effectively. Finally, the lender will try to ascertain whether the small
business can provide a reasonable amount of collateral to secure the loan.
EQUITY CAPITAL Equity capital for small businesses is also available from a
wide variety of sources. Some possible sources of equity financing include the
entrepreneur's friends and family, private investors (from the family physician to
groups of local business owners to wealthy entrepreneurs known as "angels"),
employees, customers and suppliers, former employers, venture capital firms,
investment banking firms, insurance companies, large corporations, and
government-backed Small Business Investment Corporations (SBICs).
There are two primary methods that small businesses use to obtain equity
financing: the private placement of stock with investors or venture capital firms;
and public stock offerings. Private placement is simpler and more common for
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young companies or startup firms. Although the private placement of stock still
involves compliance with several federal and state securities laws, it does not
require formal registration with Securities and Exchange Commission. The main
requirements for private placement of stock are that the company cannot advertise
the offering and must make the transaction directly with the purchaser.
In contrast, public stock offerings entail a lengthy and expensive registration
process. In fact, the costs associated with a public stock offering can account for
more than 20 percent of the amount of capital raised. As a result, public stock
offerings are generally a better option for mature companies than for startup firms.
Public stock offerings may offer advantages in terms of maintaining control of a
small business, however, by spreading ownership over a diverse group of investors
rather than concentrating it in the hands of a venture capital firm.
Factors determining capital structure
1) Minimization of Risk: a> capital structure must be consistent with business risk
b> It should result in a certain level of financial risk.
2) Control: It should reflect the managements philosophy of control over the firm.
3) Flexibility: It refers to the ability of the firm to meet the requirement of the
changing situation.
4) Profitability: It should be profitable from the equity shareholders point of view.
5) Solvency: The use of excessive debt may thereafter the solvency of the
company.

Process of capital structure decision

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Value of Firm

MEANING OF CAPITAL STRUCTURE:

A mix of a company's long-term debt, specific short-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. Short-term debt
such as working capital requirements is also considered to be part of the capital
structure.
Assumptions:
1) There are only two sources of funds i.e. the equity and debt, having a fixed
interest
2) The total assets of the firm are given and there would be no change in the
investment decision of the firm
3) EBIT (Earnings before Interest & Tax)/ NOP (Net Operating Profits) of the
firm are given and is expected to remain constant.
4) Retention ratio is NIL,, i.e., total profits are distributed as dividends. [100%
dividend pay-out ratio]
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5) The firm has a given business risk which is not affected by the financing
wise.
6) There is no corporate or personal taxes
7) The investors have the same subjective probability distribution of expected
operation profits of the firms
8) The capital structure can be altered without incurring transaction costs.
Elements of Capital Structure:A company formulating its long term financial policy should, first of all analyze its
current financial structure, the following are the important elements of the
companys financial structure that need proper scrutiny and analysis.
1) Capital Mix:- Firms have to decide about the mix of debt and equity capital,
debt capital can be mobilized from a variety of sources, How heavily does
the company depend on debt? What is the mix of debt instruments? Given the
companys risks, is the reliance on the level and instruments of debt
reasonable? Does the firms debt policy allow its flexibility to undertake
strategic investments in adverse financial condition? Ther firms and analysts
use debt ratios, debt service coverage ratios, and the funds flow statement
analyze the capital mix
2) Maturity and priority:- The maturity of securities used in the capital mix
may differ. Equity is the most permanent capital. Within debt, commercial
paper has the shortest maturity and public debt has the longest, Similarly, the
priorities of securities also differ. Capitalized debt like lease or hire purchase
finance is quite safe from the lenders point of view and the value of assets
backing the debt provides the protection to the lender. Collateralized or
secured debts are relatively safe and have priority over unsecured debt in the
event of insolvency. Do maturities of the firms assets and liabilities match?
If not, what trade off is the firms making? A firm may obtain a risk neutral
position by matching the maturity of assets and liabilities that is it may use
current liabilities to finance current assets and short medium and long term
debt for financing the fixed assets in that order of maturities. In practise,
firms do not perfectly match the sources and uses of funds. They may show
preference for retained earnings. Within debt, they may use long term funds

