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Meaning:
Capital structure refers to the mix of sources from which the long
term funds required by a business are raised.
(a) The interest rates (i.e. the form of return on the borrowed
capital) are usually less than the dividend rates (i.e. the form of return
on the equity capital).
(3) Control Factor: While planning the capital structure and more
particularly while raising additional funds, the control factor plays an
important role, especially in case of closely held private limited
companies.
If the company decides to raise the long term funds by issuing further
equity shares or preference shares, it dilutes the controlling interest of
the present shareholders / owners, as the equity shareholders enjoy
absolute voting rights and preference share holders enjoy limited
voting rights. The control factor usually does not come into the picture
in case of borrowed capital unless the lender of the long term funds,
i.e. Banks or financial institutions, stipulate the appointment of
nominee directors on the Board of Directors of the company.
(a) To maximize the profits of the owners of the company. This can be
ensured by issuing the securities carrying less cost of capital.
(b) To issue the securities which are easily transferable. This can be
ensured by listing the securities on the stock exchange.
(c) To issue the further securities in such a way that the value of
shareholding of the present owners is not affected.
(b) External Factors
(1) General Economic Conditions: While planning the capital
structure, the general economic conditions should be considered. If the
economy is in the state of depression, preference will be given to
equity form of capital as it will be involving less amount of risk. But it
may not be possible always as the investors may not be willing to take
the risk. Under such circumstances, the company may be required to
go in for borrowed capital. If the capital market is in boom and the
interest rates are likely to decline in further, equity form of capital may
be considered immediately, leaving the borrowed form of capital to be
tapped in future. It may also be possible to raise more equity capital in
boom as the investors may be ready to take risk and to invest.
COST OF CAPITAL
Introduction:
In the previous chapter, we discussed about the various sources from
which the long term requirements of the capital can be met. Each of
these sources involves some cost. The cost of capital can be defined as
"the rate of which an organization must pay to the suppliers of capital
for the use of their funds".
(1) The cost of raising funds to finance a project. This cost may be in
the form of the interest which the company may be required to pay to
the suppliers of funds. This may be the explicit cost attached with the
various sources of capital.
(2) The cost of capital may be in the form of opportunity cost of the
funds of company i.e. rate of return which the company would have
earned if the funds are not invested. E.g. suppose that a company has
an amount ofRs.100.000 which may either be utilized for purchasing a
machine or may be invested with a bank as fixed deposit carrying the
interest 10%p.a. If the company decides to use the amount for
purchasing the machine, obviously it will have to forgo the interest
which it would have earned by investing the same in fixed deposit with
the bank. Thus, the cost of capital of the capital of Rs.1,00,000 is 10%.
(1) The concept of cost of capital is used as a tool for screening the
investment proposals.(The various methods for appraising investment
purposes are discussed in details in the following chapters). E.g. In
case of the net present value method, the cost of capital is used as the
discounting rate for discounting the future inflow of funds. Any project
resulting into positive net present value only will be accepted. All other
projects will be rejected. Similarly, in case of Internal Rate of Return
Method (IRR), the resultant IRR is compared with the cost of capital. It
is expected, that if a project is to be accepted, IRR resulting tram the
same should be more than cost of capital. If project generates IRR
which is less than cost of capital, the project will be rejected.
(2) The cost of capital is used as the capitalization rate to decide the
amount of capitalization in case of a new concern.
(a) Cost of Debt: The debts may be either short term debts or long
term debts. Very naturally, the cost of capital in the form of debt is the
interest which the company has to pay. But this is not the real cost
attached with debt capital. The real cost is something less than the
rate of interest which the company has to pay. This is due to the fact
that the interest on debt is a tax deductible expenditure. If the amount
of interest is considered as a part of expenses, the tax liability of the
company reduces proportionately. As such, while computing the cost
of debt, adjustments are required to be made for its tax impact. E.g.
suppose a company issues the debentures having face value ofRs.1 00
and bearing the rate of interest of 10% p.a. If the tax rate applicable to
the company is 50%, the cost of debentures is not] 0% which is the
rate of interest, but it is to be duly reduced by the tax benefits
available due to this interest. Tax benefit is 50% of 10%, hence the
cost of debentures is only 5%. Further, the interest payable on the
debentures has to be viewed from the angle of the amount actually
received on their issue. E.g. A company issues] 000 debentures of
Rs.l00, each bearing interest @8% p.a. Company incurs the expenses
in connection with the issue of debentures to the extent of Rs.10,000
(These expenses may be in the form of discount allowed, underwriting
commission, advertisement etc.) Thus, the company will have to pay
the annual interest ofRs.8,000 on the net amount received to the
extent of only Rs.90,000 (i.e. Rs.1,OO,OOO minus Rs.10,000). Cost of
debentures in this case works out to around 8.89% and assuming that
the tax rate applicable is 50%, the tax benefit makes the cost of
debentures equal to 4.45%. However, the debt capital has a hidden
cost also. If the debt content in the capital structure of a company
exceeds the optimum level, the investors start considering company as
too risky and their expectations from equity shares increase. This is
the hidden cost of debt.
Rs.1O,OOO = 10.52%
Rs.95,000x100
D + G where
P
E.g. If the dividend per share is Re. 1 per share with the
expected growth of 6% per year perpetually, the cost of equity shares,
with the assumed market price of the share of Rs.25, will be
Re. 1 + 0.06
Rs.25
= 0.04 + 0.06
= 10%
(2) Multiply the cost of each source of funds by the weights assigned
(3) Calculate the composite cost by dividing total weighted cost by the
total weights.
