A PROJECT REPORT ON

“CAPITAL STRUCTURE”

SUBMITTED BY

“MS. MANINI SHAH”

FOR THE DEGREE OF

THE BACHELOR OF MANAGEMENT STUDIES

UNDER THE GUIDANCE OF

“MISS _____________”

HR COLLEGE OF COMMERCE AND ECONOMICS

_________ ( E ) , MUMBAI – 4000____

ACADEMIC YEAR 2010 - 2011

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I, MANINI SHAH OF THE HR COLLEGE OF COMMERCE AND

ECONOMICS, ___________( E ) , HEREBY DECLARE THAT I

HAVE COMPLETED THE PROJECT ENTITLED “CAPITAL

STRUCTURE” PARTIAL FULFILLMENT OF THE REQUIREMENT

FOR THE THIRD YEAR OF THE BACHELOR OF MANAGEMENT

STUDIES COURSE FOR THE ACADEMIC YEAR 2010-2011

I FURTHER DECLARE THAT INFORMATION SUBMITTED BY ME

IS TRUE AND ORIGINAL TO THE BEST OF MY KNOWLEDGE.

DATED:

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WHAT IS CAPITAL STRUCTURE

A firm needs capital to grow and acquire additional assets. Firms usually

finance the purchase of long-term assets with long-term capital. Retained

earnings are one source of long-term capital. But when capital

requirements exceed the firm’s ability to generate cash internally, it must

raise funds externally.

The firm’s mix of different securities is known as its capital structure. In

other terms, capital structure refers to the firms’ proportion of debt

financing, its leverage ratio.

Capital structure is the mixture of sources of funds a firm uses (debt,

preferred stock, common stock). The amount of debt that a firm uses to

finance its assets is called leverage.

PHILIP MORRIS produces food, drink, and tobacco including such well-

known products such as Marlboro cigarettes, Maxwell House coffee, and

Millers’ beer. In 200 the company generated $11 billion in cash. From this it

paid $4.5 bn as dividends and repurchased shares for $3.6 bn. The

balance of $2.9 bn was reinvested in the business but this sum was too

short for further expansion and modernization so, to make up the shortfall,

the company borrowed $10.9 bn and issued $100 mn of common stocks.

In considering how to finance its investments, Philip Morris ‘s managers

faced two basic decisions. One was the dividend decision. For example,

the company could have paid a larger dividend the cash for this would have

had to come from buying back fewer shares or selling more stock. The

second decision was whether to raise cash by debt or equity. A company’s

mix of debt and equity is termed its capital structure.

Capital structure is by definition the cumulative outcome of past financing

decisions. Past financing decisions are known to depend on past market

valuations.

An appropriate capital structure is a critical decision for any business

organization.  The decision is important not only because of the need to

maximize returns to various organizational constituencies, but also because

of the impact such a decision has on an organization’s ability to deal with its

competitive environment. 

COMPONENTS OF CAPITAL STRUCTURE

The above stated definition gives two broad options for financing the

organizations’ investments- Equity and Debt

However, within the broad categories of debt and equity there exists a

variety of financing instruments and vehicles that firm can use. Fir instance,

The Home Depot raised debt by issuing convertible bonds, while Boeing

used a combination of secured and unsecured debt, with varying

maturities. The choices are narrower for private businesses, but they do

exist. InfoSoft raised equity to fund its operations from both the current

owners of the business and venture capitalists.

EQUITY

1. Ownership interest in a corporation in the form of common stock or

preferred stock. It is the risk-bearing part of the company's capital and

contrasts with debt capital, which is usually secured and has priority over

shareholders if the company becomes insolvent and its assets are

distributed.

2. Total assets minus total liabilities; here also called shareholder's equity

or net worth or book value. It is also known as common stock or simply

stock.

Large firms generally raise the bulk of new common equity internally- that

is, by retaining a portion of earnings. But smaller or rapidly growing firms

usually also issue new common stock to raise funds. Even large firms

sometimes issue new common equity through sizable public offerings. In

addition, many firms have instituted dividend reinvestment or employee

stock purchase plans that generate additional common equity on a

continuing basis.

DEBT

No doubt we all have (mostly) borrowed money before. Like having a credit

card, we borrow money each time we use it. The card issuer pays the

merchant, and we must repay the card issuer. If we always pay the first

time we are billed, the loans are interest-free. We simply repay the amount

we have borrowed; no interest is charged. If we do not pay right away,

however, we begin to owe interest.

Here we are referring only long-term (10 or more years) debt or loan.

1. A liability or obligation in the form of bonds, loan notes, or mortgages,

owed to another person or persons and required to be paid by a specified

date (maturity).

2. A debt instrument is a contract between the issuer and investor or

holder, which provides for the periodic payments to the holder in

exchange to the, money lent to the issuer.

In other words, there is a creditor-debtor relationship between the

investor and issuer. The issuer makes a promise to pay (the holder)

interest periodically and repay principal at the end of a certain period

of time. The issuer could be a body corporate or government.

Corporate debt instruments are called debentures or bonds.

