ASSIGNMENT

Submitted To: Mr. Suleman Submitted By: UZMA SIDDIQUE

Topic:
Capital Structure

MIU

Definition of Capital Structure The capital structure of a business is the mix of types of debt and equity the company has on its balance sheet. Capital structure is sometimes referred to as a company's debt to equity ratio. Debt and Equity has a different impact on earnings, cash flow, balance sheet presentation, and taxes, Companys leverage, intensity, and a host of other metrics by which businesses are measured. Finally, each financing option brings a different type of relationship with the respective financing source. Sources of debt financing include collateralized bonds, debentures, bank loan, and lines of credit. Sources of equity financing includes seeking capital from investors through the issuance of shares these shares can be common or preferred If the capital structure is mostly based on debt investors considered the firm more risky as there are more chances of bankruptcy. Debt financing is cheaper than equity financing but the increase leverage increases the risk and investors will demand high expected return to take that risk. Financing is one of the most important functions of the firms. Firms need finance to extend their business and to accomplish other projects and operations. Firms can finance themselves by two ways: 1. Internal Financing. 2. External Financing.

Types of financing
A companys capital structure describes the composition of its permanent or long -term capital, which consist of a combination of debt and equity and hybrid securities. A good proportion of equity as opposed to debt in a companys capital structure is an indication of financial fitness.

Three types of financing needs to be considered when we talk about financing decisions: 1. Debt financing 2. Equity financing 3. Hybrid financing Debt financing A company is said to take up debt financing, when it takes money from sources other than its own Debt financing is obtainined by borrowed funds for the company Equity financing Equity financing includes owners equity, venture capital, common equity, and warrants Equity financing is obtaining funds for the company in exchange for ownership

Debt financing
Debt comes in two primary forms: senior and subordinated. Senior debt from a bank is less expensive than subordinated debt but often has more extensive covenants that provide the lender with certain remedies in the event the covenants are not satisfied . Debt financing ranges from simple bank debt to commercial paper and corporate bonds. It is a contractual arrangement between a company and an investor, whereby the company pays a predetermined claim (or interest) that is not a function of its operating performance, but which is treated in accounting standards as an expense for tax purposes and is therefore tax-deductible. The debt has a fixed life and has a priority claim on cash flows in both operating periods and bankruptcy. This is because interest is paid before the claims to equity holders, and, if the company defaults on interest payments, it will be declared bankrupt, its assets will be sold, and the amount owed to debt holders will be paid before any payments are made to equity holders.Typically,

debt financing also called asset based financing requires that some asset such as a car, house, plant, machine, or land etc be used as a collateral. A company consider itself too highly leveraged when it has much debt then equity may find itself free from the actions restricted by its creditors and/or may have its profitability hurt as a result of paying high interest cost on debt. During period of adverse economic conditions the worst situation would be having trouble in meeting operational and debt liabilities. A company in a highly competitive business, if have high debt, may find its competitors taking advantage of its problems to grab more market share. The debt-equity relationship varies according to industries involved, a companys line of business and its stage of development. Debt financing is supposed to be a good idea for short term expensive projects. Suppose you get a pretty amazing project proposal, to be completed in a certain amount of time, it is not always possible to raise all the money for it so fast. Debt capital can help you complete the project. You can then sell it, get a lot more money than what you took as debt, and pay off the loan and pocket the rest yourself. Your business capital remains untouched. Debt capital comes with an inherent risk. And an interest rate which can be quite high. Usually you have to keep an asset as a security for the debt with your creditor. And in case your plan bombs, and you are not able to generate the revenue you had budgeted, you will not be able to pay off the debt and hence stand to lose the asset you pledged If the financing is short term less then one year, the money is usually used to provide working capital to finance inventory, account receivable, or the operations of the business. The funds are typically rapid from the resulting sales and profits during the year. Long term debt lasting more then one year is frequently used to purchase some assets such as a piece of machinery, land or building, with part of the value of asset usually from 50 to 80 percent of the total value being used as a collateral for the long term loan.

