CAPITAL STRUCTURE

CHAPTER IV

CAPITAL STRUCTURE

               Capital structure refers to the compositions of long-term source of funds such as debentures, the long-term debt, Preference share capital and equity share capital including reserves and surplus in the total capitalization of the company. According to Crestionburge capital structure refers to “the makeup of a firm’s capitalization”. In other words it represents the mix of different source of long-term funds.

             Problems of capitalization and capital structure generally arise

1.      When a corporation is organized.

2.      When it is in need of additional capital because it has grow and is planning for growth.

3.      Up on merge or consolidation with other existing corporations.

4.      Upon recapitalization readjustments and reorganization.  

              In any of these situation two basic question of

1.      What amount of securities shall be issued?

2.      What kind of securities shall be issued?

              Decisions as to the amount of securities are reflected in the capitalization and decisions as to the kind of securities are reflected in the capital structure.

Forms or Patterns of capital structure

      In case of new company the capital structure may be of the following four patterns:

1.      Capital structure with equity share capital only.

2.      Capital structure with both equity and preference share.

3.      Capital structure with equity share and debenture.

4.      Capital structure with equity share preference share and debenture.

              The choice of an appropriate capital structure depends on number of patterns such as the         nature of the company’s business, conditions of the money market, attitude of the investor etc.

Criteria for determining pattern of capital structure or principles

               While choosing a suitable pattern of capital structure for the firm the finance manager should keep into consideration certain fundamental principles. These principles are militant to each other. A prudent finance manager strikes golden mean among them by giving weight age to them. Weights are assigned in the light of general state of the economy, specific conditions obtaining the industry and the circumstance within which the company is operating.

1. Cost principle

            According to this principle ideal pattern of capital structure is one that tends to minimum cost of financing and minimizes earning per share. Debt capital is cheaper than equity capital because cost of debt is limited, bondholders do not participate in superior profit, if earned, and rate of interest on bonds is usually found much less than dividend rate. Secondly interest on debt is deductible for income tax purpose, where as no deduction is allowed for dividend payable on stock. Thus the use of debt capital in the financing process is helpful in rising income of the company.

2. Risk principle

           Debt is a commitment for a long period it involves risk. If the plan on debt has issued change, debt may prove adverse to the company. If for e.g.: income of the corporation declines to such low levels that debt service cannot be met out of current income, debt may be highly risky of the firm. Consequently equity stock holders may loss part or all their assets. Similarly if the firm issue large amount of preferred stock residual owners may be left with no or little income after satisfying fixed dividend obligation in the year of low earnings. Assumption of large risk by the use of more and more debt and preferred stock affect the share value. In some risk principle places relatively grater reliance on common stock for financing capital requirements of the corporation and as far as possible reduces the use of fixed income bearing securities.

3. Control principle

         While designing sound capital structure the finance manager should also keep in mind that controlling position of residual owners remaining undistributed. The use of preferred stock and also bonds offers a means of rising capital without jeopardizing control. Management desiring retain control must rise funds through bonds.

4. Flexibility principle

          According to this principle the management should strive for such combinations of securities that the management finds it easier to maneuver source of funds. Not only several alternatives are open for assembling required funds but also bargaining position of the corporation is strengthened by dealing with the suppliers of funds. By inserting call features in both debt and preferred stock management may provide desired maneuverability. Whether the prospective investors will agree to this sort of arrangement will depend up on the respective bargaining power of the company and the suppliers of funds.

5. Timing principle

          Timing is always important in financing and more particularly in a growing concern. Important point that is to be kept in mind to make the public offering of securities, demand of different type of securities oscillates according to the business cycle. In the terms Boom when there is all round business expansion and economic prosperity and investor have strong desire to invest, it is easier to sell equity shares and raise adequate recourse. But in periods of depression bonds should be issued to attract money because investors are afraid to risk there money in stock which are less speculative. Thus timing may favor debt at one time and common stock or preferred stock at other time.