The above process can be explained with the help off 0110 wing
illustrations.
Illustration:
Let us assume that there are two companies A Ltd. and B Ltd.
which are exactly similar to each other in terms of nature of business,
size, extent of turnover etc. As such, the amount of capitalization is
also the same for both the companies which is assumed to be Rs.1
0,000. However, strategies for raising the capital are different from
each other. Assuming that the required capital can be raised either by
way of equity or debts, following particulars are available
A LTD. B LTD.
Rs. Rs.
(c) Leverages
(a) Trading on Equity:
As explained in the above example, the earnings per equity
share can be increased by the use of non-equity or debt capital.
Trading on Equity indicates utilization of non-equity sources of funds in
the overall capital structure of the company in order to increase
earnings available to the equity shareholders. In other words, trading
on equity indicates the use of debt capital in the capital structure of
the company for which the company is required to pay lower rate of
return and which increases the returns available to the equity
shareholders.
(c) Leverages:
In very simple words, the term leverage measures relationship
between two variables. In financial analysis, the term leverage
represents the influence of one financial variable over some other
financial variable. In financial analysis, generally three types of
leverages may be computed.
Indications:
A high degree of operating leverage means that the component
of fixed cost is too high in the overall cost structure. A low degree of
operating leverage means that the component of fixed cost is less in
the overall cost structure. In other words, operating leverage measures
the impact of percentage increase or decrease in sales on earnings
before interest and taxes.
E.g. In the example cited above, when sales are Rs.20,000
contribution is Rs.10,000 and earnings before interest and taxes are
Rs.5,000. As such operating leverage can be calculated as:
= Contribution =
Rs.10,000
EBIT Rs.5,000
= 2
EBIT
EBIT - INTEREST
Indications:
A high degree of financial leverage indicates high use of fixed
income earnings securities in the capital structure of the company. A
low degree of financial leverage indicates less use of fixed income
bearing securities in the capital structure of the company.
E.g. In the example cited above, in case of A Ltd., the EBIT is
Rs.5, 000 and interest on debentures is Rs.900, when sales are Rs.20,
000 whereas in case of B Ltd., the EBIT is Rs.5,000 and interest on
debentures is Rs.100 when sales are Rs.20,000. As such, the degree of
financial leverage can be computed as
EBIT
EBIT – INTEREST
A Ltd. B Ltd.
= Rs.5,000 = Rs.5,000
Rs.4,100 Rs.4,900
= 1.22 = 1.02
Limitations:
(1) It ignores implicit cost of debt. It assumes that the use of
debt capital may be useful so long as the company is able to earn
more than the cost of debt i.e. interest. But it is n01 always correct.
Increasing use of the debt capital makes the investment in the
company a risky proposition, as such market price of the shares may
decline, which may not be maximizing shareholders wealth. Before
considering the capital structure, the implicit of debt should be
considered.
(3)Combined Leverage:
The combined effect of operating leverage and financial leverage measures the
impact of charge in contribution on EPS.
It is computed as:
Operating leverage x Financial leverage
= Sales – Variable Cost x EBIT
EBIT EBIT - Interest
A Ltd. B Ltd.
= Rs.10,000 = Rs.10,000
Rs.4,000 Rs.4,900
= 2.44 = 2.04
Indications:
The indications given by the combined effect of operating and
financial leverages may be studied under the following possible
situations.
(3)Traditional Approach
(1)Firms use only long term debt capital or equity share capital to
raise funds.
50%
Present 50% Increase
Decrease
in Debt in Debt
Position
Capital Capital
Rs. Rs. Rs.
8% Debentures 6,00,000 9,00,000 3,00,000
NOI i.e. EB1T ] ,50,000 ] ,50,000 1,50,000
I 48,000 72,000 24,000
Nl 1,02,000 78,000 1,26,000
Equity Capitalisation
10% 10% 10%
Rate
Market value of
Equity
Shares (S) 10,20,000 7,80,000 12,60,000
Market value of
Debentures (B) 6,00,000 9,00,000 3,00,000
50%
Present 50% Increase
Decrease
in Debt in Debt
Position
Capital Capital
Rs. Rs. Rs.
8% Debentures 6,00,000 9,00,000 3,00,000
Overall Capitalisation
10% 10% 10%
Rate
EBlT 1,50,000 1,50,000 1,50,000
Total value of firm (V) 15,00,000 15,00,000 15,00,000
Overall cost of capital 1,50,000 1,50,000 1,50,000
15,00,000 15,00,000 \5,00,000
Equity Capitalisation
Rate
EBIT - I 1,02,000 78,000 ] ,02,000
V-B 9,00,000 6,00,000 9,00,000
11.3% 13% 10.5%
It can be seen from the above that the market value of the firm
remains unaffected by change in the capital structure. However, the
introduction of additional debentures increases the equity
capitalisation rate and vice versa.
8%
No Debt 5% Debentures
Debentures
. Rs. 3,00,000 Rs.6,00,000
Interest on
-- 15,000 48,000
debentures
10%
I.e. EBIT 9.82% 10.34%
V
It can be seen from the above that neither the no-debentures
position nor the position where debentures are issued to the extent
ofRs.6, 00,000 minimize the overall cost of capital or maximize the
total value of the firm. It is when debentures are issued to the extent of
Rs.3, 00, 000 that the overall cost of capital is minimum and total
value of the firm is maximum, hence that is the Optimal Capital
Structure.
b) http://www.maharishiinstituteofmanagement.com/articles-mp-
tsmoha.htm