CAPITAL STRUCTURE

Meaning of several terms

Capitalisation – the amount of securities issued by a firm.

Capital structure – kinds of securities and the proportionate amounts that make-up capitalisation.

Financial structure – means the entire liabilities side of balance sheet.

Definition “Capital structure of a company refers to the composition or make-up of its capitalisation and it includes all long term capital resources namely loans, reserves, shares and bonds.”

- Genestenberg

Optimum capital structure

The optimum capital structure may be defined as that capital structure, or combination of debt and equity mixture that leads to the maximum value of the firm.

Importance of capital structure

Capital structure cannot affect the total earnings of a firm but it can affect the share of earnings available for equity shareholders.

Therefore, there should be a proper mix of debt and equity capital in financing the firm’s assets.

Should consider trading on equity.

Point of Indifference / Range of earnings

The earnings per share ‘equivalency point’ or ‘point of indifference’ refers to that EBIT (earnings before interest and tax) level at which EPS remains the same irrespective of different alternatives of debt-equity mix.

At this level of EBIT the rate of return on capital employed is equal to the cost of debt and this is also known as ‘break-even level of EBIT for alternative financial palns.

Theories of capital structure Different theories have been propounded by different authors to explain the relationship between capital structure, cost of capital and value of the firm.

The theories are:

- Net Income Approach

- Net Operating Income Approach

- The Traditional Approach

- Modigliani and Miller Approach–MM Approach

Inorder to achieve the goal of optimum capital structure, the Financial Manager should be familiar with these basic theories of capital structure.

Some experts are of the opinion that the debt-equity mix can influence the value of the firm while others feel that the debt-equity proportion can not influence the value of the firm.

Net Income Approach According to this approach a firm can minimise the weighted average cost of capital and increase the value of the firm as well as market price of equity shares by using debt financing to the maximum possible extent.

This theory propounds that a company can increase its value and reduce the overall cost of capital by increasing the proportion of debt in its capital structure.

Assumptions The cost of debt is less than cost of equity

There are no taxes

The risk perception of investors is not changed by the use of debt.

The main arguiment in favour of this approach is that as the proportion of debt financing in capital structure increases, the proportion of cheaper source of funds increases.That will decrease the overall cost of capital and thereby the value of the firm will increase.

The reason for assuming cost of debt to be less than the cost of equity is that interest rates are usually lower than dividend rates due to element of risk.

Net Operating Income Approach

This theory is suggested by Durand which is just opposit to the Net Income Approach.

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

It implies that the overall cost of capital remains the same whether the debt-equity mix is 50:50 or 20:80 or 0:100.

Thus there is nothing as an optional capital structure and every capital structure is the optimum capital structure.

Assumptions The market capitalises the value of the firm as a whole.

The business risk remains constant at every level of debt-equity mix.

The reason for such assumption is that the increased use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases.

Traditional Approach This approach also known as intermediate approach. It is a compromise between two extremes of Net Income Approach and Net Operating Income 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 a cheaper source of fund than equity.

Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity share holders.

Thus, overall cost of capital, according to this theory decreases upto a certain point, remains more or less unchanged for moderate increase in debt thereafter, and increases or rises beyond a certain point.

Thus optimum capital structure can be reached by a proper debt-equity mix.

Modigliani and Miller Approach

Popularly known as MM hypothesis.

(Note)

Essential features of sound capital mix

1. Maximum possible use of leverage

2. The capital structure should be flexible

3. The use of debt should be within the capacity of the firm

4. It should involve minimum possible risk of loss of control

5. It must avoid undue restrictions in agreement of debt

Factors determining the capital structure

1. Financial leverage or trading on equity2. Growth and stability of sales3. Cost of capital4. Nature and size of the firm5. Desire to have control6. Requirements of investors7. Capital market conditions8. Purpose of financing9. Period of finance10. Cost of floatation11. Efficiency of management12. Corporate tax rate

Capital gearing It is the relationship between equity capital and long term debt. It is the ratio between the various types of securities in the capital structure of the company.

High gear – proportionately higher preferance shares and debentures

Low gear – proportionately higher equity capital

A firm can use low gear at the initial stage and after that can use high gear.

Reasons for changes in capital structure

To simplify the capital structure

To suit investors needs

To write off the deficit

To capitalise retained earnings

To fund accumulated dividend

To facilitate merger and expansion

To meet legal requirements

Leverage Dictionary meaning – An increased means of accomplishing some purpose.

In financial management leverage is used to describe the firm’s ability to use fixed cost assets or funds to increase the return to its owners.

Definition “the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return”

- James Horne

Types of leverage1. Financial Leverage or Trading on Equity

2. Operating Leverage

3. Composite Leverage

Financial Leverage or Trading on Equity

A firm can raise their required fund through two sources – Owned Capital and Borrowed Capital.