Capitalization, Capital structure and financial structure

               The terms capital, capital structure and financial structure does not mean the same, while capital is a quantitative aspect of the financial planning of the enterprise, capital structure is concerned with qualitative aspect. Capital refers to the amount of securities issued by a company while capital structure refers to the kinds of securities and the proportionate amount that make up capital. Financial structure means the entire liabilities side of the balance sheet. In the words of Nemmers & Gruniwald financial structure refers to “all the financial recourses marshaled by the firm short term as well as long term and all forms of debts as well as equity”.

Planning the capital structure

               The financial manager should plan an optimum capital structure for the company. In practice, the determination of an optimum capital structure is a formidable task and we have to go beyond the theory. A number of factors influence the capital structure decision and the theoretical model cannot adequately handle all these factors, which affect the capital structure decision. The factors are highly psychological and complex and do not always follow-accepted theory, since capital market is not perfect and the decision has to be taken under imperfect knowledge and risk.

Optimal capital structure

           The optimum capital structure is obtained when the market value per share is maximum and the average cost of capital is minimum. The optimum capital structure may be defined as “the capital structure or combination of debt and equity that leads to the maximum value of the firm”. Optimum capital structure maximize the value of the company and hence the wealth of its owners and minimize the companies cost of capital. Thus every firm should aim at achieving the optimum capital structure and then to maintain it. The following consideration should be kept in mind while determining the capital structure.

1. If the return of investment is higher than the fixed cost of funds the company should prefer to raise funds having a fixed cost. It will increase earnings per share and market value of the firm.

2. When debt is used as a source of finance the firm saves a considerable amount in payment of tax   as interest is allowed as a deductible expenditure in computation of tax, it is called tax leverage.

3. The firm should avoid undue financial risk attached with the use of increased debt financing. It will reduce the market price of shares.

4. The capital structure should be flexible.

Concept of balanced capital structure or sound or appropriate capital structure

   A capital structure will be considered to be appropriate if it possess the following features:

1. Profitability; - The capital structure of the company should be most profitable. The most profitable capital structure is one that tends to minimize cost of financing and maximize earnings per equity share.

2. Solvency;-Excess use of debt threatens the solvency of the company .The debt content should not increase the risk beyond the manageable limits.

3. Flexibility; - The capital structure should be such that it can be easily to meet the requirements of the changing condition. Moreover it should also be possible for the company to provide funds whenever needed to finance its profitable activities.

4. Conservatism; - The capital structure should be conservative in the sense that the debt content in the capital structure does not exceed the limit, which the company can bear. In other words it should be such that commensurate with the companies ability to generate future cash flows.

5. Control; -The capital structure should be so devised that it involves minimum role of loss of control of the company.

Factors determining (affecting) capital structure

           The factors influencing capital structure are discussed as follows:

1.      Financial leverage   (leverage effect on EPS)

            The use of fixed charge source of funds such as debt and preference share capital along with the owner’s equity in capital structure is described as financial leverage or trading on equity. The leverage impact is clearer in case of debt because the cost of debt is usually lower than the cost of preference capital and the interest paid on debt is tax deductible. Because of the effect on EPS, financial leverage is one of the important considerations in planning the capital structure.

2.      Growth and stability of sales

           The capital structure of a firm is highly influenced by the growth and stability of its sales. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest payments and repayments of debts. Similarly the rate of growth in sales also affects the capital structure decisions. Usually greater the rate of growth of sales, grater can be the use of debt in the financing of firm or vice versa.

3.      Cost of capital

           It refers to the minimum return expected by its suppliers. This expected return depends on the degree of risk assumed by them. The debt is a cheaper source of finance compared to equity and preference capital due to fixed rate of interest on debt and tax deductibility of interest charges. A high degree of risk is assumed by the shareholders than the debt holders due to uncertainty of their returns. The criterion in capital structure planning should be minimizing the overall cost of capital. A company can reduce its overall cost of capital by employing debt. But beyond a point of debt becomes more expensive and overall cost of capital would start increasing. So there is a combination of debt and equity, which minimizes the company’s average cost of capital.

4.      Cash flow ability to service debt

          Debt financing implies burden on fixed charge due to the fixed payment of interest and the principal. A firm which shall be able to generate large and stable cash inflows can employ more debt in its capital structure as compared to one which has unstable and lesser ability to generate cash inflows.

