Capital structure

Issues:
  

What is capital structure? Why is it important? What are the sources of capital available to a company? What is business risk and financial risk? What are the relative costs of debt and equity? What are the main theories of capital structure? Is there an optimal capital structure?

   

What is Capital Structure?



 

Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities Bonds, bank loans Ordinary shares (common stock), Preference shares (preferred stock) Hybrids, eg. convertible bonds

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference shares Ordinary shares

Fixed Assets

Financial Structure

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference shares Ordinary shares

Fixed Assets

Capital Structure

Sources of capital
Ordinary shares (common stock) Preference shares (preferred stock) Loan capital
  

  

Bank loans Corporate bonds Debentures

Ordinary shares (common stock)

 

 

Risk finance Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders A high rate of return is required Provide voting rights the power to hire and fire directors No tax benefit, unlike borrowing

Preference shares (preferred stock)



 

Lower risk than ordinary shares and a lower dividend Fixed dividend - payment before ordinary shareholders and in a liquidation situation No voting rights - unless dividend payments are in arrears Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments Participating - an extra dividend is possible Redeemable - company may buy back at a fixed future date

Loan capital


 

Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed) Bank loans or corporate bonds Interest on debt is allowed against tax

Seniority of debt


 

Seniority indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

Security


Security is a form of attachment to the borrowing firms assets. It provides that the assets can be sold in event of default to satisfy the debt for which the security is given.

Debenture


A written agreement between the corporate debt issuer and the lender. Sets forth the terms of the loan:
  

Maturity Interest rate Protective covenants



e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends

Convertible bonds


A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period. As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer. Their conversion feature also gives them features of equity securities.

The Cost of Capital

Expected Return

Risk premium Risk-free rate Time value of money _________________________________________________________ Risk _____ Ordinary Treasury Corporate Preference Bonds Shares Shares Bonds

Measuring capital structure

Debt/(Debt + Market Value of Equity) Debt/Total Book Value of Assets Interest coverage: EBITDA/Interest

Interpreting capital structures



The capital structures we observe are determined both by deliberate choices and by chance events Capital structures can be changed Leverage is reduced by
 

Cutting dividends or issuing stock Reducing costs, especially fixed costs

Leverage increased by
 

Stock repurchases, special dividends, generous wages Using debt rather than retained earnings

Business risk and Financial risk



Firms have business risk generated by what they do But firms adopt additional financial risk when they finance with debt

Risk and the Income Statement

Operating Leverage Sales Variable costs Fixed costs EBIT Interest expense Earnings before taxes Taxes Net Income Net Income No. of Shares

Financial Leverage

EPS =

Business Risk


The basic risk inherent in the operations of a firm is called business risk Business risk can be viewed as the variability of a firms Earnings Before Interest and Taxes (EBIT)

Financial Risk


Debt causes financial risk because it imposes a fixed cost in the form of interest payments. The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firms return on equity or the variability of its earnings per share.

Financial Risk vs. Business Risk



There is a trade-off between financial risk and business risk. A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even. A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).

Why should we care about capital structure?



By altering capital structure firms have the opportunity to change their cost of capital and therefore the market value of the firm

What is an optimal capital structure?



An optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value Cost of Capital:
 

Each source of financing has a different cost The WACC is the Weighted Average Cost of Capital Capital structure affects the WACC

Capital Structure Theory



Basic question


Is it possible for firms to create value by altering their capital structure? Net Income Approach Net Operating Income Approach Traditional Approach Modigliani and Miller theory

Major theories
   

Given by Durand  According to this approach, If we inc Debt or leverage then cost of capital will dec and value of firm will inc. Assumptions:1) No Taxes 2) Cost of Debt is less than equity or Kd < Ke . 3) Use of Debt does not increase risk perception or Kd, Ke are constant.


Net Income Approach ( Capital structure is relevant)

Diagram of NI approach
Y

Ke Ko/ Ke Ko Kd O X

Degree of Leverage

Net Income Approach



In this approach, V can be determined as V = E + D Where:V = total mkt value of firm E = Total Mkt value of equity D = Total Mkt value of Debt

And Overall COC is determined by:Ko = EBIT/ V Kd = Int./D Ke = (EBIT Int )

E

WHERE :Ko = Overall COC EBIT = Earning before interest & Tax V = Value of the firm

Example of NI
Ques:A) Net Income (PAT) = 80,000 ; 2,00,000 Debenture @ 8% ; Ke = 10% ; Calculate V , Ko according to NI Approach. B) If debt increases to Rs 3,00,000. What shall be V , Ko ?