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to finance current assets and assets with shorter life. Some firms are more
aggressive, and they use short term funds to finance long term assets.
3) Terms & Condition:- Firms have choices with regard to the basis of interest
payments. They may obtain loans either at fixed or floating rates of interest.
In case of equity, the firm may like to return income either in the form of
large dividends or large capital gains. What is the firms preference with
regard to the basis of payments of interest and dividend? How do the firms
interest and dividend payments match with its earnings and operating cash
flows? The firms choice of the basis of payments indicates the
managements assessment about the future interest rates and the firms
earnings. Does the firm have protection against interest rates fluctuations?
The financial manager can protect the firm against interest rates fluctuations
through the interest rates derivatives. There are other important terms and
conditions that the firm should consider. Most loan agreements include what
the firm can do and what it cant do. They may also state the schemes of
payments, pre-payments, renegotiations, etc. What are the lending criteria
used by the suppliers of capital? How do negative and positive conditions
affect the operations of the firm? Do they constraint and compromise the
firms competitive position? Is the company level to comply with the terms
and conditions in good time and bad time?
4) Currency:- Firms in a number of countries have the choice of raising funds
from the overseas markets. Overseas financial markets provide opportunities
to raise large amounts of funds. Accessing capital internationally also helps
company to globalize its operations fast. Because international financial
markets may not be perfect and may not be fully integrated, firms may be
able to issue capital overseas at lower costs than in the domestic markets. The
exchange rates fluctuations can create risk for the firm in servicing it foreign
debt and equity. The financial manager will have to ensure a system of risk
hedging. Does the firm borrow from the overseas markets? At what terms
and condition? How has firm benefited operationally and or financially in
raising funds overseas? Is there a consistency between the firms foreign
currency obligations and operating inflows?
5) Financial innovation:- Firms may raise capital either through the issue of
simple securities or through the issues of innovative securities. Financial
innovations are intended to make the security issue attractive to investors and
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reduce cost of capital. For example, a company may issue convertible

debentures at a lower interest rate rather than non convertible debentures at a
relatively higher interest rate. A further innovation could be that the company
may offer higher simple interest rate on debentures and offer to convert
interest amount into equity. The company will be able to conserve cash
outflows. A firm can issue varieties of option linked securities it can also
issue tailor made securities to a large suppliers of capital. The financial
manager will have to continuously design innovative securities to be able to
reduce the cost. An innovation introduced once does not attract investors any
more. What is the firms history in arms of issuing innovative securities?
What were the motivations in issuing innovative securities and did the
company achieve intended benefits?
6) Financial market segments:- There are several segments of financial
markets from where the firm can tap capital form example, a firm can tap the
private or the public debt market for raising long terms debt. The firm can
raise short term debt either from banks or by issuing commercial papers or
certificate deposits in the money market. The firm also has the alternative of
raising short term funds by public deposits. What segments of financial
markets have the firm tapped for raising funds and why? How did the firm
tap and approach these segments.
In Discussing the theories of capital structure we will consider the following
notations:
E= Market value of equity.
D= Market value of the Debt.
V= Market value of the firm = E+D
I= Total interest Payment
T= Tax Rate
EBIT/ NOP= Earnings Before interest and tax or Net Operating Profit
PAT= Profit after tax
Do= Dividend at time (i.e. now)
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D1= Expected dividend at the end of Year 1

Po= Current Market Price Per Share.
P1= Expected Market Price per share at the end of year 1
Kd= Cost of debts after tax 1(1-T)/d
Ke= Cost of Equity D1/P0
Ko= overall cost of capital i.e. WACC
=Kd (D/D+E) + Ke (E/D+E)
=kd (D/V) + Ke (E/V) = Kd D/ V + Ke E/V = Kd D+ Ke E/V
=EBIT/V
5.3 DIFFERENT THEORIES OF CAPITAL STRUCTURE
1> Net Income (NI) Approach
2> Net Operating Income (NOI) Approach.
3> Traditional Approach
4> Modigliani-Miller Model
a> without taxes.
b> with taxes.
5.3.1 NET INCOME APPROACH
A firm that finances its assets by equity and debt is called a levered firm. On the
other hand, a firm that uses no debt and finances its assets entirely by equity is
called and unlevered firm. Suppose firm L is levered firm and it expected EBIT or
net operating Income of Rs 100- and interest payment of Rs 300. The firms cost of
equity (or equity capitalization rate), ke, is 9.33 and the cost of debt, kd, is 6
percent. What is the firms value? The value of the firm is the sum of the values of
all of its securities. In this case, firm Ls securities include equity and debt;
therefore the sum of the values of equity and debt is the firms value. The value of
a firms value. The value of a firms share (equity), I, is the discounted value of
shareholders NOI-Interest 1000-300= Rs 700, and the cost of equity is 9.33
percent. Hence the value of Ls equity is 700/0.0933=Rs 7500
Value of equity= discounted value of net income
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E= Net Income/cost of equity =NI/ke

