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CAPITAL STRUCTURE

Capital structure: Indian industries


Studies on capital structure of Indian Industries are inconclusive
and often conflicting. A study by Sharma and Rao (1968) on 30
Engineering firms for 3 years concludes that debt due to its tax-
deductibility is a prominent determinant of the cost of capital. A study
by I. M. Pandey (1981) on cotton textiles, chemicals, and engineering
and electricity generations lends support to the traditional approach.
Bhatt (1980) in his paper concludes that the leverage ratio is very
much influenced by business risks measured in term of variability in
earnings, profitability, debt service capacity, and dividend-payout ratio.
I. M. Pandey (1984) in another study found that during 1973-81 about
80% of the assets of the companies sampled was financed by external
debt and current liabilities. Large sized companies were more levered
though a large number of small firms also courted more debt capital.
Leverage did not exhibit a definite relationship with growth and
profitability, although all the three variables moved in the same
direction. He also found that a majority of the profitability and growth
oriented companies were within the narrow bands of leverage. S. K.
Chakraborty (1977) in his study found that age, retained earnings, and
profitability were negatively correlated with the debit equity ratio,
while total assets and capital intensity were directly related to it. He
felt that a high cost of capital for all the consumer industries was due
to their low debt component. His indirect attempt to test the MM
hypothesis for 22 firms showed that cost of capital was almost
invariant to the debt equity ratios.
Before 1980s Indian financial managers courted debt due to its
low cost, tax advantages and the complicated procedures to be
observed in garnering equity capital. The substitutability of short term
debt for long term loan was another attraction. However, with the
waves of liberalization, privatization and globalization sweeping the
capital market in recent years, the corporate world has started wooing
equity capital in a big way. The arrival of a matrix of new financial
instruments such as commercial papers, asset securitisation, factoring
and forfeiting services, and the market related interest rate structure
and their stringent conditions for lending, force modern enterprises to
court equity finance.
To examine the capital structure of the TNEB, 8 financial ratios
for a period of 18 years (1981-1998) are selected on the basis of the
empirical findings of many previous studies. The relevant basic data
are collected from various reports of the TNEB statistics at a glance.
They include 1) debt equity ratio, 2) ratios of capital assets to total
assets, 3) depreciation to total assets, 4) capital expenditure to total
assets, 5) gross surplus to sales, 6) gross surplus to total assets, 7)
growth in total assets and 8) natural log of sales. The debt equity ratio
is designated as Criterion Variable while the remaining ratios are called
Tests or Control variables. Using Wherry Doolittle Selection Model the
crucial determinants of the debt equity ratio of the TNEB are identified.

After considering the various sources in which the long term


requirements of the funds can be met, the next question which arises
is that what should be the proportion in which the various sources of
long term finance should be used in order to raise the required amount
of capital. Here come into the picture the decisions regarding capital
structure.

Meaning:
Capital structure refers to the mix of sources from which the long
term funds required by a business are raised.

Goals / Principles of Capital Structure Management:


For considering the suitable pattern of capital structure, it is
necessary to consider certain basic principles which are militant to
each other. It is necessary to find a golden mean by giving proper
weight age to each of them.

(I) Cost Principle: According to this principle, ideal capital structure


should minimize cost financing and maximize earnings per share. Debt
capital is a cheaper form of capital due to-two reasons. First, the
expectations of returns of debt capital holders are less than those of
Equity shareholders. Secondly, interest is a deductible expenditure for
tax purposes whereas dividend is an appropriation.

(2) Risk Principle: According to this principle, ideal capital structure


should not accept unduly high risk. Debt capital is a risky form of
capital, as it involves contractual obligations as to the payment of
interest and repayment of principal sum irrespective of profits or losses
of the business. If the organization issues large amount of preference
shares, out of the earnings of the organization, less amount will be left
out for equity shareholders as dividend on preference shares is
required to be paid before any dividend is paid to equity shareholders.
Raising the capital through equity shares involves least risk as there is
no obligation as to the payment of dividend.

(3) Control Principle: According to this principle, ideal capital


structure should keep controlling position of owners intact. As
preference shareholders and holders of debt capital carry limited or no
voting rights, they hardly disturb the controlling position of residual
owners. Issue of equity shares disturbs the controlling position directly
as the control of the residual owners is likely to get diluted.

(4) Flexibility Principle: According to this principle, ideal capital


structure should be able to cater to additional requirements of funds in
future, if any. E.g. if a company has already raised too heavy debt
capital, by mortgaging all the assets, it will be difficult for it to get
further loans inspite of good market conditions for debt capital and it
will have to depend on equity shares only for raising further capital.
Moreover, organization should avoid capital on such terms and
conditions which limit company's ability to procure additional funds.
E.g., if the company accepts debt capital on the condition that it will
not accept further loan capital or dividend on equity shares will not be
paid beyond certain limit, then it looses flexibility.

(5) Timing Principle: According to this principle, ideal capital


structure should be able to seize market opportunities, should
minimize cost of raising funds and obtain substantial savings.
Accordingly, during the day of boom and prosperity, company can
issue equity shares to get the benefit of investors' desire to invest and
take the risk. During the days of depression, debt capital may be used
to raise the capital as the investors are afraid to take any risk.

Factors affecting Capital Structure:

Before deciding the mix of long term sources of funds, it is necessary


to consider a lot of factors which can be broadly classified as:
(a) Internal factors
(b) External factors
(c) General factors

(a) Internal factors:


(1) Cost of Capital: The process of raising the funds involves some
cost. While planning the capital structure, it should be ensured that the
use of the capital should be capable of earning the revenue enough to
meet the cost of capital. It should be noted here that the borrowed
funds are cheaper than the equity funds so far as the cost of capital is
concerned. This is because of two reasons:

(a) The interest rates (i.e. the form of return on the borrowed
capital) are usually less than the dividend rates (i.e. the form of return
on the equity capital).

