Capital Structure

Capital Structure

Capital  Budgeting

From a technical perspective, the capital structure is the careful balance between equity and debt that a business uses to finance its assets, day-to-day operations, and future growth. Capital Structure is the mix between owner’s funds and borrowed funds.

·         FUNDS = Owner’s funds + Borrowed funds.

·         Owner’s funds = Equity share capital + Preference share capital + reserves and surpluses + retained earnings = EQUITY

·         Borrowed funds = Loans + Debentures + Public deposits = DEBT

In short, Capital Structure is the mixture of long-term sources of funds. Capital Structure is optimal when the proportion of debt and equity maximizes the value of the equity share of the company. However, a company heavily funded by debt has an aggressive capital structure and poses a greater risk to investors. This risk, however, may be the primary source of the firm’s growth.

Debt vs Equity

Cost of Debt is lower than the cost of equity but Debt is riskier than equity. The reasons for this are

·         Lender earns an assured interest and repayment of capital.

·         Interest on debt is a tax-deductible expense so brings down the tax liability for a business whereas dividends are paid out of profit after tax.

Debt is more dangerous for the business as it adds to the financial risk faced by a business. Any failure with reference to the payment of interest or repayment of principal amount may lead to the liquidation of the company.

Financial Leverage

The proportion of debt in the overall capital of a firm is called Financial Leverage or Capital Gearing. When overall debt in the firm increases, cost of funds declines as debt is a cheaper source of funds.

When the proportion of debt in the total capital is high then the firm is called highly levered firm but when the proportion of debts in the total capital is less, then the firm will be called low levered firm.

Factors Affecting Capital Structure

1] Cash Flow Position

A firm’s ability to pay expenses and loans determines debt capacity. Some firms operate in volatile financial environments affecting their ability to meet financial obligations. The company may raise funds by issuing debts if it has a fluent cash flow position, as they are to be paid back after some time.

It must cover fixed payment obligations with regards to,

·         Normal business operations

·         Investment in fixed assets

·         Meeting debt services commitments as well as provide a sufficient buffer period

2] Interest Coverage Ratio

Interest Coverage Ratio is the number of times earnings before interest and taxes of a company covers the interest obligation. High-Interest coverage ratio indicates that company can have more of borrowed funds.

Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) / Interest.

3] Control

Public issues damage the reputation of the firm and make it vulnerable to takeovers. Debt generally does not cost dilution of control. To have control, the firm must issue debt. So there is a constant struggle over whether to give up control or pay more for capital.

4] Return on Investment

It will be beneficial for a firm to raise finance through borrowed funds if the return on investment is higher than the rate of interest on the debt. But if the return is uncertain and the company is not sure if it can cover the fixed cost of interest, they should opt for equity.

5] Floatation Cost

Flotation cost must be understood while selecting the sources of finance.  Cost of the Public issue is more than the floatation cost of taking a loan. The cost of issuing securities, brokers’ commission, underwriter’s fee, cost of prospectus etc is the flotation cost.

6] Flexibility

Issuing debenture and preference shares introduce flexibility. A good financial structure is flexible and sound enough to have scope for expansion or contraction of capitalization whenever the need arises.

7] Stock Market Conditions

Conditions of the stock market influence the determination of securities. During the depression, people do not like to take a risk and do not take interest in the equity shares. During the boom, investors are ready to take a risk and invest in equity shares.

8] Tax Rate

Interest on debt is allowed as a deduction; thus in case of the high tax rate, debts are preferred over equity but in case of low tax rate more preference is given to equity.

Capital Structure and Its Theories

Capital Structure means a combination of all long-term sources of finance. It includes Equity Share Capital, Reserves and Surplus, Preference Share capital, Loan, Debentures and other such long-term sources of finance. A company has to decide the proportion in which it should have its own finance and outsider’s finance particularly debt finance. Based on the proportion of finance, WACC and Value of a firm are affected.

It is synonymously used as financial leverage or financing mix. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm.

Financial leverage is the extent to which a business firm employs borrowed money or debts. In financial management, it is a significant term and it is a very important decision in a business. In the capital structure of a company, broadly, there are mainly two types of capital i.e. Equity and Debt. Out of the two, debt is a cheaper source of finance because the rate of interest will be less than the cost of equity and the interest payments are a tax-deductible expense.

There are four approaches to this, viz. 

Net Income, 

Net Operating Income, 

Traditional And

 M&M Approach.

1.)    Net income approach:  (relevance) 

This approach was first suggested by David Durand in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change in capital costs. In other words, if there's an increase in the debt ratio, capital structure increases and the weighted average cost of capital (WACC) decreases, which results in a higher firm value.
this theory is given by Durand. As per the theory the value of firm can be increased and its cost of capital can be reduced by increasing proportion of debt in its capital structure. 

The approach is based upon following assumptions:-

• Cost of debt < cost of equity  or  kd<ke (as interest rate are usually lower than dividend rates.)
• There are no taxes
• V (value of firm) = S (market value of equity share) + D (market value of debentures) Or                  V= EBIT/K_O

2.)    Net operating income approach: (irrelevance approach)
This theory is also given by Durand. This theory is totally opposite to the net income approach. As per this approach with the change in capital structure there is no change in the value of firm and cost of capital. It means if debt-equity mix is 80:20, 40:60:, 60:40 the cost of capital (ko) remains the same. There is nothing like optimal capital structure. The approach is based upon following assumptions:-

• There are no taxes
• Risk is same at all the levels of debt equity mix.
• Cost of optimal capital structure (ko) remains constant.
• And ko = kd
• V= EBIT/K_O

This theory has been criticized on the grounds that ko and kd cannot remains constant at all the levels.

3.)    Traditional approach (intermediate approach): 
it is a balance between two above discussed approaches. As per this theory of capital structure, initially the value of the firm can be increased as well as cost of capital can be decreased by using more debt as debt is a cheaper source of funds than equity. But after a particular point of time, the cost of equity start increasing.

4.)    Modigliani and miller approach:

(I) In the absence of taxes (net operating income approach): According to this approach the debt equity mix is irrelevant in determining the value of the firm. It is because with the increase in the use of the debt the cost of equity increases.

This theory of capital structure assumes:

• There are no taxes
• There is a perfect market
• Investors act rationally
• No transaction cost
• All earning goes to the shareholders

(II) In the presence of taxes (net income approach): according to this approach cost of capital will decrease and value of the firm increase with the use of debt due to taxes. The optimal capital structure can be achieved by maximizing the debt in the equity.

                            V= EBIT/K_O

If there are taxes than (1-t)

                           V= EBIT/K_O (1-t)

Therefore above are the different theories of capital structure.