The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity.

The aim of financial leverage is to increase the revenue available for equity share holders using the fixed cost funds.

Two types If the earnings is more than cost of debt – favourable leverage

If the earnings is less than cost of debt – unfavourable leverage

Measures of Financial Leverage Debt ratio – ratio of debt to total capital D/V

Debt Equity Ratio – ratio of debt to equity D/S

Interest Leverage ratio – ratio of net operating incomes to interest charges – EBIT/Interest

Value of debt ratio ranges in between 0 to 1

Value of debt equity ratio ranges in between 0 to any number.

Degree of Financial Leverage=% change in EPS ------------------------

% change in EBIT

Or EBIT/EBT

Significance of financial leverage

Planning of capital structure – debt-equity ratio

Profit planning – the EPS is affected by the degree of financial leverage. If the profitability of the firm is increasing then fixed cost funds will help in increasing the return to equity holders

Limitations Double-edged weapon – if it does not earn as much as the cost of interest bearing securities, it will work adversely.

Beneficial only to companies having stability of earnings.

Increases risk

Restrictions from financial institutions

Operating leverage Operating leverage results from the presence of fixed costs that help in magnifying net operating income fluctuations flowing from small variations in revenue.

The fixed cost is treated as a fulcrum of a leverage. Fixed cost do not change with the change in sales. Any increase in sales, fixed cost remaining the same, will magnify the operating income

The operating leverage occurs when a firm has fixed costs which must be recovered irrespective of sales volume.

When the fixed cost remaining the same, the percentage change in operating revenue will be more than the percentage change in sales. This occurance is known as operating leverage.

Operating leverage = Contribution / Operating Profit

Contribution = sales – variable cost

Operating profit = Sales – VC – FC

or

Contribution – fixed cost

Break Even Point Point of no profit and no loss

At BEP the fixed cost are fully recovered. Any increse in sales beyond this level will increse profits equal to contribution

BEP = FC / PV ratio

PV Ratio = contribution / sales

The degree of operatin leverage = % change in profits / % change in sales

Composit Leverage Combination of both financial and operating leverage.

Composit leverage = operating leverage x financial leverage

or

The degree of composit leverage = % change in EPS / % change in sales

Working capital leverage WCL = % change in ROI

----------------------

% change in CA

ROI = return on investment

CA = current assets

Dividend Theories

Introduction Dividend is the part of profit and it is the reward to the shareholders.

Management of the company is expected to take a decision regarding the extent of profit to be distributed and how far it is to be retained.

Generally speaking the value of the firm can be maximised if the shareholders’ wealth is maximised.

Schools of thought1. Dividend decision does not affect the shareholders’ wealth and

hence the valuation of the firm – The Irrelevance Concept of dividend or The Theory of Irrelevance

2. Dividend decision will affect the shareholders’ wealth and also the Value of the firm – The Relevance Concept or The Theory of Relevance

Dividend theories1. The Irrelevance Concept

a. Residual Approach

b. Modigliani and Miller Approach – MM Model

2. The Relevance Concept

a. Walter’s Approach

b. Gordon’s approach

Residual Approach According to this approach dividend decision has no effect on the wealth.

If funds are needed that can reinvest and if not needed, then, can be distributed as dividends.

This theory assumes that investors do not differentiate between dividends and retentions by the firm.

If reinvested investors will get more in future. Therefore dividend decisions can not create any change in the market value of the firm.

MM Model This model argue that whatever increase in the value of the firm results from the payment of dividend will be exactly off set by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders.

If a company distributes all of its earnings and raise funds for investment, it may lead to increase in the number of shares or payment of interest charges, resulting a fall in the earnings per share in the future.

Assumptions1. There are perfect capital market2. Investors behave rationally3. Information about the company available to all without

any cost.4. There are no floatation and transaction cost.5. There are either no tax or differences in the tax rates

applicable to dividends and capital gain.6. The firm has rigid investment policy7. There is no risk or uncertainty regarding to the future

of the firm.8. No investor is large enough to effect the market price

of shares.

Equation

P1 = P0(1+Ke) - D1

P0 = market price per share at the beginning of the period or prevailing market price of a share.D1 = dividend to be received at the end of the periodP1 = Market price per share at the end of the periodKe = Cost of equity capital or rate of capitalization

Criticism1. Perfect capital market does not exist in reality.2. Information about the company is not available to all

the persons.3. The firms have to incur floatation costs while issuing

securities4. Existance of tax rates and normally different tax

treatment for dividends and capital gains5. The firms can not follow a rigid investment policy6. The investors have to pay brokerage, fees etc while

doing any transaction7. Shareholders may prefer current income as

comparable to future gain

Walter’s Approach Prof. Walter’s approach support the doctrine that dividend decisions are relevant and affect the value of the organization.

