A Project

On
“Study of Capital Structure management”

Under the guidance Of

Mahender Sir

_________________________

Submitted by
JITESH JIKU
Roll No.520945372
__________________________

in partial fulfillment o f the requirement

for the award of the degree Of MASTER OF BUSINESS ADMINISTRATION
in Finance.

May-2011
 Acknowledgement

Firstly I would like to thank NDPL for giving the opportunity to complete my
project in the organization. I put on record my sincere thanks to Mahender sir for
his suggestions and advice. I am extremely grateful to Mamta madam for the
encouragement, discussions and critical assessment of the project.

It was a good experience for me to work with North Delhi Power Limited, a
pioneer in the field of power distribution. I am greatly obliged to Ms. Pooja and
Mr. Vineet Kumar who have shared their expertise and knowledge with me
without which the completion of project would not have been possible

2
 Bonafide Certificate:

BONAFIDE CERTIFICATE

Certified that this project report titled “Study of Capital Structure management”

is the bonafide work of “JITESH JIKU” who carried out the project work under

my supervision.

SIGNATURE SIGNATURE

HEAD OF THE DEPARTMENT FACULTY IN

CHARGE
<Academic Designation>
<Department> <Department>

3
<<Full address of the Dept & College >> Full address of the
Dept & College >

FUND FLOW AND CAPITAL

STRUCTURE

Project made by:

JITESH JIKU

4
 Financial Management

Management of funds is a critical aspect of financial management. Management

of funds acts as the foremost concern whether it is in a business undertaking or in
an educational institution. Financial management, which is simply meant dealing
with management of money matters.
By Financial Management we mean efficient use of economic
resources namely capital funds. Financial management is concerned with the
managerial decisions that result in the acquisition and financing of short term and
long term credits for the firm. Here it deals with the situations that require
selection of specific assets, or a combination of assets and the selection of
specific problem of size and growth of an enterprise. Herein the analysis deals
with the expected inflows and outflows of funds and their effect on managerial
objectives. In short, Financial Management deals with Procurement of funds and
their effective utilization in the business.
So the analysis simply states two main aspects of financial
management like procurement of funds and an effective use of funds to achieve
business objectives.

Procurement of funds:
As funds can be procured from multiple sources so procurement of funds is
considered an important problem of business concerns. Funds obtained from
different sources have different characteristics in terms of potential risk, cost and
control.
Funds issued by the issue of equity shares are the best from risk point of view for
the company as there is no question of repayment of equity capital except when
the company is liquidated.
From the cost point of view equity capital is the most expensive
source of funds as dividend expectations of shareholders are normally higher than
that of prevailing interest rates.

5
 Financial management constitutes risk, cost and control. The
cost of funds should be at minimum for a proper balancing of risk and control.
In the globalised competitive scenario, mobilization of funds
plays a very significant role. Funds can be raised either through the domestic
market or from abroad. Foreign Direct Investment (FDI) as well as Foreign
Institutional Investors (FII) is two major sources of raising funds. The mechanism
of procurement of funds has to be modified in the light of requirements of foreign
investors.

Utilization of Funds:
Effective utilization of funds as an important aspect of financial management
avoids the situations where funds are either kept idle or proper uses are not being
made. Funds procured involve a certain cost and risk. If the funds are not used
properly then running business will be too difficult. In case of dividend decisions
we also consider this. So it is crucial to employ the funds properly and profitably.

Scope of Financial Management

Sound financial management is essential in all types of organizations whether it
be profit or non-profit. Financial management is essential in a planned Economy
as well as in a capitalist set-up as it involves efficient use of the resources.
From time to time it is observed that many firms have been
liquidated not because their technology was obsolete or because their products
were not in demand or their labor was not skilled and motivated, but that there
was a mismanagement of financial affairs. Even in a boom period, when a
company make high profits there is also a fear of liquidation because of bad
financial management.
Financial management optimizes the output from the given
input of funds. In a country like India where resources are scarce and the demand
for funds are many, the need of proper financial management is required. In case
of newly started companies with a high growth rate it is more important to have
sound financial management since finance alone guarantees their survival.
Financial management is very important in case of non-profit
organizations, which do not pay adequate attentions to financial management.
However a sound system of financial management has to be
cultivated among bureaucrats, administrators, engineers, educationalists and
public at a large.
Objectives of Financial Management
6
Efficient Financial management requires the existence of some objectives, which
are as follows
1) Profit Maximization:
The objective of financial management is the same as the objective of a company
which is to earn profit. But profit maximization alone cannot be the sole objective
of a company. It is a limited objective. If profits are given undue importance then
problems may arise as discussed below.

The term profit is vague and it involves much more contradictions.

Profit maximization must be attempted with a realization of risks involved. A
positive relationship exists between risk and profits. So both risk and profit
objectives should be balanced.
Profit Maximization fails to take into account the time pattern of returns.
Profit maximization does not take into account the social considerations.

2) Wealth Maximization:
It is commonly understood that the objective of a firm is to maximize value and
wealth.
The value of a firm is represented by the market price of the
company's stock. The market price of a firm's stock represents the assessment of
all market participants as to what the value of the particular firm is. It takes in to
account present and prospective future earnings per share, the timing and risk of
these earning, the dividend policy of the firm and many other factors that bear
upon the market price of the stock. Market price acts as the performance index or
report card of the firm's progress and potential.
Prices in the share markets are affected by many factors like
general economic outlook, outlook of the particular company, technical factors
and even mass psychology. Normally this value is a function of two factors:

The anticipated rate of earnings per share of the company

The capitalization rate.

The likely rate of earnings per shares depends upon the assessment of how
profitable a company may be in the future.
The capitalization rate reflects the liking of the investors for the company.

Methods of Financial Management:

7
In the field of financing there are multiple methods to procure funds. Funds may
be obtained from long term sources as well as from short term sources. Long term
funds may be procured by owners that are shareholders, lenders by issuing
debentures, from financial institutions, banks and the general public at large.
Short term funds may be availed from commercial banks, public deposits, etc.
Financial leverage or trading on equity is an important method by which a finance
manager may increase the return to common shareholders.

At the time of evaluating capital expenditure projects methods like average rate
of return, pay back, internal rate of returns, net present value and profitability
index are used. A firm can increase its profitability without adversely affecting its
liquidity by an efficient utilization of the current resources at the disposal of the
firm. A firm can increase its profitability without negatively affecting its liquidity
by efficient management of working capital.
Similarly, for the evaluation of a firm's performance there are
different methods. Ratio analysis is a common technique to evaluate different
aspects of a firm. An investor takes in to account various ratios to know whether
investment in a particular company will be profitable or not. These ratios enable
him to judge the profitability, solvency, and liquidity growth aspect of the firm.

What is Financial Management?

Financial Management can be defined as:
The management of the finances of a business/organization in order to achieve
financial objectives
Taking a business as the most common structure, the key objectives of financial
management would be to:
• Create wealth for the business
• Generate cash, and
• Provide a return on investment keeping in mind the risks that the business is
taking and the resources invested
There are three primary elements to the process of financial management:

(1) Financial Planning

Management need to ensure that sufficient funding is available to meet the needs
of the business. In the short term, funding may be needed to invest in equipment
and stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be needed for significant
additions to the productive capacity of the business or to facilitate acquisitions.
8
(2) Financial Control
Financial control is a critically important activity to help the business ensure that
said business is meeting its goals. Financial control addresses questions such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Does management act in the best interest of the shareholders and in accordance
with business rules?

(3) Financial Decision Making

The primary aspects of financial decision making relate to investment, financing
and dividends:
• Investments must be financed in some way; however there are always financing
alternatives that can be considered. For example it is possible to raise funds from
selling new shares, borrowing from banks or taking credit from suppliers.
• A key financing decision is whether profits earned by the business should be
retained rather than distributed to shareholders via dividends. If dividends are too
high, the business may be starved of funding to reinvest in growing revenues and
profits.

What is capital structure?

Capital Structure represents the total long-term investment in a business firm. It
includes funds raised through ordinary and preference shares, bonds, debentures,
term loans from financial institutions, earned revenue, capital surpluses, etc. The
term capital structure is used to represent the proportionate relationship between
debt and equity.

The Board of Directors or the financial manager of a company should

always endeavor to develop a capital structure that would lie beneficial to the
equity shareholders in particular and to the other groups such as employees,
customers, creditors, society in general. While developing an appropriate capital
structure for its company the financial manager should aim at maximizing the
long-term market price per share. This can be done only when all these factors
which are relevant to the company's capital structure decisions are properly
analyzed and balanced.

Capital structure refers to the way a corporation finances itself

through some combination of equity, debt or hybrid securities. A firm's capital
9
structure is then the composition or 'structure' of its liabilities. For example, a
firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity
financed and 80% debt financed. The firm's ratio of debt to total financing, 80%
in this example is referred to as the firm's leverage.
An appropriate capital structure is a critical decision for any business
organization. The decision is important not only because of the need to maximize
returns to various organizational constituencies, but also because of the impact such
a decision has on an organization’s ability to deal with its competitive environment.
The capital structure of a company is the particular combination of debt, equity
and other sources of finance that it uses to fund its long term financing. The key
division in capital structure is between debt and equity. The proportion of debt
funding is measured by gearing.
This simple division is somewhat complicated by the existence
of other types of capital that blur the lines between debt and equity, as they are
hybrids of the two. Preference shares are legally shares, but have a fixed return
that makes them closer to debt than equity in their economic effect. Convertible
debt may be likely to become equity in the future. Considering the division
between debt and equity is sufficient to understand the issues involved.
Simple financial theory models show that capital structure does
not affect the total value (debt + equity) of a company. This is not completely
true, as more sophisticated models show. It is, nonetheless, an important result,
know as capital structure irrelevance.
The capital a business needs for investing in its assets comes from
two basic sources: debt and equity. Managers must convince lenders to loan
money to the company and convince sources of equity capital to invest their
money in the company. Both debt and equity sources demand to be compensated
for the use of their capital. Interest is paid on debt and reported in the income
statement as an expense, which like all expenses is deducted from sales revenue
to determine bottom-line net income. In contrast, no charge or deduction for using
equity capital is reported in the income statement. Rather, net income is reported
as the reward or payoff on equity capital. In other words, profit is defined from
the shareowners point of view, not from the total capital point of view. Interest is
treated not as a division of profit to one of the two sources of capital of the
business but as an expense, and profit is defined to be the residual amount after
deducting interest. Sometimes the owners’ equity of a business is referred to as its
net worth. The fundamental idea of net worth is this:

Net worth = assets − operating liabilities − debt

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 Net income increases the net worth of a business. The business is
better off earning net income, because it’s net worth increases by the net income
amount. Suppose another group of investors stands ready to buy the business for a
total price equal to its net worth. This offering price, or market value, of the
business increases by the amount of net income. Cash distributions of net income
to shareowners decrease the net worth of a business, because cash decreases with
no corresponding decrease in the operating liabilities or debt of the business.

