Capital structure

Determining the financial mix can be considered the same as the firm’s capital structure.
Every firm needs money to operate and start up which is called capital. The main decision to
be taken is to determine how this capital will be generated.the resultant capital structure of
the firm is called the financial mix. In simple word, it is the amount of capital generated from
debt and equity. This represents the money the company generated by issuing bonds and
issuing stocks. Keeping in mind the objective of the firm, the firm decides how the financial
mix is to be designed. It is also the maximum amount of capital that can be generated at the
lowest cost.

Capital structure
In finance, capital structure refers to the way a corporation finances its assets
through some combination of equity, debt, or hybrid securities. A firm's capital
structure is then the composition or 'structure' of its liabilities. For example, a
firm that sells $20 billion in equity and $80 billion in debt is said to be 20%
equity-financed and 80% debt-financed. The firm's ratio of debt to total
financing, 80% in this example, is referred to as the firm's leverage. In reality,
capital structure may be highly complex and include tens of sources.

Evaluating a firm’s capital structure

For stock investors that favor companies with good fundamentals, a "strong" balance sheet is
an important consideration for investing in a company's stock. The strength of a company'
balance sheet can be evaluated by three broad categories of investment-quality
measurements: working capital adequacy, asset performance and capital structure. In this
article, we'll look at evaluating balance sheet strength based on the composition of a
company's capital structure.

A company's capitalization (not to be confused with market capitalization) describes the

composition of a company's permanent or long-term capital, which consists of a combination
of debt and equity. A healthy proportion of equity capital, as opposed to debt capital, in a
company's capital structure is an indication of financial fitness.
Clarifying Capital Structure Related Terminology
The equity part of the debt-equity relationship is the easiest to define. In a company's capital
structure, equity consists of a company's common and preferred stock plus retained earnings,
which are summed up in the shareholders' equity account on a balance sheet. This invested
capital and debt, generally of the long-term variety, comprises a company's capitalization, i.e.
a permanent type of funding to support a company's growth and related assets.

A discussion of debt is less straightforward. Investment literature often equates a company's

debt with its liabilities. Investors should understand that there is a difference between
operational and debt liabilities - it is the latter that forms the debt component of a company's
capitalization - but that's not the end of the debt story.

Among financial analysts and investment research services, there is no universal agreement
as to what constitutes a debt liability. For many analysts, the debt component in a company's
capitalization is simply a balance sheet's long-term debt. This definition is too
simplistic. Investors should stick to a stricter interpretation of debt where the debt component
of a company's capitalization should consist of the following: short-term borrowings (notes
payable), the current portion of long-term debt, long-term debt, two-thirds (rule of thumb) of
the principal amount of operating leases and redeemable preferred stock. Using a
comprehensive total debt figure is a prudent analytical tool for stock investors.

It's worth noting here that both international and U.S. financial accounting standards boards
are proposing rule changes that would treat operating leases and pension "projected-benefits"
as balance sheet liabilities. The new proposed rules certainly alert investors to the true nature
of these off-balance sheet obligations that have all the earmarks of debt. (To read more on
liabilities, see Off-Balance-Sheet Entities: The Good, The Bad And The Ugly and Uncovering
Hidden Debt.)

Is there an optimal debt-equity relationship?

In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of
leverage (debt) increases the amount of financial resources available to a company for growth
and expansion. The assumption is that management can earn more on borrowed funds than it
pays in interest expense and fees on these funds. However, as successful as this formula may
seem, it does require that a company maintain a solid record of complying with its various
borrowing commitments. (For more stories on company debt loads, see When Companies
Borrow Money, Spotting Disaster and Don't Get Burned by the Burn Rate.)

A company considered too highly leveraged (too much debt versus equity) may find its
freedom of action restricted by its creditors and/or may have its profitability hurt as a result of
paying high interest costs. Of course, the worst-case scenario would be having trouble
meeting operating and debt liabilities during periods of adverse economic conditions. Lastly,
a company in a highly competitive business, if hobbled by high debt, may find its competitors
taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-
equity relationship varies according to industries involved, a company's line of business and
its stage of development. However, because investors are better off putting their money into
companies with strong balance sheets, common sense tells us that these companies should
have, generally speaking, lower debt and higher equity levels.

Capital Ratios and Indicators

In general, analysts use three different ratios to assess the financial strength of a company's
capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular
measurements; however, it's the capitalization ratio that delivers the key insights to
evaluating a company's capital position.