(b) The interest paid on borrowed capital is an allowable expenditure


for income tax purposes while the dividends are the appropriate out of
the profits.
(2) Risk Factor: While planning the capital structure, the risk factor
consideration inevitably comes into picture. If the company raises the
capital by way of borrowed capital, it accepts the risk in two ways.
Firstly, the company has to maintain the commitment of payment of
the interest as well as the installments of the borrowed capital, at a
predecided rate and at a predecided time, irrespective of the fact
whether there are profits or losses. Secondly, the borrowed capital is
usually the secured capital. If the company fails to meet its contractual
obligations, the lenders of the borrowed capital may enforce the sale of
assets offered to them as security.
On the other hand, if the company raises the capital by way of equity
capital, the risk on the part of the company is minimum. Firstly, as
dividend is the appropriation of the profits, if there are no profits, the
company may not be paying the dividend for years together, Secondly,
the company is not expected to repay the equity capital, unlike
borrowed capital, during the lifetime of the company. Thirdly, the
company is not required to offer any security or mortgage its assets for
raising the funds in the form of equity capital.

(3) Control Factor: While planning the capital structure and more
particularly while raising additional funds, the control factor plays an
important role, especially in case of closely held private limited
companies.
If the company decides to raise the long term funds by issuing further
equity shares or preference shares, it dilutes the controlling interest of
the present shareholders / owners, as the equity shareholders enjoy
absolute voting rights and preference share holders enjoy limited
voting rights. The control factor usually does not come into the picture
in case of borrowed capital unless the lender of the long term funds,
i.e. Banks or financial institutions, stipulate the appointment of
nominee directors on the Board of Directors of the company.

(4) Objects of Capital Structure Planning: While planning the


capital structure, the following objects of the capital structure planning
come into play.

(a) To maximize the profits of the owners of the company. This can be
ensured by issuing the securities carrying less cost of capital.

(b) To issue the securities which are easily transferable. This can be
ensured by listing the securities on the stock exchange.

(c) To issue the further securities in such a way that the value of
shareholding of the present owners is not affected.
(b) External Factors
(1) General Economic Conditions: While planning the capital
structure, the general economic conditions should be considered. If the
economy is in the state of depression, preference will be given to
equity form of capital as it will be involving less amount of risk. But it
may not be possible always as the investors may not be willing to take
the risk. Under such circumstances, the company may be required to
go in for borrowed capital. If the capital market is in boom and the
interest rates are likely to decline in further, equity form of capital may
be considered immediately, leaving the borrowed form of capital to be
tapped in future. It may also be possible to raise more equity capital in
boom as the investors may be ready to take risk and to invest.

(2) Level of Interest Rates: If funds are available in the capital


market, only at the higher rates of the interest, the raising of capital in
the form of borrowed capital may be delayed till the interest rates
become favorable.

(3) Policy of Lending Institutions: If the policy of term lending


institutions is rigid and harsh, it will be advisable not to go in for
borrowed capital, but the equity capital form should be tapped.

(4) Taxation Policy: Taxation policy of the Government has to be


viewed from the angles of both corporate taxation and as well as
individual taxation. The return on borrowed capital i.e. interest is an
allowable deduction for income tax purposes while computing taxable
income of the company, while return on equity capital i.e. dividend is
not considered like that as it is the appropriation out of the taxable
profits. As far as individual taxation is concerned, both interest as well
as dividend will be taxable in the hands of lender of the capital subject
to specified deductions available for the purposes.
(5) Statutory Restrictions: The statutory restrictions prescribed by
the Government and various statutes are required to be taken into
consideration before the capital structure is planned. The company has
to decide the capital structure within the overall framework prescribed
by the Government and various statutes.

(c) General Factors:


(1) Constitution of Company: While deciding about the capital
structure, the constitution of the company plays an important role. In
case of private limited company, the control factor may be more
important while in case of public limited company, cost factor may be
more important.
(2) Characteristics of Company: Characteristics of the company, in
terms of size, age and credit standing play very important role in
deciding capital structure. Very small companies and the companies in
their early stages of life have to depend more on the equity capital, as
they have limited bargaining capacity, they can't tap various sources
of raising the funds and they do not enjoy the confidence of the
investors.
Similarly, the companies having good credit standing in the market,
may be in the position to get the funds from the sources of their
choice. But this choice may not be available to the companies having
poor credit standing.
(3) Stability of Earnings: lf the sales and earnings of the company
are not likely to be stable enough over a period of time and are likely
to be subject to wide fluctuation, the risk factor plays more important
role and the company may not be able to have more borrowed capital
in its capital structure as it carries more risk.
However, if the earnings and sales of the company are fairly constant
and stable over the period of time, it may afford to take the risk, where
the cost factor or control factor may play important role.
(4) Attitude of the Management: lf the attitude of the management
is too conservative, the control factor may play an important role in
capital structure decision. If the policy of the management is liberal,
the cost factor may get more importance.

COST OF CAPITAL
Introduction:
In the previous chapter, we discussed about the various sources from
which the long term requirements of the capital can be met. Each of
these sources involves some cost. The cost of capital can be defined as
"the rate of which an organization must pay to the suppliers of capital
for the use of their funds".

In economic term, the cost of capital is viewed from two different


angles.

(1) The cost of raising funds to finance a project. This cost may be in
the form of the interest which the company may be required to pay to
the suppliers of funds. This may be the explicit cost attached with the
various sources of capital.

