CAPITAL STRUCTURE:

1. 2. 3. 4.

Proportion of Debt and Equity Financial leverage for the Firm Cost of Capital Average cost of Capital - weighted average of Cost of Debt and Equity Capital Structure Decisions PBIT /EPS Analysis ROI ROE Analysis

5. 6.

7.
8.

Compare with Debt Ratio for the Industry

Case Study on Capital Structure Planning RELIANCE INDUSTRIES (Page 535)

DIVIDEND DECISIONS :
Why Companies pay Dividend Dimensions of Dividend Policy

Dividend payout Ratio Stability of Dividend payment

Payout Ratio :
Fund Requirement Liquidity Access to External Finance Shareholder preference (Immidiate Dividend or Capital appreciation) Taxes Difference between cost of external financing and retained earning

Stability:

Stable payout ratio Stable level of Dividend amount

DIVIDEND DECISIONS :
Dividend Policy Formulation :

Funds through retained earning or external equity External Equity Right Issue or Dilution Target Payout Ratio with Target Debt/Equity Ratio Avoid Dividend cuts Cash-flow requirement for working capital and long term investment

Legal Aspects :
Payment out of current years Profit Transfer to Reserve rule

Dividend Rate 10 12.5% 12.5 15% 15 - 20% 20% plus

Must Transfer to Reserves 2.5% 5% 7.5% 10%

PROCEDURAL ASPECTS :
Board Resolution

Shareholders Approval
Record Date Dividend Payment Warrants/Electronic transfer Transfer to Dividend Accounts Dividend tax paid by Company, income is free in the

hands of Investors

The following information is available for Avinash Metals:

Net operating income Interest on debt Cost of equity

Cost of debt

: : : :

Rs 40 m Rs 10 m 18% 12%

(a)What is the average cost of capital ?

(b) What happens to the average cost of capital , if it employs Rs 100 m of debt to finance a project which earns an additional operating income of Rs 20 million ? Assume that the net operating income (NOI) method applies and there are no taxes.

Solution :
(a) The value of debt and equity are as follows:
Value of debt = (Rs 10 million / 0.12) = Rs 83.33 million Value of equity = (Rs 30 million/0.18) = Rs 166.67 million Hence, the average cost of capital for Avinash is : 83.33 166.67 12 12x --------- + 18 x --------- = 16 per cent 250.00 250.00

(b) If Avinash employs Rs 100 million of debt to finance a

project which earns an additional operating income of Rs 20 million, the following financial picture emerges:
Net operating income Interest on debt Earnings on equity Market value of equity Market value of debt Market value of firm : : : : : : Rs 60 million ( 40 + 20) Rs 22 million Rs 38 million Rs 211.11 million Rs 183.33 million Rs 394.44 million

Hence, the average cost of capital for Avinash changes to :

183.33 --------394.44 211.11 + 18 x --------- = 15.21 per cent 394.44

12 x

BASIC RELATIONSHIP PBIT and EPS:

To illustrate the relationship between PBIT and EPS, under alternative financing plans, let us consider the following data for Falcon Limited.
Existing Capital Structure Tax Rate

: 1 million equity shares of Rs 10 each : 50 per cent

Falcon Limited Plans to raise the additional capital of Rs 10 million for financing an expansion project. In this context, it is evaluating two alternative financing plans : (i) issue of equity shares (1 million equity shares at Rs 10 per share), and (ii) issue of debentures carrying 14 per cent interest.
What will be the EPS under the two alternative financing plans for two levels of PBIT. Say Rs 4 million and Rs 2 million ?

Earnings Per Share Under Alternative Financing Plans

Equity Financing PBIT : 2,000,000
Interest Profit before taxes 2,600,000 Taxes 1,300,000 Profit After Tax 1,300,000 Number of Equity shares 1,000,000 Earnings per share 2,000,000

Debt Financing PBIT : 2,000,000 PBIT : 4,000,000

4,000,000 1,400,000 600,000 1,400,000 2600000

PBIT: 4,000,000

1,000,000

2,000,000

300,000

1300000

1,000,000

2,000,000

300,000

1300000

2,000,000

2,000,000

1,000,000

1000000

0.50

1.00

0.30

1.30

Korex Limited, which requires an investment outlay of Rs 100 million, is considering two capital structures:
Capital Structure A (Rs in million) 100 Equity 0 Debt Capital Structure B (Rs in million) 50 50

Equity Debt

While the average cost of debt is fixed at 10 per cent, the ROI (defined as PBIT divided by total assets) may vary widely. The tax rate of the firm is 50 per cent.

Based on the above information, calculate the relationship between ROI and ROE (defined as equity earnings divided by net worth) under the two capital structures, A and B, at ROI levels of 5,10,15,20 and 25% :

RELATIONSHJIP BETWEEN ROI AND ROE UNDER CAPITAL STRUCTURES A AND B

Capital Structure A Capital Structure B

ROI PBIT (Rs in million) Interest Profit after Tax Tax Profit after Tax Return on equity

5% 10% 15% 20% 25% 5 0 5 2.5 2.5 10 0 10 5 5 15 7.5 7.5 15 0 20 10 10 20 0 25 12.5 12.5 25 0

5% 10% 5 5 0 0 0 0% 10 5 5 2.5 2.5 5%

15% 20% 25% 15 5 10 5 5 10% 20 5 15 7.5 7.5 25 5 20 10 10

2.5% 5% 7.5%

10% 12.5%

15% 20%

BONUS SHARES AND STOCK SPLITS :

Bonus share : Can be issued only out of free reserves.
Proportionate ownership remains unchanged Book Value, EPS and market price drop, No. of shares increase Regulations on issue of Bonus shares

Stock splits : Per value of the shares is reduced

No capitalization of reserves Book value per share, EPS ad market price drop

Share Buyback :
Company buys its own shares Methods : Tender method, Open market purchase method Impact : Share capital drops, debt equity ratio increase Legality : Started in India from 1998 only

10% of the shares can be bought per year with Board Resolution, excess by Special Resolution. Post Buyback, Debt equity ratio not to exceed 2.1 Buyback cannot exceed 25% of shareholders funds. Further issue of equity after 6 months Buyback to be done through open offer route Cannot be done as negotiated deal Process to be handled by Merchant Bankers, who does due diligence.