FINANCIAL MANAGEMENT

CAPITAL STRUCTURE

Long term financing refers to the issue of equity shares, preference shares and debentures. There is
an ideal combination of the three that maximises the equity earnings. Striking at such a combination is the
result of a conscious managerial effort, keeping in view the costs and earnings associated with the
combination.

The long term finance can be raised by a company by issuing one or more of the three financing
instruments i.e., equity shares, preference shares and debentures. The three may be combined in different
proportions. The combinations of the long term finance is called the capital structure.

Since preference capital and debenture capital carry a fixed return by way of preferential dividend
and interest on debt, they are together called the leveraged capital. As there is no such fixed commitment on
equity shares, it is called the unlevered capital.

The level of earnings of the organization affects the ability of the management to pay the committed
return on the levered capital. The problem can be appreciated from the fact that a company can never
borrow at 10% interest and earn only 8% on these funds. The following factors or deteminants must be
considered in raising the long term finance.

1. Volatility of earnings : If the corporate earnings are liable to fluctuate due to factors like seasonality,
levered capital is unattractive and the capital structure is dominated by equity.

2. Business risk : Every business has some risk inherent in the operations and it arises on account of the
unpredictability of economic and non-economic parameters like political and economic factors, labour
management relations, technological obsolescence, growth prospects, inflationary impact, competition
etc. If a company is exposed to such risk, the capital structure should consist less of debt to avoid the
threat of insolvency.

3. Cost of capital : Each component of capitalization i.e., equity, preference and debt capital has cost,
termed respectively as ke, kp and kd. The combined cost is called ko. In evolving a balanced capital
structure, the management must introduce an element of flexibility so that the present and potential ko
are minimized and the market value of the firm is maximized.

4. Degree of diversification : If a company produces a diversified product-mix, the chances are that the
variability of the total earnings will be less and may even lead to stable earnings. In the case of such
companies, the equity component in the capitalization may be less to derive the benefits of leverage.

5. Tax laws : A good incentive for employment of levered capital springs from the deductibility of
interest in computing taxable income so that the management can gain the tax shield. Since, preference
and equity dividends are not deductible in arriving at the taxable income, these two types of capital are
not so attractive as loaned capital.
Determination of Optimal Capital Structure
A firm should try to maintain an optimum capital structure with a view to maintain financial
stability. The optimum capital structure is obtained when the market value per equity share is the maximum.
It may, therefore, be defined as that relationship of debt and equity securities which maximizes the value of
a company’s share in the stock exchange. The objective of the term should therefore be to select a financing
or debt equity mix which will lead to maximum value of the firm.
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Ordinarily, new companies cannot collect sufficient debt as per their requirements so easily because
they are yet to establish their credit-worthiness in the market. Naturally, they have to depend on equity very
much. But established companies generally have track record of their profit earning capacity, which helps
them to create their credit-worthiness. The lenders feel safe to invest their funds in this type of companies.
Naturally, there is ample scope for this type of companies to collect debt. But a company cannot accept debt
freely i.e., without any limit. The company much have to chalk out a plan to collect debt in such a way that
the acceptance of debt becomes beneficial for the company in terms of increase in EPS, profitability and
value of the firm.

If the cost of capital is greater than the return, it will have an adverse effect on company’s
profitability, value of the firm and its EPS. If the company is unable to repay the debt within the scheduled
period, it will effect the goodwill of the company in the credit market and consequently may create problems
in future for collecting further debt. The company should select its appropriate capital structure with due
consideration.

In practice, financial management literature does not provide specified methodology for designing a
firm’s optimum capital structure. Consequently, human judgement must be used to resolve the many
conflicting forces in laying plans for the types of funds to be sought.

Capital structure policy involves a choice between risk and expected return. The optimal capital
structure strikes a balance between these risks and returns and thus examines the price of the stock. Those
companies which do not design their capital structure in a pre-planned way, realise difficulties in raising
funds on favourable terms in the long run to finance its development plans.