The debt ratio compares total liabilities to total assets. Obviously, more of the former means
less equity and, therefore, indicates a more leveraged position. The problem with this
measurement is that it is too broad in scope, which, as a consequence, gives equal weight to
operational and debt liabilities. The same criticism can be applied to the debt/equity ratio,
which compares total liabilities to total shareholders' equity. Current and non-current
operational liabilities, particularly the latter, represent obligations that will be with the
company forever. Also, unlike debt, there are no fixed payments of principal or interest
attached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the debt component of a
company's capital structure (the sum of obligations categorized as debt + total shareholders'
equity) to the equity component. Expressed as a percentage, a low number is indicative of a
healthy equity cushion, which is always more desirable than a high percentage of debt. (To
continue reading about ratios, see Debt Reckoning.)

Additional Evaluative Debt-Equity Considerations

Companies in an aggressive acquisition mode can rack up a large amount of purchased
goodwill in their balance sheets. Investors need to be alert to the impact of intangibles on the
equity component of a company's capitalization. A material amount of intangible assets need
to be considered carefully for its potential negative effect as a deduction (or impairment) of
equity, which, as a consequence, will adversely affect the capitalization ratio. (For more
insight, read Can You Count On Goodwill? and The Hidden Value Of Intangibles.)

Funded debt is the technical term applied to the portion of a company's long-term debt that is
made up of bonds and other similar long-term, fixed-maturity types of borrowings. No matter
how problematic a company's financial condition may be, the holders of these obligations
cannot demand payment as long the company pays the interest on its funded debt. In contrast,
bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to
call its loan. From the investor's perspective, the greater the percentage of funded debt to total
debt disclosed in the debt note in the notes to financial statements, the better. Funded debt
gives a company more wiggle room. (To read more on financial statement footnotes, see
Footnotes: Start Reading The Fine Print.)

Lastly, credit ratings are formal risk evaluations by credit-rating agencies - Moody's,
Standard & Poor's, Duff & Phelps and Fitch – of a company's ability to repay principal and
interest on debt obligations, principally bonds and commercial paper. Here again, this
information should appear in the footnotes. Obviously, investors should be glad to see high-
quality rankings on the debt of companies they are considering as investment opportunities
and be wary of the reverse.

Conclusion
A company's reasonable, proportional use of debt and equity to support its assets is a key
indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt
and a corresponding high level of equity is a very positive sign of investment quality.
To continue learning about financial statements, read What You Need To Know About
Financial Statements and Advanced Financial Statement Analysis.

Friday, March 21, 2008

Major factors affecting capital structure, Corporate Finance

1) "There are significance variations in capital structure across the different companies/
industries because there are several factors that affect capital structure". Discuss the
major factors affecting capital structure.

In every business organization, capital is the main element to establish and run its business
activities smoothly. Capital can be collected by using two sources. They are debt capital and
equity capital. Debt capital is collected by issuing debentures; bonds etc and they are related
with fixed cost of capital. Equity capital can be collected issuing different shares like
common stock, preferred stock etc. in simple words, maintaining the balance or proportion of
this capital is known as corporate capital structure. So it refers to the combination of various
sorts of securities through which funds are raised.

Sometimes some financial experts define it as all those capitals and liabilities, which are
included in balance sheet. But actually it is not a realistic approach. Capital is related only
with long term fund. Hence,

Capital Structure = Financial Structure - Current Liabilities

Capital structure may be defined as the mixture of debt and equity that comprises the
financing of its assets. Hence, the total balance of capital and liabilities is financial structure,
not a capital structure. The main objective of financial manager behind capital structure
management is to minimize the overall cost of capital and risk, and take the advantage of
favorable financial leverage and corporate tax. So while maintaining the proportion between
debt and equity, their merits and demerits should be evaluated relatively.

It is not possible to have an ideal capital structure, however, the management should target
capital structure and initial capital structure should be framed with subsequent changes in
initial capital structure to have it like target capital structure. Some companies do not plan
capital structure but they are still achieving a good prosperity.

There are significant variations in the capital structures of different industries and different
companies. There are many factors that affect capital structure. Following are the basic
factors which should be kept in view while determining the capital structure.
 1. Growth and stability of sales

Firms that are growing rapidly generally need larger amount of external capital. The
floatation costs associated with debt are generally less than those for common stock, so
rapidly growing firms tend to use more debt. At the same time, however, rapidly growing
firms often face greater uncertainty which tends to reduce their willingness to use debt. Firms
whose sales are relatively stable can use more debt and incur higher fixed charges than a
company with unstable sales.

1. Competitive structure/ stability of profit margin.

Firms with high rate of return on investment use relatively little debt. Their high rate of return
enables them to do most of their financing with retained earnings. If profit margin is constant
more debt is used.

3. Cash flow ability

The selection of capital structure is also influenced by the capacity of the business to
generate cash inflows, stability, and certainty of such inflows. Regularity of cash inflows
is much more important than the average cash inflows. A company with unstable and
unpredictable cash inflows can no longer afford to depend on debts.

