CAPITAL STRUCTURE

Capital Structure Defined

 The term capital structure is used to represent the proportionate

relationship between debt and equity.
 The various means of financing represent the financial structure
of an enterprise. The left-hand side of the balance sheet
(liabilities plus equity) represents the financial structure of a
company. Traditionally, short-term borrowings are excluded
from the list of methods of financing the firm’s capital
expenditure.

Features of An Appropriate Capital Structure

 Capital structure is that capital structure at that level of debt –

equity proportion where the market value per share is maximum
and the cost of capital is minimum.
Appropriate capital structure should have the following features
 Profitability / Return
 Solvency / Risk
 Flexibility
 Conservation / Capacity
 Control

Determinants of Capital Structure

 Seasonal Variations
 Tax benefit of Debt
 Flexibility
 Control
 Industry Leverage Ratios
 Agency Costs
 Industry Life Cycle
 Degree of Competition
 Company Characteristics
  Requirements of Investors
 Timing of Public Issue
 Legal Requirements

Debt-equity Mix and the Value of the Firm

 Capital structure theories:

 Net operating income (NOI) approach.
 Traditional approach and Net income (NI) approach.
 MM hypothesis with and without corporate tax.
 Miller’s hypothesis with corporate and personal taxes.
 Trade-off theory: costs and benefits of leverage.

Assumption of Capital Structure Theories.

There are only two sources of funds i.e.: debt and equity.
 The total assets of the company are given and do no change.
 The total financing remains constant. The firm can change the
degree of leverage either by selling the shares and retiring debt
or by issuing debt and redeeming equity.
 Operating profits (EBIT) are not expected to grow.
 All the investors are assumed to have the same expectation
about the future profits.
 Business risk is constant over time and assumed to be
independent of its capital structure and financial risk.
 Corporate tax does not exit.
 The company has infinite life.
 Dividend payout ratio = 100%.

Net Income (NI) Approach

 According to NI approach
 both the cost of debt and the cost of equity are independent of
the capital structure; they remain constant regardless of how
much debt the firm uses. As a result, the overall cost of capital
declines and the firm value increases with debt.
  This approach
C ost
has no basis in reality; the optimum capital
structure would be 100 per cent debt financing under NI
approach.

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Net Operating Income (NOI) Approach

 According to NOI approach the value of the firm and the

weighted average cost of capital are independent of the firm’s
capital structure.
 In the absence of taxes, an individual holding all the debt and
equity securities will receive the same cash flows regardless of
the capital structure and therefore, value of the company is the
same.

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MM Approach Without Tax: Proposition I

 MM’s Proposition I states that the firm’s value is independent of

its capital structure. With personal leverage, shareholders can
receive exactly the same return, with the same risk, from a
levered firm and an unlevered firm. Thus, they will sell shares of
the over-priced firm and buy shares of the under-priced firm
until the two values equate. This is called arbitrage.

A capital-structure arbitrageur seeks opportunities created by

differential pricing of various instruments issued by one
corporation. Consider, for example, traditional bonds and
convertible bonds. The latter are bonds that are, under
contracted-for conditions, convertible into shares of equity. The
stock-option component of a convertible bond has a calculable
value in itself. The value of the whole instrument should be the
value of the traditional bonds plus the extra value of the option
feature. If the spread (the difference between the convertible
and the non-convertible bonds) grows excessively, then the
capital-structure arbitrageur will bet that it will converge.