Subordinated Debt Subordinated debt is a type of debt that typically has both debt and equity characteristics and sits below senior debt in the capital structure. Since the risk exposure is great than senior debt, mezzanine debt carries a higher interest rate and some form of equity kicker (an equity interest in the company typically in the form of stock or warrants) to drive acceptable riskadjusted returns. Subordinated debt typically requires that some or all of the related interest costs be paid monthly or quarterly, placing a potential drain on a growing companys cash flow. And, subordinated interest rates are much higher than Senior debt, these payments can be significant. Accordingly, subordinated debt is commonly used specifically for recapitalizations or acquisitions.

Equity Financing
Equity financing is the money that the owner of the business puts in himself/themselves. And for the money that the owners put in the business, they get a share of the ownership and the resulting business profits after interest payments and tax. The money stays in the business and the owners (called shareholders) can receive their money only on winding up or by selling their share to someone else. Does not require collateral and offers the investor some form of ownership position in the company. The investor share in the profit of the company, as well as any disposition of its assets on a pro rate basis based on the percentage of the business owned. Debt is permanent in the company, its claim is residual and does not create a tax advantage from its payments as dividends are paid after interest and tax, it does not have priority in bankruptcy, and it provides management control for the owner. Key factors that favoring the one type of financing over another are the availability of funds, the assets of the company, and the prevailing interest rates. Usually, a creditor meets financial needs by employing a combination of debt and equity financing. All companies will have some equity, as all companies are owned by some person or institution. Although the owner may sometimes not be directly involved in the day-to-day

management of the company, there is always equity involved that is provided by the owner. The amount of equity involved will of course vary by natural by the nature and size of the company In general, analysts use three different ratios to assess the financial strength of a company's capital structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position. The debt ratio compares total liabilities to total assets. Obviously, more of the debt/equity ratio means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities. Advantages of Equity Financing: In equity financing there is a defined range of exit dates. In equity financing there is a broad level participation. There is an active involvement as appropriate. Funding amounts are based on expected future value. Equity financing is a low risk financing. The difference is of control equity holders have more control over the company than the debt holders but this control remains only till the bankruptcy.

You can use your cash and that of your investors when you start up your business for all the start-up costs, instead of making large loan payments to banks or other organizations or individuals. You can get underway without the burden of debt on your back..

Depending on who your investors are, they may offer valuable business assistance that you may not have. This can be important, especially in the early days of a new firm. You may want to consider angel investors or venture capital funding. Choose your investors wisely.

Disadvantages of Equity Financing:

Equity financing involves Higher Cost of Capital In equity financing Interest Accrued, but not Paid The business will run quite slowly and won't progress as much as it could, had it taken debt financing.

Business lack credibility Equity financing involve higher tax Since your investors own a piece of your business, you are expected to act in their best interests as well as your own, or you could open yourself up to a lawsuit. In some cases, if you make your firm's securities available to just a few investors, you may not have to get into a lot of paperwork, but if you open yourself up to wide public trading, the paperwork may overwhelm you. You will need to check with the Securities and Exchange Commission to see the requirements before you make decisions on how widely you want to open up your business for investment.

Advantages of Debt Financing

Debt financing involve low cost of capital. Interest are paid on periodic bases. Debt financing involve fixed maturity date. Debt financing involves broad observer. Debt financing allows you to have control of your own destiny regarding your business. You do not have investors or partners to answer to and you can make all the decisions. You own all the profit you make.

If you finance your business using debt, the interest you repay on your loan is tax-deductible. This means that it shields part of your business income from taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate.

The lender(s) from whom you borrow money do not share in your profits. All you have to do is make your loan payments in a timely manner.

You can apply for a Small Business Administration loan that has more favorable terms for small businesses than traditional commercial bank loans.

In case of value debt are preferred over the equity as they company pay to the debt holder first than the equity holders as they are the liability of the company.

Disadvantages of Debt Financing

The disadvantages of borrowing money for a small business may be great. You may have large loan payments at precisely the time you need funds for start-up costs. If you don't make loan payments on time to credit cards or commercial banks, you can ruin your credit rating and make borrowing in the future difficult or impossible. If you don't make your loan payments on time to family and friends, you can strain those relationships.

