CAPITAL STRUCTURE (THEORY)
Q.1. What are the features of an appropriate capital structure?
The following are the major features of an appropriate capital structure:
(1) Profitability: It should minimize the cost of financing and maximise earning per equity share.
(2) Flexibility: The capital structure should be such that company can raise funds I whenever needed.
(3) Conservation: The debt content should not exceed the maximum which the company j can bear.
(4) Solvency: The capital structure should be such that the firm does not run the risk of becoming insolvent.
(5) Control: There should be minimum risk of loss or dilution of control of the company.
Q.2. List out the other considerations in Capital Structure Planning.__________
In addition to Risk, Cost and Control, the other considerations in Capital Structure ' Planning are as under: -
(1) TRADING ON EQUITY
When the Return on Total Capital Employed (ROCE), is more than the rate of interest on borrowed funds or the rate of dividend on preference j shares, financial leverage can be used favourably to maximise EPS. In such a case, the company is said to be "trading on , equity". Loans or Preference Shares may be preferred in such situations. The effect of the financing decision on EPS and ROE I should be analysed.
(2) CORPORATE TAXATION
Interest on borrowed capital is a tax- deductible expense, but dividend is not. Also, the cost of raising finance through borrowing is deductible in the year in which it is incurred. If it is incurred during the pre-commencement period, it is to be capitalized. Due to the tax saving advantage, debt has a cheaper effective cost than preference or equity capital. The impact of taxation should be carefully
(3) GOVERNMENT POLICIES
Raising finance by way of borrowing or issue of equity is subject to policies of the Government and its regulatory bodies like SEBI, RBI etc. The monetary, fiscal and lending policies, as well as rules and regulations stipulated from time to time by these bodies have to be complied with for acquiring funds through the particular mode.
(4) LEGAL REQUIREMENTS
The applicable legal provisions should be borne in mind while deciding about the Capital Structure. Some provisions relate to maximum limit of borrowings by a company, approvals required for foreign direct investment etc.
The mode of obtaining finance depends on the marketability of the company's shares or debt instruments (debentures / bonds). In case of restrictions in marketability, it is difficult to obtain public subscription. Hence, the company has to consider its ability to market corporate securities.
Maneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement of funds. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing with prospective suppliers of funds.
It denotes the capacity of the business and its management to adjust to expected and unexpected changes in the business environment. The Capital structure should provide maximum freedom to changes at all times.
Proper timing of a security issue often brings substantial savings because of the dynamic nature of the capital market. Hence the issue should be made at the right time so as to minimise effective cost of capital. The management should constantly study the trend in the capital market and time its issue carefully.
(9) SIZE OF THE COMPANY
Small companies rely heavily on owner's funds while large and widely held companies are generally considered to be less risky by the investors. Such large companies can issue different types of debt instruments on occurities.
(10) PURPOSE OF FINANCING
Funds required for long term productive purposes like manufacturing, setting up new plant etc. may be raised through long term sources. But if the funds are required for non- productive purposes, like welfare facilities to employees such as schools, hospitals etc., internal financing may have to be resorted to.
(11) PERIOD OF FINANCE
Funds required for medium' 11 and long-term periods say 8 to 10 years may be raised by way of borrowings. But if the funds are for permanent requirement, it will be appropriate to raise them by the issue of equity shares.
(12) NATURE OF INVESTORS
Enterprises which enjoy stable earnings and dividend with a proven track record may go for borrowings or preference shares, since they are having adequate profits to pay interest/fixed charges. But companies, which do not have assured income, should preferably rely on internal resources to a large extent since it maybe difficult to woo investors towards the issue.
(13) REQUIREMENT OF INVESTORS
Different types of securities are issued to different classes of investors according to their requirement. Sometimes, the investor may be motivated by the options and advantages' available with a security, e.g. double options, convertibility, security of principal and interest etc.
(14) PROVISION FOR FUTURE GROWTH
Future growth considerations and further requirements of capital should also be considered.
Q.3. What are the components of financial Risk ?
Financial risk consists of two types.
(1) RISK OF CASH INSOLVENCY
As a firm raises more debt, its commitment towards debt service increases. This is due to two reasons. Firstly, higher the debt, the greater the amount of interest payable, even in years of insufficient profits. Secondly, the principal has to be repaid in committed instalments, even if sufficient cash is not available. Thus the risk of cash insolvency increases.
(2) RISK OF VARIATION IN THE EPS
Equity Shareholders earnings after meeting interest, tax and preference dividend. Hence, as interest increases, there will be lower probability that equity shareholders will enjoy a stable dividend. As a result of financial leverage, if debt content is high in the capital structure, the risk of variations in expected earnings available to equity shareholders will be higher.