Bond

A bond is a type of loan. A certificate of debt that is issued by a

government or corporation in order to raise money with a promise to pay a

specified sum of money at a fixed time in the future and carrying interest at

a fixed rate. Generally, a bond is a promise to repay the principal along with

interest (coupons) on a specified date (maturity). The main types of bonds

are corporate bond, municipal bond, Treasury bond, Treasury note,

Treasury bill, and zero-coupon bond. It is a tradable debt instrument that

might be sold at above or below par (the amount paid out at maturity), and

are rated by bond rating services such as Standard & Poor's and Moody's

Investors Service, to specify likelihood of default. The Federal government,

states, cities, corporations, and many other types of institutions sell bonds.

It is relatively more secured than equity and has priority over shareholders

if the company becomes insolvent and its assets are distributed.

There is no legal distinction between a debenture and a bond except that a

debenture could be either secured or unsecured, whereas a bond is

secured. The term bond is usually applied to public sector debt offerings.

These terms are used interchangeably in this project.

When a firm decides to issue debt securities, it must decide several things.

Should the debt have a fixed or a variable interest rate? When should it

mature? Should it include a sinking fund, which will retire it in installments?

Should the firm retain a call option so that it can call in the debt and refund

it if interest rates drop?

Market research shows that the volume of debt issues tends to vary with

the level of long term interest rates. During periods of rising long-term

interest rates such as 1977-1981, firms tend to favor short-term borrowing

in the hope that long-term interest rates will fall. When long-term interest

rates do fall, as they did from 1981 to 1986 and from 1990 to 1993, firms

begin to replace this short-term debt.

Features of a bond

A bond is a marketable debt instrument. The length of time before it

matures is called term to maturity, usually greater than a year. Those with

term to maturity of less than a year are called money market instruments,

and those with term greater than one year are called capital market

instruments.

The issuer generally pays a fixed rate of interest on the principal (face

value). The rate of interest is called coupon rate, and the amount itself is

called coupon.

The coupon can be paid annually or semi-annually.

Long-term debt instruments share several common features.

1. Stated maturity: This is the date by which the borrower must repay

the money it borrowed.

2. Stated principal amount: This is the amount the borrower must repay.

3. Stated coupon rate of interest: The interest rate may be a fixed rate,

or it may be a variable rate that is adjusted according to a specified

formula.

4. Mandatory redemption (or sinking fund) schedule: Some bonds

contain a sinking fund, whereas others are repaid in a single sum at

maturity. A sinking fund involves a sequence of principal repayments

prior to the maturity date. Bonds are redeemed in cash at their face

amount or else through capital market purchases.

5. Optional redemption provision: The issuer has the right to call the

issue (or some portion of it) for early redemption. A schedule of

optional redemption prices is specified at the time of issue. Callable

bonds usually provide for a grace period immediately following

issuance. Bonds are noncallable during this period. Many long-term

issues contain a weaker provision. The bonds are only

nonrefundable. During the nonrefundable period, the issuer cannot

use the proceeds from a new debt issue that ranks senior to, or on a

par with, the outstanding debt to refund it.

6. Protective Covenants: Covenants impose restrictions on the

borrower. They are designed to protect the bondholders.

Types of long term debt

There are four main classes of long-term corporate debt instruments:

Secured debt, Unsecured debt, Tax-exempt debt, and Convertible debt.

Secured debt: Secured debt is backed by specific assets. This backing

reduces both the lenders’ risk and the interest rate they require. Mortgage

bonds, collateral trust bonds, equipment trust certificates, and conditional

sales contracts are the most common types of secured debt.

Mortgage Bonds: Mortgage bonds are secured by a lien on specific

assets of the issuer. If the issuer defaults-fails to make a required payment

of principal or interest-or fails to perform some other provision of the loan

contract, lenders can seize the assets that secure the mortgage bonds and

sell them to pay off the debt obligation. The extra protection that the

mortgage provides lowers the risk. In return, that lowers the required return.

But the issuer sacrifices flexibility in selling assets. Mortgaged assets can

be sold only with the mortgaged bondholders’ permission or if the borrower

provides suitable replacement collateral.

Collateral Trust Bonds: Collateral trust bonds are similar to mortgage

bonds except that the lien is against securities, such as common shares of

one of the issuer’s subsidiaries, rather than against real property such as

plant and equipment.

Equipment Trust Certificates And Conditional Sales Contracts:

Equipment certificates and conditional sales contracts are frequently issued

to finance the purchase of aircraft or railroad “rolling stock”. Equipment trust

certificates are usually issued to finance a leveraged lease. The trust that

issues them owns the assets during the tem of the lease. Conditional sales

contracts are agreements that manufacturers use to finance customer

purchases of their goods. They are long-term receivables. The two

financing mechanisms are similar: The borrower obtains title to he assets

only after it fully repays the debt.

Unsecured Debt: Unsecured long-term debt consists of notes and

debentures. Notes are unsecured debt with an original maturity of ten

years or less. Debentures are unsecured debt with an original maturity

greater than ten years. Notes and debentures are issued on the strength of

the issuer’s general credit. A financial contract (the bond indenture)

specifies their terms; they are not secured by specific property. If the issuer

goes bankrupt, note holders and debentures holders are classified as

general creditors.

Tax-Exempt Corporate Debt: Firms can issue tax-exempt bonds for

specified purposes.