Debt financing funding Amount Based on Current Cash Flow. Debt financing involve little involvement. Debt capital comes with an inherent risk. Debt financing including a higher probability of bankruptcy, an increase in the agency conflicts between managers and bondholders

Debt financing involves loss of future financial flexibility. Debt financing involves the cost of information asymmetry.

For a new business, commercial banks may require you to pledge your personal assets before they will give you a loan. If your business goes under, you will lose your personal assets.

Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to determine how much debt your firm is in compared to its equity. Which is best; debt or equity financing? It depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business.

Types of Capital Structure Theories.

There are six types of capital structure theories which are Net income theory Net operating income theory Modigliani-Miller theorem Trade-off theory Pecking order theory Traditional theory

Assumptions of Capital Structure Theories

The total assets of a company are given and do not change. Total financing remain constant. Operating profit not expected to grow. Company has infinite life. Corporate tax does not exist. Dividend payout equal to 100% Business risk is constant overtime.

Net Income Theory

Net Income theory was propounded by David Durand and is also known as Fixed Ke Theory. This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and

decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. Interest rates are lower than dividend rates due to element of risk, For example if you have equity debt mix is 50:50 but if you increase it as 30: 70, it will increase the market value of firm and its positive effect on the value of per share. High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value. Assumptions of Net Income Theory The Kd is cheaper than the Ke. Income tax has been ignored. The Kd and Ke remain constant. There are no Taxes. Cost of debt is less then cost of equity. Use of debt does not change the perception of the investors.et O

Net Operating Income Theory

Net Operating Income Approach was suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage. At each and every level of capital structure, market value of firm will be same. The value of the Equity may be found by deducting the value of debt from the total value ofthefirmi.e.,V = EBIT/k And E = V- D And the k
e

cost

of

equity

capital,

ke

is

= EBIT - Int. / V- D

Features of Net Operating Income Approach:

At all degrees of debt, the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate. The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows: Value of Equity = Total value of the firm - Value of debt Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant.

Disadvantages of Net Operating Income Approach

It lack behavioral significance. Example: Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of the firm and the cost of equity capital (the equity capitalization rate). Solution: EBIT = $50,000 12.5%

WACC (overall capitalization rate) =

Therefore, total market value of the firm = EBIT/Ko $50,000/12.5% $400,000 Total value of debt =$200,000 Therefore, total value of equity = Total market value - Value of debt $400,000 - $200,000 $200,000 Cost of equity capital = Earnings available to equity holders/Total market value of equity shares

Earnings available to equity holders = EBIT - Interest on debt $50,000 - (10% on $200,000) $30,000 Therefore, cost of equity capital = $30,000/$200,000 15% Verification of WACC: 10% x ($200,000/$400,000) + 15% x ($200,000/$400,000) 12.5% Effect of change in Capital structure (to prove irrelevance) Let us now assume that the leverage increases from $200,000 to $300,000 in the firm's capital structure. The firm also uses the proceeds to re-purchase its equity stock so that the market value of the firm remains the same at $400,000. EBIT = $50,000 WACC = 12.5% (overall capitalization rate) Total market value of the firm = $50,000/12.5% $400,000 Less: Total market value of debt $300,000 Therefore, market value of equity = $400,000 - $300,000 $100,000 Equity-capitalization rate = ($50,000 - [10% on $300,000)/$100,000 20% Overall cost of capital = 10% x $300,000/$400,000 + 20% x $100,000/$400,000 12.5% The above example proves that a change in the leverage does not affect the total value of the firm, the market price of the shares as well as the overall cost of capital.

Modigliani Millar Approach

Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide operational justification for independence of the company's cost of capital. M&M position which is the same as the net operating approach is based on the notion that there is a conservation of investment value no matter how you divide the investment value pie between debt and equity claims, the total pie stays the same. therefore leverage is said to be irrelevant. Behavioral support for the M&M position is based on the arbitrage process.

