Capital Structure (Fm) 2003

CAPITAL STRUCTURE

SUBJECT: FINANCIAL MANAGEMENT. COLLEGE : BHAVAN’S COLLEGE. CLASS : T.Y. B.M.S. (A). GROUP NO. : 7 ACADEMIC YEAR : 2010-2011 2010-2011 (SEMESTER-V). SUBMITTED TO : PROF. RIDDHI SHARMA Page | 1

SUBMITTED BY: Sr.no.

Group Members

Roll no.

1.

PURNIMA ORASKAR

37

2.

MEETA PADAYA

38

3.

KIRA PANCHAL

39

4.

NAVIN PARGHI

40

5.

PARITA PATEL

41

6.

POOJA PATIL

42

ACKNOWLEDGEMENT:Page | 2

We the group members are thankful to Prof. RIDDHI SHARMA of FINANCIAL MANAGEMENT for giving us the opportunity to prepare a project on CAPITAL STRUCTURE. It was a fruitful experience to work on it; we learned various dimensions relating to it. At the same time the project gave us an exposure to the various complexities associated with it. We are thankful to our professor for constantly supporting us and encouraging us to work on this project and helped us in the accomplishment of  exploratory as well as result-oriented research studies.

INDEX:Page | 3

Sr.n o.

Particulars

Page.N o.

1.

Introduction TO capital structure

5.

2.

3.

5.

6.

7. 8.

Factors Determining Capital Structure

Theories of capital structure

Net Income Approach

Net Operating Income Approach Traditional Position Miller & Modigliani Approach

7.

13.

14.

18.

20. 22.

MEANING OF CAPITAL STRUCTURE:Page | 4

C

apital structure refers to the mix of  sources from where the long term funds required in a business may be raised, i.e., what should be the proportions of equity share capital, preference share capital, internal sources, debentures, and other sources of funds in the total amount of capital which an undertaking may raise for establishing its business. In planning the capital structure, the following issues must be kept in mind: 1. There is no one definite model which can be suggested/used as an ideal for all business undertakings. This is because of the varying circumstances of various business undertakings. The capital structure depends primarily on a number of factors like the nature of industry, gestation period, certainty with which the profits will accrue after the undertakings goes into commercial production and the likely quantum of return on investment. It is, therefore, important to understand that different types of capital structure would be required for different types of business undertakings.

2. Government policy is a major factor in planning capital structure. For example, a change in the lending policy of financial institutions may mean a complete change in Page | 5

the financial pattern. Similarly, the Rules and Regulations for Capital market formulated by SEBI affect the Capital structure decisions. Similarly, monetary and fiscal policies of the Government also affect the capital structure decisions.

 The finance managers of business concerns are therefore required to plan capital structure within these constraints.

Page | 6

1.Factors determining capital structure:1) Trading on Equity : A company earns the profits on its total capital (borrowed and owned). On the borrowed capital (including preference capital company pays interest or dividend at a fixed rate. If  this fixed rate is lower than the general rate of earnings of the company, the equity shareholders will have an advantage in the form of additional profits. This may be referred to as trading on equity. 2) Desire to Control the Business: Quite often, the promoters want to retain the control of the affairs of the company.  They raise the capital from the public by issuing different types of securities in such a way as to retain the control of  whole of substantially the whole of the affairs of the company with them. For this purpose, they raise a large proportion of  funds by the issue debentures and preference shares. 3) Nature of Business: A manufacturing company may give a differing capital structure from Trading, financing, extractive or public utility concerns.  These, differences enable one type of  Page | 7

business to issue securities which are not profitable to other business. So public utility concern may enjoy advantages of  fixed interest securities like bonds and debenture because of their monopoly and stability of income. But, on the other hand, manufacturing concerns do not enjoy such advantages and rely to a great extent on equity share capital. 4) Purpose of Financing: If funds are raised for betterment expenditure, it is quite apparent that it will add nothing to the earning capacity of the company. Such expenditure may be incurred either out of funds raised by issue of shares or still better out of retained earnings but, in no case, out of borrowed funds. On the other hand productive projects may be financed out of borrowings also. 5) Period of Finance: Normally funds which are required for a short time say for 5 to 10 years should be arranged through borrowing because these can easily be repaid as soon as company’s financial position improves. On the other hand, if funds are required permanently or for a fairly long time, issue of ordinary shares should be preferred. 6) Elasticity of capital structure: The capital structure should be as elastic as Page | 8

possible so as to provide for expansion for future development or to make it feasible to reduce the capital when it is not needed. Too much dependence on debentures and preference shares from the very beginning makes the capital structure of the company rigid because of  payment of fixed interest or dividend.  These sources should be kept in reserve for emergency or for expansion purposes. 7)