5.      Nature and size of the firm

          Nature and size of a firm also influences its capital structure. A public utility concern has different capital structure as compared to other manufacturing concerns. Public utility concerns can employ more debt because of stability and regularity of their earnings. Small companies have to depend mainly upon share capital and it is very difficult for them to raise long-term loans at a reasonable rate of interest. But a large company can obtain loans on easy terms and sell equity shares, preference shares and debentures to the public.

6.      Control

          When companies finance its requirements of additional funds by using new equity shares there is a risk of loss of control. The issue of equity shares affect control of the company because each new ordinary shares adds one new vote .So the promoter can retain control of the affairs of the company or avoiding loss of control by using major portion of capital in the form of debt and preference capital, because preference share holders and debt holders don’t have the voting power or voting right.

7.      Flexibility

          It means firms ability to adopt its capital structure to needs of the changing conditions. The capital structure of the firm is flexible if it has no difficulty in changes its source of funds. A firm should arrange its capital structure in such a manner that it can substitute one form of financing by other redeemable preference shares and convertible debentures may be preferred on account of flexibility.

8.      Capital market conditions

         Marketability of corporate securities like shares and debentures depends up on readiness of investors to purchase a particular type of securities at a given period of time. If the share market is depressed the company not issue equity shares but issue debt capital. But in case there is a boom period it would be advisable to issue equity shares.

9.      Policies of financial institutions

         The policies of financial institutions such as IDBI, ICICI and commercial banks are very important. The Indian financial institutions follow a general rule of thumb a debt equity ratio of 2:1. Under normal circumstances they do not permit a higher debt equity ratio.

10.  Flotation cost 

         Flotation cost refers to the expense incurred for rising fund through the issue of corporate securities though it is not an important factor influencing the capital structure it should also be taken into consideration while rising funds. Generally the cost of floating a debt is less than the cost of floating equity. This may encourage the company to dues of more debt to equity capital.

Capital gearing

          The term capital gearing refers to the relationship between equity capitals (equity shares + reserves) and long-term debt. In simple words capital gearing means the ratio between the various types of securities in the capital structure of the company. A company is said to be in high gear when it has proportionately higher or large issue of debt and preference share for raising the long-term resources, where as low gear for a proportionately large issue of equity shares.

Capital Structure Theories

          In order to achieve the goal of identifying and optimum debt equity mix it is necessary for the finance manager conversant with the basic theories under - laying the capital structure of corporate enterprise. There are four major theories / approaches explaining the relationship between capital structure, cost of capital and value of the firm.

1.      Net income approach (N I approach)

2.      Net operating income approach (N O I approach)

3.      Traditional approach

4.      Modigliani and Miller approach (M M approach)

Assumptions

1.   The firm employs only two type of capital i.e. debt and equity.

2.   There are no corporate taxes, this assumptions has been removed later.

3.   The firm pays 100% of its earnings as dividend. Thus there is no retained earnings. 

4.   The firms total financing remains constant.

5.   The operating earnings (EBIT) are not expected to grow.

6.   The business risk remains constant and is independent of capital structure and        financial risk.

7.   The firm has a perpetual life.

Terms and symbols used in capital structure Theories

     S = N I

            Ke

S – Market value of share.

NI – Net Income available to equity shareholders

Ke – Cost of equity capital

D = I

     Kd

D - Market value of debt.

I – Total interest payments.

Kd – Cost of debt

V = NOI

        Ko    

                 V – Total market value of the firm. (V = S+D)

                NOI –Net Operating Income (EBIT)

                Ko – Over all cost of capital.

Net income Theory or fixed ke Theory

        This theory was proposed by David Durand. This theory represents one extreme role of the degree of leverage in the valuation of the firm. The essence of the N I approach is that the firm can increase its value or lower the over all cost of capital by increasing the proportion of debt in the capital structure. The maximum limit of increase in leverage is when Ko = Kd. This is based up on the following assumptions.