= 700/0.0933= Rs 7,500
Similarly the value of a firms debt is the discounted value of debt-holders interest
income. The value of Ls debt is: 300/0.06 = Rs 5000
Value of debt=discounted value of interest
D=Interest/Cost of debt=INT/kd
=300/0.06= Rs 5000
The value of firm L is the sum of the value of equity and the value of debt:
Value of firm=value of equity + Value of debt
V= E+D
= 7,500+5,000= Rs 12,500
Firms Ls value is Rs12,500 and its expected net operating income is Rs 1,000.
Therefore the firms overall expected rate of return or the cost of capital is:
Firms cost of capital= Net operating income/ Value of firm.
Ko=NOI/V
= 1000/12,500=0.08 or 8%
The firms overall cost of capital is the weighted average cost of Capital (WACC).
There is an alternative way of calculating WACC. WACC is the weighted average
of costs of all of the firms securities Firm Ls securities include debt and equity.
Therefore, firms Ls WACC or Ko is the weighted average of the cost of equity
and the cost of debt firm Ls value is Rs 12,500, Value of its equity is Rs 7,500 and
value of its debt is Rs 5000. Hence the firms debt ratio (D/V) is 5000/12500 =0.40
or 40 percent and equity ratio (E/V) is 7,500/12,500 = 0.60 or 60 percent. Firms
Ls weighted average cost of capital is:
WACC= Cost of equity x equity weight + cost of debt x debt weight
Ko = ke x E/V + Kd x D/V
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Ko = 0.0933 x 7,500/12,500 + 0.60 x 5000/12,500

Ko = 0.0933 x 0.60 + 0.06 x 0.40
= 0.56 + 0.025 = 0.08 or 8 percent
As suggested by David Durand, this theory states that there is a relationship
between the capital structure and the value of the firm.
Assumption
1> Total capital requirement of the firm are given and remain constant
2> Kd< Ke
3> Kd and Ke are constant
4> Kd decreases with the increase in leverage.

Kd

Illustration
Particulars

Firm A

Firm B

Earnings Before interest of Tax (EBIT)

2,00,000

2,00.000

Interest

50,000

Equity earnings (E)

2,00,000

1,50,000

Cost Of Equity

12%

12%
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Cost of Debt

10%

10%

Market Valu of Equity =E/Ke

16,66,667

12,50,000

Market value of debt = I/Ke

Nil

5,00,000

Total value of the firm [E+D]

16,66,667

17,50,000

Overall cost of capital (Ko) = EBIT/E+d

12%

11.43%

5.3.2 NET OPERATING INCOME (NOI) APPROACH:

According to David Durand, under NOI approach, the total value of the firm will
not be affected by the composition of capital structure.

Assumption:1) Ko and Kd is constant.

2) Ke will change with degree of leverage
3) There is no tax.

Kd

Illustration
A firm has an EBIT of Rs 5,00,000 and belongs to a risk class of 10%. What is the
cost of equity if it employs 8% debt to the extent of 30%, 40% or 50% of the total
capital fund of Rs 20,00,000?
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Solution
Particulars

30%

40%

50%

Debt (Rs)

6,00,000

8,00,000

10,00,000

Equity (Rs.)

14,00,000

12,00,000

10,00,000

EBIT (Rs.)

5,00,000

5,00,000

5,00,000

Ko

10%

10%

10%

50,00,000

50,00,000

44,00,000

42,00,000

40,00,000

Interest @ 6% (Rs.)

36,000

48,000

60,000

Net Profit
(Rs.)

4,64,000

4,52,000

4,40,000

10.54%

10.76%

11%

Value of the Firm (V)

(Rs.)
50,00,000
(EBIT/Ko)
Value of Equity (E) (Rs.)
(V-D)

Ke (NP/E)

(EBIT-Int..)

5.3.3 TRADITIONAL APPROACH:

It takes a mid-way between the NI approach and the NOI approach
Assumption
1> The value of the firm increases with the increase in financial leverage. Upto a
certain limit only.
2> Kd is assumed to be less than Ke

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Kd Kd

(Part 1)

(Part 2)

Traditional viewpoint on the Relationship

between Leverage, cost of capital
and the value of the firm.
5.3.4 MODIGLIANI MILLER (MM) HYPOTHESIS
The Modigliani- Miller hypothesis is identical with the net operation Income
approach, Modigliani and Miller argued that, in the absence of taxes the cost of
capital and the value of the firm are not affected by the changes in capital structure.
In other words, capital structure decision are irrelevant and value of the firm is
independent of debt-equity mix.
Basic propositions
M- M Hypothesis can be explained in terms of two propositions of Modigliani and
Miller They are:
1) The overall cost of capital (Ko) and the value of the firm are independent of the
capital structure. The total market value of the firm is given capitalising the
expected net operating income by the rate appropriate for that risk class.