(2) The cost of capital may be in the form of opportunity cost of the
funds of company i.e. rate of return which the company would have
earned if the funds are not invested. E.g. suppose that a company has
an amount ofRs.100.000 which may either be utilized for purchasing a
machine or may be invested with a bank as fixed deposit carrying the
interest 10%p.a. If the company decides to use the amount for
purchasing the machine, obviously it will have to forgo the interest
which it would have earned by investing the same in fixed deposit with
the bank. Thus, the cost of capital of the capital of Rs.1,00,000 is 10%.

Concepts of Cost of Capital:


Besides the general concept of cost of capital, the following concepts
are also used
frequently.

(a) Component Cost and Composite Cost


Component cost refers to the cost of individual components of capital
viz. equity shares, preference shares, debentures and so on.
Composite cost of capital refers to the combined or weighted average
cost of capital of the various individual components. For capital
budgeting decisions, it is the composite cost of capital which is
considered.

(b) Average Cost and Marginal Cost:


The average cost refers to the weighted average cost of capital.
Marginal cost refers to the incremental cost attached with new funds
raised by the company.

(c) Explicit Cost and Implicit Cost:


Explicit cost is the one which is attached with the source of capital
explicitly or apparently. Implicit cost is the hidden cost which is not
incurred directly. E.g. In case of the debt capital, the interest which the
company is required to pay on the same is explicit cost of capital.
However, if the company introduces more and more doses of debt
capital in the overall capital structure, it makes the investment in the
company a risky proposition. As such, the expectations of the investors
in terms of return on their investment may increase and share prices of
the company may decrease. These increased expectations of the
investors or the decreased share prices may be considered to be
implicit cost of debt capital.

Importance of Cost of Capital:

The term cost of capital is important for a company basically for


following purposes:

(1) The concept of cost of capital is used as a tool for screening the
investment proposals.(The various methods for appraising investment
purposes are discussed in details in the following chapters). E.g. In
case of the net present value method, the cost of capital is used as the
discounting rate for discounting the future inflow of funds. Any project
resulting into positive net present value only will be accepted. All other
projects will be rejected. Similarly, in case of Internal Rate of Return
Method (IRR), the resultant IRR is compared with the cost of capital. It
is expected, that if a project is to be accepted, IRR resulting tram the
same should be more than cost of capital. If project generates IRR
which is less than cost of capital, the project will be rejected.

(2) The cost of capital is used as the capitalization rate to decide the
amount of capitalization in case of a new concern.

(3) The concept of cost of capital provides useful guidelines for


determining the optimal capital structure. (This concept is discussed in
details in the following pages). Optimal capital structure is the one
where overall cost of capital is minimum and the overall valuation of
the firm is maximum.

Measurement of Cost of Capital:

(a) Cost of Debt: The debts may be either short term debts or long
term debts. Very naturally, the cost of capital in the form of debt is the
interest which the company has to pay. But this is not the real cost
attached with debt capital. The real cost is something less than the
rate of interest which the company has to pay. This is due to the fact
that the interest on debt is a tax deductible expenditure. If the amount
of interest is considered as a part of expenses, the tax liability of the
company reduces proportionately. As such, while computing the cost
of debt, adjustments are required to be made for its tax impact. E.g.
suppose a company issues the debentures having face value ofRs.1 00
and bearing the rate of interest of 10% p.a. If the tax rate applicable to
the company is 50%, the cost of debentures is not] 0% which is the
rate of interest, but it is to be duly reduced by the tax benefits
available due to this interest. Tax benefit is 50% of 10%, hence the
cost of debentures is only 5%. Further, the interest payable on the
debentures has to be viewed from the angle of the amount actually
received on their issue. E.g. A company issues] 000 debentures of
Rs.l00, each bearing interest @8% p.a. Company incurs the expenses
in connection with the issue of debentures to the extent of Rs.10,000
(These expenses may be in the form of discount allowed, underwriting
commission, advertisement etc.) Thus, the company will have to pay
the annual interest ofRs.8,000 on the net amount received to the
extent of only Rs.90,000 (i.e. Rs.1,OO,OOO minus Rs.10,000). Cost of
debentures in this case works out to around 8.89% and assuming that
the tax rate applicable is 50%, the tax benefit makes the cost of
debentures equal to 4.45%. However, the debt capital has a hidden
cost also. If the debt content in the capital structure of a company
exceeds the optimum level, the investors start considering company as
too risky and their expectations from equity shares increase. This is
the hidden cost of debt.

(b) Cost of Preference Shares: The cost of capital preference


shares is the dividend rate payable on them. As in case of debentures,
the cost of capital is adjusted for the amount excess or less received
on the issue of preference shares. E.g. Suppose, a company issues
1,000 preference shares of Rs.100 each at the value of Rs.105 each.
Rate of dividend is 10% and the expenses involved with the issue of
preference shares amount to Rs10,000. Thus the net amount received
works out to Rs.95,000 whereas the amount of the dividend is
Rs.10,000. Here, the cost of capital works out to.

Rs.1O,OOO = 10.52%
Rs.95,000x100

As the amount of dividend payable on preference shares is not a


tax deductible Expenditure, there is no question of further adjustment
for tax benefit

(c) Cost of Equity Shares: Computation of cost of equity shares is


the most complex procedure. It is due to the fact that unlike
preference shares or debentures, equity shares do not have either the
interest or dividend to be paid at a fixed rate. The cost of equity shares
basically depends upon the expectations of the equity shareholders.
There are following approaches to compute the cost of equity shares.
(1) D/P Approach: According to this approach, before an investor
pays certain price for purchasing equity shares of the company, he
expects certain return on the investment which is in the form of the
dividend. This expected rate of dividend is the cost of equity shares.
This means, that the investor calculates the market price of the shares
by capitalizing the present dividend rate which is expected to be the
same for all the times to come. E.g. If the market price of Equity
Shares of a company (Face value Rs.l0) is Rs.15 and if the company at
present is paying the dividend @ 20% which is expected to be
continued in future also; the cost of Equity Shares will be:

20% X Rs.10 = 13.3%


Rs.15
However, it can also be argued that the cost of equity shares
may be 20%, because on the expectation of rate of dividend at 20%,
market price of the shares is Rs.15.
This approach is objected on certain grounds. Firstly, this
presupposes that an investor looks forward only to receive dividend on
equity shares. This may not always be correct. He may also look
forward to capital appreciation in the value of his shares. Secondly, this
approach assumes that the company will not earn on its retained
earnings and that the retained earnings will not result in either
appreciation of the market price or increase in dividends. This
assumption can be a wrong assumption which may lead to wrong
conclusions.