Convertible Debt: A convertible bond is a bond that can be converted into

a predetermined number of shares of the common stock, at the discretion

of the bondholder. Although it generally does not pay to convert at the time

of the bond issue, conversion becomes a more attractive option as stock

prices increases.

Advantages of debt:

1. It provides a tax benefit because interest expenses are tax

deductible.

2. For some firms, it can force managers to now more disciplined in their

investment choices.

Disadvantages of Debt:

1. Debt increases the risk that a firm will be unable to meet its fixed

payments and go bankrupt.

2. As firms borrow money, they increase the potential for conflicts

between lenders and equity investors.

3. Firms that borrow money lose some flexibility with regard to future

financing.

THEORIES OF CAPITAL STRUCTURE

In practice it is difficult to specify an optional capital structure-indeed,

managers even feels uncomfortable about specifying an optional capital

structure range. Thus, financial managers worry primarily about whether

their firms are using too little or too much debt, not about the precise

optimal amount of debt. Even if a firm’s actual capital structure varies

widely from the theoretical optimum, this capital structure decisions are

secondary in importance to operating decisions, especially those relating to

capital budgeting and the strategic direction of the firm.

In general, financial managers focus more on identifying a “prudent” level of

debt than on setting a precise optimal level. A prudent level is defined as

one that captures most of the benefits of debt yet (1) keeps financial risk at

a manageable level, (2) ensures future financing flexibility, and (3) allows

the firm to maintain the desirable credit rating. Thus, a prudent level of debt

will protect the company against financial and capital markets under

conditions

Establishing the right capital structure is an imprecise process at

best, and it should be based on both informed judgment and

quantitative analyses.

Basic Assumptions in Capital Structure theories: The study of the

following basic assumption is necessary before studying the capital

structure theories under traditional and modern views:

The company distributes all its earnings as dividends to its

shareholders and no consideration of dividend and retention policies.

The taxation and its effect on cost of capital are ignored.

Business risk is treated constant at different capital structure of a

company.

There are no transaction costs and a company can alter its capital

structure without any transaction costs.

The continuous and perpetual earning of profits to the expectations of

the stockholders.

Traditional View (Weighted average Cost of Capital)

The cost of 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 a 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.

WACC is defined as the weighted average of the cost of various sources of

finance. Weights being the market value of each source of finance

outstanding, cost of various sources of finance refers to the return expected

by the respective investors. The debt component should be raised up to the

level where the WACC of the firm is at the lowest which is called optimum

cost of capital. Till the optimum level reaches a firm can rise its debt

component to minimize WACC and for increasing returns to the equity

holders. After the optimum level, any further increase in debt increases the

risk to the equity holders.

The above figure shows that the cost of debt lower than cost of equity.

Firms can borrow at low rate of interest in the beginning. With the increase

Cost Of EquityWACC

Cost of Equity

Optimum PointDegree of Leverage

Cost Of Capital (Rs.)

in leverage, lenders being to worry about the repayment of interest and

principal and security available to them. The interest rate will be higher on

additional loans. Therefore, average cost of debts begins to rise.

Simultaneously, when the equity holders will not much bother when the

debt levels of the company are lower. But which increasing leverage, the

equity holders are much concerned about the level of interest payments

affecting the volatility of cash flow for equity. Then the equity holders

demand for more rates of return for taking an additional risk. Thus, a

combination of both the sources of finance, with the increase in leverage,

the overall cost of capital will also start raising after the optimum level of

gearing.

WACC is undoubtedly an important tool in determining optimal capital

structure. To minimize the value of the firm as well as the market value of

the stock, the firm should strive to minimize WACC. Thus, considerable

weight is placed on WACC for achieving the ultimate objective of increasing

the stockholders worth by choosing an appropriate capital mix. Other

conditions, like cash flow, ability of the firm to meet fixed charges, degree

of leverage, fluctuations of EBIT and its likely impact on EPS for alternative

methods of financing etc. should also be taken into consideration with due

weight age for the purpose.

The above figure shows the impact of leverage on value of the firm. The

value of the firm is maximum where the level of gearing for each firm at

which the cost per unit of capital is at its lowest point. Therefore, a firm

should identify and maintain capital structure at this optimum level.

Net Income Approach

This is approach is given by Durant 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 he cost of

capital and also in the total value of the firm. A higher debt content in the

capital structure means high financial leverage and this results in decline in

the overall or weighted average cost of capital. This result in increases in

the value of the firm and also increases in the value of the equity shares. In

Value of firm

Value of equity

Optimal level of capital

Value of debt

Degree of leverage

Market value

an opposite situation, the reverse conditions prevail. There are usually

three basically assumptions of this approach:

Corporate taxes do not exist.

Debt content does not change the risk perception of the investors.

Cost of debt is less than cost of equity i.e., debt capitalization rate is

less than the equity capitalization 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) Where,

V = S+B S = Market value of Equity

B = Market value of Debt

Net operating Income Approach:

According to net operating income approach (NOI) value of the firm is

independent on 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.

A change in proportion of various sources of finance cannot alter the

weighted average cost of capital and as such, the value of firm remains

unaltered for all degrees of leverage. Under this approach optimal capital

structure does not exist, as average cost of capital remains constant for

varied types of financing mix.

