Financial Management

Unit 7

Unit 7
Structure:

Capital Structure

7.1 7.2 7.3 7.4

7.5 7.6 7.7

Introduction Learning Objectives Features of Ideal Capital Structure Factors affecting Capital Structure Theories of Capital Structure Net income approach Net operating income approach Traditional approach Miller and Modigliani approach Basic proposition Criticisms of MM proposition Summary Terminal Questions Answers to SAQs and TQs

7.1 Introduction
The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company. With the objective of maximising the value of the equity shares, the choice should be that pattern of using of debt and equity in a proportion which will lead towards achievement of the firms objective. The capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact on the operating earnings of the firm. Such decisions influence the firms value through the earnings available to the shareholders. The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the companys market price. The proper mix of funds is referred to as optimal capital structure. The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the EPS.

7.1.1 Learning Objectives Sikkim Manipal University Page No. 129

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After studying this unit, you should be able to:

Explain the features of ideal capital structure. Name the factors affecting the capital structure. Mention the various theories of capital structure.

7.2 Features of an Ideal Capital Structure

The features of an ideal capital structure are (see figure 7.1) profitability, flexibility, control and solvency.

Figure 7.1: Features of an ideal capital structure Profitability

The firm should make maximum use of leverage at a minimum cost.

Flexibility

An ideal capital structure should be flexible enough to adapt to changing conditions. It should be in a position to raise funds at the shortest possible time and also repay the money it borrowed, if they appear to be expensive. This is possible only if the companys lenders have not put forth any conditions like restricting the company from taking further loans, no restrictions placed on the assets usage or laying a restriction on early repayments. In other words, the finance authorities should have the power to take decisions on the basis of the circumstances warrant.
Control

The structure should have minimum dilution of control.

Solvency

Use of excessive debt threatens the very existence of the company. Additional debt involves huge repayments. Loans with high interest rates are to be avoided however attractive some investment proposals look. Some companies resort to issue of equity shares to repay their debt for equity holders do not have a fixed rate of dividend
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7.3 Factors affecting Capital Structures

The major factor affecting the capital structure is leverage. There are a few different other factors effecting them also. All the factors are explained briefly here.
Leverage

The use of fixed charges sources of funds such as preference shares, loans from banks and financial institutions and debentures in the capital structure is known as trading on equity or financial leverage. Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized companies, while they insist on 3:1 ratio for SSI. Debt equity ratio is an indicator of the relative contribution of creditors and owners. The debt component includes both long term and short term debt and this is represented as debt/equity. A debt equity ratio of 2:1 indicates that for every 1 unit of equity, the company can raise 2 units of debt. By normal standards, 2:1 is considered as a healthy ratio, but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 5:1 is considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering companies. Debt equity ratio is generally perceived as that lower the ratio, higher is the element of uncertainty in the minds of lenders. Increased use of leverage increases commitments of the company, the outflows being in the nature of higher interest and principal repayments, thereby increasing the risk of the equity shareholders. The other factors to be considered before deciding on an ideal capital structure are: Cost of capital High cost funds should be avoided. However attractive an investment proposition may look like, the profits earned may be eaten away by interest repayments. Cash flow projections of the company Decisions should be taken in the light of cash flows projected for the next 3-5 years. The company officials should not get carried away at the immediate results expected. Consistent lesser profits are any way preferable than high profits in the beginning and not being able to get any after 2 years.
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Dilution of control The top management should have the flexibility to take appropriate decisions at the right time. The capital structure planned should be one in this direction. Floatation costs A company desiring to increase its capital by way of debt or equity will definitely incur floatation costs. Effectively, the amount of money raised by any issue will be lower than the amount expected because of the presence of floatation costs. Such costs should be compared with the profits and right decisions taken.

7.4 Theories of Capital Structure

As we are aware, equity and debt are the two important sources of longterm sources of finance of a firm. The proportion of debt and equity in a firms capital structure has to be independently decided case to case. A proposal, though not being favourable to lenders, may be taken up if they are convinced with the earning potential and long-term benefits. Many theories have been propounded to understand the relationship between financial leverage and firm value.
Assumptions

The following are some common assumptions made: The firm has only two sources of funds debt and ordinary shares. There are no taxes both corporate and personal The firms dividend pay-out ratio is 100%, that is, the firm pays off the entire earnings to its equity holders and retained earnings are zero The investment decisions of a company are constant, that is, the firm does not invest any further in its assets The operating profits EBIT are not expected to increase or decrease All investors shall have identical subjective probability distribution of the future expected EBIT A firm can change its capital structure at a short notice without the occurrence of transaction costs The life of the firm is indefinite
Based on the assumptions regarding the capital structure, we derive the following formulae. Sikkim Manipal University Page No. 132