4. Cost of capital

If the cost of capital is too high, borrowing is costly. So at that situation equity capital is
preferable. As compared with other securities, the equity shares are more economical
because they have least cost of capital. In the processing of trading, no more floatation
costs, brokerage costs etc are incurred.

5. Control

The consideration of retaining "Control" is also very important. The ordinary shareholder
can elect the directors of the company. If company sells the common stock, it will bring
new voting investors into the firm, making the control difficult. To maintain control
within the hand of limited members, a firm has to use more amount of debt or preferred
stock because they have no management and voting right. If the firm wants to more
equity shares the management right will be diversified.

6. Marketability or lender's attitude

The term 'Marketability' refers to the readiness of investors to purchase a security in a

give n period of time. The capital markets keep changing continuously. The capital
structure will have to be customized to the attitudes of investors prevailing at the time of
issue of capital. If investors demand preference shares, firm must have issue of preference
share capital. Due to the changing market sentiments, the company has to decide whether
to raise funds with a common shares issue or with a debt issue.

7. Size of the company

The availability of funds is greatly influenced by the size of the enterprises. A small
company finds it difficult to raise debt capital. The terms of debentures are less favorable
to small companies so they have to rely on equity share and retain earning for funding
business. Large companies are generally considered to be less risky by the investors and,
thus, they can issue common shares, preference shares and debentures to the public.

8. Floatation cost

Floatation costs take place only when the funds are externally raised. Floatation costs
consist of some or all of the following expenses; printing of prospectus, advertisement,
underwriting and brokerage etc. Generally, the cost of floating a debt is less than the cost
of floating an equity issue. This may lure the company to issue debt than common shares.
The company will save in terms of floatation cost if it raises funds through large issue of
securities but the company should raise only that much of funds which can be employed
profitably. In large companies flotation cost is not a significant consideration.

9. Development of capital market

It's an important factor in capital structure. It refers to the extend which the capital market
is developed (i.e. equity or debt market). More developed equity market means more
equity used and less developed equity means less equity used. Similarly, more developed
debt market means more debt used and vice versa.

10. Growth opportunities

The growth opportunities of business can be either tremendous or very low. Depending
upon the growth opportunities the debt ratio fluctuates. Higher growth opportunities exist
then higher debt is used otherwise vice versa.

11. Agency costs

While determining capital structure, having least agency cost is preferred but if there is
agency problem than debt is used largely for funding the business.

12. Other sources of tax shield

 In order to take the advantage of low tax, borrowing is preferable for a firm because
interest is considered as deductible expenditure according to the income tax law. But
dividends are not considered deductible expenses and they are paid out of profits after
tax.

13. Level of economic development

If the level of economic development is high then more debt is required. Level of
economic development plays significant role in capital structure. In Nepal investors ar
shifting to India. Since India is becoming economic giant, Nepali investors are also
investing in Indian organization.

http://jungtulsi.blogspot.com/2008/03/major-factors-affecting-capital.html

In financial accounting, operating cash flow (OCF), cash flow provided by operations or
cash flow from operating activities, refers to the amount of cash a company generates from
the revenues it brings in, excluding costs associated with long-term investment on capital
items or investment in securities.[1]

Operating cash flow = Cash generated from operations less taxation and interest paid,
investment income received and less dividends paid gives rise to operating cash flows per
International Financial Reporting Standards.[2]

To calculate cash generated from operations, one must calculate cash generated from
customers and cash paid to suppliers. The difference between the two reflects cash generated
from operations.

Cash generated from customers

• revenue as reported
• - increase (decrease) in trade receivables
• - investment income (disclosed separately)
• - other income that is non cash and non sales related

Cash paid to suppliers

• costs of sales
• + other expenses as reported less
• - increase (decrease) in trade payables
• - non cash items such as depreciation, provisioning, impairments, bad debts, etc.
• - financing expenses

[edit] Operating Cash Flow vs. Net Income, EBIT, and

EBITDA
Since it adjusts for liabilities, receivables, and depreciation, operating cash flow is a more
accurate measure of how much cash a company has generated (or used) than traditional
measures of profitability such as net income or EBIT. For example, a company with
numerous fixed assets on its books (e.g. factories, machinery, etc.) would likely have
decreased net income due to depreciation; however, as depreciation is a non-cash expense[3]
the operating cash flow would provide a more accurate picture of the company's current cash
holdings than the artificially low net income.[4]

Earnings before interest, taxes, depreciation and amortization (EBITDA) is a non-GAAP

metric that can be used to evaluate a company's profitability based on net working capital.
The difference between EBITDA and OCF would then reflect how the entity finances its net
working capital in the short term. OCF is not a measure of free cash flow and the effect of
investment activities would need to be considered to arrive at the free cash flow of the entity.