An appropriate capital structure should incorporate the following features:

1. Flexibility: A sound capita1 structure must be flexible. The consideration of

flexibility gives the financial manager ability to alter the firm's capital structure
with a minimum cost and delay warranted by a changed situation. It should also
be possible for the company to provide funds whenever needed to finance its
profitable activities.

2. Profitability: A sound capital structure is also one that also possesses the
feature of profitability, i.e., it must be advantageous to the company. It should
permit the maximum use of leverage at a minimum cost with the constraints.
Thus a sound capital structure tends to minimize 'cost' of financing and maximize
earnings per share (EPS).

3. Solvency: A sound capital structure should also have the feature of solvency,
i.e., it should use the debt capital only up to the point where significant risk it not
added. As has been already observed the use of excessive debt threatens the
solvency of the company.

4. Conservation: The capital structure should be conservative in the sense that

the debt capacity of the company should not exceed. The debt capacity of a
company demands on its ability to generate future cash flows. It should have
enough cash to pay creditors fixed charges and principal amount. It should be
remembered that cash insolvency might also lead to legal insolvency.

5. Control: The capital structure should involve minimum risk of loss of control
of the company.

The Need for Profit Planning

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"Profit is a condition of survival. It is the cost of the future, the cost of staying in
business". Peter Drucker
Profit is an essential cost of business activity and must be planned and
managed just like other costs. Successful business performance requires
balancing costs and revenues as illustrated by the following model.
Costs of the future (profit) + current costs (expenses) = Average revenue
per unit sold x sales volume (net revenue).

The effective manager must make trade-offs among these variables to keep this
equation in balance and this requires effective profit planning. A business must
earn sufficient profit to maintain access to the capital markets for the investment
it needs to grow and prosper. This profit can be difficult to determine but it
cannot be less than the business' cost of capital.
Cost of capital is the cost the business must pay for its debt and equity
financing. These minimum profit requirements enable the business sustain its
current operations and maintain its wealth producing potential. A growth strategy
may require additional profit to fund market and/or product research and
development or strategic acquisitions. These profits come from the surplus
generated from business operations or operating profit (also known as net income
before interest and taxes).

Types of Business Finance

We have mentioned above, that funds are required by business firms for different
purposes — to acquire fixed assets, to provide for operating expenses, and to
improve methods of production. Depending on the nature and purpose to be
served, we may distinguish between three types of finance. These are:
(i) Long term finance;
(ii) Medium term finance;
(iii) Short term finance.

(i) Long term finance: Funds which are required to be invested in the business
for a long period (say more than five years) are known as long term finance. It is
also known as long term capital or fixed capital. This type of finance is used for
acquiring fixed assets, such as land, building, plant and machinery, etc. The
amount of long term funds required naturally depends on the type of business and
the investment required for fixed assets. For example, the manufacture of steel,
cement, chemicals, etc. involve heavy expenses to be incurred on buildings,
machinery and equipments. A small factory or a small workshop repairing
12
electrical goods will require much smaller investment in fixed assets. On the other
hand, traders generally, require smaller amounts for long term investment as
compared to the requirement of manufacturers. This is because trading concerns
do not require expensive long-lived assets to be used for their activities. The size
of the business firm also determines the amount to be invested in fixed assets.
Large scale manufacturing and trading activities will obviously require more long
term capital than small scale enterprises. Long term finance is required for
acquisition of assets and modernization purposes.

(ii) Medium term finance:

Business firms often need funds for a period exceeding one year and not more
than 5 years for particular purposes. This is referred to as medium term finance or
medium term capital. They may include expenses on modernisation of plant and
machinery, or introduction of a new product, adoption of new methods of
production or distribution, or an advertisement campaign. The necessity of this
type of finance generally, arises on account of changes in technology or
increasing competition. Manufacturing industries are more often in need of such
finance. The amount required depends on the nature or purpose. The expenditure
incurred is regarded as an investment because higher returns are expected out of
it.

(iii) Short term finance: This type of finance is required for a short period upto
one year. It refers to funds
EXTERNAL TRADE 187 needed to meet day-to-day requirements and for
holding stocks of raw materials, spare parts, etc. to be used for current operations.
Short term finance is often called working capital or short term capital, or
circulating capital. As soon as goods are sold and funds are recovered the amount
is again used for current operations. Generally, speaking, production processes
are completed within a year and goods are ready for sale. Hence, short term funds
can be used over and over again from year to year.
How much short term finance will be required depends on (a) the nature of
business undertaken; (b) the time gap between commencement of production or
purchase of goods and their sale; and
(c) The volume of business. Trading firms normally require proportionately more
of short term capital than long term capital. Manufacturing concerns, on the other
hand, need relatively smaller amounts of short term capital as compared to long
term capital.

13
Again, if production time and the time gap between production and sale is shorter
(say one or two months), it will require much less short term finance than if the
time gap is one year. The volume or scale of business activity also determines the
amount of short term finance. Thus, a small factory needs much less short term
capital than a large manufacturing enterprise.

Sources of Finance
The primary responsibility of financing a business venture is that of the owners of
the business. However, loans and credits also meet the financial requirements of
business firms. In sole proprietorship business, the individual proprietor
generally, invests her/his own savings to start with. She/he may reinvest a part of
the profits earned in course of time. She/he may also borrow money on her/his
personal security or the security of assets. Similarly, the capital of a partnership
firm consists partly of funds contributed by the partners and partly of borrowed
funds. If necessary they may also decide to reinvest their own shares of profit.
The company form of organization enables the promoters to raise necessary funds
from the public, who may contribute capital and become shareholders of the
company. In course of its business, the company can raise loans directly from
banks and financial institutions or by issue of debentures to the public. Besides,
profits earned may also be reinvested instead of being distributed as dividend to
the shareholders. Thus, for any business enterprise, there are two sources of
finance, that is, funds contributed by owners, and funds available from loans and
credits. In other words, the financial resources of a business may be provided by
owner’s funds and borrowed funds. Let us examine the characteristics of these
two sources:

Owners Funds or Ownership Capital

It may be useful to distinguish between the term funds and the term capital. 188
BUSINESS STUDIES Ownership capitals consist of the amounts contributed by
owners as well as profits. This is because profits ultimately belong to the owners.
But the term fund has wider scope and coverage. It includes the profits reinvested
in the business, and amounts received from any other inward remittance. The key
features of ownership funds are as follows:

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(i) Provision of risk capital: One major characteristic of owner’s fund as a
source of finance is that it provides risk capital. It is known as risk capital
because every business runs the risk of loss or low profits, and it is the owners
who bear this risk. In the event of low profits they do not have adequate return on
their investment. If losses continue, the owners may be unable to recover even
their original investment after meeting the loan obligations. However, in times of
prosperity and in the case of a flourishing business the high level of profits earned
accrue entirely to the owners of the business.

(ii) Permanent source of capital:

The second characteristic of this source of finance is that ownership capital
remains permanently invested in the business. It is not refundable like loans or
borrowed capital. Hence, a large part of it is generally, used for acquiring long
term fixed assets. It is also used to finance a part of the working capital which is
permanently required to hold a minimum amount of cash, stocks etc. Besides, this
type of finance is available for all purposes throughout the life of the business.

(iii) Separation of ownership and management: Another characteristic of

ownership capital relates to the management of business. In case of a company, it
is managed by the officers under the control and supervision of the board of
directors, who are elected by the shareholders. Although the owners of the
company are the shareholders, the responsibility of management does not rest
with them.

(iv)No security required: No security of assets is to be offered against

ownership capital.

Merits
Arising out of its characteristics, the advantages of ownership capital may be
briefly stated as follows:

(i) It provides risk capital, which makes it possible for creditors to deal
confidently with the company. Ownership capital forms the basis for raising
loans.

(ii) It is a source of permanent capital,

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i.e., it is not returnable. It is nonrefundable until such time that business ceases.
Therefore, the company is confident of retaining such amounts to meet any
problems and unforeseen contingencies.

(iii) Capital forms the basis on which owners acquire their right of control and
supervision over management. The final say in the management of the
organization rests with the owners, who invest money in the business. This in turn
ensures that the business is conducted in their best interest. EXTERNAL TRADE
189

(iv) Since management is separate from ownership professional managers can be

employed to look after the interests of all stakeholders.

(v) Since no security is required for equity, the assets of the company are free to
be used for raising loans. Thus, it can be used to enhance the capital base of the
firm.

(vi)Unlimited amount of capital can be raised. The capacity of the proprietor of a

sole proprietorship firm is extremely limited. In a partnership, capital is limited to
the financial capability of the partners. In the case, of a company, a large number
of members may participate. Thus, it can generate huge amounts of capital.

Limitations
There are also certain limitations of ownership capital as a source of finance.
These are:

(i) Diffusion of control: A joint stock company can raise amounts by issuing
shares to the public. But it leads to an increased number of people having
ownership interest and right of control over management. This may reduce the
original promoter’s power of control over management.
(ii) Possibility of under utilization of ownership funds: Being a permanent
source of capital, ownership funds cannot be reduced easily in the case of a
company. Share capital is non-refundable as long as the company is in existence.
This may mean a part of this fund remaining idle when there is no scope for
expansion or fresh investment opportunities.

Borrowed Funds or Borrowed Capital

16
It includes all funds available by way of loans or credit. Its chief characteristics
are:
(i) Time horizon: Loans can be raised by business firms for specified periods at
fixed rates of interest. Thus, borrowed funds may serve the purpose of long term,
medium term or short term finance.