(2) E/P Approach: According to this approach, the cost of equity


shares is based upon the stream of unchanged earnings earned by a
company. This approach holds that each investor expects a certain
amount of earnings whether distributed by way of dividend or not,
from the company in whose shares he invests.
Thus, if an investor' expects that the company in which he is
investing should have at least 20% rate of earnings, cost of equity
shares will be calculated on that basis. If a company is expected to
earn 30%, he will be prepared to pay RS.150 for one share of Rs.100
each.
This approach can be objected on the following grounds. Firstly,
it wrongly assumes that the earnings per share will remain constant in
future. Secondly, the market prices of the shares will not remain
constant as the share holders will expect capital gains as a result of
reinvestment of retained earnings. Thirdly, all the earnings may not be
distributed among the shareholders by way of dividend.
(3) D/P + G Approach: According to this approach, the investor is
prepared to pay the market price of the shares as he expects not only
the payment of the dividend but also expects a growth in the dividend
rate at a uniform rate perpetually.

Thus, the cost of equity shares can be calculated

D + G where
P

D = Expected dividend per share

P = Market Price per share

G = Growth in expected dividends

E.g. If the dividend per share is Re. 1 per share with the
expected growth of 6% per year perpetually, the cost of equity shares,
with the assumed market price of the share of Rs.25, will be

Re. 1 + 0.06
Rs.25
= 0.04 + 0.06

= 10%

This approach involves the difficulty of determining the growth


rate.

(4) Realized Yield Approach: According to this approach, the cost of


equity shares may be decided on the basis of yields actually realized
over the period of past few years which may be expected to be
continued in future also. This approach basically considers D/P + G
approach, but instead of considering the future expectations of
dividends and growth factor, the actual yields in past are considered.

(d) Cost of Retained Earnings: Many a times, it is argued that the


retained earnings do not cost anything to the company. It is argued
like this as there is no obligation, either formal or implied, to pay return
on retained earnings even though they constitute one of the major
sources of funds for the company. In case of debt, the company has
fixed obligation to pay interest on it. Almost similar obligation exists in
case of preference shares also. In case of equity shares, though there
is no legal obligations the expectations of the shareholders at least
provide a starting point for computing the cost of equity shares. The
retained earnings do not involve any of such obligations, either formal
or implied. As such, it may be felt that retained earnings involve no
cost as they are not raised from outside source. But this contention is
not correct. Retained earnings involve cost and this cost is in the form
of the opportunity cost in terms of dividends foregone by or withheld
from the equity shareholders.
E.g. assuming that the profits earned by the company are not
retained but are distributed among shareholders by way of dividend.
These amounts of dividends which would have been received by the
shareholders, after due adjustments for tax deducted at source, could
have been invested by the shareholders elsewhere to earn some
return. The company, by retaining the profits, prohibits the shareholder
from earnings these returns. As such, the company is required to earn
on the retained earnings at least equal to the rate which would have
been earned by the shareholders if they were distributed to them. This
is the cost of retained earnings.

Composite Cost of Capital:


After ascertaining the cost of each source of the capital constituting
the capital structure, the next step is to compute the composite cost of
capital which is defined as the weighted average of the cost of each
specific type of capital. The reason behind considering weighted
average and not the simple average is to give consideration to the
proportion of various sources of funds in the capital structure of the
company. Thus, the process of computing the composite cost of capital
is carried on by following the steps stated below.

(1) Assign weights to various sources of funds. It may be stated here


that the weights may be in the form of book value of funds or market
value of funds.

(2) Multiply the cost of each source of funds by the weights assigned

(3) Calculate the composite cost by dividing total weighted cost by the
total weights.

The above process can be explained with the help off 0110 wing
illustrations.

Illustration:

The capital structure of a company and the cost of specific sources of


funds is as below.

Sources of funds Book value Specific Weighted cost


(weights) Rs. Cost Rs.
1 2 3 ( X 2)
Debentures 1,50,000 5% 7,500
Preference
50,000 9% 4,500
shares
Equity shares 2,00,000 15% 30,000
Retained
1,00,000 8% 8,000
earnings
5,00,000 50,000

Composite cost of capital =Total weighted costs x 1 00


Total weights
= 50,000 x 100
5,00,000
= 10%

Trading on Equity, Capital Gearing and


Leverages
Before we go on discussing the inter related concepts of Trading
on Equity, Capital Gearing and Leverage, let us consider the following
example.

Let us assume that there are two companies A Ltd. and B Ltd.
which are exactly similar to each other in terms of nature of business,
size, extent of turnover etc. As such, the amount of capitalization is
also the same for both the companies which is assumed to be Rs.1
0,000. However, strategies for raising the capital are different from
each other. Assuming that the required capital can be raised either by
way of equity or debts, following particulars are available

A Ltd. (Rs.) B Ltd. (Rs.)

Equity Share Capital

(Shares of Rs.10/- each) 1,000 9,000

10% Debentures 9,000 1,000


10,000 10,000
Profitability statements of both the companies, when sales are
Rs.20,000 and Rs.18,000 are as below:

A LTD. B LTD.
Rs. Rs.