1.      The equity capitalization rate (Ke) and the debt capitalization rate (Kd) remain constant with a change in leverage because the use of debt does not change the risk perception of investors.

2.      The cost of debt is less than the cost of equity. (Kd < Ke).

3.      The corporate income taxes don’t exist.

           On the basis of the above assumptions, it has been held in the N I approach that increased use of debt will magnify the share holders earnings (because Kd and Ke will remain constant) and there by result in share value of equity and so also the value of the firm.

Graphical representation

        y           

    

                                                                 ke

                                   ko

                                                                  kd

                 

 

               Degree of Leverage             x

Net Operating income Theory (N O I) / Fixed Ko Theory / varying ke Theory

             N O I approach is just opposite to N I approach. This theory was also proposed by David Durand. According to this approach changes in the capital structure of a company does not affect the market value of the firm and the over all cost of capital remains constant irrespective of the method of financing. It implies that the over all cost of capital remains the same whether the debt equity mix is 50:50 i e 1:1 or 20:80 or 0:100. When the firm increases its degree of leverage it will become more risky to equity shareholders. Hence the advantage of debt is offset exactly by the increase in the equity capitalization rate (Ke).

           Thus there is nothing as an optimum capital structure and any capital structure will be optimum according to this approach.

 

The crucial assumptions of the N O I approach are:

1.      The debt capital rate (Kd) and overall cost of capital (Ko) remain constant regardless of any changes in the degree of financial leverage.

2.      The firm is evaluated as a whole by the market and therefore the split between debt and equity is not relevant.   ie   V = NOI  / Ko

3.      The use of debt increases the risk of equity shareholders this results in increase in equity capitalization rate (Ke).

4.      Corporate taxes don’t exist.

Graphical representation                           

                                                                  

      y                                                            ke  

                                                                     

                                                                      ko

                                                                     

                                                                      kd

 

               Degree of Leverage                  x

Traditional approach

          The traditional view, which is also known as an intermediate approach, is a compromise between the N I approach and the N O I approach. According to this theory the value of the firm can be increased initially, or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds than equity. Thus an optimum capital structure can be reached by a proper debt equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity.

        According to the traditional position the manner in which the overall cost of capital reacts to changes in capital structure can be divided in to 3 stages.

Stage 1

Increasing value

         The first stage starts with the introduction of debt in the firm’s capital structure. In this stage the cost of equity (Ke) remains constant or rises slightly with a debt. But even when it increases, it doesn’t increase fast enough to offset the advantage of low cost debt. During this stage the cost of debt (Kd) remains constant. As a result the over all cost of capital (Ko) fall with increasing leverage.

Stage 2

Optimum value 

        Once the firm has reached a certain degree of leverage, increases in leverage have a negligible effect on the value or the cost of capital of the firm. This is so because the increase in the cost of equity due to the added financial risk offsets the advantage of low cost debt within that range or at the specific point the value of the firm will be maximum or the cost of capital will be minimum.

Stage 3

Declining value

       Beyond the acceptable limit of leverage the value of the firm decreases with leverage or the cost of capital increases with leverage. This happens because investors preserve a high degree of financial risk and demand a higher equity capital rate (Ke), which offsets the advantage of low cost debt.

Graphical representation

    Y

   

                                                                  ko

                                                                   kd

 

                               Stage

             

         Stage I           II         Stage III

                                              

              Degree of Leverage                      X

Modigliani Miller approach

         Till late 1950’s it was general view that favorable financial leverage, decrease the cost of capital, increase the total value, increase the value of equity share and helps in determining an optimum capital structure. But in 1958 Franco Modigliani and Morton H Miller published a research paper the cost of capital, corporation finance and the theory of investment and focused on theory of capital structure. They revised the theory of N O I or fixed Ko theory. This has been regarded as the single most important research paper ever published.

         The MM hypothesis is identical with N O I approach, identified by Durant. They argue that in the absence of taxes a firm’s market value and the cost of capital are independent of capital structure changes. They deny the existence of an optimum capital structure in a firm. In their 1958 article they provide analytically sound and logically constituent behavioral justification in favor of their hypothesis and reject any other capital structure theory as incorrect.