(ii) Need for security: Borrowing is possible against personal security but
generally, it is against the security of assets. Banks and financial institutions give
loans against the security of assets. A company can raise loans on different terms
and conditions, or by different modes.
(iii) Repayment: Interest on borrowed capital is payable at periodic intervals.
The principal amount is to be repaid according to the terms and conditions of the
loan. In other words, the borrowing of funds involves two types of liabilities, one
is the payment of interest at regular intervals; and the other is the repayment of
principal amount. These liabilities have to be met even if the earnings are low or
there is loss.

(iv)Control: Ordinarily lenders and creditors do not have any right of control
over the management of the borrowing firm. But, they can sue the
190 BUSINESS STUDIES firm in a law court if there is default in payment of
interest or repayment of loan amount.

Merits
From the business point of view, borrowed capital has several merits:

(i) It does not affect the owners’ control over management.

(ii) Interest is treated as an expense, so it can be charged against income and the
amount of tax liability is thereby reduced.

(iii) It provides flexibility to the capital structure. Finance may be raised when it
is required and repaid when it is not required, according to convenience and
needs.

(iv)A fixed rate of interest is to be paid even when profits are very high. With a
given rate of return, since the rate of interest remains fixed, the balance of profit

17
belongs to the shareholders. Thus, the owners may enjoy a much higher rate of
return on investment than the lenders.

Limitations
Against the above merits, borrowed capital has certain limitations:

(i) Fixed liability: Payment of interest and repayment of loans cannot be avoided
even if there is no profit. Default in meeting these obligations may create
problems for the business. To begin with business may suffer on account of
decline of its credit worthiness. Continuing default may even lead to insolvency
of the firm.

(ii) Adequate security: It requires adequate security to be offered against loans.

Borrowed funds are usually, available up to 80 per cent of the value of assets,
depending on the nature and value of the asset. We have discussed the
characteristics of ownership capital (owners’ funds) and borrowed capital
(creditors’ funds) as sources of business finance. Whether it is a trading or
manufacturing concern, a proprietary, partnership or company form of
organization, owners’ funds and borrowed funds are taken together to meet the
financial needs of business enterprises. We have stated earlier that the company
form of organization is best suited for undertaking large scale business. This is
mainly because a company is in a position to raise much larger amounts of capital
than a proprietary or partnership firm. We shall now discuss the various sources
which may be adopted by a company to raise both ownership capital and
borrowed capital.

Sources of Company Finance

The sources of long term finance include:
(i) Issue of shares;
(ii) Issue of debentures;
(iii) Loans from financial institutions;
(iv)Retained profits; and
(v) Public deposits.

Let us examine the characteristics and implications of each of the long term
sources. EXTERNAL TRADE 191
18
(i) Issue of shares: The amount of capital decided to be raised from members of
the public is divided into units of equal value. These units are known as shares
and the aggregate value of shares is known as share capital of the company.
Those who subscribe to the share capital become members of the company and
are called shareholders. They are the part owners of the company. Hence, shares
are also described as ownership securities.
Two types of shares may be issued by a company to raise capital: (a) equity
shares; and (b) preference shares.

(a) Equity shares: The amount raised by the issue of equity shares is known as
equity share capital, it is the most important source of raising long term capital
for a company. Equity capital represents ownership capital as equity shareholders
collectively own the company. They enjoy the reward as well as bear the risk of
ownership.

There is no promise to shareholders of a fixed dividend. The liability is generally,

limited to the amount agreed to be subscribed by the shareholders.
Equity share capital may be

(i) with equal rights; or (ii) with differential rights as to dividend, voting or
otherwise.
This has been permitted after an amendment to the Companies Act in 2000. Prior
to this, public companies were not allowed to issue equity shares with differential
rights.

Equity shares have the following distinct characteristics:

(i) The holders of equity shares are the primary risk bearers. It is the issue of
equity shares that mainly provides risk capital. This implies that in case the
company suffers losses and has to be closed down, the equity shareholders may
lose the entire amount they had invested. Creditors’ dues must be met before any
payment is made to the preference or equity shareholders.

19
(ii) Equity shareholders have a residual claim in the firm. In other words, the
income left after satisfying the claims of all creditors, outsiders, and preference
shareholders, belongs to equity shareholders.

(iii) Equity shareholders are likely to enjoy a higher profit as well as higher
increase in the value of the shares.

(iv)Equity share capital is the basis on which loans can be raised. It provides
credibility to the company and confidence to the loan providers.
(v) Since equity shareholders have the right to vote for the election of the board of
directors, collectively they ensure that the company is managed in the best
interests of the shareholders.

Merits
From the company’s point of view, there are several merits of issuing equity
shares to raise long term finance.

(i) It is a source of permanent capital without any commitment of a fixed 192

BUSINESS STUDIES return to the shareholders. The return on capital depends
ultimately on the profitability of business.

(ii) It facilitates a higher rate of return to be earned with the help of borrowed
funds because loans carry a fixed rate of interest.
Hence, equity shareholders are likely to enjoy a higher rate of return based on
profitability.

(iii) It is on the basis of equity share capital that loans can be raised.
Equity provides the credibility to the company and confidence to the prospective
loan provider.

(iv)Democratic control over management of the company is assured due to the

voting rights of equity shareholders.

Limitations
Although there are several advantages of issuing equity shares to raise long term
capital, there are certain limitations also of this source of finance:

20
(i) Equity shares have the risk of fluctuating returns and the risk of fluctuating
market value of shares.
In times of adversity, there may be low returns or even no returns.

(ii) Equity share capital is a permanent source of finance. It cannot be refunded

during the life of the company. When there is no scope for expansion or new
investment during periods of economic depression, the equity capital may remain
idle, the rate of return may be reduced since there is no commitment to pay and
no fixed obligations to be met on equity capital, there is always the possibility of
putting it to sub optimal uses.

(iii) Issue of additional equity shares to raise funds for expansion poses a threat to
the existing shareholders as regards their power of control over management of
the company.
Existing shareholders are generally, offered the new issue of shares and in case
they decline, the shares are offered to the public.
New shareholders may exercise their voting rights against the continuation of
existing directors.

(iv)There are too many procedural delays and too many time consuming
formalities to be completed before any public issue of shares can be made.

(v) An equity issue cannot be made any time the company wants. It depends on
market conditions. These generally, determine the time of issue of shares and the
value of the shares.
(b) Preference shares: The amount of share capital which is raised by the issue
of preference shares is called preference share capital. It is referred to as
preference shares as the owners of these shares have a preferential claim over
dividends and repayment of capital. Preference shares represents a hybrid form of
financing in that, it consists of some characteristics of equity shares and some
attributes of debentures. It resembles equity shares in the following ways:
(i) preference dividend is payable only out of profit after tax;

(ii) The payment of preference dividend is entirely within the discretion of

directors. It is not an obligatory payment, even if there is a profit. It resembles
debentures because it gets a fixed rate of return.

Preference shares have the following distinct characteristics:

21
(i) Preference shareholders have the right to claim dividend out of profits at the
fixed rate, which is decided according to the terms of issue of shares.

(ii) Preference shareholders have also the preferential right of claiming repayment
of capital in the event of winding up of the company. Preference capital has to be
repaid out of assets after meeting the loan obligations and claims of creditors but
before any amount is repaid to equity shareholders. Different kinds of preference
shares may be issued as:

(i) Cumulative or non-cumulative;

(ii) Participating or non-participating;
(iii) Redeemable or non-redeemable;
(iv)Convertible cumulative preference shares.
In the case of cumulative preference shares, if dividend cannot be paid due to
inadequate profits in a particular year the arrears of dividend accumulate and
become payable in subsequent years when profits are adequate. Non-cumulative
preference shares have no such provision. If the shareholders, in addition to the
fixed rate of dividend, are entitled to a further share in the surplus profits after a
reasonable dividend has been paid to equity shareholders, the shares are known as
participating preference shares. Where the terms of issue do not provide for it, the
shares are known as non-participating preference shares. Redeemable preference
shares are those which the company undertakes to redeem (that is, repay) after a
specified period. Where there is no such undertaking, the shares are called
irredeemable preference shares. However, these shares can also be redeemed by
the company after specified period by giving notice as per the term of issue. It
may be noted that companies are no longer permitted to issue irredeemable
preference shares.
A company may decide to issue a type of cumulative preference share which can
be converted into equity share. These are known as convertible cumulative
preference shares. Under present rules in India conversion of such shares can be
decided to be made 194 BUSINESS STUDIES between the end of one and 5
years. In India preference shares usually, are cumulative with reference to
dividends.

Merits
Issue of preference shares as a source of finance is preferred by many companies
due to the following reasons:
22
(i) It helps to enlarge the sources of funds as some financial institutions and
individuals prefer to invest in preference shares due to the assurance of a fixed
return. This helps the company to attract investors.
(ii) Dividend is payable only when there are profits. There are no fixed liabilities
as is the case with loans and borrowings.
(iii) A higher return is possible if the company is in good times, in the case of
participating preference shares.
(iv) It does not affect the equity shareholders control over management.
(v) The rate of preference dividend is fixed. Hence, in years of prosperity, the rate
of return on equity capital is likely to be higher than it would be otherwise, due to
preference share capital.

Limitations
The limitations of preference shares relate to some of its main features:
(i) Dividend paid cannot be charged to the company’s income as an expense;
hence, there is no tax saving as in the case of interest on loans.
(ii) Issue of preference share does not attract many investors as there is no assured
return, and the return is generally, low and lesser than the rate of interest on loan.
(iii) The holders of preference shares have a right to vote on any resolution of the
company directly affecting their rights, which includes any resolution for winding
up the company, repayment or reduction of its share capital, etc.

(ii) Debentures: Debentures are instruments for raising long term debt capital.
When a company decides to raise loans from the public, the amount of loan raised
from a particular issue of debentures is divided into units of similar value. A
debenture certificate is issued by the company to acknowledge its debt. Those
who invest money in debentures are known as debenture holders. They are
creditors of the company. Debentures are, therefore, called creditor ship
securities.
Debentures have the following characteristics:
(a) Debentures carry a fixed rate of interest.