Q.4. What are the general assumptions in Capital Structure Theories? "The following are the general assumptions in Capital Structure Theories.
(a) There are only two sources of funds viz., debt and equity. [No Preference Share Capital]
(b) The Total Assets of a firm and its Capital Employed are fixed. [No. change in capital Employed]. However, debt equity mix can be changed:
• Either by borrowing debt to repurchase (redeem) equity shares
• Or by raising equity capital to retire (repay) debt.
(c) All earnings are distributed to equity shareholders, [No retained earnings]
(d) The firm earns operating profits and it is expected to grow. [No losses]
(e) The business risk is assumed to be constant and is not affected by the financing mix decision.
[No change in fixed costs or operating risks]
(f) There are no corporate or personal taxes. [No taxation]
(g) The investors have the same subjective probability distribution of expected earnings.
[No difference in investors' expectations
Q.5. Explain the Net Income Approach of Durand.
Apart from the general assumptions, the following additional assumptions are made:
(1) There are no corporate Taxes.
(2) Kd = Debt Capitalisation Rate and Ke = Equity Capitalisation Rate.
(3) The Cost of Debt (Kd) is always less than Cost of Equity (Ke).
(4) Kd and Ke remain constant at all levels of debts-equity mix. This is because, the use of debts content does not remain constant at all perception of investors.
THEORY OR EXPLANATION
(1) Debt is a cheaper source of finance than equity due to tax saving effect and investor's risk expectations.
(2) Use of cheaper debt funds in total capital structure will reduce the Overall or Weighted Cost of Capital since Debt percentage increases in the total capital structure.
(3) Hence, as the degree of financial leverage increases, the WACC will decline with every increase in he debt content in total funds employed.
(4) Since Value of Firm = EBIT / WACC, the value of firm will increase for every decline in WACC.
(5) Where debt content is reduced, the reverse will happen, i.e. WACC will increase thereby reducing the value of the firm. .
(6) Thus, a firm can increase its value and lower the overall cost of capital by increasing the proportion of debt in the capital structure.
(7) The Value of the Firm will be maximum at a point where WACC is minimum.
(8) Thus, the theory suggests total or maximum possible debt financing for minimising the cost of capital.
Application: The application of theory in determining WACC involves the following steps:
|2||Compute EBT (Net Income) = EBIT less Interest on Debt Funds|
|3||Compute Market Value of Equity (S) = EBT (Net Income) / Cost of Equity (Ke)|
|4||Compute Market Value of Debt (D) = Interest / Cost of Debt (Kd),|
|5||Compute Market Value of Firm (V) = S + D = Market Value of Equity + Market Value of Debt|
|6||Compute Overall Cost of Capital (Ko) = EBIT / Value of Finn (V)|
Q.6. Explain the Traditional Theory to Cost of Capital.
Apart from the general assumptions, the following additional assumptions are made:
(1) The Cost of Debt (Kd) is always less than Cost of Equity (Ke).
(2) Kd and Ke vary with change in debt-equity mix. As debt content increases, financial risk increases, causing increase in the expectations of equity investors and rise in the cost of equity.. Also additional loans can be taken only at a higher rate of interest. So Cost of Debt also rises , beyond a certain level of debt content.
(3) Increase in Cost of Equity is more steeper and higher than increase in cost of debt.
THEORY OR EXPLANATION
(1) Debt is a cheaper source of finance than equity due t tax saving effect and investor's risk expectations.
(2) Use of cheaper debt funds in total capital structure will reduce the Overall or Weighted Cost of Capital since Debt percentage increases in the total capital structure. This is because the benefits of cheaper debt may be so large that even in offsetting the effect of increase in cost of equity, the WACC may go down.
(3) Hence, as the degree of financial leverage increases, the WACC will decline with every increase in the debt content in total funds employed.
(4) However, if financial leverage increases beyond an acceptable limit (called the optimal point), the cost of debt and cost of equity start rising. This is because of the high financial risk associated with the firm.
(5) The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall cost of capital to increase.
(6) The firm should strive to reach the optimal capital structure and maximise its total value through a judicious use of both debt and equity in the capital structure. At the optimal capital structure the overall cost of capital will be minimum and the value of the firm is maximum.
(7) Thus: as per the Traditional Theory the firm should try to achieve the optimal Capital Structure' by minimising WACC and maximising its value.
The application is the same as that of Net Income approach, except that Ke and Kd : differ for different degrees of debt-equity mix. The least WACC