Capital Structure Theories

In order to achieve the goal of identifying an optimum debt-equity mix, it is necessary for the finance
manager to be conversant with the basic theories underlying the capital structure of corporate enterprises.
There are four major theories explaining the relationship between capital structure, cost of capital and value
of the firm.

1. Net Income Approach.

2. Net Operating Income Approach.
3. Modigliani-Miller Approach.
4. Traditional Approach.

Net Income Approach (NI Approach) : This approach has been suggested by Durand. According to this
approach, capital structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure causes a corresponding change in the overall cost of capital as well as the total value of the
firm.
According to this approach, a higher debt content in the capital structure (i.e., high financial
leverage), will result in decline in the overall or weighted average cost of capital. This will cause increase in
the value of the firm and consequently, increase in the value of equity shares of the company. Reverse will
happen in a converse situation. Net Income Approach is based on the following three assumptions :

 There are no corporate taxes.

 The cost of debt is less than cost of equity.
 The debt content does not change the risk perception of the investors.
The value of the firm on the basis of NI Approach can be ascertained as follows :

V = S + B
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Where :
V = Value of the firm.
S = Market value of equity.
B = Market value of debt.

Market value of equity can be ascertained as follows :

S = NI / ke
Where :

S = Market value of equity.

NI = Earnings available for equity shareholders.
Ke = Equity capitalization rate.

Thus, according to Net Income (NI) Approach, a firm can increase or decrease its total value and
decrease or increase its overall cost of capital by increasing or decreasing the debt content or the degree of
leverage in its capital structure. An increase in the value of the firm, would result in increase in the market
value of its shares and vice-versa.

Net Operating Income Approach (NOI Approach) : This is just opposite of Net Income Approach.
According to this approach, the market value of the firm is not at all affected by the capital structure
changes. The market value of the firm is ascertained by capitalizing the net operating income at the overall
cost of capital (ko), which is considered to be constant. The market value of equity is ascertained by
deducting the market value of the debt from the market value of the firm. The NOI approach is based on the
following assumptions :

 The overall cost of capital (ko) remains constant for all degrees of debt equity mix.
 The market capitalizes the value of the firm as a whole and therefore, the split between debt and equity is
not relevant.
 The use of debt having low cost increases the risk of equity shareholders, this, results in increase in
equity capitalization rate.
 Thus, the advantage of debt is set off exactly by increase in the equity capitalization rate.
 There are no corporate taxes.

According to NOI approach, the value of a firm can be determined by the following equation.
V = EBIT / ko
Where :
V = Value of firm;
ko = Overall cost of capital;
EBIT = Earnings before interest and tax.

The value of equity (S) is a residual value, which is determined by deducting the total value of debt (B) from
the total value of the firm (V). Thus, the value of equity (S) can be determined by the following equation :

S = V - B
Where :
S = Value of equity;
V = Value of firm;
B = Value of debt.

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Therefore, according to NOI approach, the total value of the firm remains constant irrespective of the debt-
equity mix. The market price of equity shares also not change on account of change in debt-equity mix.
Hence, there is nothing like optimum capital structure. Any capital structure will be optimum according to
this approach.

Modigliani-Miller Approach (MM Approach) : The MM approach is similar to the Net Operating
Income approach. In other words, according to this approach, the value of the firm is independent of its
capital structure. Hence, they argued that any rational choice of debt and equity results in the same cost of
capital and that there is no optimal mix of debt equity. They have maintained that under a given set of
assumptions, the capital structure and its composition has no effect on the value of the firm. There is
nothing which may be called as optimal capital structure.

The MM model is based on the following assumptions :

 There is a perfect market and the investors act rationally.
 Information about the market conditions is perfect.
 The securities of each firm are perfectly substitutable in the market.
 Institutional investors are free to deal in securities.
 There are no taxes.
 There does not exist transaction cost.
 Rate of interest at which company and individuals could borrow is the same.
 100% pay-out ratio i.e., all earnings are distributed to shareholders as dividends.