MM’s Proposition II

 The cost of equity for a levered firm equals the constant overall
cost of capital plus a risk premium that equals the spread
between the overall cost of capital and the cost of debt
multiplied by the firm’s debt-equity ratio. For financial leverage
to be irrelevant, the overall cost of capital must remain
constant, regardless of the amount of debt employed. This
implies that the cost of equity must rise as financial risk
increases.
MM Hypothesis With Corporate Tax

 Under current laws in most countries, debt has an

important advantage over equity: interest payments on
debt are tax deductible, whereas dividend payments and
retained earnings are not. Investors in a levered firm
receive in the aggregate the unlevered cash flow plus an
amount equal to the tax deduction on interest.
Capitalising the first component of cash flow at the all-
equity rate and the second at the cost of debt shows that
the value of the levered firm is equal to the value of the
unlevered firm plus the interest tax shield which is tax rate
times the debt (if the shield is fully usable).
 It is assumed that the firm will borrow the same amount of
debt in perpetuity and will always be able to use the tax
shield. Also, it ignores bankruptcy and agency costs.
Capital structure in the real world
If capital structure is irrelevant in a perfect market, then imperfections
which exist in the real world must be the cause of its relevance. The
theories below try to address some of these imperfections, by
relaxing assumptions made in the M&M model.

Trade-Off Theory of Capital Structure

The Trade-Off Theory of Capital Structure refers to the idea that a
company chooses how much debt finance and how much equity
finance to use by balancing the costs and benefits. The classical
version of the hypothesis goes back to Kraus and Litzenberger who
considered a balance between the dead-weight costs of bankruptcy
and the tax saving benefits of debt. Often agency costs are also
included in the balance. This theory is often set up as a competitor
theory to the Pecking Order Theory of Capital Structure An important
purpose of the theory is to explain the fact that corporations usually
are financed partly with debt and partly with equity. It states that there
is an advantage to financing with debt, the tax benefits of debt and
there is a cost of financing with debt, the costs of financial distress
including bankruptcy costs of debt and non-bankruptcy costs (e.g.
staff leaving, suppliers demanding disadvantageous payment terms,
bondholder/stockholder infighting, etc). The marginal benefit of further
increases in debt declines as debt increases, while the marginal cost
increases, so that a firm that is optimizing its overall value will focus
on this trade-off when choosing how much debt and equity to use for
financing.
Pecking Order Theory
In the theory of firm's capital structure and financing decisions, the
Pecking Order Theory or Pecking Order Model was developed by
Stewart C. Myers and Nicolas Majluf in 1984. It states that
companies prioritize their sources of financing (from internal
financing to equity) according to the Principle of least effort, or of
least resistance, preferring to raise equity as a financing means of
last resort. Hence, internal funds are used first, and when that is
depleted, debt is issued, and when it is not sensible to issue any
more debt, equity is issued.

Agency Costs
There are three types of agency costs which can help explain the
relevance of capital structure.
• Asset substitution effect: As D/E increases, management has
an increased incentive to undertake risky (even negative NPV)
projects. This is because if the project is successful, share
holders get all the upside, whereas if it is unsuccessful, debt
holders get all the downside. If the projects are undertaken,
there is a chance of firm value decreasing and a wealth transfer
from debt holders to share holders.
• Underinvestment problem: If debt is risky (e.g., in a growth
company), the gain from the project will accrue to debtholders
rather than shareholders. Thus, management have an incentive
to reject positive NPV projects, even though they have the
potential to increase firm value.
• Free cash flow: unless free cash flow is given back to
investors, management has an incentive to destroy firm value
through empire building and perks etc. Increasing leverage
imposes financial discipline on management.
Objective
The objective of this project is to understand the relevance and the
applicability of the importance of capital structure in real economic
environment ,for that we have considered real time ex-post financial
data of three sectors and 3 different companies with in each sector as
to determine if capital structure differs from one industry to another
and within the industry if there are any trends that differentiate one
company from another in their capital build up resources.
For the purpose of undertaking our study we have considered three
important sectors of economy which reflect the dynamics of the
economy to a certain extent.
These sectors are
Automobile Industry
Telecom Industry
Infrastructure Industry

With in these three sectors we have taken 3 different companies

operating in the same environment and try to analyse the capital
made up of these companies within the sector first and then make
conclusions for the respective sectors and make comparisons with
different sectors there after.
For this purpose we will consider different variables that will help us in
establish the basis for the study. The variables that we consider to
analyse the impact and relevance of different aspects in capital
structure decision are

