CAPITAL STRUCTURE DECISIONS

Capital may also be expressed as total assets minus current liabilities. Further, capital of a company may broadly be categorized into equity and debt. Equity consists of the following: Equity share capital + Preference share capital + Share premium + Free reserves + Surplus profits + Discretionary provisions for contingency + Development rebate reserve Debt consists of the following: All borrowings from Government, Semi-Government, Statutory financial corporations and other agencies + Term loans from banks, financial institution etc. + Debentures + All deferred payment liabilities.

Financial structure in the entire left hand side of

the companys balance sheet which includes current liabilities (equivalent to asset structure). While capital structure refers to sources of longterm funds. The term total capital structure denotes mix of owners funds and outsiders funds or it is proportionate relationship of firms permanent long-term financing represented by equity and debt.

The optimum capital structure is that capital structure or combination of debt and equity that leads to the maximization of the value of the firm.

Control Risk Income Tax consideration Cost of Capital Trading on Equity Investors Attitude Flexibility Timing Legal Provisions Profitability Growth Rate Government Policy Marketability Company Size Manoeuverability Financing Purpose

Basic Assumptions A study of the following basic assumptions is necessary, before we study the capital structure theories under traditional and modern views: (i) The company distributes all its earnings as dividends to its shareholders and no consideration of dividend and retention policies. (ii) The taxation and its effect on cost of capital is ignored.

(iii) Business risk is treated constant at different

levels of capital structure of a company. (iv) There are no transaction costs and a company can alter its capital structure without any transaction costs. (v) The continuous and perpetual earning of profits to the expectations of the stockholders.

The following points should be considered before selecting the firms debt-equity ratio as a measure for determining the capital structure: (a) There is an optimal capital structure where the marginal tax benefit is equal to the marginal cost of anticipated financial distress. (b) The debt-equity ratio depends on both the levels and volatility of cash flows. (c) Survival of the firm is the top priority of any firm and hence the lower debt-equity ratio is preferable for high risk business firms.

(d) The trade cycles and industry cycles and

other reasons may some times cause financial distress to the firm and hence the debt-equity ratio should be selected keeping in view the distress conditions which may occur in future. (e) In balancing debt-equity ratio, the first step always should be the increase of equity which gives more financial flexibility. (f) Increasing equity can be used as a base to justify and sustain more debt.

The debt-equity ratio affects the firms cost of capital when a debt-equity ratio of a firm increases, its cost of capital will decline and vice versa. When a firm depends on higher debt, result in payment of interest to the suppliers of loan capital which will lower the amount of tax payable by the company, and simultaneously its overall cost of capital will also decrease . But, any non-payment of principal and interest payments of the loans outstanding may result in bankruptcy costs. The impact of debt-equity composition on cost of capital is explained in the illustration given below.

Particulars Alternative-I Equity capital 750 Long-term debt(14%) 250 1,000

(Rs. lakhs) Alternative-II 250 750 1,000

The firms corporate tax rate is 40% . It maintains a dividend of 18% on the equity capital . Now the firms cost of capital is calculated as follows:

(Rs. lakhs)
Particulars
Dividend on equity shares (@ 18%) Interest on long-term debt (@ 14%) 35

Alternative-I
135

Alternative-II
45 105

Less: Tax
Composite Cost of Capital

(@ 40%)

14

21
156

42

63
108

(156/1,000) X 100 = 15.6%

(108/1,000) X 100 = 10.8%

Analysis From the analysis of the above we can observe that when the debt-equity ratio is 1: 3, the composite cost of capital stands at 15.6%. When the debt-equity ratio altered to 3: 1, the firms cost of capital has drastically reduced to 10.8% . This is due to the advantage of tax shield and the supply of debt at cheaper cost than the equity capital.

EBIT-EPS approach is an important tool for designing the optimal capital structure framework of the firm.