Nature of Investors: Some investors who prefer security of investment and stability of income usually go in for debentures. Preference shares will be preferred by those who want a higher and stable income with enough safety of  investment. Equity shares will be taken up by those who are ready to take risks for higher income and capital appreciation. Those who want to acquire control over the affairs of the company like equity shares.

8) Market Conditions: Conditions of  capital market have an important bearing on the capital structure of the company because investor is very often influenced by the general mood or sentiment of the capital market although his own mood or sentiments guide him to invest his funds. For example, in times of depression, investor will look more for safety than to Page | 9

income and will be willing to invest in debenture and not in equity shares. During boom period, when people have plethora of funds, any type of security can be sold easily hence equities can have a better market. The management while designing the capital structure of  the company must watch the mood or sentiments of the capital market.

9) Legal restrictions : every company has to comply the law of the country regarding the issues of different types of  securities therefore, hands of the management are tied by these legal restrictions. For example in India, banking companies are not allowed to issue any type of securities except equity shares under the Indian banking companies act. within this overall frame work ,the management should strive towards capital structure. 10)Policy of term financing institutions : If financial institutions offer credit to the industry on strictly restrictive terms and adopt harsh policy of lending .they allow raising of fresh capital by specific manner. 11)stability of earning or

possibilities or regular and fixed Page | 10

income: The stability of capital structure of a company very much depends upon the possibilities of regular and fixed income. a) if company expects sufficient regular income in future ,debenture should be issued . b) preference share may be issued if  company does not expect regular income but it is hopefull that its average earnings for a few years may be equal to or in excess of the amount of dividend to be paid on such preference shares. c)if company does not expect any regular income in future, it should never issue any type of securities other then equity shares . 12) Trends in capital market: Capital markets conditions determine not only the types of securities to be issued but also the rate of interest on debenture ,fixed rates on dividends on preference shares and the prices of equity shares . 13)Cost of capital and availability of 

funds: 14)Tax benefit. 15) Assets structure: Assets structure also influences one sources of financing Page | 11

in different ways .firms with long lived fixed assets,especially when demand foe the output is relatively assured can use long term debts.firm whose assets are mostly receivable and inventory whose vale is dependent on the continued profitability of the individual firm can rely less long term debt financing and more on short term funds. 16)Attitude and temperament of 

management . 17)leaders attitude: Sometimes the leaders attitude is also an important determinant of capital structure.in the majority of cases,the firms management discussies its capital structure with leaders and gives much weight to their advice.but where management is the confident of future,it may use leverage beyond norms for the industry. 18)Fiscal incentives and tax concessions : incentives and tax concessions being provided by the government to various types of industrial units like relaxation of security margin,15% subsidy by the government,of repayment period extension beyond 10 years,gestation period 2 years,reduction in application to Page | 12

the extent of 50% in application is made for the promotion in backward areas also affect the capital structure. 19)Advance given by financing agencies:Such agencies are specialised in tendering expert financial advice concerning the capital structure of  firms .their advice should be given due weight and consideration in financial plan of the concern.  Thus we see the determination of a thorough consideration of a large number of factors .there can be no ideal patern of  capital structure for all companies ebven in the same industry .so each company has to be studied as an individual case.

THEORIES OF CAPITAL STRUCTURE: 1. NET INCOME APPROACH.