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2) The financial risk increases with more debt content in the capital structure. As a
result cost of equity (Ke) increases in a manner to offset exactly the low- cost
advantage of debt. Hence overall cost of capital remains the same.
Assumptions of the MM Approach
1) There is a perfect capital market. Capital markets are perfect when
a) Investors are free to buy and sell securities
b) They can borrow funds without restriction at the same terms as the firms
do,
c) They behave rationally
d) They are well informed, and
e) There are no transaction costs.
2) Firms can be classified into homogeneous risk classes. All the firms in the
same risk class will have the same degree of financial risk
3) All investors have the same expectation of a firms net operating income
(EBIT)
4) The dividend payout ratio is 100% which means there are no retained
earnings
5) There are no corporate taxes. This assumption has been removed later.
Preposition 1
According to M-M for the firms in the same risk class, the total market value is
independent of capital structure and is determined by capitalising net operating by
the rate appropriate to that risk class. Preposition 1 can be expressed as follows
V = S+D = X/Ke =NOI/Ke
Where V = the market value of the firm
S = the market value of equity
D = the market value of debt
According the preposition 1 the average cost of capital is not affected by degree of
leverage and determined as follows
Ke = X/V
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According to M-M the average cost of capital is constant as shown in the following
firms

5.4 ARBITRAGE PROCESS

According to M-M two firms identical in all respects except their capital structure,
cannot have different market values or different cost of capital. In case, these firms
have different market values, the arbitrage will take place and equilibrium in
market values restored in no time. Arbitrage process refers to switching of
investment of investment from one firm another. When market values are different,
the investors will try to take advantage of it by selling their securities with high
market price and buying the securities with low market price. The use of debt by
the investors is known as personal leverage or home made leverage.
Because of this arbitrage process, the market price of securities in higher valued
market will come down and the market price of securities in the lower valued
market will go up, and this switching process is continued until the equilibrium is
established in the market values, so M-M argue that there is no possibility of
different market value for identical firms
Reverse Working Of Arbitrage Process
Arbitrage process also works in the reverse direction, Leverage has neither
advantage nor disadvantage. If an unlevered firm (With debt Capital) has higher
market value than a levered firm (With debt capital) arbitrage process works in
reverse direction. Investors will try to switch their investments from unlevered firm
to levered firm to levered firm so that equilibrium is established in no time
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Thus M-M proved in terms of their proposition 1 that the value of the firm is not
affected by debt equity mix.
Preposition 2
M-M argue that Ko will not increase with the increase in the leverage because the
low-cost advantage of debt capital will be exactly offset by the increase in the cost
of equity as caused by increased risk to equity shareholders. The crucial part of the
M-M thesis is that an excessive us of leverage will increase the risk to the debt
holders which results in an increase in cost of debt (Ko). However this will not
lead to a rise in Ko, M-M maintain that in such a case Ke, will increase at a
decreasing rate or even it may decline. This is because of the reason that at an
increased leverage. The increased risk will be shared by the debt holders. Hence
Ko remain constant. This is illustrated in the figure given below.