It is the minimum level of EBIT needed to satisfy all fixed financial charges i.e., interest and preference dividends. It denotes the level of EBIT for which the firms EPS just equals zero. If EBIT is less than financial break-even point, then EPS will be negative. But if the expected level of EBIT exceeds than that of break-even point, more fixed costs financing instruments can be induced in the capital structure. Otherwise the use of equity would be preferred.

When two alternative financial plans do produce the level of EBIT where EPS is the same, this situation is referred to as indifferent point. In case, the expected level of EBIT exceeds the indifference point, the use of debt financing would be advantageous to maximize the EPS. The indifference point may be defined as the level of EBIT beyond which the benefits of financial leverage begins to operate with respect to earnings per share.

FIGURE 9.2 DEBT AND EQUITY : INDIFFERENCE POINT

EPS (Rs.)

Debt
Equity

Indifference point

EBIT (Rs.)

The indifference point between the two financing alternatives can be ascertained as follows: (EBIT I1) (1 t)

N1

(EBIT I2) ( 1 t) N2

where, EBIT = Earnings before interest and taxes

t = Corporate rate of tax I1 = Interest charges in Financing alternative 1 N1 = Number of equity shares in Financing alternative 1 I1 = Interest charges in Financing alternative 2 N2 = Number of equity shares in Financing alternative 2

American Express Ltd. Is setting up a project with a capital outlay of Rs. 60,00,000. It has the following two alternatives in financing the project cost: Alternative 1 : 100% Equity finance Alternative 2 : Debt-equity ratio 2:1 The rate of interest payable on the debt is 18% p.a. The corporate rate of tax is 40% . Calculate the indifference point between two alternative methods of financing.

Alternatives in financing and its financial charges (1) By issue of 6,00,000 equity shares of Rs. 10 each amounting Rs. 60 lakhs. No financial charges involved. (or) (2) By raising the funds in the following way:
Debt Equity = Rs.40 lakhs = Rs.20 lakhs (2,00,000 equity shares of Rs.10 each) = Rs. 7,20,000

Interest payable on debt = Rs.40,00,000 X 18/100

Now we can calculate the indifference point of the above two financing alternative s as follows:

(EBIT 0) (1 0.40) = (EBIT 7,20,000) (1 0.40) 6,00,000 2,00,000 (EBIT 0) (0.60) (EBIT -7,20,000) (0.60) 6,00,000 2,00,000 ( in lakhs) (EBIT 0) (0.60) (EBIT 7.2) (0.60) 6 2 0.60 EBIT X 2 = (0.6 EBIT X 6) [(0.6 X 7.2) X 6] 0.60 X 7.2 X 6 = (0.60 EBITX6) - (0.60 EBT X 2) 25.92 = 3.6 EBIT 1.2 EBIT 2.4 EBIT = 25.92 EBIT = 25.92/2.4 = 10.80 say Rs. 10,80,000 The EBIT at indifference points explains that the EPS for two methods of financing is equal.

This approach is given by Durand David. According to this approach, the capital structure decision is relevant to the valuation of the firm. As such a change in the capital structure causes an overall change in the cost of capital and also in the total value of the firm. A higher debt content in the capital structure means a high financial leverage and this results in decline in the overall or weighted average cost of capital. This results in increase in the value of the firm and also increase in the value of the equity shares.

FIGURE 9.5 DURANDS VIEW OF CAPITAL STRUCTURE cost of capital Cost of equity Average cost of capital

Cost of debt

Degree of leverage

Assumption There are usually three basic assumptions of this approach: (a) Corporate taxes do not exist. (b) Debt content does not change the risk perception of the investors. (c) Cost of debt is less than cost of equity i.e., debt capitalisation rate is less than the equity capitalisation rate. According to net income approach, the value of the firm and the value of equity are determined as given below: value of Firm (V) = S + B Where, S = Market Value of Equity B = Market Value of Debt Market Value of Equity (S) = NI Ke where, NI = Net income available for equity shareholders Ke = Equity capitalization rate

Glamour Ltd. Earned a profit of Rs.20 lakhs before providing for interest and tax. The companys capital structure is as follows: (i) 4,00,000 Equity shares of Rs.10 each and its market capitalisation rate is 16%. (ii) 25,000 14% Secured redeemable debentures of Rs.150 each. You are required to calculate the value of the firm under Net Income Approach. Also calculate the overall cost of capital of the firm.