Page | 13

2. NET OPERATING INCOME APPROACH 3. TRADITIONAL APPROACH. 4. MILLER AND MODGLIANI APPROACH.

NET INCOME APROACH:Net income approach stats that a firm can minimize the weighted average cost of capital and increased the value of the firm as well as the market price of equity shares by using debt financing to the maximum possible extend. This theory states that a firm can increase its value and reduces the overall cost of capital by increasing the proportion of debt in its capital structure. Net Page | 14

income approach is based on the following assumption. 1. The cost of debt is less than the cost of  equity. 2. There are no taxes. 3. The risk perception of the investors is not charged by this use of debt.  The increase in the debt financing in the capital structures decreases the proportion of equity capital and this results in decreases in the weighted average cost of capital resulting in an increase in the value of the firm. The cost of debt is less than the cost of equity because of two reasons: Debt involves less risk then equity. Interest being – deductible expenses. • •

According to this approach net income i.e. expected profit after tax (profit to shareholders) is estimable, based on expectation of shareholders. Hence, Ke can be estimated. Based on this value of  Ke, we can calculate Ko. This Ke is independent variable and Ko is a dependent variable.  The equation for this approach is same as:

Ko = WeKe + WdKd

We know that equity is costlier sources of capital. Debt is relatively cheaper. This is because lenders take less risk. They get their interest payment irrespective of quantum of profit or loss. Page | 15

Hence equity, being a costlier sources; should be used less. Debt being a cheaper source; should be used more in proportion. Average cost will be less when we use more proportion of debt. We can summarize this approach as fallows: As per net income approach: Ko = WdKd + WeKe a. Expected return on equity is estimable using appropriate estimation of  shareholders, which is Ke. b. Cost of debt is estimable using rate of  interest and tax rate, which is Kd. c. Overall cost Ko is calculated based on weighted average of Ke and Kd. d. Thus, Ko is dependent variable and Ke and Kd are independent variables. e. In this case, cost and proportion of equity as well as debt is estimated. This is used to calculate overall cost of capital i.e. weighted average cost of capital Ko. In this case, cost and proportion of equity as well as debt is estimated. This is used to calculate overall cost of capital i.e. weighted average cost of  capital Ko.  This approach is called as net income approach.  This is because Ke depends upon net income available to shareholders i.e. PAT is estimable.

According to this approach Ko declines as debts: equity ratio Dm/Em increases. This is because as Dm/Em increases, the proportion of the cheaper capital i.e. debt (Kd) increases. It is graphically represented as fallows: Page | 16

From this graph it is clear that as leverage i.e. Dm/Em increases, Ko decreases. This is because cheaper capital viz. Debt, in proportion, increases.

Net Operating Income Approach:Page | 17

Cost of equity is estimatedsbn based on expectations of shareholders. Such estimation is always debatable. Another argument is that the net operating income i.e. PBIT is better estimable for a proposed new venture. So total return on investment is known i.e. Ko is estimable and wil remain constant irrespective of debt: equity proportion or capital structure. Using Ko, we can estimate the return available to equity shareholders and check whether it is in the acceptable range.This approach is called as Net Operating Income Approach.  This approach assumes overall cost of capital i.e. Ko and cost of debt Kd to be constant. Ke is variable. Hence the equation: Ko= Wd Kd + We Ke  This is now rearranged as : Ke= Ko + (Ko -Kd) × (Dm/Em) We can summarise this approach as follows: As per net operating income approach: Ke = Ko + (Ko - Kd) × (Dm/De) Expected return on total investment is estimable which is Ko Cost of debt is estimable using rate of interest and tax rate, which is Kd Return available to shareholders Ke is calculated based on Ko and Kd  Thus, Ke is a dependent variable and Ko and Kd are independent variables. In this case cost and proportion of equity as well as debt is estimated. This is used to calculate return on equity i.e. Ke

Page | 18

 This approach is called as Net Operating Income approach. This is because Ko depends upon net income on total investment i.e. PBIT is estimable. In this approach, as overall cost Ko is treated as constant. So return on equity increases as leverage Dm/Em increases. The implied meaning of this is that the market discounts the leverage risk in price of equity and expectations (the opportunity cost) of equity increases. This may be graphically represented as follows:

(Leverage level)

It may be observed from the graph that Ke increases as the degree of leverage increases.

