Capital Structure

CA BUSINESS SCHOOL POSTGRADUATE DIPLOMA IN BUSINESS & FINANCE SEMESTER 3: Financial Strategy

M B G Wimalarathna

(FCA, FCMA, MCIM, FMAAT, MCPM)(MBA–PIM/USJ)

Introduction Capital structure refers the combination of debt and equity used to finance whole organization at a given time. It also can argue that capital structure denotes how company owned its (mostly the long term) resources to run the business. Equity represents the owners’ funds while debt represents any other finance/funds except owners’ funds in the organization. Ordinary share capital and long term reserves claim as equity capital while preference share capital(conditionally) and long term liabilities (prior charge capital) claim as debt capital of an organization. Determining an optimum capital structure of an organization is obviously a crucial at all the time. Improper composition of capital structure could even lead the organization towards bankruptcy. (the ultimate worst thing) Optimum capital structure is the right combination of debt and equity at which value of the organization is recorded as its highest.

Key Determinants Current phase of the product life cycle is one of the key factor which determines composition of the capital structure of an organization. Following are also key in the event of determining suitable capital structure;

Overall business risk (might be at the first day of business)

Size of the company

Industry (in which company operates) and its current trends

Size of the operations/business

Level of complexities involved in operational activities/business

Degree of volatility of results with key macro economic factors

Degree of volatility of results with PEST factors

Overall financial risk (more suitably, later in the business)

Nature of the financial market (flexibility/diversity/opportunity)

Attitude of the key management personal

Debt or Equity

As we have already understand, equity represents owners capital in an organization. At initial phase, by means of IPO and later, additional share issues/right issues/private placement will bring capital to the business. In contrast, debt represents the capital brought into the business by various means other than equity finance. Merits of equity over debt: (this is quite comparable analysis) You are allowed to use the cash/funds for business activities without carrying a burden of repayment. If you developed a business model and convince your shareholders, only the possible source that you get required funds with no additional costs which compensated by the level of business risks. Investors may offer valuable business assistance that you may not have at the beginning. (pressure in positive move) Assist you to become big and enhance corporate value in the long run as a results of the strong relationship.

Debt or Equity (Contd.)

Demerits of equity over debt: Investors do expect a share of the profits where if you obtain debt financing banks or individuals only expect their loans repaid. Since your investors own a piece of your business, you are expected to act in their best interests as well as your own which creates additional operational complexities. (Conflicts of interests. Agency theory)

Merits of debt over equity: Debt financing allows you to have control of your own destiny. If you finance your business using debt, the interest you repay shall be tax-deductible. The lenders from whom you borrow money do not share in your profits.

Demerits of debt over equity: You may have large amount of loan payments at the time you need funds for the operational activities. Commercial banks may require you to pledge your precious assets at the event of granting a loan. Any time you use debt financing, you are surrounding the risk of bankruptcy.

Gearing Level/Position In finance, gearing represents composition and their respective influence/impact of debt and equity of a particular organization at a given time. But, in reality, gearing measures (affirmed) long term going concern of the company. Since it is purely a financial indicator, gearing could be measured in many ways. Common formulae: [debt capital/equity capital] Based on the composition, an organization could be categorized as either high geared or low geared. There could be even no geared organizations. Which one is best suits shall basically depend on many factors (some has discussed in earlier). In general, high geared companies carries high risk than low geared companies. When company is having more debt in its capital structure, there will be high finance cost involved which results reduces earnings to ordinary shareholders. As a result, risk of their investment will high and ultimately cost of equity will also be high. But company need debt. Any attempts that make return from borrowed funds exceed the cost of such funds will be benefited at all the times. (essentially need establishment with acceptance by STKHs)

Impact on changes in Capital Structure

Changes in capital structure will have direct impact to many areas in the business. Some can argue that changes in capital structure will lead even the company towards bankruptcy. Drastic changes in the capital structure directly impact to the EPS of the company. Higher the debt cause lower the EPS in principle. Higher the debt in capital structure will adversely affect on the value of the company in the long run. Changes in capital structure determines the level of risks that equity/debt contributors take investing in the company. This results, both equity and debt contributors claim high/low return on their respective investment. Dramatic changes in capital structure is also directly affect key accounting ratios such as gearing/EPS/DPS/interest cover and PER.