NOI approach is opposite to NI approach. According to this approach, the

market value of the firm depends upon the net operating profit or EBIT and

the overall cost of capital, weighed average cost of capital (WACC). The

financing mix or the capital structure is irrelevant and does not affect the

value of the firm. The NOI approach is based on certain assumptions:

The investors see the firm as a whole and thus capitalize the total

earnings of the firm to find the value of the firm as a whole.

The overall cost of capital, Ko, of the firm is constant and depends

upon the business risk, which also is assumed to be unchanged.

The cost of debt, Kd, is also constant.

There is no tax.

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 i.e., Ke.

The NOI approach believes that the market value 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.

Ascertainment of value of firm and value of equity

Value of Firm (V)

V = EBIT Where,

Ko EBIT = Earnings before interest and tax

Ko = Overall cost of capital

Value of Equity (S)

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

the change in the risk of the shareholders due to change in debt-equity mix

therefore, Ke, will be changing linearly with change in debt proportion.

The NOI approach can be illustrated with the help of the above diagram.

The diagram shows that the cost of the debts and the overall cost of capital

are constant for all level of leverage. As the debt proportion or the financial

leverage increases the risk of the shareholders also increases and thus,

the cost of the equity capital also increases. However, the increase in the

cost of the equity capital does not affect he overall value off the firm and it

remains same.

It is to be noted that an all- equity firm the cost of equity capital is just equal

to WACC as the debt proportion is increased, the cost of the equity also

increases. However, the overall cost of the capital remains constant.

Because increase in cost of equity is just sufficient to offset the benefit of

cheaper debt financing.

The NOI approach believes that leverage has no effect on the WACC and

value of the firm. Hence, every capital structure is optional.

Cost of Equity

WACCCost of Debt

Level of gearing

Cost of capital

The MM approach is quite similar to NOI approach in many respects. But

still NOI approach is only conceptual in the sense and it fails to give

operational justification to the fact that the capital structure is not important

for the valuation of the firm. MM approach also supports the NOI approach

but it provides justification for the independence of the total valuation and

cost of capital from the capital structure.

Modigliani and Miller Theory (Modern View)

The traditional view of capital structure as explained in Weighted average

cost of capital is rejected by the proponents Modigliani and Miller (MM)

(1958). According to them cost of capital is independent of capital structure

and, therefore, there is no optimal value. According to them, under

competitive conditions and perfect markets, the choice between equity

financing and borrowing does not affect a firm’s market value because the

individual investor can alter investments to any mix of debt and equity the

investor desires.

Assumptions of MM theory:

The MM theory is based on the following assumptions:

Perfect capital markets exist where individuals and companies can

borrow unlimited amounts at the same rate of interest.

There are no taxes or transaction costs.

The firms’ investment schedules and cash flows are assumed

constant and perpetual.

The stock markets are perfectly competitive.

Investors are rational and expect other investors to behave rationally.

It means according to MM approach the weighted average cost of capital

does not change with change in debt-equity mix i.e., change in capital

structure. Whenever the debt equity ratio changes, the expectations of the

equity shareholders also change. Result is that the overall cost of capital of

the enterprise remains unaffected. This is exactly what MM approach says.

MM Theory: No Taxation

The debt is less expensive than equity. An increase in debt will increase

the required rate of return on equity. With the increase in the levels of debt,

there will be higher level of interest payments affecting the cash flow of the

Cost of Equity

Average cost of capital

Cost of debt

Level of Leverage0

Cost of capital

company. Then equity shareholders will demand for more returns. The

increase in cost of equity is just enough to offset the benefit of low cost

debt, and consequently average cost of capital is constant for all levels of

leverage as shown in the above figure.

In MM theory the following symbols will be used:

Vu = Market value of ungeared company i.e., company with 100% equity

financing.

Vg = Market value of a geared company i.e., the capital structure of the

company includes both debt and equity capital.

D = Market value of debt in a geared company.

Veg = Market value of equity in a geared company and then

Vg = Veg + D

Ku = Cost of equity in an ungeared company.

Kg = Cost of equity in geared company.

Kd = Cost of debt.

PROPOSITION – І

The market value of nay firm is independent of its capital structure,

changing the gearing ratio cannot have nay effect on the company’s annual

cash flow. It is determined by the assets in which the company has

invested and not how those assets are financed.

The value of the Geared Company is as follows:

Vg = Vu

Vg = Profit before interest WACCVu = Vg = Earnings in ungeared company Ku

WACC is independent of the debt/equity ratio and equal to the cost of

capital, which the firm would have with no gearing in its capital structure.

PROPOSITION – П

The rate of return required by shareholders increases linearly as the

debt/equity ratio is increased i.e., the cost of equity rises exactly in line with

any increase in gearing to precisely offset any benefits conferred by the

use of apparently cheap debt.

MM went on arguing that the expected return on equity of a geared

company is equal to the return on a pure equity stream plus a risk premium

dependent on the level of capital structure.

The premium for financial risk can be calculated as debt/equity ratio

multiplied by the difference between the cost of equity for an ungeared

company and the risk free cost of debt.

The cost of equity of a geared company is calculated as follows:

Kg = Ku + [ (Ku – Kd) x D ] Veg

By introducing debt in capital structure, the cost of equity raises linearly to

offset the lower cost of debt directly given a constant weighted average of

capital irrespective of the level of gearing.