WD= weight of Debt

WE= weight of owners capital(equity+ Reserves & Surplus)
RE= cost of Equity
RD= Cost of Raising Debt
Rf= Risk free rate of return
BETA= Systematic Risk of a security
WACC=Total cost of capital
Tax Shield
Free Cash Flows
Dividend Payout
 A) AUTOMOBILE SECTOR
Automobile industry is a very capital intensive and heavy capital
investment industry. So devising a proper capital structure policy and
sources of funds become very critical to the overall cost of capital for
the company. All the above mentioned variables will help us in
establishing if at all they affect the existing capital structure of the
company depending upon their future requirements.
Three companies that we have considered in the automobile sector
represent the passenger vehicle , commercial vehicles and two
wheeler segments of the automobile industry.
These three companies are
Maruti Suzuki Ind. Ltd.
Mahindra & Mahindra
Hero Honda
We have considered the past data of the past 3 financial years of
each of these companies and calculated their WACC, Free Cash
Flows and Tax Shield and overviewed some essential Ratios year on
year to come some conclusion that justifies the relevance of Capital
Structure theory in the practical world of Finance.
Table 1
Beta and Security Return
Company\Year 2007-08 beta/ 2008-09 2009-10
Return
Maruti Suzuki 0.6719/0.064 0.7011/0.030 0.6932/0.266
8 3 5

M&M 0.7353/0.016 0.9587/- 1.0486/0.255

5 0.1331 7

Hero Honda 0.4743/0.054 0.3324/0.198 0.6310/0.280

8 5 6

Market Return 0.109305 -0.15753 0.25295

From the above table we can interpret that for Maruti Suzuki and
Hero Honda the beta is less than that of Mahindra and Mahindra,
M&M stock returns over the 3 year period are almost similar to that of
the market. In case of Maruti and HH who are in the maturity stage of
their Business Life Cycle have initially lower return in the year 2007-
08 but during recession 2008-09 have given positive return where as
the market gave negative returns on index and have given above the
benchmark return in the Year 2009-10.
Table 2
Cost of Equity and Debt

Company\Year 2007-08 2008-09 2009-10

Maruti Suzuki Re=0.0983 Re=0.0692 Re=0.1998
Rd=0.0662 Rd= 0.0729 Rd=0.0431

M&M Re=0.1014 Re=0.0692 Re=0.2613

Rd=0.0338 Rd=0.033 Rd=0.0544

Hero Honda Re=0.0936 Re=0.0692 Re=0.1891

Rd=0.102 Rd=0.1661 Rd=0.1687

Table 3
Debt and Equity (By Weight)

Company\Year 2007-08(D/E) 2008-09 2009-10

Maruti Suzuki 0.0966/0.903 0.0695/0.930 0.0648/0.935
3 4 1

0.1346/0.8653 0.4365/0.563 0.2691/0.730

M&M
4 8
Hero Honda 0.042/0.9576 0.023/0.9797 0.0187/0.981
3

Table 4
WACC From the Period 2007 till 2010

Company\Year 2007-08 2008-09 2009-10

Maruti Suzuki 0.093181279 0.068101883 0.18881323

M&M 0.072977889 0.050934117 0.201695586

Hero Honda 0.092519863 0.070490572 0.188012157

From Table 2 and Table 3 we can see that during the Year 2007-08
Both HH and MS have been able to provide Greater rate of return to
their investors as compared to M&M where the CoC is almost equal
to the RF rate of return and the D/E weights are very high as
compared to that of MS and HH.MS and HH are almost equity funded
with very little exposure to Debt.
Coming out of the recession period both MS and HH have been able
to keep their CoC at similar levels of around 18% where as M&M
have a higher CoC primarily due to its high Cost of Equity but as they
have a major Debt component M&M have been able to drag the
overall CoC to lower levels.
For MS and HH the overall CoC is almost equal to the Cost of Equity
as the weight of Debt to the over all source of capital is significantly
low and they have not been able to lower the over cost of capital coz
the debt is raised at high Cost which nullifies any chances of the
lowering the CoC due to introduction of Debt to the capital Structure.