This model is based on the relationship between firm’s return on investment (r) and the cost of capital or required rate of return (k).

Three conditions1. If r > k, if the firm earns a higher rate of return on

investment than the required rate of return, the firm should retain the earnings. Such firms are growth firms and optimum pay-out would be zero. This would maximize the value of the shares.

2. If r < k, if the firm earns lower than the required rate, the firm should distribute the entire earnings as dividends. They are declining firms.

3. If r = k the dividend policy will not affect the market value. The shareholders will get the same return from the firm as expected by them. They are normal firms.The value of the firm would not change with the change in dividend rate.

Assumptions1. The investments of the firm are financed through retained earnings only

and the firm does not use external source of funds.

2. The internal rate of return and the cost of capital of the firm are constant .

3. Earnings and dividends do not change while determining the value.

4. The firm has a very long life.

Walter’s equation D r (E-D) / keP = ---- + --------------- ke keWhere

P = market price per shareD = dividend per shareKe = cost of capitalr = internal rate of returnE = Earnings per share

Criticism of Walter’s model

1. The basic assumption is that investments are financed through retained earnings only is seldom true in real world. Firms may raise funds by external sources.

2. The internal rate of return ‘r’ also does not remain constant. As a matter of fact, with increased investment the rate of return also changes.

3. The assumption that cost of capital ‘k’ will remain constant also does not hold good.

Gordon’s Approach According to this model, dividend policy is relevant. Dividend policy of a normal firm (r = k), can also affect the value of the firm.

This argument is based on the fact that investors are rational and they always prefer current income if there is no special advantage in future.

Rational investors always prefer current dividend and they discounts the future dividends because future is uncertain.

Assumptions1. 100% of the capital employed by the firm is financed by equity

share holders.

2. The internal rate of return, ‘r’ of the firm is constant.

3. Coporate taxes do not exist.

4. The retention ratio ‘b’ once decided will remain constant and therefore the growth ratio g=br is constant.

5. The cost of capital of the firm is greater than the growth rate, ke>g.

Gordon’s equation E (1 – b)P = ------------- ke – br

Where,P = price of shareE = EPSb = retention ratioKe =cost of capitalBr = growth rate

The bird in the hand argument

According to Gordon’s model dividend policy is irrelevant where r = k. But Gordon concludes that dividend policy will affect the value of the share even in case of a normal firm.

Investors behaving rationally and risk averse and therefore have preference for current income from investment.

Investors prefer to avoid uncertainty and would be willing to pay higher price for the share that pay dividend at a higher rate.

Determinants of dividend policy

1. Legal restrictions According to sec. 93, 205, 205A, 206 and 207 of the Companies Act 1956, dividend can be paid only out of the current profits or past profits after providing for depreciation or out of the moneys provided by the Government for the payment of dividend.

The Companies Rules 1975 requires, a company providing more than 10% of dividends should transfer certain percentage of current year’s profits to reserves.

Dividends cannot be paid out of capital.

2. Magnitude and trend of earnings According to law, dividends can be paid only out of present or past year’s profits.

Therefore earnings of a company fix the upperlimits on dividends.

3. Desire and type of shareholders Dividend or reinvestment ?

Financially sound persons prefer capital appreciation rather than present dividend.

4. Nature of industry Certain industries have a comparatively steady and stable demand irrespective of the prevailing economic conditions.

eg: liquor industry.

Such industries can follow a consistent dividend policy.

5. Age of the firm

6. Future financial requirements

7. Govt.’s economic policy – sometimes govt may fix the maximum limit of dividend.

8. Taxation policy

9. Inflation

10. Stability of dividends

Types of dividend policy1. Regular dividend policy – payment of dividend at the usual

rate.

2. Stable dividend policy – payment of certain minimum amount of dividend regularly.

3. Irregular dividend policy – due to uncertainty of earnings.

4. No dividend policy.

Advantages of regular and stable dividend policy

1. It establishes a profitable record of the co.

2. It creates confidence among shareholders

3. It aids in long term financing

4. It stabilises the market value of shares

5. The equity shareholders view dividend as a source of their income

Forms of dividend1. Cash dividend2. Scrip or bond dividend – in case of a company

does not have sufficient funds to pay dividends in cash, it may issue promisory notes or bonds for amounts due to the shareholders.

3. Property dividend – payment in the form of some assets other than cash. Not popular in India.

4. Stock dividend – issue of bonus shares to the existing shareholders. If the company has no sufficient liquid fund, it is better to issue bonus shares.

Dividend policy in practice In actual practice most firms determine the amount of dividend first and then retained earnings.

There is no choice with the companies between paying of dividends and not paying of dividends.

Most of the companies believe that by following a stable dividend policy with a high pay-out ratio, they can maximise the market value of shares.