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Debt capital being constant, Kd is the cost of debt which is the discount rate at which the discounted future constant interest payments are equal to the market value of debt, that is, Kd = I/B where, I refers to total interest payments and B is the total market value of debt. Therefore value of the debt B = I/Kd Cost of equity capital Ke = (D1/P0) + g where D1 is dividend after one year, P0 is the current market price and g is the expected growth rate. Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. Now we know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net income to equity holders and S is market value of equity shares. The net operating income being constant, overall cost of capital is represented as K0 = W1 K1 + W2 K2. That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S is the market value of equity and V is the total market value of the firm and can be given as (B+S). The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1 being the debt component and Ke being the equity component) which can be expressed as K0 = I + NI/V or EBIT/V or in other words, net operating income/market value of firm.

7.4.1 Net income approach Net income approach is suggested by Durand and he is of the view that capital structure decision is relevant to the valuation of the firm. Any change in the financial leverage will have a corresponding change in the overall cost of capital and also the total value of the firm. As the ratio of debt to equity increases, the WACC declines and market value of firm increases. The NI approach is based on 3 assumptions no taxes, cost of debt less than cost of equity and use of debt does not change the risk perception of investors. We know that, K0 = [B/(B+S)]Kd + [S/(B+S)]Ke The following graphical representation of net income approach may help us understand this better (see figure 7.2).

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Figure 7.2: Net income approach Solved Problem Given below are two firms A and B, which are identical in all aspects except the degree of leverage employed by them, clearly shown in the table 7.1. What is the average cost of capital of both firms? Table 7.1: Details of firms A and B Firm A Net operating income EBIT Interest on debentures I Equity earnings E Cost of equity Ke Cost of debentures Kd Market value of equity S = E/Ke Market value of debt B Total value of firm V Rs. 1, 00, 000 Nil Rs. 1, 00, 000 15% 10% Rs. 6, 66, 667 Nil Rs. 6, 66, 667 Firm B Rs. 1, 00, 000 Rs. 25, 000 Rs. 75, 000 15% 10% Rs. 50, 000 Rs. 2, 50, 000 Rs. 7, 50, 000

Solution Average cost of capital of firm A is: 10% * 0/Rs. 666667 + 15% * 666667/666667 = 0

+ 15 = 15%

Average cost of capital of firm B is: 10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10 = 13.4% Interpretation: The use of debt has caused the total value of the firm to increase and the overall cost of capital to decrease.

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Solved Problem The net income approach may be illustrated with a numerical illustration. Consider two firms X and Y, which are identical in all respects except in the degree of leverage employed by them. Table 7.2 shows the financial data of these firms
Table 7.2: Details of firms X and Y
Firm X Net operating income Interest on debentures i Equity earnings E Cost of equity Ke Cost of debentures Kd Market value of equity S = E/Ke Market value of debt B Total value of firm V Rs.50, 000 Nil Rs.50, 000 13% 10% Rs.2, 66, 667 Nil Rs.2, 66, 667 Firm Y Rs.50, 000 Rs.10, 000 Rs.45, 000 13% 10% Rs.1, 00, 000 Rs.1, 50, 000 Rs.5, 00, 000

Solution Average cost of capital of firm X is: 10% * 0/2,66,667 + 13% * 2,66,667/2,66,667 = 13% Average cost of capital of firm Y is: 10% * 1,50,000/5,00,000 + 13% * 1,00,000/1,50,000 = 11.67% 7.4.2 Net operating income approach (NOI) Net operating income approach is propounded by Durand and is totally opposite of the Net Income Approach. Durand says that any change in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of capital. The overall capitalisation rate is the same for all degrees of leverage. We know that: K0 = [B/(B+S)]Kd + [S/(B+S)]Ke As per the NOI approach the overall capitalisation rate remains constant for all degrees of leverage. The market values the firm as a whole and the split in the capitalisation rates between debt and equity is not very significant. The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to compensate this, they expect a higher return on their investments. Thus the cost of equity is
Ke = K0 +[ (K0 Kd)(B/S)] Sikkim Manipal University Page No. 135

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Cost of debt

The cost of debt has two parts as shown in the figure 7.3

Figure 7.3: Cost of debt

Explicit cost can be considered as the given rate of interest. The firm is assumed to borrow irrespective of the degree of leverage. This can result to a conclusion that the increasing proportion of debt does not affect the financial risk of lenders and they do not charge higher interest. Implicit cost is nothing but increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralised by the implicit cost resulting in Ke and Kd being the same. Graphical representation of the debts is shown in figure 7.4:

Ke

Percentage cost

K0

Kd

Leverage B/S Figure 7.4: Graphical representation of debts

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Solved Problem

Given below in table 7.3 are figures of two firms X and Y, which are similar in all aspects except the degree of leverage employed. Calculate the equity capitalisation rates of the firms.
Table 7.3: Details of firms X and Y
Firm X Net operating income EBIT Overall capitalisation rate K0 Total market value V = EBIT/K0 Interest on debt I Debt capitalisation rate Kd Market value of debt B= I/Kd Market value of equity S=VB Leverage B/S Rs. 10000 18% 55555 Rs. 1000 11% Rs. 9091 Rs. 46464 0.1956 Firm Y Rs. 10000 18% 55555 Rs. 2000 11% Rs. 18181 Rs. 37374 0.2140

Solution

The equity capitalisation rates are Ke = K0 +[ (K0 Kd)(B/S)] Firm X = 0.18 + [(0.18 0.11)(0.1956)] = 19.36% Firm Y= 0.18 + [(0.18 0.11)(0.4865)] = 21.40%

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Solved Problem Consider two firms MA and CMA, which are similar in all respects other than the degree of leverage employed by them. Table 7.4 shows the financial data of both these firms. Calculate the equity capitalisation rates of the firms.
Table 7.4: Details of firms MA and CMA Firms MA Net operating income EBIT Overall capitalisation rate K0 Total market value V = EBIT/K0 Interest on debt i Debt capitalisation rate Kd Market value of debt B = i/Kd Market value of equity S = V-B Leverage B/S Rs.1, 500 13% Rs.11, 538 Rs.55, 128 0.21 Rs.3, 000 13% Rs.23, 077 Rs.43, 589 0.53 Rs.20, 000 19% 66, 666 Firms CMA Rs.20, 000 19% 66, 666

Solution The equity capitalisation rates are Ke = K0 +[ (K0 Kd)(B/S)] Firm MA = 0.19 + [(0.19 0.13)(0.21)] = 0.2026 = 20.26% Firm CMA = 0.19 + [(0.19 0.13)(0.53)] = 0.2218 = 22.18%

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7.4.3 Traditional Approach

The traditional approach has the following propositions:

Kd remains constant until a certain degree of leverage and there-after rises at an increasing rate Ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply As a sequence to the above 2 propositions, K0 decreases till a certain level, remains constant for moderate increases in leverage and rises beyond a certain point

Graphical representation based on the propositions made on the traditional approach is as shown in figure 7.5

Figure 7.5: Propositions of traditional approach

7.4.4 Miller and Modigliani Approach

Miller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and K0 remains constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is elucidated as in net operating income(NOI) approach. The assumptions regarding Miller and Modigliani (MM) approach are (see figure 7.6): Perfect capital markets, Rational behaviour, Homogeneity, Taxes and Dividend Pay-out.

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Figure 7.6: Analysis of Miller and Modigliani approach

Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and sell securities (both shares and debt instruments), there are no hindrances on the borrowings, no presence of transaction costs, securities are infinitely divisible, availability of all required information at all times. Investors behave rationally: They choose the combination of risk and return which is most advantageous to them. Homogeneity of investors risk perception: All investors have the same perception of business risk and returns. Taxes: There is no corporate or personal income tax. Dividend pay-out is 100%: The firms do not retain earnings for future activities. 7.4.4.1 Basic propositions Three propositions can be derived based on the assumptions made on Miller and Modigliani approach: Proposition I: The market value of the firm is equal to the total market value of equity and total market value of debt and is independent of the degree of leverage. Therefore, the market value of the firm can be expressed as: Expected NOI

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Expected overall capitalisation rate V + (S+D) which is equal to O/K0 which is equal to NOI/K0 V + (S+D) = O/K0 = NOI/K0 Where V is the market value of the firm, S is the market value of the firms equity, D is the market value of the debt, O is the net operating income, K0 is the capitalisation rate of the risk class of the firm The graphical representation of proposition 1 is as shown in figure 7.7

Figure 7.7: Representation of Proposition 1 The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism. Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in return buy shares of the firm whose value is lower. They will earn the same return at lower outlay and lower perceived risk. Such behaviours are expected to increase the share prices whose shares are being purchased and lowering the share prices of those share which are being sold. This