(b) Debentures are redeemable i.e., repayable after a certain period which is
specified at the time of issue. They may become due for repayment after a period
of 5 years or more.
EXTERNAL TRADE 195
23
(c) When debentures are sold to the public and involve a considerable number of
persons, a trustee is appointed and a trust deed is formed to convey the property
of the company to her/him. The trustee is usually a bank, an insurance company
or a financial institution. The trustee is appointed to ensure that the borrowing
firm fulfills its contractual obligations.
Depending upon the terms and conditions of issue there are different types of
debentures. These are:
Secured or unsecured debentures, convertible or non-convertible debentures.
Debentures which are secured by a charge on the immovable properties, of the
company are Secured debentures. Debentures which are not secured by a charge
or mortgage of any asset are called unsecured debentures. The holders of these
debentures are treated as ordinary creditors. A company may issue debentures
which are convertible into equity shares at the option of debenture holders.
The ratio of conversion and the period during which conversion can be effected
are specified at the time of debenture issue. Such debentures are known as
convertible debentures. If there is no mention of conversion at the time of issue,
the debentures are regarded as nonconvertible debentures.

Merits
Debenture issue is a widely used method of raising long term finance by
companies. This is due to the following merits:
(i) The cost of debt capital, represented by debentures is lower than the cost of
preference or equity capital. This is because the interest on debentures is tax
deductible and hence, it helps in increasing the rate of return. Thus, debenture
issue is a cheaper source of finance.
(ii) Debenture financing does not result in dilution of control of equity
shareholders, since debenture holders are not entitled to vote.
(iii) The fixed monetary payment associated with debentures is interest. This
fixed return appeals to many investors, since they are not affected by the
fluctuating fortunes of the company.
(iv)Funds raised by the issue of debentures may be used in business to earn a
much higher rate of return than the rate of interest. As a result, the equity
shareholders earn more.

Limitations
We have noted above the advantages of debenture issue as a source of finance.
24
But, it has certain limitations also:
(i) It involves a fixed commitment to pay interest regularly and fixed obligation to
pay the amount when it is due on the part of the company.
196 BUSINESS STUDIES
(ii) This liability must be discharged even if the company has no earnings. The
burden may be difficult to bear in times of falling profits.

(iii) Retained profits: Retained earnings are the undistributed profits after
payment of dividends and taxes, commonly referred to as reserves and surplus.
They represent the internal sources of finance available to the company. The
company’s use of surplus or free reserves is termed as ploughing back of profits.
It provides the basis of financial expansion and growth of companies. It is
considered as a very important source of funding. Since it is internally generated,
this method of financing is known as self financing. The retained earnings serve
many purposes:
(a) They provide a cushion of security in times of adversity, which the company
can fall back upon.
(b) In certain industries such as pharmaceuticals research and development
activities are of vital importance. Constant innovation and new products are
essential for survival. Funds for these purposes can be available out of retained
profits.
(c) Finance for new projects and expansion plans are sometimes required to enter
new forays which are important areas for the future. Retained profits prove useful
such times.
Since profits belong to the shareholders, retained profit is considered to be an
ownership fund. It serves the purpose of medium and long term finance. The total
amount of ownership capital of a company can be determined by adding the share
capital and accumulated reserves. Companies may convert reserves and surplus
into share capital by issuing bonus shares. From the company viewpoint, bonus
shares are issued free of cost and do not result in any outflow of cash. Investors
too are benefited by the issue of shares free of cost.

Merits
This source of finance has the following
Advantages:
25
(i) As an internal source, it is more dependable than external sources. It does not
depend on the investors’ preference and market conditions.
(ii) Use of retained profit does not involve any cost to be incurred for raising the
funds. There are no expenses on prospectus, advertising, etc.
(iii) There is no fixed commitment to pay dividend on such funds.
(iv)Control over the management of the company remains unaffected as there is
no addition to the number of shareholders.
(v) Unlike debentures, no charge is created against the assets and no restrictions
are put on the management.
(vi)Retained earnings add to the financial strength and improved credibility of the
company. An EXTERNAL TRADE 197 company with large reserves can face
unforeseen contingencies, trade cycles and any other crisis.

Limitations
Use of retained earnings may result in the following drawbacks:

(i) The management of a company may not always use the retained earnings in
the best interest of shareholders. It may misuse them by investing in unprofitable
or undesirable channels. Excessive reserves may make the management wasteful
and extravagant.
(ii) Large retention of earnings over a long period of time may cause
dissatisfaction among shareholders as they do not receive the expected rate of
dividend.
(iii) If the quantum of retained earnings is too high, the management may issue
bonus shares to equity shareholders. Frequent
Capitalization of reserves may result in over capitalization.

(iv)Public deposits: These are unsecured deposits invited by companies from the
public mainly to finance working capital requirements. Public deposits can be
invited by companies for a period of 6 months to 3 years as per rules. However,
they can be renewed from time to time. Though, they are primarily sources of
short term finance, the renewal facility enables them to be used as medium term
finance. Fixed deposits are simple to raise. A company intending to invite
deposits simply has to advertise in the newspapers. Any member of the public can
fill up the prescribed form and deposit the money with the company.
The company in return issues a deposit receipt which is an acknowledgement of
debt by the company. The terms and conditions of the deposit are printed on the
26
back of the receipt. Earlier interest rates were subject to a ceiling. But now,
interest rates are in tune with the market trends but generally, public deposits pay
out a higher rate than the interest rate on bank deposits. The rate of interest on
public deposits depends on the period of deposit and reputation of the company.
Since these deposits are unsecured, a company which has public deposits is
required to set aside, as deposit or investment, in the current year an amount equal
to 10 per cent of the deposits maturing by the end of the year. The amount so set
aside can be used only for repaying such deposits. Public deposits cannot exceed
25 per cent of share capital and free reserves.

Merits
The merits of public deposits are the following:
(i) The procedure for obtaining public deposits is much simpler than equity and
debenture issues. Thus, there are fewer administrative costs for deposits. 198
BUSINESS STUDIES
(ii) Public deposits are unsecured. Thus, the assets are free to be used as mortgage
in future, if need arises.
(iii) Interest paid on public deposits is tax deductible. Hence, it helps in bringing
down the tax liability.
(iv)Public deposits introduce flexibility in the financial structure of the company.
This is because the deposits can be repaid when they are not required.
(v) There is no dilution of shareholders’ control because the depositors have no
voting rights.

Limitations
Raising finance through public deposits suffers from the following limitations:
(i) The amount of funds that can be raised by way of public deposits is limited,
because of legal restrictions.
(ii) The maturity period is relatively short. The company cannot depend on them
for long term financing requirements.
(iii) Public deposits are an uncertain and unreliable source of finance.
The depositors may not respond when conditions in the economy are uncertain.
Also, deposits may be withdrawn whenever, the depositors feel shaky about the
financial health of the company.
27
Sources for raising the long-term funds for a large-scale organization for
growth of a company are:

Owned and Borrowed funds:

Working capital management or short-term financial management is a

significant facet of financial management. It is important due to 2 reasons:

Investment in current assets represents a substantial portion of total investment

Investment in current assets and the level of current liabilities have to be geared
quickly to changes in sales.
Working capital involves activities such as arranging short-term finance,
negotiating favorable credit terms, controlling the movement of cash,
administrating accounts receivables, and monitoring the investment in inventories
also take a great deal of time.

A company can mobilize working capital by:

Existing cash reserves
Profits
Bank overdrafts or lines of credit
Commercial papers
Inter-corporate Deposits
Spontaneous sources

Existing cash reserves: Every Company will maintain cash reserve to meet the
working capital needs. If the company does not have any cash reserves, then it
can go for the alternatives. Mostly, the new companies will not keep more cash
reserves, as it will become a blocked reserve.

Profits: If the company is earning profits, it can turn some percent of profits
towards working capital reserves. In the time of inflation or depression, company
can use this reserve as working capital.

28
Bank overdrafts or lines of credit: Banks play vital role in financing the working
capital to the organizations. However, banker will look the following before
financing:
Working capital management or short-term financial management is a significant
facet of financial management. It is important due to 2 reasons:

Investment in current assets represents a substantial portion of total investment

Investment in current assets and the level of current liabilities have to be geared
quickly to changes in sales.

Working capital involves activities such as arranging short-term finance,

negotiating favorable credit terms, controlling the movement of cash,
administrating accounts receivables, and monitoring the investment in inventories
also take a great deal of time.

Banks play vital role in financing the working capital to the organizations.
However, banker will look the following before financing:

The amount required by the company (Amount of Assistance.)

Form of issuing the working capital.
Security to be taken.
Regulations applicable for issuing the working capital.

The form of assistance may be either Non-fund based or Fund based lending. In
case of non-fund based lending, the banker will not commit any physical outflow.
It will be in the form of Bank Guarantee or Letter of Credit. Both the Bank
Guarantee and Letter of Credit helps the organization to make purchases and
selling goods overseas. These will also act as guarantee for the goods that are
supplied.

Commercial papers:

Commercial Paper (CP) is widely used by top-rated corporate and an institution

as a flexible short-term instrument that provides a cost-effective diversification of
funding sources away from the banking sector.

29
It is an unsecured obligation issued by a corporation or bank to finance its short-
term credit needs, such as accounts receivable and inventory. Maturities typically
range from 15 to 365 days. Commercial paper is available in a wide range of
denominations, can be either discounted or interest bearing, and usually have a
limited or nonexistent secondary market. Companies with high credit ratings
usually issue commercial paper, meaning that the investment is almost always
relatively low risk.

Who can issue?

A company with a tangible net worth of more than 4 crores as per the latest
audited balance sheet.
Borrowed amount of the company is classified as a standard asset by the bank.

The company needs to obtain satisfactory credit rating (Minimum rating required
is p-2 of CRISIL or equal lent) from any credit rating agency before issuing CPs.
The RBI approved credit rating companies are:

CRISIL
CARE
ICRA
Fitch Rating India (P) Ltd.

Who can invest?

NRIs, Individuals, Banks, Corporate Bodies, Foreign Institutional Investors.

Nature:
The maturity period ranges from 15 to 365 days.
The value of the CP is Rs.5 Lakhs.
Every renewal will be considered as a fresh issue.
It is not a deposit as per Provisions of Section 58-A of Companies Act, 1956.