Sales 20,00 18,000 20,00 18,000


Less: Variable Cost 0 9,000 0 9,000
Contribution 10,00 10,00
Less: Fixed Cost 0 0
Earning before Interest & Tax 10,00 9,000 10,00 9,000
(EBIT) 0 5,000 0 5,000
Less: Interest on Debentures 5,000 5,000
Earning Before Tax (EBT) 5,000 4,000 5,000 4,000
Less: Taxes @ 50% 900 900 100 100
Earning After Tax (EAT) 4,100 3,100 4,900 3,900
2,050 1,550 2,450 1,950
Number of Equity Shares 2,050 1,550 2,450 1,950
Earning per shares 100 100 900 900
20.50 15.50 2.72 2.16

It can be noted from the above example that A Ltd. is able to


earn more amount per equity share because in its capital structure,
the amount of the debentures is more and also because the interest
paid on debentures is tax deductible expenditure and amount of tax is
less in case A Ltd.

It can also be noted from the above example that a 10%


reduction in sales in case of A Ltd. reduces the earnings per share by
around 24% while the same percentage of reduction in sales in case of
B Ltd. reduces the earnings per share by around 20%. It happens so
because the risk of reduction in sales and earnings gets distributed
among less number of equity shares in case of company A Ltd., while
the said risk gets distributed among more number of equity shares in
case of company B Ltd.

The principles which are highlighted by the above example can


be studied under the following headings:

(a) Trading on Equity

(b) Capital Gearing

(c) Leverages
(a) Trading on Equity:
As explained in the above example, the earnings per equity
share can be increased by the use of non-equity or debt capital.
Trading on Equity indicates utilization of non-equity sources of funds in
the overall capital structure of the company in order to increase
earnings available to the equity shareholders. In other words, trading
on equity indicates the use of debt capital in the capital structure of
the company for which the company is required to pay lower rate of
return and which increases the returns available to the equity
shareholders.

Advantages and Disadvantages:


As stated earlier, trading on equity is the best device available to the
company to increase the returns to the equity shareholders. However
the company has to be very very careful while using this device,
otherwise it may prove to be non-profitable. Firstly, if the company can
earn more rate of return by investing the debt capital than the one it is
required to pay on debt capital, then and then only trading on equity
will be profitable. If the rate of return earned by the company by
investing the debt capital is less than the one it is required to pay on
the same, the trading on equity may prove to be fatal to the company.
Secondly, by using the device of trading on equity, the company
accepts the obligation of paying interest as well as repayment of
principal amount inspite of the non-availability of sufficient earnings.
As such, the device of trading on equity may not be suitable device is
in case of the companies having irregular or unstable earnings. Thirdly,
it may so happen that the company is having stable earnings and is
also prepared to accept the risk attached with debt capital. However,
already existing debt component in the existing capital structure may
prohibit the company from borrowing further. Fourthly, the suppliers of
debt capital have limited participation in the company's profits. As
such, they are interested in getting sufficient protection for the money
they are lending to the company. Hence, trading on equity may not be
a suitable device unless the company is having sufficient tangible
assets to offer as security or the company is having Goodwill and credit
standing to attract the lenders of capital. Lastly, unless the
management of the company is mentally prepared to accept the risk
attached with trading on equity, it may not be a success.

(b) Capital Gearing:


As has already been discussed previously, the debt capital is a
cheaper source of capital as compared to the own capital. It is basically
due to two facts.
(a) The expectations of lenders of debt capital of the return on
funds i.e. interest, are comparatively lower.

(b) Interest paid on debt capital is expenditure deductible for


tax purposes.

However, raising of capital in the form of debt capital involves


risk also, as the payment of interest as well as installments is required
to be made irrespective of the profits or losses.
As such while deciding the capital structure of a company, the
ratio of own capital and debt capital has to be decided in such way that
it is economical in terms of cost and it is safe as well. Capital Gearing
indicates the proportion which the various fixed income bearing
securities bear with the total capitalization. The capital gearing ratio
can be computed as:

Fixed Income bearing securities


Total Capital Employed

A company is said to be highly geared if a large portion of its income


goes for the Payment of return to the holders of fixed income bearing
security.

A company is said to be low geared if a small portion of its


income goes for the payment of return to the holders of fixed income
bearing securities.

It should be noted here that the fixed income bearing securities


may be in the form of either preference shares or debentures.

In simple words, a high gear is indicated by proportionately large


issue of preference shares and debentures, whereas low gear is
indicated by proportionately larger issue of equity shares.

(c) Leverages:
In very simple words, the term leverage measures relationship
between two variables. In financial analysis, the term leverage
represents the influence of one financial variable over some other
financial variable. In financial analysis, generally three types of
leverages may be computed.

(1) Operating Leverage

(2) Financial Leverage

(3) Combined Leverage


(1) Operating Leverage:
It measures the effect of change in sales quantity on Earnings
before Interest and Taxes (EBIT)

It is computed as:Sales – Variable Cost (i.e. Contribution)


Earnings before interest and tax

Indications:
A high degree of operating leverage means that the component
of fixed cost is too high in the overall cost structure. A low degree of
operating leverage means that the component of fixed cost is less in
the overall cost structure. In other words, operating leverage measures
the impact of percentage increase or decrease in sales on earnings
before interest and taxes.
E.g. In the example cited above, when sales are Rs.20,000
contribution is Rs.10,000 and earnings before interest and taxes are
Rs.5,000. As such operating leverage can be calculated as:

= Contribution =
Rs.10,000
EBIT Rs.5,000
= 2

It means that every I % increase in contribution will increase the


EBIT by 2% and vice versa. As such, when contribution is Rs.9,000
instead ofRs.1 0,000 i.e. when the contribution is reduced by I 0%, the
EB IT is reduced by 20% i.e. the EB IT will become Rs4,000 instead of
Rs.5,000.