Table 5
Free Cash Flows
Company\Year 2007-08 2008-09 2009-10
Maruti Suzuki -1,159.20 1,989.30 1,568.40

M&M -452.60 -487.45 997.90

Hero Honda 318.55 596.80 2,544.10

Table 6
Tax Shield
Company\Year 2007-08 2008-09 2009-10
Maruti Suzuki 19.11372 13.7598 10.4855

M&M 22.2391 22.98817 42.39656

Hero Honda 4.645803 3.906784 2.531008

Table 5 and Table 6 also highlight the fact that MS and HH have been
able to meet its capex requirements from its internal resources but
have raised very little Debt to meet their capital requirements even if
it comes at a higher cost. Whereas in case of M&M have resorted to
infusing Debt in order to meet its Capital requirement and also
bringing the overall CoC lower as its Cost of Equity is quite High as
compared to its industry contemporaries.

From the above interpreted data it can be concluded that of the three
companies operating in the automobile sector the two companies
who have been able to optimize their production and resource
utilization , have not exposed themselves to the advantage of
Financial Leverage.
Which actually defies the premises of the bringing the Total Cost of
Capital by introducing Debt with the acceptable levels of Debt into the
capital Structure.

Also considering that all these companies have been paying

Dividends regularly to its share holders and have a consistent payout
ratios and in case of M&M the tax shield provide a large cushion for
the shareholders as against the case of MS and HH shareholders as
they are not able to take much benefit out of the Tax Shield.
 B)Telecom
Telecom sector in India is in the growth phase of its Business life
cycle and has a huge potential to tap further growth opportunities. We
will see what sort of capital structure policies these companies
believe in order to meet their Capital requirements
The companies we have considered in this sector are
Airtel
Idea
RCOM
These three companies encompass the different stages of growth in
the telecom sector. While Airtel is the first Mobile service Provider in
India, Idea was earlier Birla Tatan At&T and was taken over by Aditya
Birla Group , it started the consolidation phase in the Telecom sector
where as Rcom entered the Indian Mobile Service with CDMA
technology with cheap fares and then diversified into GSM operator
and also has a subsidiary in the form of Tower business.
Major capital expenditure areas for telecom industry have been in
setting up Network Coverage Areas and acquiring Spectrum from the
Govt. And with the 3G services being launched in INDIA, Telecom
Mojors paid around RS.1.2 lakh crore to Govt. of India for the
spectrum which has put pressure on its profits and existing capital
structure.
Table 1
Beta and Security Return
Company\Year 2007-08 beta/ 2008-09 2009-10
Return
Airtel 0.7930/0.081 0.8765/- 0.7545/-
6 0.0511 0.1654

Idea 0.8044/0.085 1.0120/- 1.0956/0.161

6 0.2108 8

RCOM 1.2010/0.141 1.4156/- 1.3320/0.039

1 0.3167 8

Market Return 0.109305 -0.15753 0.25295

Table 2
Cost of Equity and Debt
Company\Year 2007-08 2008-09 2009-10
Airtel Re=0.1023 Re=0.0598 Re=0.2104
Rd=0.0598 Rd=0.0563 Rd=0.0451
Idea Re=0.1034 Re=0.06922 Re=0.269497
094
Rd=0.1068 Rd=0.1592
Rd=0.1505

RCOM Re=0.115280 Re=0.06922 Re=0.3104

584

Rd=0.0373 Rd=0.0512
Rd=0.0429

Table 3
Debt and Equity (By Weight)