Procedure to issue CPs:

Company should appoint a Schedule bank as the Issuing and Paying Agent.
IPA will check the credit rating and the documents submitted by the issuing
company and the valid agreement.
The issuing company needs to disclose the financial status of the company to the
IPA.
30
After the deal is confirmed, the issuing company needs to issue physical
certificates to the investor.
Every issue of CP should be reported to RBI through IPA within three days from
the date of completion of the issue.
Inter-corporate Deposits: This business involves movement of funds from funds-
surplus companies to credit worthy corporate borrowers. However, these are not
treated as deposits as per the provisions of Section 58-A of the Companies Act,
1956 and as such the regulations applicable to the public deposits do not apply to
ICDs.

ICDs are short-term loans, i.e., for three to six months.

These are unsecured.
The company on its own decides the rate of interest, and the period.

Spontaneous sources: These are the sources through which working capital is
generated automatically and these are unsecured sources. For e.g.: If the company
has good net worth, it can make purchases on credit and can avail a gap to make
the payment.
The bank may not issue the extending amount in the form of cash. Based upon the
documents produced and good will of the company, the form differs. The
following are the two different forms:

Non-Fund based lending.

Fund based lending.
Non-Fund based lending:

Instead of providing cash funds to the company, the bank will provide working
capital assistance in other forms, they are:

Bank Guarantee:

This is the document supplied by the bank by certifying that the company has the
sufficient funds on deposit at the bank and can enter into the transaction. To issue
the bank guarantee, the company needs to provide the information about the raw
material or machinery that is purchasing. Bank will issue a letter to the company
about the amount that can be used as working capital. After utilizing the bank
guarantee, company needs to provide the corresponding documents.

31
Letter of Credit:

This is the primary or secondary source of security for a bond issue. Either a
commercial bank or a private corporation can issue this. This is normally found in
the International trade. If the company is importing any goods from other country,
he can approach the bank for the letter of credit on the exporter name. The banker
will undertake to pay the exporter or accept the bills of draft drawn by the
exporter on the exporter fulfilling the terms and conditions specified in the letter
of credit.

There are different varieties:

Revocable or Irrevocable.
Confirmed or Unconfirmed.
Fund based lending:
In case of Fund based lending, the bank commits physical outflow of funds. As
such, the funds position of the lending bank does get affected. The fund based
lending can be in the following forms:

Loans.
Overdraft.
Cash credit.
Bills purchased/discounted.
Working capital term loans.
Packing credit.

Security:
To avail working capital assistance, the company needs to provide security to the
bank. The following are the different forms of security:

Hypothecation: Under this method, the company needs to provide any moveable
property as security. The bank will not possess the security, unless the company
has an outstanding amount. The banker has the right to sell the security.

Pledge: Under this method, the company needs to provide any moveable property
as security. The bank will possess the security and provides assistance. If the
company has an outstanding amount, the banker has the right to sell the security
with issuing a notice to the company.
32
Lien: Under this method, the banker will keep the security with the bank. The
company needs to clear the loan and can handover the security provided.

Mortgage: This mode is for immovable properties. If the company is providing

buildings, machinery etc., then it will be treated as mortgage. The company need
not possess the property to the banker at the time of availing the loan and he can
use the same for production purpose. But, banker has the right to verify the
security at any time and incase of outstanding amount he can sell the same.

Debentures
Preference Shares
Equity Shares.

To meet the capital requirement, the company can issue shares, debentures and
can also take term loans, accept public deposits and go for leasing and hire
purchasing. The total amount is subdivided and allocated as per the requirements.
However, equity shares, debentures, and preference shares are the sources for
long-term funding. On the strength of these only, a company can avail short &
medium term loans.

Debentures:

A debenture is a document called as “Acknowledgement of Indebtedness”, which

is issued by the company. It is an agreement by the company to the investor that
contains the date of repayment, interest rate, interest payments interval details etc.
The characteristics are:

The investors are called as creditors, as the company needs to repay the
investment as described in the “Acknowledgement of indebtedness.”
Funds rose in the form of debentures need to be repay in the stipulated time.
Hence, these are considered as long-term sources.
The company will offer the investors a security against their investments.
Interest should be paid, even though the company did not earn profits.
The risk involved with debentures is two-fold in the company’s point. If the
company is not earning profits, it has to pay interest and after maturity period, it
has to repay the investment.

33
The debentures will not carry any voting rights, as the debenture holders are
treated as creditors.

Advantages associated by issuing debentures:

Cost associated with debentures is less when compared to equity shares.

During depression, if the investors are not ready to invest further, the company
can issue debentures, as it is the other source for long-term loans.
By issuing debentures, the company can clear all the short term and medium term
loans. This in return gives more profits.
As the “Debenture redemption reserve” is maintained, the company can easily
repay the investments made by the debenture holders within the said time.

Preference shares:

Preference shares are the other sources for the company to acquire long-term
loans. It provides a specific dividend that is paid before any dividends are paid to
common stock holders, and which takes precedence over common stock in the
event of liquidation. Like common stock, preference shares represent partial
ownership in a company, although preferred stock shareholders do not enjoy any
of the voting rights of common stockholders. Also unlike common stock,
preference shares pay a fixed dividend that does not fluctuate, although the
company does not have to pay this dividend if it lacks the financial ability to do
so. The main benefit to owning preference shares is that the investor has a greater
claim on the company’s assets than common stockholders.

Preferred shareholders always receive their dividends first and, in the event the
company goes bankrupt, preferred shareholders are paid off before common
stockholders. Also, the company needs to clear off the preference shares with-in
20 years. The features are:

Investors are not the absolute owners.

Funds raised as preference shares should be repaid within 20 years as per section
80 of Companies Act
The amount acquired is not treated as a permanent capital.

34
These shares will not carry any voting rights. However, as per companies Act,
1956, a preference share holder will have the right to vote under the following
circumstances:

If any resolution directly affecting the rights of preference shareholders is

discussed by the equity shareholders.
If the dividend has not been paid, the preference shareholders can vote on all the
matters before the company in the meeting of the equity shareholders. However,
the following criteria should be satisfied:

If the dividend is not paid for cumulative preference shares for an aggregate
period of two years.
If the dividend is not paid for non-cumulative preference shares either for a period
of two consecutive years or for an aggregate period of three years out of the six
preceding years.

Also, the company can issue the following types of preference shares:
It is advised to issue convertible preference shares, as they can be converted to
equity shares after a stipulated time. This helps the company to have long-term
capital and the rate of dividends payable will also reduce after certain time.

Equity shares:
The Equity shares play the vital role of the financial structure of the company. On
the strength of these shares the company can procure other sources of capital. The
characteristic features are:
Investors are treated as real owners. The investors are entitled to the profits
earned and the losses incurred by the company.
The funds raised in the form of equity shares need to be repaid at the time of
closure of the company.
Funds raised in the form of equity shares are on unsecured basis, i.e., company
need not offer any security against the investment.
Company needs to pay the dividend in return, which is not fixed.
Equity shares are risk free source income to the company.
The investors have the right to vote. By exercising the voting rights, the investors
can participate in the affairs regarding the business of the company.
However, the recent amendments to the
Companies Act, 1956 – It may be possible for the companies to issue equity
shares with disproportionate voting rights.
35
7. The equity shareholder cannot compel the company to pay dividend. However,
if the company wants to issue additional equity shares, they need to be offered to
the existing shareholders first, and then announce in the open market. These are
called as “Pre-emptive rights”. Some of the advantages are:

To the company:
Need not offer any security.
Need not commit the repayment.
Need not offer a fixed dividend.

To the investor:
Limited liability, only to the extent of the face value.
Possibility of higher returns when compared to preference shareholders and
debenture holders, as he will get dividend and good value in secondary market.
Easily transferable.
Hence, the equity shares will be the good sources to acquire the capital.
SEBI guidelines affecting the public issue and rights issue of shares & issue
of debentures while raising the long-term capital for a company?

Capital market is the place where a company can raise the long-term requirement
of funds. Due to the liberalization measure and reforms taken in 1990’s, it became
easy to the companies to raise funds. The main changes that have taken place are:

Repeal of capital issues (Control) Act, 1947 and abolition of the Office of
Controller of Capital issues.
Enactment of the Securities & Exchange Board of India Act, 1992 and formation
of SEBI.
In order to protect the interests of the investors, SEBI has been
empowered to issue the directions from time to time. As such, at present, the only
regulatory framework applicable to the companies trying to raise the funds is by
issuing their securities in the market by following the guidelines of SEBI.

In the primary market, a company can raise funds by issuing:

Public issue.
Rights issue.
Private placement of securities.

36
The guidelines, which the company needs to follow, are:

Guidelines for Public & Rights issues:

A company that is going for a public issue needs to submit the draft prospects to
SEBI, through an eligible Merchant banker, at least 21 days before it is filed with
Register of companies.

A listed company cannot make the rights issue, if the aggregate value exceeds
Rs.50 Lakhs. It should file a letter of offer with SEBI, through an eligible
merchant banker, at least 21 days before it is filed with Regional Stock Exchange.

An unlisted company has to satisfy the following criteria to be eligible to make a

public issue:

Pre-issue net worth of the company should not be less than Rs.1 crore in last 3 out
of last 5 years with minimum net worth to be met during immediately preceding 2
years and

Track record of distributable profits for at least three (3) out of immediately
preceding five (5) years and

The issue size (i.e. offer through offer document + firm allotment + promoters’
contribution through the offer document) shall not exceed five (5) times its pre-
issue net worth.

In case an unlisted company does not satisfy any of the above criterions, it can
come out with a public issue only through the Book-Building process. In the
Book Building process the company has to compulsorily allot at least sixty
percent (60%) of the issue size to the Qualified Institutional Buyers (QIBs),
failing which the full subscription monies shall be refunded.

Eligibility norms for a listed company for making the public issue?

A listed company is eligible to make a public issue if the issue size (i.e. offer
through offer document + firm allotment + promoters’ contribution through the
offer document) is less than five (5) times its pre-issue net worth.

37
If the issue size is more than or equal to 5 times of pre-issue net worth, then the
listed company has to take the book building route and allot sixty percent (60%)
of the issue size to the Qualified Institutional Buyers (QIBs), failing which the
full subscription monies shall be refunded.

Restrictions on pricing by companies:

The companies can freely price their equity shares. However they have to give
justification of the price in the offer document / letter of offer

Requirements regarding promoters’ contribution and lock-in:

In case of an Initial Public Offer (IPO) i.e. public issue by unlisted company, the
promoters have to necessarily offer at least 20% of the post issue capital.