               The M-M hypothesis can be best explained in terms of their proposition 1 and proposition 2 and these propositions are based on certain assumptions.

These assumptions are;

1. The securities are traded in the perfect capital market situation. This means that;

a. Investors are free to buy or sell securities.

b. They can borrow without restrictions at the same terms as the firms do.

c. The investors behave rationally.

d. The transaction cost does not exist.

2. Business risk is equal among the entire firm with similar operating environment. Firms within    the same industry are generally considered to constitute a homogeneous risk class.

3. All investors have the same expectations of firms N O I with which to evaluate the value of any firm.

4. Firm distribute all the net earnings to the shareholders as dividend, which means a 100% dividend payout ratio.

5. Corporate income tax does not exist. This assumption is removed later.

Graphical representation

 

V

                                                                Ko

 

           Degree of Leverage

The MM hypothesis in the absence of taxes

Proposition 1

              The first proposition states that for firms in the same risk class, the total market value is independent of the debt equity mix and is obtained by capitalizing the expected N O I by the rate appropriate to that risk class. Similarly the cost of capital as well as the market price of shares must be the same regardless of the financing mix.

             The operational justification for the MM hypothesis is the arbitrage process. The term arbitrage refers to an act of buying an asset / securities in one market (at lower price) and selling it in another (in higher price); as a result equilibrium is resorted in the market price of the security in different markets. The arbitrage process is essentially a balancing operation.

               The MM approach illustrates the arbitrage process with reference to valuation in terms of two firms, which are exactly similar in all respects except leverage. So that, one of them has debt in its capital structure while the other does not. In there opinion is that if two identical firms except of the degree of leverage have different market value, arbitrage (switching) will take place to enable investors to engage in personnel or home made leverage as against the corporate leverage to restore equilibrium in the market.

Proposition 2

               The second proposition of M.M defines the cost of equity (ke). In this proposition, they provide a method for determining cost of equity (ke). The cost of equity formula can be derived from M.M’s definition of the average cost of capital. (ko).

                           Ke = Ko + risk premium

                                       Or

                           Ke = Ko + (ko-kd) D/S

           This states that, for any firm in a given risk class the cost of equity equal to the constant average cost of capital (ko), plus a premium for the financial risk. Thus leverage will results not only in more earnings per share to shareholders but also increased cost of equity. The benefit of leverage is exactly offset by the increased cost of equity and consequently the firms’ market value will remain unaffected by leverage. M.M concludes that the market value of the firm or the cost of capital is not affected by leverage.

The MM hypothesis under corporate taxes

              In reality corporate taxes exist an interest paid to debenture holders is treated as a deductible expense while calculating tax. Dividends paid to share holders on the other hand are not tax deductible. Thus unlike dividends return to debt holders are not subject to the taxation at the corporate level. This makes debt-financing advantages. In there article 1963 Modigliani and Miller shows that the value of the firm will increase big debt due to the deductibility of interest for tax computation and the value of levered firm will be higher than un-levered firm.

Interest tax shield          = Tax x Interest

                                       = T x Kd x D

Present value of tax shield = T x Kd x D    = T x D

                                                      Kd

Value of Un-levered firm = EBIT    (1-T)

                                                Ko

Value of levered firm     =Vu+ Present Value of tax shield

                                                   = Vu + (T x D)

Limitations of M M hypothesis.

       The arbitrage process is the behavioral foundation for the MM hypothesis. However the arbitrage process fails to bring the desired equilibrium in the capital markets on account of the following reasons:

1.      The assumptions made under the MM hypothesis that the firms and individuals can borrow and lend at the same rate of interest do hold good in actual practice.

2.      It is incorrect to assume that personnel leverage (home made leverage) is a perfect substitute for corporate leverage.

3.      The existence of transaction or flotation cost also interferes with the working of arbitrage process.

4.      The switching option from un-levered to livered firm and wise versa is not available to all investors particularly institutional investors like LIC, UTI etc. Institutional restrictions also affect the working of arbitrage process.

5.      The assumption of low corporate tax is basically wrong. Nowhere in the world corporate income has been untaxed?