PROPOSITION – Ш

MM theories’ third proposition asserts that the cut off rate for new

investments will in all cases be average cost of capital and will be

unaffected by the type of security used to finance the investment.

MM Theory: Arbitrage

The cost of equity will rise by an amount just sufficient to offset any

possible saving or loss. The supply of debt is determined by the lenders.

The optimal level is simply the maximum amount of debt which lenders are

prepared to subscribe in any given circumstances. For example, level of

inflation, rate of economic growth, level of profits etc. The investors will

exercise their own leverage by mixing their own portfolio with debt and

equity. They call this the Arbitrage process. Under these conditions of

investments the average cost of capital is constant.

If two different firms which same level of business risks but with levels of

gearing sold for different values, then shareholders would move from

overvalued firm to the undervalued firm and adjust their level of borrowings

through the market to maintain financial risk at the same level. The

shareholders would increase their income through this method. While

maintaining their net investment and risk at the same level. This process of

arbitrage would dive the twice of the two firms to a common equilibrium

total value.

The word arbitrage is a technical term referring to a situation where two

identical commodities are selling in the same market for different prices,

then the market will reach equilibrium by the dealers start buy at a lower

price and sell at the higher price, thereby making profits. The increase in

demand will force up the prices of a lower priced goods and increase in

supply will force down the high priced commodities.

The arbitrage in the MM theory show that the investors will move quickly to

take advantage and will make profits in an equilibrium capital market, then

this would represent an arbitrage opportunity.

MM Theory: Corporate Taxation

In our previous discussion, MM theory has ignored the tax relief on debt

interest. MM has further modified their theory by considering tax relief

available to a geared company when the debt component is existing in the

capital structure. The tax burden on the company will lessen to the extent

of relief available on interest payable on the debt, which makes the cost of

debt cheaper, which reduces the weighted average capital of the firm to the

lower where capital structure of a company has debt component. This MM

theory adjusted to taxation is shown in the following figure.

0

Weighted average cost of a geared firm

Kg = (Cost of equity x % of equity) + (1-T) (Cost of debt x % of debt)

Under the assumption of tax relief being available on debt interest, the total

market value of the company is increasing function of the level of gearing.

Kg = Ku + (1-T)(Ku - Kd) x D where T = corporate tax rateKd = Pretax cost of debt

MM theory assumes that the value of the geared company will always be

greater than an ungeared company with similar business risk but only by

the amount of debt-associated tax saving of the geared company. Value of

geared company

Vg = Vu + DT

When corporate taxation is introduced, the tax deductibility of debt interest

creates value for shareholders via the tax shield, but this is a wealth

Cost of Equity

WACC

Cost of debt (after tax)

Cost of capital

Level of gearing

transfer from taxpayers. The value of a geared company equals the value

of an equivalent ungeared company plus the tax saving. A further effect of

corporate taxation is to lower WACC, which will fall continuously as gearing

increases.

MM Theory: Personal Taxation:

Miller (1977) argued that the existence of tax relief on debt interest but not

on equity dividends, would make debt capital more attractive than equity

capital to companies. When the company offers an after personal tax return

on debt at least as equal to the after personal tax return on equity, the

equity supply will switch over to supply debt to the company. Suppliers of

funds would be prepared to take up debt provided that they were

compensated by a high return so that the after tax return on debt was at

least equal to the after tax return on equity.

MM Theory: In Real World:

Under the modern view of capital structure decisions, the favorable tax

implications of borrowing will help reduce of average cost of capital even

the levels of leverage increases. It is based on the assumption that interest

payments on debt are allowed as a tax deduction whereas dividends on

equity capital are not allowed for tax deduction.

0

Financial Distress and Capital Structure

The assumption is that when firm has very level of borrowing they are more

likely to run into the costs of financial distress and cost of bankruptcy as it

is very likely that at some stage it will not be able to make annual interest

payments and loan repayments.

Pecking Order Theory

There is a theory, which explains the inverse relationship between profitability

and debt ratios. It goes like this,

Firms prefer internal finance

They adapt their target dividend payout ratios to their investment

opportunities while trying to avoid sudden changes in dividends

Sticky dividend policies, plus unpredictable fluctuations in profitability and

investment opportunities, mean that internal generated cash flow is

sometimes more than capital expenditures and at other times less. Is it is

Total Corporation debt

Optimum point

Demand for debt

Supply for debt

Interest rate %

less, the firm first draws down its cash balance or sells its marketable

securities

If external finance is required, firms issue the safest security first. I.e., they

start with debt, they possibly hybrid securities such as convertible bonds,

then perhaps equity as a last resort.

The pecking order explains why the most profitable firms generally borrow less-

not because they have low target debt ratios, but because they don’t need

outside money. Less profitable firms issue debt because they do not have

internal funds sufficient for their capital investment program, and because debt

financial is first on the pecking order of external financing.

The pecking order theory rests on

1. Sticky dividend policy

2. The preference for internal funds

3. An aversion to issuing equity

APPLICATION OF CAPITAL STRUCTURE THEORY

These following concepts will be helpful in designing capital structure in

real life situations.

Operating and financial leverage

The concept of fixed and variable costs was introduced under break-even

analysis. Fixed operating costs do not change with volume changes in the

short run. Fixed costs include depreciation on plant and equipment,

buildings, etc., insurance, and managerial remuneration. Variable costs, on

the other hand, vary directly with the level of output. These include raw

materials; direct labor costs and certain administrative expenses.