In case of public issues by listed companies, the promoters shall participate either
to the extent of 20% of the proposed issue or ensure post-issue share holding to
the extent of 20% of the post-issue capital.

In case of any issue of capital to the public the minimum contribution of

promoters shall be locked in for a period of 3 years, both for an IPO and Public
Issue by listed companies.

In case of an IPO, if the promoters’ contribution in the proposed issue exceeds the
required minimum contribution, such excess contribution shall also be locked in
for a period of one year.

In case of a public issue by a listed company, participation by promoters in the

proposed public issue in excess of the required minimum percentage shall also be
locked-in for a period of one year as per the lock-in provisions as specified in
Guidelines on Preferential issue.

Beside the above, in case of IPO the entire pre-issue share capital i.e. paid up
share capital prior to IPO and shares issued on a firm allotment basis along with
issue shall be locked-in for a period of one year from the date of allotment in
public issue.

Basis of allotment:
38
In case of over-subscription in a fixed price issue the allotment is done in
marketable lots, on a proportionate basis.

In case of a book building issue, allotment to Qualified Institutional Buyers and

Non-Institutional buyers are done on a discretionary basis. Allotment to retail
investors is done on a proportionate basis as per provisions of Clause No. 7.6.1 of
Guidelines.

Allotment:

Companies are required to finalize the basis of allotment within 30 days from the
closure of the issue in case of a fixed price issue and within 15 days from the
closure of the issue in case of a book building issue or else they are liable to pay
interest @ 15% p.a.
Partly paid shares:
The company cannot make the issue of equity shares unless all the partly paid
shares have been fully paid.

Guidelines for issuing debentures:

Issue: A company cannot issue fully convertible debentures having a conversion

period of more than 3 years unless conversion is made optional with “put” and
“call” option.

Price: Where fully convertible debentures are to be issued, the issuer can freely
determine the interest rate.

Debenture Redemption Reserve: Companies are required to create a Debenture

Redemption Reserve (DRR) equivalent to 50% of the amount of debenture issue
before debenture redemption commences.

Debenture trustee: The appointment and duties of the trustees are dealt with in
Section 117B of the Act. As per the section, a company, before issuing a
prospectus or letter of offer to the public for subscription of its debentures, is
required to fulfill the following conditions:

Appoint one or more debenture-trustees for such debentures; and

39
State on the face of the prospectus or letter of offer that the trustees have given
their consent to be so appointed.

This is subject to the further condition that a person shall not be appointed as a
trustee if he:
Beneficially holds shares in the company;
If he is beneficially entitled to monies which are to be paid by the company; and
Has entered into any guarantee in respect of principal debts secured by the
debentures or interest thereon.

The section also lays down that, subject to the provisions of the Act, the functions
of the trustee shall generally be to:
Protect the interests of the debenture-holders (including creation of securities
within the stipulated time); or
Redress the grievances of the debenture-holders.
In addition, the debenture-trustee may take any of the following steps, as he may
deem fit, to:
Ensure that the assets of the company issuing debentures and each of the
guarantors are sufficient to discharge the principal amount at all times;

Satisfy him that the prospectus or the letter of offer does not contain any matter
which is inconsistent with the terms of the debentures or with the trust deed;

Ensure that the company does not commit any breach of the covenants and
provisions of the trust deed;

Take such reasonable steps to remedy any breach of covenants of the trust deed or
the terms of issue of the debentures;

Take all steps to call a meeting of debenture-holders as and when such meeting is
required to be held.

If the trustee considers at any time that the assets of the company are insufficient
or likely to be insufficient to discharge the principal amount as and when it
becomes due, he may file a petition before the Company Law Board (CLB). The
CLB may, after hearing the company and any other person, by an order, impose
such restrictions on the incurring of any further liabilities as it thinks necessary in
the interest of the debenture-holders.
40
Credit rating:

The debt securities to be issued should also carry an investment-grade credit

rating. For issues above Rs 100 crore, investment-grade rating from two credit
rating agencies will be required, as per SEBI. The company needs to provide all
the information even though the debt instruments may be secured or unsecured, as
per SEBI guidelines. It should provide all the credit ratings obtained during the
three preceding years for any listed securities of the company are to be disclosed.

Security:

The company shall create the security within 6 months from the date of issue of
debentures.

THE TARGET CAPITAL STRUCTURE

Firms should first analyze a number of factors, and then establish a target capital
structure. This target may change over time as conditions change, but at any
given moment, management should have a specific capital structure in mind. If
the actual debt ratio is below the target level, expansion capital should generally
be raised by issuing debt, whereas if the debt ratio is above the target, equity
should generally be issued.

Capital structure policy involves a trade-off between risk and return:

Using more debt raises the risk borne by stockholders.
However, using more debt generally leads to a higher expected rate of return on
equity.
Higher risk tends to lower a stock’s price, but a higher expected
rate of return raises it. Therefore, the optimal capital structure must strike a
balance between risk and return so as to maximize the firm’s stock price.

Four primary factors influence capital structure decisions.

1. The business risk or the riskiness inherent in the firm’s operations if it used no
debt. The greater the firm’s business risk, the lower its optimal debt ratio.

41
2. The firm’s tax position. A major reason for using debt is that interest is
deductible, which lowers the effective cost of debt. However, if most of a firm’s
income is already sheltered from taxes by depreciation tax shields, by interest on
currently outstanding debt, or by tax loss carry-forwards, its tax rate will be low,
so additional debt will not be as advantageous as it would be to a firm with a
higher effective tax rate.

3. Financial flexibility or the ability to raise capital on reasonable terms under

adverse conditions. Corporate treasurers know that a steady supply of capital is
necessary for stable operations, which is vital for long-run success. They also
know that when money is tight in the economy, or when a firm is experiencing
operating difficulties, suppliers of capital prefer to provide funds to companies
with strong balance sheets. Therefore, both the potential future need for funds and
the consequences of a funds shortage influence the target capital structure—the
greater the probable future need for capital, and the worse the consequences of a
capital shortage, the stronger the balance sheet should be.

4. Managerial conservatism or aggressiveness. Some managers are more

aggressive than others; hence some firms are more inclined to use debt in an
effort to boost profits. This factor does not affect the true optimal, or value-
maximizing, capital structure, but it does influence the manager determined target
capital structure.
These four points largely determine the target capital structure, but operating
conditions can cause the actual capital structure to vary from the target.

Business risk depends on a number of factors, the more important of which

are listed below:

1. Demand variability. The more stable the demand for a firm’s products, other
things held constant, the lower its business risk.

2. Sales price variability. Firms whose products are sold in highly volatile
markets are exposed to more business risk than similar firms whose output prices
are more stable.

3. Input cost variability. Firms whose input costs are highly uncertain are
exposed to a high degree of business risk.

42
4. Ability to adjust output prices for changes in input costs. Some firms are
better able than others to raise their own output prices when input costs rise. The
greater the ability to adjust output prices to reflect cost conditions, the lower the
degree of business risk.

5. Ability to develop new products in a timely, cost-effective manner.

Firms in such high-tech industries as drugs and computers depend on a constant
stream of new products. The faster its products become obsolete, the greater a
firm’s business risks.

6. Foreign risk exposure. Firms that generate a high percentage of their earnings
overseas are subject to earnings declines due to exchange rate fluctuations. Also,
if a firm operates in a politically unstable area, it may be subject to political risks.
See Chapter 16 for a further discussion.

7. The extent to which costs are fixed: operating leverage. If a high percentage
of costs are fixed, hence do not decline when demand falls, then the firm is
exposed to a relatively high degree of business risk. This factor is called
operating leverage, and it is discussed at length in the next section. Each of these
factors is determined partly by the firm’s industry characteristics, but each of
them is also controllable to some extent by management. For example, most firms
can, through their marketing policies, take actions to stabilize both unit sales and
sales prices. However, this stabilization may require spending a great deal on
advertising and/or price concessions to get commitments from customers to
purchase fixed quantities at fixed prices in the future.

OPERATING LEVERAGE

Business risk depends in part on the extent to which a firm builds fixed costs into
its operations—if fixed costs which are high, even a small decline in sales can
lead to a large decline in ROE (return on equity). So, other things held constant,
the higher a firm’s fixed costs, the greater its business risk. Higher fixed costs are
generally associated with more highly automated, capital intensive firms and
industries. However, businesses that employ highly skilled workers who must be
retained and paid even during recessions also have relatively high fixed costs, as
43
do firms with high product development costs, because the amortization of
development costs is an element of fixed costs.
If a high percentage of total costs are fixed, then the firm is said to have a high
degree of operating leverage. In physics, leverage implies the use of a lever to
raise a heavy object with a small force. In business terminology, a high degree of
operating leverage, other factors held constant, implies that a relatively small
change in sales results in a large change in ROE (return on equity)

The Optimal Capital Structure

The Optimal Capital Structure Is the one that minimizes the firm’s cost of
capital and maximizes firm value. The right proportion or the appropriate mix of
the debt and equity should increase the market value of share held by
shareholders

The various factors affecting the capital structure decision are:

1. Leverage or trading on equity

2. Sales Promotion
3. Management attitudes
4. Assets structure.
5. Cash Flow ability of a company
6. External environment such as the state of capital market, taxation policy, state
regulations etc
7. Size of the business
8. Age of the company
9. Period of finance
10. Lender attitude

1. Leverage or Trading on equity: Trading on equity or leverage refers to the

financial process. This enables the owners of a company to enhance their return
on equity by borrowing funds for one rate of interest, and using the money to earn
a higher rate of return, keeping the different for them. It is thus, called making
money by using other people's money. Some of the main conclusions regarding
the leverage in the capital structure such as use of fixed cost or fixed return
sources of finances may be reemphasized. Debts and per share capital results' into
44
magnifying the earnings per share (EPS) prevailed the firm earns more on the
assets purchased with these funds. Than the cost of their use. Earnings before
interest and taxes (EBIT) and EPS relationship are the means to examine the
effect of leverage. Out of per share capital and debt,' the leverage impact is felt
more in the case of debt because their source of finance costs lower, than per
share capital and also the interest payable on, debt is, tax deductible. The use of
fixed cost sources of finances also adds to the financial risk of the company and,
therefore, it should not be used beyond a point where the amount of fixed
commitment charges equals the level of EBIT. To give, up because of its effect
on EPS financial leverage is one the important consideration in planning the
capital structure for the company.

