FINANCIAL MANAGEMENT

TOPIC

Capital structure

GROUP MENBERS : SWAPNIL KOCHREKAR

SUSHANT PATIL
TUSHAR

HOLEY
GANESH KHADE
BHASKAR YADAV
ROHAN VICHARE
JAYESH DHUMAL

: 30
: 51
: 17
: 27
: 70
: 68
: 14

Introduction
DEFINATION:

Capital Structure:
Capital structure of company refers to the make-up of its capitalization and it
includes all long term capital resources viz , shares loans reserves and bonds.
_gerstenberg.

Capitalizations includes capital stock and debt.

_dewing.

Capitalisation is the total accounting value of the capital stock, surpluses in

whatever from it may appear and Long term debt.
_Lillian dories.

Capital

structure consist of:

1.Owned funds:
Owned funds includes share capital ,free reserve and
surplus.
2.Borrow funds :
borrowed funds are represented by debentures, bonds and
long term loans provided by banks and term lending
institutions.

What is capital structure?

Capital Structure represents the total long-term investment in a
business firm. It includes funds raised through ordinary and
preference shares, bonds, debentures, term loans from financial
institutions, earned revenue, capital surpluses, etc. The
term capital structure is used to represent the proportionate
relationship between debt and equity.
The Board of Directors or the financial manager of a company
should always endeavor to develop a capital structure that would lie
beneficial to the equity shareholders in particular and to the other
groups such as employees, customers, creditors, society in general.
While developing an appropriate capital structure for its company
the financial manager should aim at maximizing the long-term
market price per share. This can be done only when all these factors
which are relevant to the company's capital structure decisions are
properly analyzed and balanced.

What is Financial structure?

Balance Sheet

Current assets

Current liabilities

Fixed assets

Debentures &
preference shares

Ordinary shares

Financial
structure

What is Capital Structure?

Balance Sheet

Current assets

Current liabilities

Fixed assets

Debentures &
preference shares

Ordinary shares

Capital structure

Features of an Optimal Capital

Structure
An optimal capital structure should have the following
features:
Profitability - The company should make maximum use of
leverage at a minimum cost.
Flexibility - The capital structure should be flexible to be
able to meet the changing conditions. The company should be
able to raise funds whenever the need arises and also retire
debts whenever it becomes too costly to continue with that
particular source.

CONT.
Control

- The capital structure should involve

minimum dilution of control of the company.

Solvency

- The use of excessive debt threatens the

solvency of the company. In a high interest rate
environment, Indian companies are beginning to
realize the advantage of low debt. Companies are
now launching public issues with the sole purpose of
reducing debt. The recent equity issue of more than
Rs.30 crore by Ballarpur Industries was purely aimed
at repaying term loans and retiring debentures.

Essentials of an optimum capital structure

1.Economy :
the capital structure must ensure the maximum use of
leverage at minimum cost.
2.Efficiency :
the capital structure must ensure intensive utilization of
available resources.
3.Simplicity:
the capital structure must be made easy to understand by
avoiding doubts and complexities.

CONT
4.Safety:
the capital structure should ensure safety in the business
by maintaining adequate cash flow (liquidity) in the
business.
5.control:
while designing the capital structure it should be kept in
mind that the controlling position of present
shareholders remains undisturbed.

Determinants of capital structure

1.Nature of business:
those business exposed to more risk and unstable income
should prefer equity shares whereas firms engaged in producing
commodities and public utilities .
2.Stability of earning :
if the volume ,stability and predictability of earning are there
then the firm will be service the fixed obligation of debts and
dividend on preference share with less risk.
3.Amount of initial capital required:
in the initial stages of business since the risk involved is high
an ideal capital structure in such a case would be equity only.

CONT..
4.Growth rate

in the initial stages the of growth is high gradually

decreasing as the markets saturation point is reached.
5.Nature of investors:
investors have generally different preferences and are
of different economic status.
6 Financial leverage or trading on equity:
the firm has to determine an appropriate debt-equity mix ,
where the capital structure would be optimum.

CONT
7.Return on investment :
if the firm earns a high rate of return it can finance the
expansion from internal sources .
8.Trends in capital market :
the conditions prevailing in the capital market determine the
types of securities to be issued and also the rate interest on
debenture and rate of dividend on preference share.
9.Government regulation:
govt. may influence the issue of securities on capital issues
and taxation policies.
10.Lenders attitude:
if the attitude of lending institution is favorable then the
company can get debt finance easily and that too at lower
rate of interest.

