CAPITAL STRUCTURE

In order to run and manage a company funds are needed right from the promotional stage upto end, finances play an important role in a companys life.If funds are inadequate the business suffers and if the funds are not properly managed the entire organization suffers.it is therefore necessary that correct estimate of the current and future need of capital be made.

Capital structure is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long term debt, preference share capital and shareholders funds.

FORMS/PATTERNS OF CAPITAL SRUCTURE: Equity shares only Equity and preference shares Equity shares and debentures Equity shares, Preference shares, and debentures

FACTORS DTERMINING THE CAPITAL STRUCTURES: GROWTH AND STABILITY OF SALES:The capital structure of a firm is highly influenced by the growth and stability of its sales.If the sales of a firm are expected to

NATURE AND SIZE OF A FIRM:Nature and size of firm also influences its capital structure. All public utility concerns have different capital structures as compared to other manufacturing concerns. Public utility concerns may employ more of a debt because of stability and regularity of their earnings. On the other hand a concern which cannot provide stable earnings due to nature of its business will have to rely mainly on equity capital.

remain fairly stable,it can raise a higher level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest payment and repayments of debt.

CONTROL:Whenever additional funds are required by a firm the management of the firm wants to raise the funds without any loss or control over the firm. In case the funds are raised through the issue of equity shares the control of the existing shareholders is diluted. Hence they might raise the additional funds by way of fixed interest bearing debt and preference share capital. Preference shareholders and debenture holder do not have voting rights. Hence from point of view of control debt financing is recommended.

FLEXIBILITY:Capital structure of the firm should be flexible, i.e it should be such as to be capable of being adjusted according to the needs of the changing conditions.

It should be possible to raise additional funds,wherever the need be without much of difficulty and delay. A firm should arrange its capital structure in such a way that it can substitute one form of financing by another.

CAPITAL MARKET CONDITIONS:-

Capital market conditions do not remain the same forever. Sometimes there may be depression while at other times there may be boom in the market. The choice of the securities is also influenced by market conditions.

ASSET STRUCTURE:-

The liquidity and the composition of assets should also be kept in mind while selecting the capital structure. If fixed assets

Constitute a major portion of the total assets of the company, it may be possible for the company to raise more of long term total debts.

PURPOSE OF FINANCING:-

If funds are utilized for productive purpose debt financing is suitable and the company should issue debentures as interest can be paid out of the profits generated from the investment. If the funds are required for unproductive purpose or general development,we should prefer equity capital.

PERIOD OF FINANCE:-

The period for which the finances are required is also an important factor to be kept in mind while selecting an appropriate capital mix. If the finances are required for a limited period debentures can be preferred to shares. If funds are needed on permanent basis equity share capital is more appropriate.

THEORIES OF CAPITAL STRUCTURE:-

Different kinds of theories have been propounded by different authors to explain the relationship between capital structure, cost of capital and value of the firm. 1.NET INCOME APPROACH 2.NET OPERATING INCOME APPROACH 3.TRADITIONAL APPROACH 4.MODIGILIANI AND MILLER APPROACH

1.NET INCOME APPROACH:

Net income approach is that as the proportion of debt financing increases which results in the decrease in the overall weighted average cost of capital leading to an increase in the value of the firm. On the other hand if the proportion of debt financing decreases weighted average cost of capital increases and the value of the firm decreases.

2.NET OPERATING INCOME APPROACH:

According to this approach change in the capital structure of a company does not effect the market value of the firm and the overall cost of capital remains constant irrespective of the method of financing.

Problem: A company expects a net operating income of Rs1,00,000. it has Rs 5,00,000, 6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm and equity capitalization according to the net operating income approach. b) If the debenture debt is increased to 7,50,000 what will be the effect on the value of the firm and equity capitalization rate?