2. Sales Position: Sales position covers growth rate of future sales and sales
stability. The future growth of sales is a measure of the extent to which the
earnings per share (EPS) of the rum are likely to be magnified by leverage. The
greater the external financially that is usually required. This is so because the
likely volatility and uncertainty of future sales have important influences upon the
business risk the less equity that should be employed. Similarly, sales stability
and debt ratios are directly related, that is, the greater the stability in sales and
earnings the greater the debt that should be employed. It is because of this factor
that public utilities employ more debt than equity because they are assured of
their future sales and earnings.

3. Management Attitudes: Management's attitude concerning control of

enterprise and risk, involved determine the debt or equity in the capital structure
and any analysis of capital structure planning can hardly afford to ignore this
factor. In fact every addition of equity unit in the capital structure presents
management to participate in the company affairs to that extent. Therefore, while
planning capital structure, firms may prefer debt to be assumed of continued
control.

4. Assets Structure: Composition and liquidity of assets may also influence the
capital structure decision of the firm. Firms with long lived fixed assets,
especially when demand for their output is relatively assured utilities for example
- use long-term debt extensively similarly greater the liquidity the more debt that
generally can be used all other factors remaining constant.
The less liquid the assets of firm the less flexible the firm can be in meeting its
fixed charged obligations.
45
5. Cash flow ability of the company: When considering the appropriate capital
structure it is extremely important to analyze the cash flow ability of the firm to
serve fixed commitment charges. The fixed commitment charges include payment
of interest on debentures and other debts, preference dividend and principal
amount. Thus the fixed charged depend upon both the amount of senior securities
and the terms of payment. The amount of fixed charges will be high if the
company employs a large amount of debt or preference capital with short-term
maturity. It is therefore, prudent that for servicing fixed charges at proper time,
the management must ensure the availability .of cash because inability on the part
of management may result in financial insolvency. Therefore, cash flow analysis
is essential to consider while planning appropriate capital structure. Obviously,
the greater and more stable the expected future cash flows of the firm, the greater
the debt capacity and vice-versa. To be on a safe side the cash flow ability must
be determined in the period of depression very carefully.

6. External Environment: Any decision relating to the pattern of capital

structure must be made keeping in view the external factors such as state of
capital market, taxation policy, state regulations etc. If the capital market is likely
to be planned in bearish state and interest rates are expected to decline the
management should postponed the debt for the present in order to take advantage
of' cheap debt at a larger stage. However, if debt will become costlier and will be
on scarce supply owing to bullish trends of the capital market, the management
may inject additional doses of debt in capital structure.
Similarly, taxation policy with regard to the various
sources of finance affects the capital structure decision of the company. The
present taxation provisions are in favor of debt capital because interest payment
on debt is a tax deductible expense. On the contrary dividend payable on equity
capital preference share capital is subject to tax state regulation is another exterior
factor that must be taken into account while planning capital structure.

7. Size of the company: Smaller companies confront tremendous problem in

raising fund and these companies have to pay higher interest on debt and have to
agree to inconvenient terms of loan. These companies as a result are compelled to
depend heavily on retained earnings and share capital.

8. Age of company: Age of company plays an important role. New companies

face a lot of uncertainty in the initial periods of operation, as they are completely
46
unknown to the suppliers of funds. These companies are compelled to depend
upon their own, sources of funds. Small firms or newly started funds have low
standing in the market and they are compelled to pay a higher rate of interest on
long-term debts.

9. Period of finance: The period of finance should be paid due attention in the
capital structure decision. When funds are required for permanent investment in a
company, equity share to capital is preferred. When funds are required to finance
modernization programs such as overhauling of machines and equipment and
aggressive advertising campaign, the company can issue preference share and or
debentures.

10. Lender's attitudes: Lender's attitudes are frequently important and

sometimes the most important determinant of capital structure. Before adopting a
capital structure the management may discuss their strategies with its prospective
lenders if possible. The above-listed factors and difference analysis would help
the financial manager to determine within some range the appropriate capital
structure.

11. Asset structure. Firms whose assets are suitable as security for loans tend to
use debt rather heavily. General-purpose assets that can be used by many
businesses make good collateral, whereas special-purpose assets do not. Thus,
real estate companies are usually highly leveraged, whereas companies involved
in technological research are not.

12. Operating leverage. Other things the same, a firm with less operating
leverage is better able to employ financial leverage because it will have less
business risk.

13. Growth rate. Other things the same, faster-growing firms must rely more
heavily on external capital (see Chapter 4). Further, the flotation costs involved in
selling common stock exceed those incurred when selling debt, which encourages
47
rapidly growing firms to rely more heavily on debt. At the same time, however,
these firms often face greater uncertainty, which tends to reduce their willingness
to use debt.

14. Profitability. One often observes that firms with very high rates of return on
investment use relatively little debt. Although there is no theoretical justification
for this fact, one practical explanation is that very profitable firms such as Intel,
Microsoft, and Coca-Cola simply do not need to do much debt financing. Their
high rates of return enable them to do most of their financing with internally
generated funds.

15. Taxes. Interest is a deductible expense, and deductions are most valuable to
firms with high tax rates. Therefore, the higher a firms tax rate, the greater the
advantage of debt.

16. Control. The effect of debt versus stock on a management’s control position
can influence capital structure. If management currently has voting control (over
50 percent of the stock) but is not in a position to buy any more stock, it may
choose debt for new financings. On the other hand, management may decide to
use equity if the firm’s financial situation is so weak that the use of debt might
subject it to serious risk of default, because if the firm goes into default, the
managers will almost surely lose their jobs. However, if too little debt is used,
management runs the risk of a takeover. Thus, control considerations could lead
to the use of either debt or equity, because the type of capital that best protects
management will vary from situation to situation. In any event, if management is
at all insecure, it will consider the control situation.

17. Market conditions. Conditions in the stock and bond markets undergo both
long- and short-run changes that can have an important bearing on a firm’s
optimal capital structure. For example, during a recent credit crunch, the junk
bond market dried up, and there was simply no market at a “reasonable” interest
rate for any new long-term bonds rated below triple B. Therefore, low-rated
companies in need of capital were forced to go to the stock market or to the short-
term debt market, regardless of their target capital structures. When conditions
eased, however, these companies sold bonds to get their capital structures back on
target.
48
18. The firm’s internal condition. A firm’s own internal condition can also have
a bearing on its target capital structure. For example, suppose a firm has just
successfully completed an R&D program, and it forecasts higher earnings in the
immediate future. However, the new earnings are not yet anticipated by investors,
hence are not reflected in the stock price. This company would not want to issue
stock— it would prefer to finance with debt until the higher earnings materialize
and are reflected in the stock price. Then it could sell an issue of common stock,
retire the debt, and return to its target capital structure. This point was discussed
earlier in connection with asymmetric information and signaling.

By necessity, the final decision regarding capital structure based on objective

analysis supplemented with subjective intuitiveness of the management. In this
way, the company shall be able to obtain a capital structure, which has direct
influence on maximizing the wealth of shareholders.

Capital structure Theories:

I. CAPITAL STRUCTURE MATTERS: THE NET INCOME APPROACH

Equity-capitalization rate and Debt- capitalization rate
Debt- capitalization rate is less than Equity- capitalization rate

The essence of the net income (NI) approach is that the firm can increase its value
or lower the Overall cost of capital by increasing the proportion of debt in the
capital structure. The crucial assumptions of this approach are:
the use of debt does not change the risk perception of investors
Ke and kd remain constant with changes in leverage. .
The corporate income taxes do not exist.
The first assumption implies that, if ke and kd are constant, increased use of debt,
by magnifying the shareholders' earnings, will result in higher value of the firm
via higher value of equity. Consequently, the overall, or the weighted average
cost of capital, ko, will decrease.

II. CAPITAL STRUCTURE DOES NOT MATTER: THE NET OPERATING

INCOME APPROACH
Capitalizes firm’s value
Overall capitalization rate
Advantages of debt
49
Debt- capitalization rate is constant
Corporate taxes do not exist

According to the net operating income (NOI) approach the market value of the
firm is not affected by the capital structure changes. The market value of the firm
is found out by capitalizing the net operating income at the overall, or the
weighted average cost of capital, ko which is a constant.
The critical assumptions of the NOI approach are:
the market capitalizes the value of the firm as a whole. Thus, the split between
debt and equity is not important.
the market uses an overall capital is at ion rate, ka to capitalize the net operating
Income. kO depends on the business risk. If the business risk is assumed to
remain Unchanged, kO is a constant.
The Use of less costly debt funds increases the risk of shareholders.
This causes the equity capitalization rate to increase. Thus, the advantage of debt
is offset exactly by the increase in the equity capitalization rate, ke.
the debt-capitalization rate kef is a constant.
the corporate income taxes do not exist.

TRADITIONAL APPROACH:
CRITICISMS
Firm’s market value depends upon NOI and risk
Total risk can be altered
Cost of equity remains unaffected by leverage up to a limit

A PRACTICAL VIEW POINT

The NI and the NOI approach hold extreme views on the relationship between the
leverage, cost of capital and the value of the firm. In practical situations, both
these approaches seem to be unrealistic. The traditional approach takes a
compromising view between the two and incorporates the basic philosophy of
both. It takes a mid way between the NI approach (that the value of the firm can
be increased by increasing the leverage) and the NOI approach (that the value of
the firm is constant irrespective of the degree of financial leverage).As per the
traditional approach, a firm should make a judicious use of both the debt and the
equity to achieve a capital structure, which may be called the optimal capital
structure.
At this capital structure, the overall cost of capital, WACC, of the firm will be
minimum and the value of the firm maximum. The traditional viewpoint states
50
that the value of the firm increases with increase in financial leverage but up to a
certain limit only. Beyond this limit, the increase in financial leverage will
increase its WACC (WEIGHTED AVERAGE COST OF CAPITAL) also and
hence the value of the firm will decline. Under the traditional approach, the cost
of debt, kd, is assumed to be less than the cost of Equity, ke In case of 100%
equity firm, ko is equal to the k. but when (cheaper) debt is Introduce in the
capital structure and the financial leverage increases, the ke remains same as the
equity investors expect a minimum leverage in every firm. The ke does not
increase even with increase in leverage. The argument for ke, remaining
unchanged may be that up to a particular degree of leverage, the interest charge
may not be large enough to pose a real threat to the dividend payable to the
shareholders. This constant ke, and kd makes the ko to fall initially. Thus, it
shows that the benefits of cheaper debts are available to the firm. But this position
does not continue when leverage is further increased. The increase in leverage
beyond a limit increases the risk of the equity investors also and as result the ke
also starts increasing. However, the benefits of use of debt may be so large that
even after offsetting the effects of increase in ke the ko may still go down or may
become constant for some degree of leverages.
However, if the firm increases the leverage further, then the risk of the
debt investor may also increase and consequently the kd also starts increasing.
The already increasing k, and the now increasing kd make the ko to increase.
Therefore, the use of leverage beyond a point will have the effect of increase in
the overall cost of capital of the firm and thus results in the decrease in value of
the firm.