Net Operating Income Approach



According to this approach,as we increase the value of debt Kd is const but Ke inc since the firm becomes risky and equity SH demand more return.Thus an inc in use of debt funds which are a cheaper source of funds is offset by an inc in Ke. => Ko remains const and total value of the firm remains the same. Thus, change in the capital structure of a company does not affect the market value of the firm and the overall cost of capital remains the same. This approach said that every capital structure is the optimum capital structure.

Diagram of NOI approach

Y
Ke

Ko Ko/ Ke Kd X

Degree of Leverage

Assumption of NOI
  

No Corporate Taxes Kd const Ko const.

But increase use of Debt, increase financial risk of the equity shareholder and hence, the cost of equity increases.

V = EBIT/ Ko ; E = V- D ; I)/E

Ke = (EBIT-

Example of NOI Approach

Ques:a) A company expect a net operating income of Rs 1,00,000. It has 5,00,000 6% Debenture; Ko = 10% . Calculate V , Ke according to NOI. b) If debenture increases to Rs 7,50,000. What will be the effect on the value of the firm and the equity capitalization rate ?

Traditional Approach
 

Midway Approach between 2 extreme of NI and NOI . According to this theory, as we start introducing debt in the capital structure , ke remains constant for some time and starts increasing only after a certain degree of leverage . This is because upto a particular degree of leverage the interest charge may not be large enough to pose a threat to the dividend payable to the SH.Thus Ke remains same .Const Kd and Ke makes Ko to fall initially .But after a cetain limit a further increase in the amount of debt inc Ke and Kd as the risk of equity SH inc.This results in an inc in Ko.Thus there exist a capital structure at which Ko is minimum which is the optimal capital structure.

Modigliani and Miller (MM)



Basic theory: Modigliani and Miller (MM) in 1958 and 1963 Old - so why do we still study them?


Before MM, no way to analyze debt financing First to study capital structure and WACC together Won the Nobel prize in 1990
Kevin Campbell, University of Stirling, October 2006

34

Modigliani and Miller (MM)



  

Most influential papers ever published in finance Very restrictive assumptions First no arbitrage proof in finance Basis for other theories

Kevin Campbell, University of Stirling, October 2006

35

M-M Approach
  A)

MM Approach is identical to NOI( if taxes are ignored) MM is identical to NI ( If taxes considered) If taxes are ignored:- This theory says that COC is unaffected by change in capital structure or say debt- equity is irrelevant in determining total value of the firm. In opinion of MM : 2 identical firm are there:- (kd = 10% and debt for X is 30,00,000)
X (debt) Y (equity)

EBIT -INT EASH Ke E D V Ko =(EBIT/V)

10,00,000
3,00,000 7,00,000 0.2 35,00,000 30,00,000 65,00,000 15.38 % V PURCHASE

10,00,000
0 10,00,000 0.2 50,00,000 0 50,00,000 20% inc; Mp inc Sell

Assumption of MM Approach
   

No Corporate Taxes There is a prefect market. Investor act rationally All earning are distributed to shareholder. Value = EBIT/ Ke Mv of equity = E= V-D

MM Approach


IF Taxes Exist:V = EBIT (1-t)/ Ko

When corporate taxes are there:

Y
V
Tax shield

Value (Rs)

Vu

Degree of Leverage

VL = VU + tax shield on debt

Problem MM Approach
Ques:-There are 2 firms X and Y which are similar in all respects except that firm X has 10 percent Rs. 10,00,000 debentures. The earning before interest and tax (EBIT) of both the firms are the same, that is Rs 1,50,000 . The equity capitalization rate of the firm X is 20% while that of firm Y is 12.5%.You are required to ascertain the total mkt value of each firm.

Limitation of MM Approach


Cost of borrowing is not same for individual and firms. Transaction cost is there ( buying and selling of shares requires cost) The extend of risk is not same for the investor when he himself borrow or the firm borrows. Availability of complete information.