Example

Consider two firms that have the following cost structure:

(In Rs cr.)

Firm A Firm B

Sales 2047 7736

Variable cost 1642 6186

Fixed cost 144 1089

Depreciation 55 164

EBIT 206 297

If sales were to increase by 30 percent

Sales 2660 10056

Variable costs 2134 8041

Fixed costs 144 1089

Depreciation 55 164

EBIT 327 762

Percentage change in EBIT 58.9% 157

For the same percentage change in sales, percent change in EBIT for firm

A is much lower than that for firm B. this is due to the different cost

structures. Firm B has substantial fixed costs. The percentage change in

EBIT for a given percentage change in sales is called operating leverage.

The impact of operating leverage is that there is more than proportional

change in profits when sales change, in either direction. The degree of

sensitivity of a firm’s operating profit to changes in sales is called the

degree of operating leverage (DOL).

DOL = Percentage change in EBIT

Percentage change in sales

The operating leverage employed by some of the prominent companies is

given below:

Company %age change in sales %age change in profitsO.L.

ITC 15.7 15.9 1.01

CMC Ltd. 18.4 24.8 1.34

Wipro tube 31.2 133.0 1.26

Investment 9.5 30.3 3.19

Grasim -12.8 -13.5 1.05

L&T 18.0 6.0 0.33

Videocon 15.6 70.9 4.54

The operating leverage should be measured over a period of time rather

than on the basis of 1-year data. DOL changes from year to year. An

average of DOL for the recent past may be taken. Many executives tend to

believe that operating leverage is same as business risk. They are not

same. The volatility in sales and expenses gives rise to business risk.

Other things remaining same, the higher the degrees of operating leverage,

the higher the business risks.

Financial leverage

Just the presence of fixed operating costs can boost earnings above the

break-even point, the presence of fixed cost financing can boost per share

and return on equity.

Consider two firms A and B. A is all equity financed, whereas firm B has 40

per cent debt. Both employ Rs 500000. Both generate earnings before

interest and tax of Rs. 150000. The interest rate on debt is 14 percent.

Firm A Firm B

Equity 500000 300000

Debt -- 200000

EBIT 150000 150000

Interest -- 28000

Tax @ 35% 52500

42700

Profit after tax 97500

79300

No. of shares 50000

30000

Outstanding EPS 1.95 2.64

The above example illustrates the effect of leverage on EPS. As expected,

EPS increases when debt is injected to the capital structure. This is

because firm B has issued lesser number of shares. Extending the

example further, it can be verified that the volatility of EPS increases when

firms resort to debt financing due to the presence of fixed interest cost.

When earnings are high, debt financing boosts EPS; and when earnings

are low, debt financing depress EPS. The level of EBIT at which EPS is

zero is called break-even EBIT. It is to be understood that the increase in

EPS may not be cost free. The investors may expect higher returns as risk

have gone up. The degree of sensitivity of a firm’s EPS to changes in

operating profit is called the degree of financial leverage (DFL).

DFL = Percentage change in EPS

Percentage change in EBIT

Other things remaining constant, the higher the degree of financial

leverage, the higher the financial risk.

Total leverage

The product of degree of operating leverage and degree of financial

leverage is called degree of total leverage (DTL). It is the ration of

percentage change in EPS and percentage change in sales that causes the

change.

DTL = Percentage change in EPS

Percentage change in sales

DEBT CAPACITY

Interest on debt is a fixed obligation that should be met regardless of the

firm’s profitability at the time of payment. A default can lead to, in an

extreme case, bankruptcy. Normally only debt is considered a fixed

obligation. To stay competitive, a firm may have to maintain R&D

expenditure, invest in working capital and fixed assets and these

investments are largely determined by product market conditions. In this

sense, investment in fixed assets and working capital can also be

considered as fixed obligation.

The debt level a firm can maintain is the level at which the cash flow from

operation is adequate to service debt and maintain investment in fixed

assets, working capital, R&D, etc. that is,(eq. 1)

NOPAT + Depreciation + Borrowing = After tax interest payment + Capital

expenditure + Increases in working capital +

Principal repayment

The interpretation in the above equation is fairly simple. The cash flow from

operations coupled with external borrowing is used to pay interest, invest in

fixed assets and working capital. Extending this logic, external equity can

be included as well.

NOPAT + Depreciation + Borrowing + Equity = Interest payments + Capital

expenditure + working capital

It has been seen that in real life that firms hate to cut dividends. They’d

prefer to maintain or increase dividends. So dividend payment can also be

considered a fixed payment.

NOPAT + Depreciation + Borrowing + Equity = Interest payments + Capital

expenditure + change in working

capital + Dividends

This equation holds good if the firm has access to unlimited external

financing. Whenever cash flow falls short of I + CE + WC + D, the firm can

sell securities to bridge the gap. But unlimited external finance is not a

realistic assumption. If cash flow cannot cover even interest payments.

Further, if debt or equity is not available, the company will be in financial

distress. So assessing, debt capacity involves assessing the risk of default

given the fact that product market condition and competitive market

conditions determine cash flow and capital market condition determine

availability of external financing.