Assumptions of MM approach:
Capital markets are perfect. All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm. Within similar operating environments, the business risk is equal among all firms. 100% dividend payout ratio. An assumption of "no taxes" was there earlier, which has been removed.

Limitations of MM hypothesis:
Investors would find the personal leverage inconvenient. The risk perception of corporate and personal leverage may be different. Arbitrage process cannot be smooth due the institutional restrictions. Arbitrage process would also be affected by the transaction costs. The corporate leverage and personal leverage are not perfect substitutes. Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.

Trade-Off Theory
Miller & Modigliani showed (with unrealistic assumptions) that shareholder value would be maximized with nearly 100% debt. Doesnt hold in the real world because interest rates rise as leverage rises, and because expected taxes go down as debt rises, and bankruptcy costs rise as leverage rises. The trade off theory also recognize that capital raised by firms is constituted by both debts and equity, however the theory states that there is an advantage of financing through debts due to tax benefit of the debts, however some costs arises as a result of debt costs and bankrupt costs and non bankrupt costs, the theory also states that the marginal benefit of debts declines as the level of debts decrease and at the same time the marginal cost of debts increases as debts increase, therefore a rational firm will optimize by the trade off point to determine the level of debts and equity to finance its operations, the theory also states that as the debt equity ratio increases (D/E) then there is a tradeoff between bankruptcy and tax shield and this as a result causes an optimal capital structure for the firm

M&M's original proposition

Firm Value

Value reduced by bankruptcy costs

Zero Leverage

Traditional Approach
The Net Income theory and Net Operating Income theory stand in extreme forms. Traditional approach stands in the midway between these two theories. Traditional theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this theory a proper and right combination of the use of debt and equity will always lead to market value enhancement of the firm. This approach accepts that the equity shareholders perceive financial risk and expect premiums for the risks undertaken. This theory also states that after a level of debt in the capital structure, the cost of equity capital increases. The traditional approach to capital structure and valuation assume that there is an optimal capital structure and that management can increase the total value of the firm through the judicious use of financial leverage. Example: Let us consider an example where a company has 20% debt and 80% equity in its capital structure. The cost of debt for the company is 10% and the cost of equity is 14%. According to the traditional approach the overall cost of capital would be: WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity) (20% x 10%) + (80% x 14%) 2+ 11.2 13.2% If the company wants to raise the debt portion in the capital structure to be 60%, the cost of debt as well as equity would increase due to the increased risk of the company. Let us assume that the cost of debt rises to 10% and the cost of equity to 15%. After this scenario, the overall cost of capital would be: WACC = (60% x 10%) + (40% x 15%) 6 + 6 12%

In the above case, although the debt-equity ratio has increased, as well as their respective costs, the overall cost of capital has not increased, but has decreased. The reason is that debt involves lower cost and is a cheaper source of finance when compared to equity. The increase in specific costs as well the debt-equity ratio has not offset the advantages involved in raising capital by a cheaper source, namely debt. Now, let us assume that the company raises its debt percentage to 80%, thereby pushing down the equity portion to 20%. Due to the increased and over debt content in the capital structure, the firm has acquired greater risk. Because of this fact, let us say that the cost of debt rises to 15% and the cost of equity to 20%. In this scenario, the overall cost of capital would be: WACC = (80% x 15%) + (20% x 20%) 12 + 4 16% This decision has increased the company's overall cost of capital to 16%. The above example illustrates that using the cheaper source of funds, namely debt, does not always lower the overall cost of capital. It provides advantages to some extent and beyond that reasonable level, it increases the company's risk as well the overall cost of capital. These factors must be considered by the company before raising finance via debt.

Pecking Order Theory

The pecking order theory which was developed by Myers in 1984 states that firms will finance through a hierarchy of finance options, therefore this theory supports the fact that debts are preferred by firms than equity, the firm will finance itself internally, and then finance itself using debts and when these debts are depleted then the firm will finance through equity through sales of stock. Therefore equity financing is as a last option to the firm, the firm prefers to finance through a hierarchy of financing whereby they will finance through available funds, when these funds are used up the firm will

acquire debts and finally when this is exhausted they will decide on to finance through equity.