Ko

MM Hypothesis and Cost Of Capital

5.5 CRITICISM OF MM HYPOTHESIS
The arbitrage process is the behavioral and operational foundation for M M
Hypothesis. But this process fails the desired equilibrium because of the following
limitation.
1) Rates of interest are not the same for individuals and firms. The firms generally
have a higher credit standing because of which they can borrow funds at a
lower rate of interest as compared to individuals
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2) Home- Made leverage is not a perfect subsititute for corporate leverage. If the
firm borrows, the risk to the shareholders is limited to hi shareholding in that
company. But if he borrows personally, the liability will be extended to his
personal property also. Hence, the assumption that personal home-made
leverage is a perfect substitute for corporate leverage is not valid.
3) The assumption that transactions costs do not exist is not valid because these
costs are necessarily involved in buying and selling securities
4) The working of arbitrage is affected by institutional restrictions, because the
institutional investors are not allowed to practise home-made leverage.
5) The major limitation of M-M hypothesis is the existence of corporate taxes.
Since the interest charges are tax deductible, a levered firm will have a lowes
cost of debt due to tax advantage when taxes exist
5.6 M-M HYPOTHESIS CORPORATE TAXES
Modigliani and Miller later recognized the importance of existence of corporate
taxes. Accordingly, they agreed that the value of the firm will increase or the cost
of capital will decrease with the use of debt due to tax deductibility of interest
charges. Thus, the optimum capital structure can be achieved by maximizing debt
component in the capital structure.
According to this approach, value of a firm can be calculated as follows
Value of Unlevered firm (Vu) = EBIT/Ke (I-t).
Where EBIT = Earnings before interest and taxes
Ke = overall cost of capital
T = tax rate
I = interest on debt capital.
5.7 AGENCY COSTS
In practice, there may exist a conflict of interest among shareholders, debt holders
and management. These conflicts give rise to agency problems, which involve
agency costs. Agency costs have their influence on a firms capital structure.
1) Shareholders-Debt holder conflict:- Debt holders have a preferential, but
fixed claim over the firms assets. Shareholders, on the other hand, have a
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residual, but unlimited claim on the firms assets. They also have limited
liability for the firms obligations. In financial crisis, shareholders can simply
opt out from owing the firm. In a highly geared (levered) firm, the debt holders
risk is very high since shareholders have limited liability. They are not
compensated for the added risk of default, which tantamount to transfer of
wealth from debt-holders to shareholders. The conflict between shareholders (or
managers working on behalf of shareholders) and debt holders arise because of
the possibility of shareholders transferring the wealth of debt holders in their
favor. The debt holders may lend money to invest in low risk projects while the
firm may invest it in high risk projects while the firm may invest it in high risk
projects. Firm may also raise substantial risky new debt and thus, increase the
debt holders risk.
2) Shareholders- Managers Conflict:- Shareholders are the legal owners of a
company, and management is required to act in their best interest as their
agents. The conflict between shareholders and managers may arise on two
counts. First, managers may transfer shareholders wealth to their advantage by
increasing their compensation and perquisites. Second, managers may not act in
the best interest of shareholders in order to protect their jobs. Managers may not
undertake risk and forego profitable investments
3) Monitoring and agency costs:- The agency problems arising from the
conflicts between shareholders, debt-holders and managers are handled through
monitoring and restrictive covenants. External invertors know that managers
may not function in their interests, therefore, they have a tendency of
discounting the prices of the firms securities. These investors require
monitoring and restrictive covenants to protect their interests. Debt holders put
restrictions on the firm in terms of new debt. They also involve experts and
outsiders to evaluate the soundness of the firm and monitor the firms
subsequent actions. Similarly, shareholders create many monitoring
mechanisms to ensure that managers raise and invest funds keeping in mind the
principle of Shareholders Wealth Maximization. The costs of monitoring and
restrictive covenants are called agency costs. Agency costs of debt take account
of the likelihood of the shareholders attempt to expropriate wealth. Agency
costs of equity comprise incentives to managers to motivate them to act in the
best interests of shareholders by maximizing their wealth. The implications of
agency costs for capital structure are that management should use debt to the
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extent that it maximizes the shareholders wealth agency costs reduce the tax
advantage of debt.
5.8 PECKING ORDER THEORY
The Pecking Order theory is based on the assertion that managers have more
information about their firms than investors. This disparity of information is
referred to as asymmetric information. Other things being equal, because of
asymmetric information, managers will issue debt when they are positive about
their firms future prospects and will issue equity when they are unsure. A
commitment to pay to fixed amount of interest and principal to debt-holder implies
that the company expects steady cash flows. On the other hand, an equity issue
would indicate that the current share price is overvalued. Therefore, the manner in
which managers raise capital vies a signal of their belief in their firms prospects to
investors. This also implies that firms always use internal finance when available,
and choose debt over new issue of equity when external financing is required.
Myers has of equity when external finance is required. Myers has called it the
Pecking Order theory since there is not a well-defined debt equity target, and
there are two kinds of equity, internal and external, one at the top of pecking order
and one at the bottom, debt is cheaper than the costs of internal and external equity
due to interest deductibility, internal equity is cheaper and easier to use than
external equity. Internal equity is cheaper because
1) Personal taxes might have to be paid by shareholders on distributed earnings
while no taxes are paid on retained earnings, and
2) No transaction costs are incurred when the earnings are retained
Managers avoid signaling adverse information about their companies by using
internal finance. The profitable firms have lower debt ratios not because they have
lower targets but because they have internal funds to finance their activities, they
will issue equity capital when they think that shares are overvalued. Because of
this, it has been found that the announcement of new issue of shares generally
causes share prices to fall. Thus the pecking order theory implies that managers
raise finance in the following order
1) Managers always prefer to use internal finance.

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2) When they do not have internal finance, they prefer issuing debt. They first
issue secured debt and then unsecured debt followed by hybrid securities such
as convertible debentures.
3) As a last resort, managers issue shares to raise finances.
The pecking order theory is able to explain the negative inverse relationship
between profitability and debt ratio within an industry. However, it does not full
explain the capital structure differences between industries.

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