Page | 19

Traditional Approach Theory: This approach is similar to Net Income Approach.. According to this, the value of firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper source of funds then equity. Thus optimum capital structure can be reached by a proper debtequity mix. Optimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm.  Thus as per the traditional approach the cost of  capital is a function of financial leverage and the value of firm can be affected by the judicious mix of debt and equity in capital structure. The increase of financial leverage upto a point favorably affects the value of firm. At this point the capital structure is optimal & the overall cost of capital will be the least.  There are two type of risks-

Business risk – Business risk includes factors such as market fluctuations, availability of materials etc. and it will always be there more or less of risks. Financial risks- Financial risk keeps on increasing after a certain stage as more and more debt commitments are undertaken.

Page | 20

 This theory states that there is a correlation between the weighted average cost of the debt and equity ratio. The relation between the two when presented graphically takes the form of a U-shaped curve. Cost of capital will be very high if the debtequity ratio is zero. When debt is injected into the capital structure step- by- step the weighted average cost of capital will progressively come down only up to the lowest (optimum) point and then the cost of capital will go up with the further introduction of debt , since the debenture holders have to be offered a higher rate of interest.

Page | 21

MILLER AND MODIGLIANI POSITION:According to this approach the total cost of  capital of particular firm is independent of its methods and level of financing. Modigliani and Miller argued that the weighted average cost of  capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital.  They gave a simple argument in support of their approach. They argued that according to the traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, they argued, is determined from the level of shareholder’s expectations. Now, if  shareholders expect 16% from a particular company, they do take into account the debt equity ratio and they expect 16^ merely because they find that 16% covers the particular risk which this company entails. Suppose, further that the debt content in the capital structure of this company increases; this means that in the eyes of  shareholders, the risk of the company increases, since debt is a more risky mode of finance. Hence, shareholders will now start expecting a higher rate of return from the shares of the company. Hence, each change in the debt equity mix is automatically offset by a change in the expectations of the shareholders from the equity share capital. This is because a change in the debt equity ratio changes the risk element of the company, which in turn changes the expectations of the shareholders from the particular shares of the company. Modigliani and Miller, therefore, argued that financial leverage has nothing to do with the overall cost of capital Page | 22

and the overall cost of capital of a company is equal to the capitalization rate of pure equity stream of its class of risk. Hence, financial leverage has no impact on share market prices nor on the cost of capital.

Modigliani and Miller make the following propositions:1. The total market value of a firm and its cost of  capital are independent of its capital structure. The total market value of the firm is given by capitalizing the expected stream of operating earnings at a discount rate considered appropriate for its risk class.

2. The cost of equity (K e) is equal to capitalization rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, K e increases in a manner to offset exactly the use of  less expensive source of funds.

3. The cut off rate for investment purpose is completely independent of the way in which the investment is financed.

Page | 23

ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH:1. The capital markets are assumed to be perfect.  This means that investors are free to buy and sell securities. They are well informed about the riskreturn on all type of securities. These are no transaction costs. The investors behave rationally.  They can borrow without restrictions on the same terms as the firms do.

2. The firms can be classified into ‘homogeneous risk class’. They belongs to this class if their expected earnings is having identical risk characteristics.

3. All investors have the same expectations from a firm’s net operating income (EBIT) which are necessary to evaluate the value of a firm.

4. The dividend payment ratio is 100%. In other words, there are no retained earnings.

Page | 24

5. There are no corporate taxes. However this assumption has been removed later.

Modigliani and Miller agree that while companies in different industries face different risks which will result in their earnings being capitalized at different rates, it is not

possible for these companies to affect their market values, and therefore their overall capitalization rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in company’s capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate leverage. This is illustrated below:

Suppose there are two companies A & B in the same risk class. Company A is financed by equity and company B has a capital structure which includes debt. If market price of share of company B is higher than company A, market participants would take advantage of difference by selling equity shares of company B, borrowing money to equate there personal leverage to the degree of  corporate leverage in company B, and use these funds to invest in company A. The sale of Company B share will bring down its price until the market value of company B debt and equity equals the Page | 25

market value of the company financed only by equity capital.

Advantages: •

In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is that capital structure is important because one or more of  the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure.

Disadvantages: •

Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, Page | 26

which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratios.

CONCLUSION: Thus capital structure is the financing mix of the firm.

Page | 27

BIBLIOGRAPHY:SITES REFERED :1) 2) 3)

www.google.com www.referenceforbusiness.com www.wikipedia.org

BOOKS REFERED:-

1)

Page | 28

THANK YOU!

Page | 29