Cost of Capital and WACC

It is quite well established phenomena that business models with return in excess over its cost of capital will survive in the long run and vice versa. Some also called COC as cut-off rate. As name implied, it is the rate (cut-off point) at which business models could either be categorized as viable or not. Hence cost of capital is treated as fundamental principle in capitalist market economy. You also might experience that selection of most suitable business model(s) and allocation of scares resources (funds) is mainly depend on the cost of capital figure. Cost of capital is being treated as a qualitative phenomena which we transformed to a quantitative number in order to make decision making easy and fast.

Cost of Capital and WACC (Contd.) In general, overall capital of an organization represents O/Sc., Reserves, P/Sc. and debt. Hence, we consider calculation of cost of capital as follows; Cost of equity Cost of preference share capital Cost of debt Cost of Equity (owners’ capital) Theoretically, the calculation of cost of equity will be straightforward. But, in reality, it is a very difficult task. Equity comprised O/Sc and retained earnings. Cost of equity figure must reflect the return that the equity investors expect to reward in order to compensate risk taken by them. Even though some are misunderstand that retained earnings are free source of finance, it obviously carries enormous value (at least) by means of opportunity cost of the dividend forgone. Formulas : No dividend growth,Ke = D/Po with growth of div., Ke = [D1/Po] +g Po should be ex.div. D1 = [Do *(1+g)] g is the div. growth factor/rate.

Cost of Capital and WACC (Contd.)

Cost of Preference Share Capital Calculation of cost of P/Sc is same as cost of equity and most of the assumptions used will remains unchanged. Formulas : Kp = D/Po Cost of Debt Based on its nature, debt could be divided into irredeemable and redeemable. Irredeemable debt: cost of this type of debt will ascertain as same we did in the O/Sc and P/Sc. Make a note that interest you accrue on debt is tax deductible. Formulae: Kd = [I (1-t)]/Po I = annual interest, t = corporate tax rate, Po = MV of debt ex. interest Redeemable debt: the particular debt will be redeemed at the given future date. The cost of this types of debt is an Internal Rate of Return (IRR).

Cost of Capital and WACC (Contd.)

Weighted Average Cost of Capital (WACC) In practice, company raises finance to provide funds for the selected business models/projects from pool of different financing models rather than one specific fund raising mechanism. Hence, when such pool of funds used, it is most suitable to consider costs of pool of funds rather than one distinctive as discussed in above. WACC represents the costs of pool of funds of any organization at any given time. It is ideal to consider the MV of each sources of finance rather than book value. But book value more used in practice. Formulae: WACC = [Ke (Ve) + Kp (Vp) + Kd (Vd)]/[Ve + Vp + Vd] Assumptions: The capital structure is reasonably constant The new investment does not carry any significant risk profile The new investment is marginal to the company

MM Theory

Modigliani and Miller’s (MM) (Franco Modigliani and Merton Miller) (1958) theory form the basis to determine how taxes and financial distress affect a company’s capital structure decision. MM theory basically developed on following assumptions and ultimate conclusion is optimum capital structure is the combination/composition of equity and debt at which firm’s value will be at its highest. All investors are having homogeneous expectation on future cash

flows Shares and bonds are traded in perfect markets Investors can borrow and lend at the same rate There are no agency costs Investment and financing decisions are independent of one

another

MM Theory (Contd.)

Following are the key propositions developed by MM theory. Proposition I The market value of the firm/company is not affected by the capital structure. no taxes involved no agency costs no costs of financial distress

Proposition II The cost of equity does represent a linear function of the company’s debt/equity ratio. no taxes involved no agency costs no financial distress debt become low costs source of finance due to prior charge more use of debt creates high Ke since seniority WACC remains constant since more use debt compensate high Ke

MM Theory (Contd.)

Proposition III The optimum capital structure of the company is the point at which almost debt only (99.99%) represents the capital structure. corporate taxes involved no agency costs no costs of financial distress

Proposition IV The optimum capital structure is the composition of equity and debt at which company experience its highest ever corporate value. corporate taxes involved agency costs will be applicable costs of financial distress is also applicable

Exercise The following information is pertaining to the ABC & Co. Ltd. F/Y 31/03/2014 O/Sc. (LKR 10/- each) 350,000 Reserves 450,000 P/Sc. 300,000 Bank Loan (12% p.a.) 100,000 Total 1,200,000

It revealed that ordinary share capital is currently traded in the market at LKR 19/- while the bank loan traded at LKR 95/- on face value of LKR 100/-. Preference share capital price remains unchanged. You are required to; a. Calculate the gearing by using book values b. Calculate the gearing by using market values