The third equation is useful to,

Establish the relationship between earnings and debt level;

Arrive at the earnings level that the firm should maintain in order to

service the debt and maintain a certain level of investment.

RATIO ANALYSIS

The amount of debt a project can support depends on the amount of cash

flow the project can generate to service debt- interest and principal, credit

support available to the project and the lender’s coverage requirements.

Two ratios are widely used to measure a project’s ability to service debt;

interest coverage ratio and debt service coverage ratio.

Interest coverage ratio = EBIT Interest

It measures the adequacy of operating profits to cover interest charges. A

ratio less than one indicate that earnings are not adequate to meet interest

charges and hence cannot support that level of borrowing. Lenders may

typically insist that interest coverage ratio never fall below 1.25.

DSCR = EBIT Interest expense + Principal repayment

1 – Tax rate

While interest coverage ratio conveys how comfortable a company is in

making interest payments, the firm’s ability to make principal repayment is

ignored. DSCR considers both. The higher the DSCR, the better.

CREDIT RATING CONSTRAINTS

Whenever a company sells debt, it should get its issue rated by a credit

rating agency such as CRISIL, CARE or ICRA. The issue approaches the

agency to rate its issue and update the rating throughout the life of the

issue. For this service, the agency is paid a fee. The credit rating is an

attempt to judge the probability of default. The highest rating of AAA is

given to those companies, which have negligible default risk.

A debt rating is not an evaluation of the issuing company but is security

specific.

ADJUSTING FOR BANKRUPTCY COSTS

Bankruptcy cost is the cost associated with going bankrupt. It includes

direct, deadweight costs such as administrative and legal expenses and

indirect costs such as lost sales, lost investment opportunities, interest paid

on emergency loan (if any), higher salary for chief executive (due to

increased riskiness of leverage), etc. there is no surefire formula to

estimate bankruptcy cost. It is to be noted that it is the expected bankruptcy

cost (i.e., present value at the time of borrowing) that we are interested in

and not the actual expenses incurred in the year of going bankrupt.

PV of expected bankruptcy costs = Probability of going bankrupt x PV of

bankruptcy costs

COST OF UNUSED DEBT CAPACITY

Unused debt capacity is like excess cash or inventory (financial inventory).

Just as a purchase manager should know the cost of holding raw material

inventory, a finance manager should know the cost of holding financial

reserves. The decision not to use Rs 1 million of debt capacity is equivalent

to holding Rs 1 million more equity than needed. Using equity instead of

debt has an implicit cost. If the cost of new equity is 18% and after tax cost

of debt is 8.45 %, the cost of not borrowing is (18 – 8.450 9.55%. in rupee

terms this works out to (9.55% of 1 million) Rs 95500.

MANAGEMENT INCENTIVES AND DEBT CAPACITY

It is generally difficult to convince managers that debt is something

beneficial and that free cash flow needs to be returned to shareholders

when debt is available and/or the company is under-leveraged.

Bringing them all together

Operating leverage constraint

Credit rating constraint Debt policy Cost of disruption

Choice of securities

Cost of capital and firm value

ISSUES IN CAPITAL STRUCTURE

For listed companies higher the level of debt it seems to send a signal to

the stock market and the stock prices go up. Conversely, reducing the level

of debt is associated with the more severe decline in stock price.

Two possible explanations for this effect are,

1. Managers borrow more when business looks less risky. Investors

recognize this and buy more shares on the expectation of better or

less risky returns. Managers reduce their debt when business

looks more risky, causing investors to react negatively.

2. Managers only issue new shares when they think the market is

overvaluing their company. By doing so, they gain extra money fro

their company. If they think that their stock price is undervalued

they will choose to borro2w money rather than sell equity.

Investors know that managers have better information about their

company’s prospects and respond to the debt/ equity choice.

Debt ratios vary widely across different industries. Businesses based on

valuable fixed assets such as construction, hotels, metals and paper tend

to be highly leveraged while businesses relying on intangible knowledge

based assets such as pharmaceuticals, IT, and biotechnology tend to have

little debt

MAKING A CHANGE IN CAPITAL STRUCTURE

Hat should a firm do when it finds that its desired capital structure differs

significantly from its current capital structure? There are two basic choices:

change its capital structure slowly or change it more quickly. A firm can

alter its capital structure slowly by adjusting its future financing mix

appropriately.

Fir example, suppose a firm’s target capital structure consists of 35% long-

term debt and 65% common equity, and its current capital structure

consists 25% long-term debt and 75% common equity. The firm could cure

the underleveraged condition by using long-term debt for all new external

financing until the long-term debt ratio reached 35%. However, this means

that the firm’s capital structure would continue to be “suboptimal” while the

firm changed it over time.

Alternatively, the firm could change its capital structure quickly through an

exchange offer, recapitalization offer, debt or share repurchase, or stock-

for-debt swap. Of course, such a quick change is not without cost either.

The firm will incur transaction costs, and there will be signaling effects

associated with he change.

If the difference between a firm’s actual capital structure and its target

corresponds to one full rating category or more, some type of one time

transaction to make an immediate change in capital structure is probably

warranted. A leverage increase for a significantly underleveraged firm is

likely to increase he firm’s share price. If the firm is less than one full

category away from its rating objective (for example, it is a weak single- A

and wants to come a strong single A), altering its retention ratio and its

external financing mix is probably most cost effective.