Sources of capital
Ordinary

shares (common stock)

Preference
Loan

shares (preferred stock)

capital
Bank loans
Corporate bonds

Ordinary shares (common stock)

Risk

finance

Dividends

are only paid if profits are made and only after

other claimants have been paid e.g. lenders and preference
shareholders

A high

rate of return is required

Provide
No

voting rights the power to hire and fire directors

tax benefit, unlike borrowing

Preference shares (preferred stock)

Lower

risk than ordinary shares and a lower dividend

Fixed

dividend - payment before ordinary shareholders and in

a liquidation situation

No

voting rights - unless dividend payments are in arrears

Cumulative

- dividends accrue in the event that the issuer does

not make timely dividend payments

Participating
Redeemable

- an extra dividend is possible

- company may buy back at a fixed future date

Loan capital
Financial

instruments that pay a

certain rate of interest until the
maturity date of the loan and then
return the principal (capital sum
borrowed)
Bank loans or corporate bonds
Interest on debt is allowed against tax

Seniority of debt
Seniority

indicates preference in position

over other lenders.
Some debt is subordinated.
In the event of default, holders of
subordinated debt must give preference to
other specified creditors who are paid first.

CURRENT YEAR (2007-2008)

INTERPRETATION:

COMPOSITION OF CAPITAL STRUCTURE

Loan Fund = 48%
Reserves = 51%
Share Capital = 1%
1.2
1

0.01

0.8

0.48

0.6
0.4
0.51

0.2
0

0
1

The above graph clearly depicts that the proportion of debt in the financing mix
of Hindalco is much more as compared to share capital. The debt content is 48%
whereas the proportion of share capital and reserves and surplus is 1% and 51%
respectively.

Capital Structure of Hindalco for Four Years (2004-05 to 2007-08)

Particulars
Share
Capital
Reserves
Loan
Funds

2007-08

2006-07

2005-06

2004-05

1226

1043

986

928

171737
83286

123105
73592

95017
49034

75644
38000

180000
160000
140000
120000
100000
80000
60000

Share
Capital

40000

Reserves

20000

Loan Fund

0
Years

2007-08

2006-07

2005-06

2004-05

Illustration 1
Goodshape Company has currently an ordinary share capital of Rs. 25 lakhs,
consisting of 25,000 shares of Rs. 100 each. The management is planning to
raise another Rs. 20 lakhs to finance a major programme of expansion
through one of four possible financing plans. The options are:
(i) Entirely through ordinary shares.
(ii) Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through long-term
borrowings at 8 per cent interest per annurn.
(iii) Rs. 5 lakhs through ordinary shares and Rs. 15 lakhs through long-term
borrowings at 9 per cent interest per annum.
(iv) Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through preference
shares with 5 per cent dividend.
The company's expected Earnings Before Interest and Tax (EBIT) will be Rs.
8 lakhs. Assuming a corporate tax rate of 50 per cent, determine the Earnings
Per Share (EPS) in each alternative, and comment on the implications of
22
financial leverage.

Solution :-

23

Comments
The above analysis shows that Proposal 3 gives the highest
earning per share. It is on account of the following reasons:
Rate of interest on loan is fixed and independent of the profit or
loss and is treated as an expense by the Income Tax authorities.
Thus, the company's profit is taxed after deduction of this
interest charge.
Dividend per share is more. It will, therefore, attract
shareholders for further investment.
The borrowers are not the owners, hence there will be least
interference from them in the management of the company:

Ratio to be used for capital

structure analysis
Earnings per share.
Dividend per share.
P/E ratio.
Dividend pay-out ratio.
Debt-equity ratio.
Interest coverage ratio.
Return on investment.

Per share data (As on 31st March)

2007-08

2006-07

2005-06

2004-05

2003-04

Net earnings (Rs. mn.)

28,609

25,643

16,556

13,294

8,389

Cash earnings (Rs. mn.)

34,487

32,024

21,767

17,927

11,563

EPS (Rs.)

24.51

25.52

16.79

134.48

8.53

CEPS (Rs.)

29.55

31.87

22.07

18.18

11.76

1.85@

1.70

2.20

2.00

1.65

9.3@

7.9

14.9

16.0

20.5

142.09

118.97

97.40

82.54

74.16

Price to earning

6.7

5.1

10.9

9.0

13.4

Price to cash earning

5.6

4.1

8.3

6.7

9.7

Price to book value

1.2

1.1

1.9

1.6

1.7

Dividend per share (Rs.)

Dividend pay out (%)
Book value per share (Rs.)

Earning per share

EPS shows the profitability of the firm on a per share basis, it does not
reflect how much is paid as dividend and how much is retained in the
business.