Company\Year 2007-08(D/E) 2008-09 2009-10

Airtel 0.245/0.7549 0.2182/0.078 0.1206/0.879
18 4

Idea 0.6475/0.352 0.4016/0.598 0.3629/0.637

5 4 1

RCOM 0.4495/0.550 0.3742/0.625 0.3247/0.675

5 8 3

Table 4
WACC From the Period 2007 till 2010

Company\Year 2007-08 2008-09 2009-10

Airtel 0.090645278 0.017285972 0.190217758

Idea 0.100662742 0.099326924 0.219682612

RCOM 0.075039805 0.0499031 0.123173651

From the above 4 tables we can interpret that though Rcom has a
very high Cost of Equity but the overall CoC for Rcom is very
reasonable and it can be inferred from the fact that Rcom has a good
mix of Debt and Equity in their Capital Structure . the same situation
can be inferred for Idea as well but the cost of Raising Debt for Idea
is on a higher side than that of RCOM, where RCOM is being
competitive in bringing its Total Cost of Capital to around 12.3% as
compared to Airtlel’s 19% and Idea’s 21.9% in the Financial Yr 2009-
10.
One important thing that must be observed that while keeping ist over
all cost of capital at reasonal levels, Rcom has been bringing its Debt
to Equity Ratio to more conventional numbers as any further
introduction of Debt can raise issue of insolvency .
Both RCom and Airtel have been able to raise their Debt at very
competitive rates which has not been the case with Idea and that has
contributed to a high Cost of Capital .

Also where RCOM has gained advantage is that for new projects and
capex , it has used internal sources of fund as against Airtel and Idea
as both of them have diluted their equity to raise new capital.
Table 5
Free Cash Flows
Company\Year 2007-08 2008-09 2009-10
Airtel -700.89 13,776.19 9,757.24

Idea 2,135.34 -702.24 4,071.06

RCOM -7,305.64 -1,883.32 -3,635.51

Table 6
Tax Shield
Company\Year 2007-08 2008-09 2009-10
Airtel 34.97593 14.50094 15.92427

Idea 50.03162 113.7588 119.2682

RCOM 347.672 609.1414 7773.808

From the above two tables we can infer that Rcom has been able to
put the advantage of raising Debt and its Tax shield to provide its
share holders with an increasing Dividends over the period under
study .
 C) Infrastructure Industry
Infrastructure sector has been identified as the emerging sector
in the economy where the progress has been very slow and the
scope of growth is the way forward for the economy. The
demand for basic infrastructure in the rail transportation , road
highways and airport infrastructure is growing and the Govt.
has undertaken various Mega Projects to build nation’s
infrastructure on war footing and this policy provides a Golden
opportunity for the Companies in the Infrastructure sphere to
ride on and be the leaders in the industry
The companies which we have considered for studying the Capital
structure are
GMR
GVK
Reliance Infrastructure Ltd.
Profiling these companies brings out the fact that these are the few
companies who have undertaken major public infrastructure projects .
Table 1
Beta and Security Return
Company\Year 2007-08 beta/ 2008-09 2009-10
Return
GMR 1.3295/0.069 1.0744/- 1.1679/-
8 0.0719 0.0557

GVK 0.9598/- 1.0697/- 1.2894/0.315

0.2294 0.0659 7

Reliance Infra 1.6808/0.486 1.6817/- 1.3982/0.305

3 0.2256 4

Market Return 0.109305 -0.15753 0.25295

Table 2
Cost of Equity and Debt
Company\Year 2007-08 2008-09 2009-10
GMR Re=0.1190 Re=0.0692 Re=0.2820
Rd=0.0529 Rd=0.0566 Rd=0.0275

GVK Re=0.1081 Re=0.0692 Re=0.3030

Rd=0 Rd=0 Rd=0.015
Reliance Infra Re=0.1295 Re=0.0692 Re=0.3218
Rd=0.0427 Rd=0.0616 Rd=0.0451

Table 3
Debt and Equity (By Weight)