Value of the Firm (V) Where, S B

=S+B = Market value of equity = Market value of debt (Rs)

20,00,000 5,25,000 14,75,000

Profit before interest and tax Less: Debenture interest (@ 14%) Net income available to equity shareholders

Market Value of Equity (S) S = NI Ke Where, NI = Net income available for equity shareholders i.e., Rs.14,75,000 Ke = Equity capitalisation rate i.e., 16% or 0.16 S = Rs. 14,75,000 0.16 = Rs. 92,18,750 Now, we can Calculate the Value of the Firm V =S+B = Rs. 92,18,750 + Rs. 37,50,000 = Rs. 1,29,68,750 Calculation of Overall Cost of Capital Ke = EBIT = Rs. 20,00,000 X 100 = 15.42% V Rs. 1,29,68,750

According to Net Operating Income Approach (NOI), value of the firm is independent of its capital structure. It assumes that the weighted average cost of capital is unchanged irrespective of the level of gearing. The underlying assumption behind this approach is that the increase in the employment of debt capital increases the expected rate of return by the stockholders and the benefit of using relatively cheaper debt funds is offset by the loss arising out of the increase in cost of equity.

Assumptions The NOI approach is based on certain assumptions: (a) The investors see the firm as a whole and thus capitalise the total earnings of the firm to find the value of the firm as a whole. (b) The overall cost of capital, (Ko), of the firm is constant and depends upon the business risk which also is assumed to be unchanged. (c)The cost of debt, (Kd) is also constant. (d) There is no tax. (e) The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the increase in the cost of equity capital (Ke).

The NOI approach believes that the market values of the firm as a whole for a given risk complexion. Thus, for a given value of EBIT, the value of the firm remains the same irrespective of the capital composition, and instead depends on the overall cost of the capital. Value of Firm (V) = EBIT Ke Where, EBIT = Earning before interest and tax Ko = Overall cost of capital Value of Equity (S) = V B Where, V = Value of firm B = Value of debt

Thus, financing mix is irrelevant and does not affect the value of the firm. The value remains same for all types of debt-equity mix. Since there will be changes in risk of the shareholders due to change in debt-equity mix, therefore, Ke will be changing linearly with change in debt proportions.

Jupiter Constructions Ltd. Has earned a profit before interest and tax Rs. 5 lakhs. The companys capital structure includes 20,000 14% Debentures of Rs. 100 each. The overall capitalisation rate of the firm is 16%. Calculate the total value of the firm and the equity capitalisation rate.

Value of Firm (V) V = EBIT K Where, EBIT = Earning before interest and tax i.e., Rs. 5,00,000 K = Overall capitalisation rate i.e., 16% or 0.16 V = 5,00,000 = Rs. 31,25,000 0.16

Value of Equity (S) S=VB Where, V = Value of firm B = Value of debt S = 31,25,000 20,00,000 = Rs. 11,25,000 Equity Capitaline Rate (Ke) Ke = EBIT I X 100 VB = 5,00,000 2,80,000 X 100 = 2,20,000 X 100 = 19.55%
31,25,000 - 20,00,000 11,25,000

Verification The NOI approach can be verified by calculating the overall cost of capital of the firm as follows: K = K e S + Kd B V V = 19.555% 11,25,000 + 14% 20,00,000 = 7.04% + 8.96% = 16%
31,25,000 31,25,000

The cost capital is interdependent on the degree of leverage. The lowest component in the cost of capital relates to the fixed interest bearing investments. Traditionally, optimal capital structure is assumed at s point where weighted average cost of capital (WACC) is minimum. For a project evaluation, this WACC is considered as the minimum rate of return required from project to pay off the expected return of the investors and as such WACC is generally referred to as the required rate of return.