(2) Financial Leverage:


It indicates the firm's ability to use fixed financial charges to
magnify the effects of changes in EBIT on the firm's EPS. It indicates
the extent to which the Earnings per Share (EPS) will be affected with
the change in Earnings before Interest and Tax (EBIT). It is computed
as:

EBIT
EBIT - INTEREST

Indications:
A high degree of financial leverage indicates high use of fixed
income earnings securities in the capital structure of the company. A
low degree of financial leverage indicates less use of fixed income
bearing securities in the capital structure of the company.
E.g. In the example cited above, in case of A Ltd., the EBIT is
Rs.5, 000 and interest on debentures is Rs.900, when sales are Rs.20,
000 whereas in case of B Ltd., the EBIT is Rs.5,000 and interest on
debentures is Rs.100 when sales are Rs.20,000. As such, the degree of
financial leverage can be computed as

EBIT
EBIT – INTEREST

A Ltd. B Ltd.

Financial Leverage = Rs.5,000 = Rs.5,000

Rs.5,000 – Rs.900 Rs.5,000 –


Rs.900

= Rs.5,000 = Rs.5,000
Rs.4,100 Rs.4,900

= 1.22 = 1.02

High degree of financial leverage is supported by the knowledge


of the fact that in the capital structure of A Ltd. 90% is the debt capital
component, whereas in case of B Ltd. 10o/c is the debt capital
component.

It means that in case of A Ltd. every 1 % increase in EBIT will


increase EPS by 1.22o/c and vice versa.

As such, when EBlT is reduced from Rs.5,000 to Rs.4,OOO (i.e.


20% reduction), EPS of A Ltd. gets reduced from Rs.20.50 to RS.15.50
(i.e. 24.40% reduction) and EPS of E Ltd. gets reduced from RS.2.72 to
RS.2.16 (i.e. 20.40% reduction).

Uses of Financial Leverage:


The degree of financial leverage gives an indication regarding
the extent to which EPS may be affected due to every change in EB IT.
As the use of debt capital in the capital structure increases the EPS,
the company may like to use more and more debt capital in its capita
structure by using the financial leverage.

As explained in the example cited above, EPS in case of A Ltd. is


RS.20.50 when sales are Rs.20, 000, as 90% of its capital is debt
capital. But in case of B Ltd. EPS is only RS.2. 72 when sales are Rs.20,
000 as on 10% on its total capital is debt capital. As such, the phrase is
often used that 'financial leverage magnifies both profits and losses'.
However, though financial leverage magnifies the profits as well
as EPS, the use ofdeb1 capital beyond a certain limit will not
necessarily give favorable impact. Use of financial leverage is useful as
long as debt capital costs less than what it earns. It reduces profits or
EPS if it costs more than what it earns. As such, financial leverage also
acts as a guide in setting maximum limit up to which the company
should use the debt capital.

However, the technique of financial leverage suffers from some


limitations.

Limitations:
(1) It ignores implicit cost of debt. It assumes that the use of
debt capital may be useful so long as the company is able to earn
more than the cost of debt i.e. interest. But it is n01 always correct.
Increasing use of the debt capital makes the investment in the
company a risky proposition, as such market price of the shares may
decline, which may not be maximizing shareholders wealth. Before
considering the capital structure, the implicit of debt should be
considered.

(2) It assumes that cost of debt remains constant regardless of


degree leverage which is not true. With every increase in debt capital,
the interest rate goes on increasing due to that increased risk involved
with the same.

(3)Combined Leverage:
The combined effect of operating leverage and financial leverage measures the
impact of charge in contribution on EPS.

It is computed as:
Operating leverage x Financial leverage
= Sales – Variable Cost x EBIT
EBIT EBIT - Interest

= Sales – Variable Cost


EBIT - Interest
E.g. In the example cited above, in case of both A Ltd. and B Ltd.
when sales are Rs.20,000, contribution is Rs.10,000 but earnings after
interest and before tax are Rs.4, I 00 and Rs.4,900 respectively. As
such combined leverage can be computed as:

Sales – Variable Cost (i.e. Contribution)


EBIT - Interest

A Ltd. B Ltd.

= Rs.10,000 = Rs.10,000
Rs.4,000 Rs.4,900

= 2.44 = 2.04

It means that in case of A Ltd. every I % increase in contribution


will increase EPS by 2.44% and vice versa, while in case of B Ltd. every
I % increase in contribution, will increase EPS by 2.04%. As such when
contribution gets reduced from RS.I 0,000 to Rs.9,000 i.e. 10%
reduction, EPS of A Ltd. gets reduced from Rs.20.50 to RS.15.50 (i.e.
24% reduction) and EPS of B Ltd. gets reduced to RS.2.16 (i.e. 20.4%
reduction.)

Indications:
The indications given by the combined effect of operating and
financial leverages may be studied under the following possible
situations.

(1) High Operating Leverage, High Financial Leverage:


It indicates very very risky situation as a slight descrease in sales
and/or contribution may affect the EPS to a very great extent. As far as
possible, this situation should be avoided.

(2) High Operating Leverage, Low Financial Leverage:


It indicates that a slight decrease in sales and/or contribution
may affect EB IT to a very great extent due to existence of high fixed
cost but this possibility is already taken care of by low proportion of
debt capital in the overall capital structure.

(3) Low Operating Leverage, High Financial Leverage:


It indicates that the decrease in sales/contribution will not affect
EBIT to a very great extent as the component of fixed cost is negligible
in the overall cost structure. As such, the company has accepted the
risk of borrowing more debt capital in order to increase EPS to the
maximum possible extent. This may be considered to be an ideal
situation.