Company\Year 2007-08(D/E) 2008-09 2009-10

GMR 0.0787/0.921 0.0686/0.931 0.306/0.6939
2 3

GVK 0/1 0/1 0.039/0.9609

Reliance Infra 0.404/0.5959 0.312/0.6879 0.3931/0.606

8

Table 4
WACC

Company\Year 2007-08 2008-09 2009-10

GMR 0.113691797 0.06810778 0.203467828

GVK 0.108113282 0.06922 0.291616824

Reliance Infra 0.091441467 0.062695822 0.210329321

The first 4 tables which give out the basic information about the
Capital structure of the three companies in the Infrastructure sector
and the inference can be made that the where GMR and Reliance
Infra score over GVK is the substantial Debt component in their
Capital structure.
Raising Equity come at a high cost for the industry but the Debt can
be raised at a very competitive cost and a good mix of Debt and
Equity eventually brings down the overall Cost of Capital for the
Companies.
The reason for a high cost of equity in the industry can be attributed
to the past performance of the industry and the regular delays in the
implementation and execution of the proposed projects and
bottlenecks that the industry faces in the form of regulations and
restrictions. Also the debt can be collateralised again the property so
it come as a much cheaper rates.
It is where both GMR and Relaince infra score in framing theri capital
structure. Debt forms a 40 % of the total capital at the present stage
and that is adding to the projects viability .
Table 5
Free Cash Flows
Company\Year 2007-08 2008-09 2009-10
GMR -4,185.63 1,571.64 -2,130.36

GVK -855.74 475.84 -275.74

Reliance Infra -2,077.60 -8,812.08 -5,737.37

Table 6
Tax Shield
Company\Year 2007-08 2008-09 2009-10
GMR 1.123891 1.467843 1.123891

GVK 0.575014 0.044436 0.4032

Reliance Infra 43.53065 66.5069 50.5004

Table 5 and 6 gives us insight into the free cash flow position of the
companies and we can deduct from the balance sheet and ratio
analysis of the 3 companies that Reliance Infra has actually bought
back some shares signalling a positive trend for its future prospects
and have raised new loans to meet the requirements and have
passed on the benefit of the Tax Shield to the share holders by
regularly declaring Dividends.
On the other hand GVK has restrained itself from introducing any
substantial debt into their Capital Structure , where as GMR has
issues equity and borrowed funds for its future projects .
With no dividend policy as of now both GMR and GVK consider
themselves as growth Firms and would like to reward its shareholders
by maximizing their wealth in the long run rather than pass on any
free cash until they have resources and projects for positive NPV
projects.
Conclusion

By comparing the companies within their sector we can infer that

there is no particular trend that I being followed by any particular
industry when it comes to raising capital and deciding upon the
Capital Structure.
Companies within the industry also have their own unique policy to
raise capital with no co relation to what the other counterpart is doing
but the only reason to alter the capital structure is the cost of
individual source of capital.
Equity being costly than Debt, companies who require major capital
expenditure and for other expenses resort to debt financing in order
to bring down with Total Cost of capital.

It is the policy of some companies to make sure that along with their
future project funding requirement they distribute some amount to
their shareholders as dividends and don’t alter their existing dividend
policy as in the case of Reliance ADA group companies operating in
two different sectors namely RCOM in Telecom and Reliance Infra in
Infrastructure industry.

While mature companies who are able to meet their capex

requirements from their internal sources have not resorted to much of
debt into their capital structure and along with Positive Project
executions have been following a regular dividend policy as in case of
Maruti Suzuki and Hero Honda in the Auto industry.

Finally concluding that though an optimum level of Debt will always

help to bring the Cost of Capital for firms to set realistic targets but in
case the companies are sure about their future cash flows , they will
most likely to depend on internal sources of financing rather than
going for Debt inclusion and that doesn’t mean that these companies
are not competent , but in fact they are the market leaders of their
respective industries like in case of Maruti Suzuki and Hero Honda.

Bibliography

http://economictimes.indiatimes.com/markets/

http://en.wikipedia.org/wiki/Capital_structure

Corporate Finance Ross Westerfield Jaffe 7th edition Chapter 15 and

16.