On the basis of these assumptions, the MM model derived that :

(a) The total value of the firm is equal to the capitalized value of the operating earnings of the firm. The
capitalization is to be made at a rate appropriate to the risk class of the firm.
(b) The total value of the firm is independent of the financing mix i.e., the financial leverage.
(c) The cut-off rate for the investment decision of the firm depends upon the risk class to which the firm
belongs, and thus is not affected by the financing pattern of these investment.
Modigliani-Miller concludes that the financing decision does not matter in maximization of market price per
share. According to them, “the market value of any firm is independent of its capital structure and is given
by capitalizing its expected return at the rate appropriate to its class”.

Traditional Approach : The traditional approach or the inter-mediate approach is a mid-way between the
NI approach and NOI approach. It partly contains features of both the approaches as given below :
(a) The traditional approach is similar to NI approach to the extent that it accepts that the capital
structure or leverage of the firm affects the cost of capital and its valuation. However, it does not
subscribe to the NI approach that the value of the firm will necessarily increase with all degree of
leverages.
(b) It subscribes to the NOI approach that beyond a certain degree of leverage, the overall cost of capital
increases resulting in decrease in the total value of the firm. However, it differs from NOI approach
in the sense that the overall cost of capital will not remain constant for all degree of leverage.

The essence of the Traditional approach lies in the fact that a firm through judicious use of debt-equity mix
can increase its total value and thereby reduce its overall cost of capital. This is because debt is relatively a
cheaper source of funds as compared to raising money through shares because of tax advantage. However,
beyond a point raising of funds through debt may become a financial risk and would result in a higher equity
capitalization rate. Thus, upto a point, the content of debt in the capital structure will favourably effect the
value of the firm. However, beyond that point, the use of debt will adversely affect the value of the firm. At
this level of debt equity mix, the capital structure will be optimum. At this level, the average or the
composite cost of capital will be the least.
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E.B.I.T -- E.P.S. Analysis
 It is one of the basic objectives of Financial Management to design an appropriate capital structure
which can provide the highest EPS. EPS is a yard stick to evaluate the firm’s performance for the investors.
The level of EBIT varies from year to year shows how successful the firm’s operations are. EBIT-EPS
analysis is an important tool for designing the optimal capital structure framework of the firm. EBIT-EPS
analysis is widely used by Finance Manager because it provides a simple picture of the consequences of
alternative financing methods.

The EBIT-EPS Analysis essentially involves the comparison of alternative methods of financing under
various assumptions of EBIT. A firm has the choice to raise funds for financing its investment proposals
from different sources in different proportions. For eg.,

(1) Exclusively use of equity capital;

(2) Exclusively use of debt;
(3) Exclusively use of preference capital;
(4) Use of combination of (1) and (2) in different proportions;
(5) A combination of (1) , (2) and (3) in different proportions;
(6) A combination of (1) and (3) in different proportions.

The choice of the combination of the various sources, also called as financial plan or capital structure, would
be one which, given the level of earnings before interest and taxes, would ensure the largest EPS.

Indifference Point

The EBIT level at which the EPS is same for two alternative financial plans is referred to as the
indifference point.

The indifference point may be defined as the level of EBIT beyond which the benefits of financial
leverage begin to operate with respect to EPS.

In operational terms, if the expected level of EBIT is to exceed the indifference level of EBIT, the
use of fixed charge source of funds (debt) would be advantageous from the view point of EPS i.e., financial
leverage will be favourable and lead to an increase in EPS available to shareholders.

If however, the expected level of EBIT is less than the indifference point, the advantage of EPS
would be available from the use of equity capital. Mathematically, the indifference point can be obtained by
using the following symbols :

X = EBIT at indifference point.

N1 = No. of equity shares if only equity shares are issued.
N2 = No. of equity shares outstanding if both debentures and equity shares are issued.
N3 = No. of equity shares outstanding if both preference shares and equity shares are issued.
N4 = No. of equity shares outstanding if both preference shares and debentures are issued.
I = Interest on debentures.
P = Dividend on preference shares.
T = Corporate income tax rate.
For a newly formed company, the indifference point can be determined by using the following equations :
(1) Equity shares Vs. Equity shares + Debentures

(2) Equity shares Vs. Equity shares + Preference shares

(3) Equity shares Vs. Eq. Shares + Pref. shares + Debentures