EPS= Profit after tax / No. of shares

Significance
The EPS helps in determining the market price of the equity shares of the
company. A comparison of earning per share of the company with another
will also help in deciding whether the equity share capital is being
effectively used or not. Helps in estimating the companys capacity to pay
dividend to its equity shareholder.
EPS of Hindalco
Particulars

2007-08

Earnings per 24.51

share

2006-07

2005-06

2004-05

25.52

16.79

13.48

Interpretation
The EPS of Hindalco shows an upward trend since FY-04. There is a
considerable increase in EPS till FY-07 but there is a decrease in FY-08 i.e.
24.51.

Dividend Per Share

It indicates the amount of profit distributed to shareholders per share.
It is calculated as:
DPS = PAT / No. of Equity shares
DPS of Hindalco
Particulars
2007-08
Dividend
1.85
per
share
(computed)

2006-07
1.70

2005-06
2.20

2004-05
2.00

Interpretation
Over the years the DPS of Hindalco has been increasing from Rs.2.00 per
share to Rs.2.20 per share till FY 2006.But it decreased in FY 2007 to
1.70 again showing increase in FY 2008 to Rs.1.85. This dividend
payment is quite low showing that retaining most of its earnings for future
investments in projects.

Price to Earning
This ratio indicates the number of times the earning per share is covered
by its market price.
P/E ratio = MP per share / EPS
Significance
P/E ratio helps the investor in deciding whether to buy or not to buy the
share of the company at a particular market price.
Price to Earning of Hindalco
Particulars

2007-08

2006-07

2005-06

2004-05

Price to
Earning

6.7

5.1

10.9

9.04

Interpretation
P/E ratio of Hindalco considerably increased in FY 2004, but it has
decreased to great extent in FY 2007 again showing an increased in FY
2008 i.e. 6.7 Thus, the EPS is covered by its market price by 6.7 times.

Dividend Payout Ratio

The ratio indicates what proportion of EPS has been used for paying
dividend.
Payout ratio = DPS/ EPS
Significance
The payout ratios are indicators of the amount of earning that have been
ploughed back in the business. Lower payout, the higher the amount
earnings ploughed back in the business and vice-versa.
Pay-out ratio of Hindalco
Particulars
DPS(Rs)
EPS(Rs)
Pay-out
ratio

2007-08
1.85
24.51
0.07

2006-07
1.70
25.52
0.07

2005-06
2.20
16.79
0.13

2004-05
2.00
13.48
0.15

Interpretation
The ratio has decreased to a large extent in 2007 as compared to previous
financial years maintaining the same in 2008 i.e. 0.07. It indicates that
company is ploughing back a large amount of its earnings for future
expansion of business.

Debt Equity Ratio

The relationship between borrowed funds and owners capital is a popular
measure of the financial solvency of a firm. That is shown by debt equity
ratio. It is a ratio of the outsiders fund to the owners fund.
Debt-Equity ratio = Total Debt / Net Worth
Particulars

2007-08

Debt Equity 0.48

Ratio

2006-07

2005-06

2004-05

0.59

0.51

0.50

Interpretation
The debt equity ratio has shown a considerable increase till FY 2007 i.e.
0.59 but again resulted in a decrease i.e. 0.48 in the FY 2008.Thus, it is
apparent that there is a scope for the company to raise further loan
capital.

Interest- Coverage Ratio

The interest coverage ratio shows the number of times the interest
charged is covered by funds that are ordinarily available for the
payment. Since taxes are computed after interest, interest-coverage
is calculated in relation to before tax earning. Depreciation is a noncash item. Therefore, funds equals to depreciation are also available
to pay interest charges. We can thus calculate interest coverage ratio
as earning before depreciation, interest and taxes divide by interest.
ICR = EBIDTA / Interest
Particulars
Interest
Coverage
Ratio

2007-08
13.88

2006-07
18.09

2005-06
12.65

2004-05
14.98

Interpretation
The interest coverage ratio is considered to be ideal if it is 5 to 6 times of
interest charge is covered by funds that are ordinarily available for the
payment. Interest coverage ratio of Hindalco is showing a downward trend
in 2007-08 as compared to other years showing a negative effect.

Return on Capital Employed

It is calculated by dividing EBIT by capital employed.
ROCE = EBIT / Capital Employed
Particulars
EBIT
Capital
Employed

2007-08
33062
270881

2006-07
38323
208999

2005-06
23279
157370

2004-05
20833
125869

ROCE

0.12

0.18

0.14

0.16

Interpretation
The ROCE has increased in the FY 2007 i.e.18% but decreased in the FY
2008.Now it stands at 12%