Net operating incomeOverall cost of capitalMarket value of the firm1,00,000*100/10=10,00,000

1,00,000 10% EBIT/Ko

Market value of firmLess-MV of debentures Total MV of equity

10,00,000 5,00,000 5,00,000

Equity capitalization rate=Earnings available to equity shareholders/total MV of equity Earnings available- (EBIT-I)1,00,000-30,000=70,000 30,000=5,00,000*6% MV of shares(V-D)10,00,000-5,00,000=5,00,000 V=value of firm D=debt capital 70,000/5,00,000*100=14%

b)If the debenture debt is increased to Rs.7,50,000, the value of the firm shall remain unchanged at Rs10,00,000. then the equity capitalization rate will be: Equity capitalization rate=EBIT-I/V-D 1,00,000-45,000/10,00,000-7,50,000*100 =22%

THE TRADITIONAL APPROACH:-

According to this theory the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is the cheaper source of funds than equity. Thus optimum capital structure can be reached by proper debt equity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. Thus the over all cost of capital according to this theory decreases upto a certain point remains more or less unchanged for moderate increase in debt. Even the cost of debt may increase at this stage due to increases financial risk.

MODIGILIANI AND MILLER APPROACH:-

In the absence of taxes(Theory of irrelevance): The theory proves that the cost of capital is not affected by changes in the capital structure. The reason argued is that though debt is the cheaper source to equity with increased use of debt as a source of finance the cost of equity increases. This increase in equity offsets the advantage of the low cost of debt. The theory further propounds that beyond a certain limit of debt the cost of debt increases(due to increased financial risk) but the cost of equity falls there by balancing the two costs. In the Modigiliani and Miller approach two identical firms in all respects except their capital structure cannot have different market values according to the arbitrage process. In case two, two identical firms except for their capital structure have different market values, arbitrage will take place and investors will engage in personal leverage.

i,e they will buy equity of other company in preference to the company having lesser value.
ARBITRAGE PROCESS: Arbitrage process is the operational justification for the ModiglianiMiller hypothesis. Arbitrage is the process of purchasing a security in a market where the price is low and selling it in a market where the price is Arbitrage is process of utilising differences in price in two markets to make financial gains. Generally each market has a different demand-supply position and hence price of same product is different in different market.

NSE is a much larger stock exchange compared to BSE and hence Demand-supply ratios are slightly different than BSE. Thus there is always some difference of price between a stock's price on both exchanges. When referred to Indian stock markets, this term generally means taking advantage of price difference between a stock's price in BSE and NSE.

 When the corporate taxes are assumed to exist(Theory of relevance):

Modigiliani and Miller have recognized that the value of the firm will increase or the cost of capital will decrease with the use of debt on account of deductibility of interest charges for tax purpose. Thus the optimum capital structure can be achieved by maximising the debt mix in the equity of a firm.

IMPORTANCE OF CAPITAL STRUCTURE

The term capital structure refers to the relationship between the various long term forms of financing such as debentures preference share capital,equity share capital. Financing the firms asset is a very crucial problem an every business and as a general rule there should be proper mix of debt and equity capital. For eg:Say a company has an equity capital of 1000 shares of 100 each fully paid and earns an avg profits of 30,000. Now the company wants to make an expansion and needs another 1,00,000. The options available are either to issue new shares or raise loans @ 10% p.a.Assuming that the company would earn same rate of profit.

Problem: ABC company has currently an all equity capital structure consisting of 15,000 equity shares of 100 each. The management is planning to raise another 25lakhs to finance a major programme of expansion and considering 3 alternative methods of financing:I. To issue 25,000equity shares of 100 each. II. To issue 25,000, 8%debentures of 100 each. III. To issue 25,000, 8%preference shares of 100 each. A companys earnings before interest and tax will be 8lakhs. Assuming a tax rate of 50% determine the EPS.

PARTICULARS EBIT LESS-INTEREST

EQUITY 8.00 -

DEBT 8.00 2.00

PREFERENC E 8.00 -

EBT LESS-TAX(50%) EAT LESS-PREFERENCE DIVIDEND EARNINGS FOR EQUITY HOLDERS NO.OF EQUITY SHARES EPS

8.00 4.00 4.00 4,00,000 40,000 10

6.00 3.00 3.00 3,00,000 15,000 20

8.00 4.00 4.00 2.00 2,00,000 15,000 13.33

Comment: As the EPS is highest in debt financing the company should issue 25,000 8% debentures of 100 each. It double the earnings of the equity shareholders.

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