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switching operation will continue till the market prices of identical firms become identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium. Ke = K0 +[(K0Kd)D/S] Proposition III: The average cost of capital is not affected by the financing decisions as investment and financing decisions are independent. 7.4.4.2 Criticisms of MM Proposition There were kind of many criticisms over MM propositions which are described briefly and shown below in the form of a diagram as figure 7.8

Figure 7.8: Criticisms of MM proposition

Risk perception The assumptions that risks are similar is wrong. The risk perceptions of investors are personal and corporate leverage is different. The presence of limited liability of firms in contrast to unlimited liability of individuals puts firms and investors on a different footing. All investors lose if a levered firm becomes bankrupt but an investor loses not only his shares in a company but would also be liable to repay the money he borrowed. Arbitrage process is one way of reducing risks. It is more risky to create personal leverage and invest in unlevered firm than investing in levered firms. Convenience Investors find personal leverage inconvenient. This is so because it is the firms responsibility to observe corporate formalities and procedures whereas it is the investors responsibility to take care of personal leverage. Investors prefer the former rather than taking on the responsibility and thus the perfect substitutability is subjected to question. Transaction costs

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Another cost that interferes in the system of balancing with arbitrage process is the presence of transaction costs. Due to the presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the same amount of return.
Taxes

When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails to explain the financing decision and firms value. Agency costs A firm requiring loan approaches creditors and creditors may sometimes impose protective covenants to protect their positions. Such restriction may be in the nature of obtaining prior approval of creditors for further loans, appointment of key persons, restriction on dividend pay-outs, limiting further issue of capital, limiting new investments or expansion schemes etc.
Self Assessment Questions

Fill in the blanks: 1. Financing decisions are ________ and have no impact on the _______ of the firm. 2. The value of the firm is dependent on its _____ and the ________. 3. ______ and _________ are two important sources of long-term sources of finance of a firm. 4. As the ratio of debt to equity increases, the ________ declines and ______ of the firm increases. 5. As per the NOI approach the ___________ remains constant for all degrees of leverage. 6. ___ is the process of buying a security at a lower in one market and selling it in another market at a higher price bringing about ____. 7. The criticisms over Miller and Modigliani approach are ______, __________, _________, _________, _________. 8. Define Arbitrage. 9. The features of an ideal capital structure are _______, __________, ________, __________. 10. The Miller and Modigliani approach fails to explain ______ decisions and _____ value.

7.5 Summary
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According to the NOI approach, overall cost of capital continuously decreases as and when debt goes up in the capital structure. Optimal capital structure exists when the firm borrows maximum. NOI approach believes that capital structure is not relevant. K0 is dependent business risk which is assumed to be constant. Traditional approach tells us that K0 decreases with leverage in the beginning, reaches its maximum point and further increases. Miller and Modigliani Approach also believes that capital structure is not relevant.

7.6 Terminal Questions

1. What are the assumptions of MM approach? 2. The following data, shown under in table 7.5, are available in respect of 2 firms. What is the average cost of capital?
Table 7.5: Data of a company Firm A Net operating income Interest on debt Equity earnings Cost of equity capital Cost of debt Market value of equity shares Market value of debt Total value of firm Rs.5,00,000 Nil Rs.5,00,000 15% Nil Rs.20,00,000 Nil Rs.20,00,000 Firm B Rs.5,00,000 Rs.50,000 Rs.4,50,000 15% 10% Rs.14,00,000 Rs.4,00,000 Rs.18,00,000

3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? 4. The market values of debt and equity of a firm are Rs. 10 Cr. and Rs. 20 Cr. respectively and their respective costs are 12% and 14%. The overall capital is 13.33%. Assuming that the company has a 100%
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dividend pay-out ratio and there are no taxes, calculate the net operating income of the firm. 5. If a company has equity worth Rs. 300 lakhs, debentures worth Rs. 400 lakhs and term loan worth Rs. 50 lakhs, calculate the WACC.

7.7 Answers to SAQs and TQs

Answers to Self Assessment Questions Investment decisions, operating earnings Expected future earnings, required rate of return Equity debt WACC, market value Overall capitalisation rate Arbitrage, equilibrium Risk perception, convenience, transaction costs, taxes and Agency costs. 8. Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher price bringing about equilibrium. Thus arbitrage process is a balancing act. 9. Profitability, flexibility, control and solvency. 10. Financing, firms
Answers to Terminal Questions

1. 2. 3. 4. 5. 6. 7.

1. 2. 3. 4. 5.

Refer to 6.44 Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt Hint : we =0.4; W d = 0.533; wt = 0.067

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