TAX SHIELD:

What Does Tax Shield Mean?

A reduction in taxable income for an individual or corporation achieved through claiming
allowable deductions such as mortgage interest, medical expenses, charitable donations,
amortization and depreciation. These deductions reduce taxpayers' taxable income for a given
year or defer income taxes into future years.

Tax shields vary from country to country, and their benefits will depend on the taxpayer's
overall tax rate and cash flows for the given tax year.

Investopedia explains Tax Shield

For example, because interest on debt is a tax-deductible expense, taking on debt can act as a
tax shield. Tax-efficient investing strategies are a cornerstone of investing for high-net-worth
individuals and corporations, whose annual tax bills can be very high. The ability to use a
home mortgage as a tax shield is a major benefit for many middle-class people whose home
is a major component of their net worth.

Case A

Consider one unit of investment cost $1,000 and returns $1,100 at the end of year 1. Assume
tax rate of 20%. If an investor pays $1,000 of capital, at the end of the year, he will have
($1,000 return of capital, $100 income and -$20 tax) $1,080. He earned net income of $80, or
8% return on capital.

[edit] Case B

Consider the investor has an option to borrow $4000 at 8% interest (same rate as return of
capital in Case A). By borrowing $4,000 (+$1,000 capital), the investor can purchase 5 units
of investment. At the end of the year he will have ($5,000 return of capital, -$4,000
repayment of debt, $500 revenue, -$320 interest payment and -$36 tax) considering $1000
initial capital he is left with $1,144. He earned net income $144, or 14.4%.

The reason that he was able to earn additional income is because the cost of capital
(opportunity cost, 8%) is not deductible for tax purposes, but the cost of debt (interest, 8%) is.

[edit] Value of the Tax Shield

In most business valuation scenarios, it is assumed that the business will continue forever.
Under this assumption, the value of the tax shield is: interest bearing debt x tax rate.

Using the above examples:

• Assume Case A brings $80 after tax income per year, forever.
• Assume Case B brings $144 after tax income per year, forever.

• Value of firm in Case A: $80/0.08 = $1,000

• Value of firm in Case B: $144/0.08 = $1,800
• Increase in firm value due to tax shield: $1,800 - $1,000 = $800
• Debt x tax rate: $4,000 x 20% = $800

When debt is used in the capital structure to reduce payments for income tax.
This is done because interest is a deductible tax expense and dividends are not.

The equation to determine the tax shield of debt is:

Tax Shield=(income-(debt*interest rate))*tax rate

A tax shield is the tax saving made by using debt rather than equity. Because of
tax shields, it is necessary to adjust the cost of debt when comparing it to the
cost of equity.

A typical tax shield adjustment is that usually done in WACC calculations, where
the usual approach is to multiply the interest rate by:

1/(1 - t)

Where t is the percentage tax rate.

This does not mean that debt capital is always a lot more tax efficient than
equity — although it usually is. Interest income is often taxed at a higher rate
than equity dividends in the hands of investors, which can offset its tax
advantage at the company level.

An alternative to adjusting the cost of debt using tax shields is to use an APV:
using the cost of equity as the discount rate and then make separate
adjustments for tax (and any other) effects of financing on cash flows.

What Does Debenture Mean?

A type of debt instrument that is not secured by physical asset or collateral. Debentures are
backed only by the general creditworthiness and reputation of the issuer. Both corporations
and governments frequently issue this type of bond in order to secure capital. Like other types
of bonds, debentures are documented in an indenture.

Investopedia explains Debenture

Debentures have no collateral. Bond buyers generally purchase debentures based on the
belief that the bond issuer is unlikely to default on the repayment. An example of a
government debenture would be any government-issued Treasury bond (T-bond) or Treasury
bill (T-bill). T-bonds and T-bills are generally considered risk free because governments, at
worst, can print off more money or raise taxes to pay these type of debts.

What Does Compulsory Convertible Debenture - CCD Mean?

A type of debenture in which the whole value of the debenture must be converted into equity
by a specified time. The compulsory convertible debenture's ratio of conversion is decided by
the issuer when the debenture is issued. Upon conversion, the investors become shareholders
of the company.

Investopedia explains Compulsory Convertible Debenture - CCD

The main difference between convertible debentures and other convertible securities is that
owners of the debentures must convert their debentures into equity, whereas in other types of
convertible securities, the owner of the debenture has an option.

Some CCDs, which are usually considered equity, are structured in a manner that makes them
more like debt. Often, the investor has a put option which requires the issuing companies to
buy back shares at a fixed price.