MODIGLIANI-MILLER MODEL: ABSENCE OF TAXES

Assumptions:
Perfect Capital Market situation
Firms – Homogeneous risk Classes
100% dividend pay out
NO corporate taxes
The present section examines the Modigliani-Miller model
(MM), which was presented in 1958 on the relationship between the leverage and
cost of capital and the value of the firm.
They have maintained that under a given set of assumptions, the capital structure
and its composition has no effect on the value of the firm. They have shown that
the financial leverage does not matter and the cost of capital and value of firm are
independent of the capital structure. There is nothing, which may be called the
51
optimal capital structure. They have, in fact, restated the NOI approach and have
added to it the behavioral justification for their model. The MM model is based
on the following assumptions.

1. The capital markets are perfect and complete information is available to all the
Investors free of cost. The implication of this assumption is that investors can
borrow and lend funds at the same rate and can move quickly from one security to
another without incurring any transaction cost.

2 The securities are infinitely divisible.

3 Investors are rational and well informed about the risk-return of all the
securities.

4 All the investors have same probability distribution about the expected future
earnings.
MODIGLIANI-MILLER MODEL: PRESENCE OF TAXES

Proposition l:
52
Kd = Capitalization rate of a pure equity stream of its class
Proposition II:
Defines Cost of equity
Ke = Sum of capitalization rate & premium for financial risk
ke = ko + (ko – kd)D/E

This approach advocates that the firm can increase its value or lower the overall
cost of capital by increasing the proportion of debt in the capital structure.
Corporate tax laws favor debt financing over equity financing. With corporate
taxes, the benefits of financial leverage exceed the risks: More EBIT goes to
investors and less to taxes when leverage is used.
MM shows that: VL = VU + TD.
VL= Value of Levered firm
VU=Value of Unlevered firm
TD= Tax deducted
If T=40%, then every dollar of debt adds 40 cents of extra value to firm.
The following assumptions are made in the propositions with taxes:
· Corporations are taxed at the rate TC on earnings after interest,
· No transaction cost exist, and individuals and corporations borrow at the same
rate The MM model argues that if two firms are alike in all respect except that
they differ in respect of their financing pattern and their market value, then the
investors will develop a tendency to sell the shares of the overvalued firm
(creating a selling pressure) and to buy the shares of the undervalued firm
(creating a demand pressure). These buying and selling pressures will continue
till the two firms have same market values.
The Arbitrage Process:
Firms which are identical in all respects except for their capital structure must
have the same value

The arbitrage process refers to undertaking by a person of two related actions or

steps simultaneously in order to derive some benefit e.g., buying by a speculator
in one market and selling the same at the same time in some other market; or
selling one type of investment and investing the proceed in some other
investment. The profit or benefit from the arbitrage process may be in any form:
increased income from the same level of investment or same income from lesser
investment. This arbitrage process has been used by MM. to testify their
hypothesis of financial leverage, cost of capital and value of the firm.

53
FACTORS INFLUENCING CAPITAL STRUCTURE

Financial Leverage
Cash Flow ability
Control
Flexibility
Market conditions
Floatation costs
Legal framework
Nature of business
Cost of financing
Period and purpose of financing

In the real world taking decisions on capital structure is not as easy as it is made
out till now. In deciding the capital structure of a company, the following points
need to be considered:
Corporate Strategy
Corporate strategy is the main factor determining the financial structure of a
company. The market growth rates form a basis for defining the Organization
structure, Investment in Assets and Overall Capital Intensity (Debt/Equity
Financing). The fact that the company has to source funds from the markets,
makes it imperative to factor in the market responsiveness to the company's call
for funds. Capability to service the funds, both debt and equity and the growth
phase of the business have to be considered in tandem. Other strategic decisions
like management control level, risk averseness or risk taking nature of the
management, etc. have also to be considered.

Ultimately, the most appropriate capital structure will be the one,

which most closely supports the strategic direction of the business with the least
cost and at a reasonably acceptable risk level.

Nature of the Industry

The nature of the industry plays an important role in capital structure decisions.

Capital Intensity: Capital structure should factor in the type of the assets being
financed. Capital intensive firms rely mostly on long term debt and equity.
Generally speaking, long term assets should be financed by a balance between
term debt and equity and short term assets should be financed less by long term
54
sources (like term debt and equity) and more by short term debt. The terms
current (short term) and fixed (long term) assets are determined by the nature of
the industry and the business itself. For example, a rapidly growing non-seasonal
and non-cyclical business may regard part of its investments in short term assets
like inventories and accounts receivable, as permanent investments and fund it by
long term sources. If on the other hand, the business is seasonal in nature, the
seasonal peaks fund requirements may have to be funded by short term debt.

Cyclical Business: In businesses like construction, capital and higher consumer

goods their volumes, and hence requirements of funds, are affected by the
changes in the national and global scene. Businesses subject to such variations
need a capital structure that can buffer the risks associated with such swings.
Again maneuverability of capital structure is at a premium during times of
contraction.

Competition: The degree of competition is also a major factor to be considered

in deciding the capital structure. In highly competitive industry with low entry
barriers, companies with deep pockets can only survive in the long run.

Product or business life cycle: During the initial phase of the growth curve of a
business/product the risk is high. Debt is hard to come by due to the riskiness of
the venture and funding has to be through the venture capital equity. Financial
leverage is low, which could be increased as the product/business establishes
itself. As the business matures, increased cash flows may reduce the need for debt
funds.
Current and Past capital Structure
Current capital structure of a company is determined largely by past decisions.
Investment decisions of the past, acquisitions, take-over, financing policy,
dividends etc. go into forming the current capital structure which is difficult to
change overnight. Altering current capital structure can be done by raising capital,
retiring debts, buying back shares, taking on debt, altering dividend payout
policies, alteration in earning capacity, etc. Also, as past decisions decide current
capital structure, current changes in the capital structure decide the future capital
structure. Hence, utmost care has to be exercised in decision and implementation
of changes in the capital structure.

While making the capital structure decisions, the company has to

consider the different life cycle stages which are:
55
• the pioneering stage
• the expansion stage
• the stagnation/stabilization stage

The pioneering stage is one of rapid increase in demand for the

products/services of the company. The risk is highest at this stage of the life cycle
of the company and the efficient companies are the ones to survive. The financial
cost of borrowing is very high at this stage, due to the risk perception about the
company. To survive this capital structure should orient more towards equity and
if available utilize soft loans from the government.
The expansion stage is the next stage, during which the strong
companies survive the competitive struggle and aim to expand their market share
and volumes. During this stage, huge investments are made to expand
production/service capacity. Requirement of funds is high during this stage.
Subject to the corporate strategy of funding projects and the market conditions,
the company may raise capital at the lowest possible cost. As the earnings
stabilize, the company will be in a position to weather any small variations in
business, and then it can seek to financially leverage itself within a pre-fixed
ceiling, by bank loans or financial institutional loans. It is during this stage that
companies are typically expected to reward their investors with dividend and
stock dividend/splits.

Stabilization/stagnation stage is the last and final stage. A dynamic

management will always be on the lookout for expansion/diversification into new
projects. It could, again depending on corporate strategy, go in for green-field
projects or take over existing units, seek mergers, acquisitions and strategic
alliances, etc. Usually a recession in economy opens up a vast number of such
opportunities which cash rich companies can take advantage of. In case of lack of
such opportunities, the company could reduce the financial leverage and save on
interest and if possible down size the equity by buy back of shares. Buy back of
shares acts to boost investor confidence in the company and also makes equity
serviceable during recession.

Capital gearing: The relative proportion between different securities and the
ratio of each security to the total capitalization is known as capital gearing.
Equity is traded upon:
Trading on equity
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Capital gearing
Financial leverage

There are two main types of risk that a company faces:

Business risk - the variability in a firm’s EBIT. This type of risk is a function of
the firm’s regulatory environment, labor relations, competitive position, etc. Note
that business risk is, to a large degree, outside of the control of managers
Financial risk - the variability of the firm’s earnings before taxes (or earnings per
share). This type of risk is a direct result of management decisions regarding the
relative amounts of debt and equity in the capital structure

Break-Even Analysis

When we undertake a sensitivity analysis of a project or when we look at

alternative scenarios, we are asking how serious it would be if we have
misestimated sales or costs. Managers sometimes prefer to rephrase this question
and ask how far off the estimates could be before the project begins to lose
money. This exercise is known as break-even analysis. For many projects, the
make-or-break variable is sales volume. Therefore, managers most often focus on
the break-even level of sales. However, you might also look at other variables, for
example, at how high costs could be before the project goes into the red. As it
turns out, “losing money” can be defined in more than one way. Most often, the
break-even condition is defined in terms of accounting profits. More properly,
however, it should be defined in terms of net present value.

The accounting break-even point is the level of sales at which profits are zero or,
equivalently, at which total revenues equal total costs. As we have seen, some
costs are fixed regardless of the level of output. Other costs vary with the level of
output.
Break-even level of revenues = fixed costs including depreciation
Additional profit from each additional Rs of sales

Break-even analysis examines the cost tradeoffs associated with demand

volume.

Break-even analysis can be an effective tool in determining the cost

effectiveness of a product.

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Required quantities to avoid loss.

Use as a comparison tool for making a decision.

Benefits and Uses:

The evaluation to determine necessary levels of service or production to

avoid loss.
Comparing different variables to determine best case scenario.

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Figure 1: < Caption of the Figure>

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