Capital Structure Decisions In Financial Management 5 November

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CAPITAL STRUCTURE DECISIONS IN FINANCIAL

MANAGEMENTDr. T.K. Jain.

AFTERSCHO☺OLCentre for social entrepreneurship

Bikaner M: 9414430763tkjainbkn@yahoo.co.in

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What is capital structure?

• Combination of capital is called capital structure. The firm may use only equity, or only debt, or a combination of equity + debt, or a combination of equity+debt+preference shares or may use other similar combinations.

How do you design capital structure?

1. It should minimise cost of capital2. It should reduce risks3. It should give required flexibility4. It should provide required control to the

owners 5. It should enable the company to have

adequate finance.

What are the risks associated with capital structure decisions?

• Meaning of risk = variability in income is called risk.

• Business risk = it is the situation, when the EBIT may vary due to change in capital structure. It is influenced by the ratio of fixed cost in total cost. If the ratio of fixed cost is higher, business risk is higher.

• Financial risk = it is the variability in EPS due to change in capital structure. It is caused due to leverage. If leverage is more, variability will be more and thus financial risk will be more.

Degree of financial leverage?

• It shows the extend of financial risk. Higher the DFL, higher is the financial risk.

• Formula = • % change in EPS / % change in EBIT. • Suppose EBIT changes 10%, due to this

EPS changes 20%, • 20/10 = 2 • DFL is 2.

EBIT - EPS analysis

• Generally cost of debt is lower than cost of equity. Therefore raising debt (trading on equity) increases EPS and it gives benefit to the shareholders. However, excess of debt will create more risk and therefore it is not advisable. A firm can identify an ideal level of quantum of debt and equity so that it is within proportion.

Formula

• [(EBIT – I1) (1-t)]/ E1 = [(EBIT – I2) (1-t)]/ E2

• E1 = equity in 1st alternative (no debt or minimum debt)

• E2 = equity in 2nd alternative (no debt or max. debt)

• I1 and I2 represent interest payable in the 2 alternatives respectively.

What do you understand from trading on equity?

• With capital, we can raise debt, and raise our EPS, this is called trading on equity.

What is coverage ratio or DSCR?

• DSCR = debt service coverage ratio• Coverage ratio denotes the extent to which

interest is covered by the EBIT. It denotes whether we have sufficient earnings to meet our interest obligation. If DSCR is 1 or less than one, it is dangerous situation.

• Formula = EBIT / interest. • Higher the DSCR, less is the risk (because

there is higher coverage).

Theory of optimal capital structure?

• This theory states that we can have an optimum capital structure – as we raise the debt, we can raise the value of the firm to some extent. Thus level of debt can be increased upto some level. That level is the ideal capital structure.

• Ultimate objective of Finance manager is to raise the value of the firm and raise the wealth – which is possible by an ideal capital structure.

Is there indifference point?

Solve the following • Goti continental Inc. a profit makipg company, has a paid-

up capital of Rs. 100 lakhs consisting of 10 lakhs ordinary shares of Rs. 10 each. Currently, it is earning an annual pre-tax profit of Rs. 60 lakhs. The company’s shares are listed and are quoted in the range of Rs. 50 to Rs. 80. The management wants to diversify production and has approved a project which will cost Rs. 50 lakhs and which is expected to yield a pre-tax income of Rs. 40 lakhs per annum. To raise this additional capital, the following options are under consideration of the management:

• (a) To issue equity capital for the entire additional amount. It is expected that the new shares (face value of Rs. 10) can be sold at a premium of Rs. 15.

• (b) To issue 16% non-convertible debentures of Rs. 100 each for the entire amount. Tax rate = 30%

Solution

• (a) raising additional equity – how much equity required?

• One share will give you 10 + 15 = 25• Capital required = 50 lakhs.• 50/25 = 2 lakh shares. (we already have

10 lakh shares)

Solution • (a) All equity : • Earnings = 60 + 40 = 100• Tax: 30• EAT = 70• No. of shareholders: 12

lakh shares• EPS = 70 / 12=5.83

• (B) All debt• Earnings = 60 + 40 = 100• Payment of interest: • 16% of Rs. 50 lakhs =8

lakhs• EAIBT = 92• Tax: 30% = 27.6• EAT = 64.4• No. of shareholders: 10

lakh shares• EPS = 64.4 / 10=6.44

Analysis

• From the above analysis, it is clear that EPS is higher in the case when we are raising debt. (therefore this option is better and the firm should go for raising debt).

• We also have to look at the overall market capitalisation and overall value of the firm.

• Suppose, PE ratio of the industry is 20, the value of the firm is as under:

Solution • (a) all equity • 5.83 *20 = 116.6• Multiply it with 12 lakhs,• The value of the firm is

1399.2 lakhs. Thus from this analysis, this option is better.

• Debt • Use of debt will reduce

the PE ratio to some extent as Beta will increase. However, let us calculate using 20 as PE ratio:

• 20*6.44 = 128.8 *10 lakhs + 16 lakhs

• =1304 lakhs

Theories of capital structures . .

• There are 4 theories: 1. NI approach (net income approach)2. NOI approach (net operating income

approach)3. MM approach (Modigliani Millar

Approach)4. Traditional approach

Assumptions in capital structure theories …..

1. There are only 2 sources of finance – debt and equity

2. Taxes are ignored3. Dividend payout ratio is 100%4. Business risk is constant5. Firm’s total financing remains constant.

NI approach (net income approach)

• When you raise debt, leverage will increase. The overall value of the firm will incrase. Debt will have lower cost, so overall cost of capital will reduce (it is better if the cost of capital reduces).

• V = S+ D• V = value of the firm, S = equity, D = debt• An increase in leverage will increase the value of

the firm, it will raise EPS, it will raise the market price of the shares and it will reduce weighted average cost of capital, thus leverage is always beneficial.

NOI approach (Net operating income approach)

• Capital structure decision is irrelevant. If you raise debt, the cost of equity will increase. The overall cost of capital will remain constant in spite of leverage. Thus there is no advantage of raising debt. As we raise the debt, the cost of equity increases in the same proportion. The market discounts the firm, which is leveraged. Thus capital structure decision has no relevance.

MM approach

• It is similar to NOI approch

Traditional approach

• It says that with the use of debt, the overall cost of capital comes down upto some extent and thereafer the overall cost of capital increases. Thus there is an ideal point, upto which the overall cost of capital will decrease with the help of increase in debt, beyond which the use of debt is detrimental to the company.

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Capital Structure Decisions In Financial Management 5 November

Economy & Finance

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