FACTORS INFLUENCING CAPITAL STRUCTURE DECISIONS

In reality the following factors have a great practical implications for capital

structure:

1. Tax advantage of debt: The first factor is the tax advantage of debt.

Interest paid on debt is deductible from income and reduces a firm’s

tax liabilities, therefore, debt has a tax advantage over equity and by

increasing the amount of debt issued, and a firm increases its

earnings available to shareholders.

2. Investor’s attitude to risk and return: The second factor is related

to segmented market, with different sets of investors measuring risk

differently or simply charging different rates on the capital that they

invest. By choosing the instrument that taps the cheapest market,

firms lower their cost of capital. However, the trade-off in terms of

availability of funds always exists.

3. Financing decision and firm’s risk exposure: The third factor is the

impact of financing decisions on the riskiness of a firm. As firms pile

on more and more debt, their ability to meet fixed interest payments

out of current earnings diminishes. This affects the probability of

bankruptcy and as a result, the cost (or risk premium) of both debt

and equity. Firms that adjust their capital structure in order to keep

the riskiness of their debt and equity reasonable should have a lower

cost of capital.

4. Control of firm: When the promoters do not wish to dilute their

control, the company, may rely more on debt funds than by issue of

fresh shares. If the promoters are more answerable to the existing

shareholders about improvement in EPS, the only mode of finance

left for the company is to raise finance by way of borrowing.

5. Flexibility: It is more important consideration with the raising of debt

is flexibility. As and when the funds are required, the debt may be

raised and it can be paid off and when desired. But in case of equity,

once the funds raised through of issue of equity shares, it cannot

ordinarily be reduced except with the permission of the court and

compliance with lot of legal provisions. Hence, debt capital has got

the characteristic of more flexibility than equity capital, which will

influence the capital structure decisions.

6. Timing: The time at which the capital structure decision is taken will

be influenced by the boom, or recession conditions of the economy.

In times of boom, it would be easier for the firm to raise equity, but in

times of recession, the equity investors will not show much of interest

in investing. Then the firm is to rely in raising debt.

7. Legal provisions: Legal provisions in raising capital will also play a

significant role in planning capital structure. Raising of equity capital

is more complicated than raising debt.

8. Profitability of the company: A company with higher profitability will

have low reliance on outside debt and it will meet its additional

requirement through internal generation.

9. Growing companies: The growing companies will require more

funds for its expansion schemes, which will be met through raising

debt.

10. Sales stability: A firm whose sales are relatively stable can safely

take on more debt and incur higher fixed charges than a company

with unstable sales. Utility companies because of their stable

demand, have historically been able to use more financial leverage

than industrial firms.

11. Asset structure: Firms whose assets are suitable as security

for loans tend to use debt rather heavily. General-purpose assets that

can be used by many businesses make good collateral, whereas

special- purpose assets do not. Thus real estate companies are

usually highly levered, whereas companies involved in technological

research are not.

12.Operating leverage: Other things the same, a firm with less

operating leverage is better able to employ financial leverage because

it will have less business risk.

13.Growth rate: Other things the same, faster growing firms must rely

more heavily on external capital. Further, the flotation costs involved

in selling common stock exceed those incurred when selling debt,

which encourages rapidly growing firms to rely more heavily on debt.

At the same time, however, these firms often face greater uncertainty,

which tends to reduce their willingness to use debt.

14.Lender and rating agency attitudes: Regardless of managers’ own

analyses of the proper leverage factors for their firms, lenders’ and

rating agencies’ attitudes frequently influence financial structure

decisions. In the majority cases, the corporation discusses its capital

structure with lenders and rating agencies and gives much weight to

their advice.

15.Market conditions: Conditions on stock and bond markets undergo

both long- and short- term changes that can have an important

bearing on an optimal capital structure.

16.The firm’s internal condition: A firm’s own internal condition can

also have a bearing on its target capital structure. For example,

suppose a firm has just successfully completed an R & D program,

and it forecasts higher earnings in the immediate future. However, the

new earnings are not yet anticipated by investors, hence are not

reflected in stock price. This company would not want to issue stock-

it would prefer to finance with debt until the higher earnings

materialized and are reflected in the stock price. Then it could sell an

issue of common stock, retire the debt, and return to its target capital

structure.

Putting all these thought together gives rise to the goal of maintaining

financial flexibility, which, from an operational viewpoint, means maintaining

adequate reserve borrowing capacity. Determining an “adequate” reserve

borrowing capacity is judgmental, but it clearly depend s on the factors

discussed in the chapter, including the firms forecasted need for funds,

predicted capital market conditions, management’s confidence in its

forecasts, and the consequences of a capital shortage.

BIBLIOGRAPHY

Principles of Corporate Finance - Brealey Myres (7th ed.)

Corporate Finance Theory and Principles – Vishwanath S. R.

Financial Management Theory and Practice – Brigham (10th ed.)

Financial Management – Ravi Kishore (5th ed.)

Corporate Finance Management – Emery and Finnerty

Corporate Finance – Aswath Damodaran

http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm

http://www.westga.edu/~bquest/2002/rethinking.htm

http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page22.htm