(4) Low Operating Leverage, Low Financial Leverage:


It indicates that the decrease in sales/contribution will not affect
EBIT to a very great extent as the component of fixed cost is negligible
in the overall cost structure. But still, the company has not accepted
the risk of having large component of debt capital in its capital
structure. It may indicate very very cautious policy followed by the
management which need not be necessary, as it will not maximize the
shareholders' wealth. At the same time, it may also indicate that the
company is not utilising its borrowing capacity properly and fully.
Theories of Capital Structure
Capital Structure and Cost of Capital

In the previous pages we have seen that the introduction of debt


capital in the capital structure increases the earning per share of
equity shareholders. We have also seen that the introduction of debt
capital increases the risk also which is the risk of insolvency due to
non availability of cash and variability of earnings available to equity
shareholders. As such, increasing the debt component beyond a
certain limit will not increase the earnings per shares. If debt
component crosses a particular limit, the expectations of the lenders of
money also increase due to the risk factor involved. Similarly, the
share holders also will demand a higher rate of return on their
investment to compensate for the risk arising out of additional amount
of debt capital in the capital structure. As such, introduction of a heavy
amount of debt capital in the capital structure will not only reduce the
valuation of the firm but will also increase the cost of capital.
However, this view is not universally accepted. It is not a
accepted principle that the valuation of a firm and its cost of capita I
may be affected by the change in financing mix. Different views have
been expressed in this context. We will categories these views in the
form of following tour theories of capital structure.

(1)Net Income Approach

(2)Net Operating Income Approach

(3)Traditional Approach

(4)Modigliani – Miller Approach

For this purpose, following assumptions have been made.

(1)Firms use only long term debt capital or equity share capital to
raise funds.

(2)Corporate Income Tax does not exist.

(3)Firms follow policy of paying 100% of its earnings by way of


dividend

(4)Operating earnings are not expected to grow.


Following definitions and symbols are also used.

S = Market Value of Equity shares

B = Market Value of Debt

V = Total Market value of firm


NOI = Net Operating Income i.e. EBIT

I = Total Interest Payments

NI = Net Income available to equity shareholders


I.e. EBIT – I

Overall cost of capital = EBIT


V

(a) Net Income Approach:


According to this approach as proposed by Durand, there exists a
direct relationship between the capital structure and valuation of the
firm and cost of capital. By the introduction of additional debt capital in
the capital structure, the valuation of the firm can be increased and
cost of capital can be reduced and vice versa.

To explain the approach more precisely, we will consider the


following example.

50%
Present 50% Increase
Decrease
in Debt in Debt
Position
Capital Capital
Rs. Rs. Rs.
8% Debentures 6,00,000 9,00,000 3,00,000
NOI i.e. EB1T ] ,50,000 ] ,50,000 1,50,000
I 48,000 72,000 24,000
Nl 1,02,000 78,000 1,26,000
Equity Capitalisation
10% 10% 10%
Rate
Market value of
Equity
Shares (S) 10,20,000 7,80,000 12,60,000
Market value of
Debentures (B) 6,00,000 9,00,000 3,00,000

Total value of firm

V = S +B ] 6,20,000 16,80,000 15,60,000


Overall cost of capital 9.26% 8.93% 9.62%

It can be seen from above, that by the increase in debentures,


the total value of the firm increases and cost of capital reduces and
vice versa. However, this will hold good only if the cost of debentures
i.e. rate of interest is less than the equity capitalisation rate.

(b) Net Operating Income Approach:


According to this approach, also proposed by Durand, the
valuation of the firm and its cost of capital is independent of its capital
structure. Any change in the capital structure does not affect the value
of the firm or cost of capital, though the further introduction of debt
capital may increase equity capitalisation rate and vice versa.

To explain the approach more precisely, we will consider the


following example.

50%
Present 50% Increase
Decrease
in Debt in Debt
Position
Capital Capital
Rs. Rs. Rs.
8% Debentures 6,00,000 9,00,000 3,00,000
Overall Capitalisation
10% 10% 10%
Rate
EBlT 1,50,000 1,50,000 1,50,000
Total value of firm (V) 15,00,000 15,00,000 15,00,000
Overall cost of capital 1,50,000 1,50,000 1,50,000
15,00,000 15,00,000 \5,00,000

EBlT/V 10% 10% 10%


Market value of
Debentures (B) 6,00,000 9,00,000 3,00,000

Market value of Equity


shares (S) i.e. V - B 9,00,000 6,00,000 12,00,000

I 48,000 72,000 24,000

Equity Capitalisation
Rate
EBIT - I 1,02,000 78,000 ] ,02,000
V-B 9,00,000 6,00,000 9,00,000
11.3% 13% 10.5%

It can be seen from the above that the market value of the firm
remains unaffected by change in the capital structure. However, the
introduction of additional debentures increases the equity
capitalisation rate and vice versa.

(c) Traditional Approach:


This is the mean between two extreme approaches of net income
approach on one hand and net operating income on another. It
believes the existence of what may be called "Optimal Capital
Structure". It believes that up to a certain point, additional introduction
of debt capital, inspite of increase in cost of debt capital and equity
capitalisation rate individually, the overall cost of capital will reduce
and total value of the firm will increase. Beyond the point, the overall
cost of capital will tend to rise and total value of the firm will tend to
reduce. Thus, by judicious mix of debt and equity capital, it is possible
for the firm to minimize overall cost of capital and maximize total value
of the firm. Such a capital structure where overall cost of capital is
minimum and total value of the firm is maximum is called "Optimal
Capital Structure".

To explain this approach, more precisely, we will consider the


following example.

8%
No Debt 5% Debentures
Debentures
. Rs. 3,00,000 Rs.6,00,000

EBIT 1,50,000 1,50,000 1,50,000


Less:

Interest on
-- 15,000 48,000
debentures

NI 1,50,000 1,35,000 1,02,000'


Cost of Equity
10% 11% 12%
Capital
Market value of
Equity
Shares (S) 15,00,000 12,27,273 8,50,000
Market value of
Debentures (B) -- 3,00,000 6,00,000
Total value of firm
i.e. V = S + B 15,00,000 15,27,273 14,50,000

Overall capital cost

10%
I.e. EBIT 9.82% 10.34%
V
It can be seen from the above that neither the no-debentures
position nor the position where debentures are issued to the extent
ofRs.6, 00,000 minimize the overall cost of capital or maximize the
total value of the firm. It is when debentures are issued to the extent of
Rs.3, 00, 000 that the overall cost of capital is minimum and total
value of the firm is maximum, hence that is the Optimal Capital
Structure.

(d) Modigliani - Miller (M and M) Approach:


This approach closely resembles net operating income approach.
According to this approach, value of the firm and its cost of capital are
independent of its capital structure. It argues that overall cost of
capital is the weighted average of cost of debt capital and cost of
equity capital. Cost of equity capital depends upon shareholders'
expectations. Now, if shareholders expect 10% from a certain
company, they already take into consideration debt capital in the
capital structure. For every increase in debt capital, the expectations of
the shareholders also increase as in the eyes of shareholders, risk in
the company also increases. Thus, each change in the mix of debt
capital and equity capital is automatically offset by change in the
expectations of shareholders which in turn is attributable to change in
risk element. As such, they argue that, leverage i.e. mix in debt capital
and equity capital, has nothing to do with overall cost of capital and
overall cost of capital is equal to the capitalization rate of pure
equity stream of a risk class. Hence, leverage has no impact on share
market prices or cost of capital.
Empirical Determinants - Capital Structure

Most of the empirical works on capital structure, both abroad and


in India using multiple regressions with proxies for the unobservable
theoretical attributes, are marked by many limitations. Though unique
representations are not ruled out for many attributes, often more than
one proxy explains a particular attribute. It is also plausible that a
proxy may radiate information relating to many attributes. In the
absence of well-defined guidelines, financial economists are
constrained to include in their econometric models only those proxies
that work well in terms of Goodness of fit criterion. Besides the
selectivity bias in the collection of data, the presence of dubious
correlations among the chosen variables, often renders the estimated
coefficients spurious. Not withstanding these limitations, regression
analyses on capital structure do shed light on the influence of certain
variables, and their inter-relationships in arriving at a near-optimal
capital structure.

BALAI and MASULIS, JENSEN and MACKLING and MYERS


postulate a direct kinship between the debt equity ratio of a firm and
the collateralization of its debt. Since all projects are seldom
collateralized, firms often go in for equity finance rather than borrowed
capital. MYERS and MAJLUF observed that the issue of debt
buttressed by assets with known values, do away with the costs
associated with the issue of new shares3. SCOTT believes that a firm
can maximize the value of its equity by disposing secured debts to
unsecured creditors. GROSMEN and HART believe that at a higher
debt level a firm that is exposed to the threat of bankruptcy is
burdened with rising agency costs. This cripples its ability to garner
additional funds. The collateral value attribute is captured by the ratio
of intangible assets to total assets, and the ratio of inventory (plus
gross plant and equipment in money terms) to total assets. The first
ratio is negatively related to the collateral value of assets while the
second is positively related to it4.

DE ANGELO and MASULIS argue that enterprises with large tax


benefits relative to their expected cash inflows, prefer less debt in their
capital structure5. When a levered firm prospers, owing to its
increasing agency costs, its growth will have a negative relationship
with the long term debt. To mitigate the effect of bulging agency costs,
when enterprises mobilize short term debts, growth will cultivate a
positive relationship with it. Convertible debentures can also cut
agency costs to size. Hence growth will assume a direct relationship
with convertible debt ratios. Capital expenditure to total assets, and
the increase in total assets measured by its percentage change, can
also be indicators of growth. Since progressive enterprises earmark
more funds for R&D to innovate and generate new investment
opportunities, the ratio of the above to sales too can be a proxy for
growth6.

TITMAN concludes that firms manufacturing specialized products to


meet the specific needs of the customers normally go for equity
financing. In such cases a negative relationship between equity and
debt is plausible. In certain empirical studies the ratios of selling
expenses to sales and R&D to sales are treated as proxies for
uniqueness of a firm. WARNER, AUG, CHUA and MCCONNELL
observe that larger firms with greater degree of diversification are less
prone to bankruptcy and liquidation. Such firms are hence highly-
levered. The size of a firm is often gauged by the natural log of sales.
Some financial analysts believe that the optimum debt level is a
decreasing function of the volatility of earnings. Such firms prefer more
equity and less debt. The Standard Deviation of the percentage of
change in operating income can capture this attribute7.

MYERS and BREALE give more prominence to retained earning as a


source of capital structure. When debt level is low at higher
profitability, promising firms rely more on equity and less on debt for
their expansion and diversification, since they can easily mobilize
equity funds on attractive terms. Even debt on a massive scale with
soft terms can knock at their doors. The relationship between
profitability and debt hence can be both direct as well as indirect.
Profitability is measured by the ratio of operating income to sales, and
operating income to assets8. Thus determinants of capital structure of
a firm are governed by a myriad of factors which make the
identification of optimal capital structure an uphill task.
Bibliography:

a) Principles of Financial Management – Satish M. Inamdar

b) http://www.maharishiinstituteofmanagement.com/articles-mp-
tsmoha.htm

c) Capital Structure of SAFLOW Products Pvt. Ltd.