Capital structuring decision

Different kinds of analyses are used in

practice to choose the capital structure. These include: Ratio analysis Cash flow analysis Comparative analysis Leverage analysis EBIT EPS analysis ROI ROE analysis

RATIO ANALYSIS
Firms use certain ratios to assess whether the proposed

capital structure is satisfactory.

The most commonly used ratios are: Interest coverage Cash flow coverage Debt service coverage Fixed asset coverage ratio

CASH FLOW ANALYSIS

Depending on the risk attitude of the

management, tolerance limit on the probability of default is determined Cash flows are projected after considering probability distribution Fixed charges (interest plus principal) are then calculated Based on the above comparison, the highest permissible debt capacity is estimated.

COMPARATIVE ANALYSIS
A common approach to analysing the capital

structure of a firm is to compare its debtequity ratio to the average debt-equity ratio of the industry to which the firm belongs.
Since the firms in an industry may differ on

factors like operating risk, profitability, and tax status it makes sense to control for differences in these variables.

LEVERAGE ANALYSIS

Leverage arises from the presence of fixed costs in a firms cost / financial structure.

Leverage is used to magnify the effects of change in one variable on another dependent variable :
leverage magnifies the effect of change in sales on PBIT

Operating

Financial

Leverage magnifies the effect of change in PBIT on EPS.

Basic cost structure (Example)

Sales Less: Variable costs Contribution Less: Fixed cost Profit(EBIT) 100000 60000 40000 10000 30000

Basic Income stt. (Example)

PBIT Less: Interest PBT Less: Taxes(40 %) PAT Less: Preference dividend Equity earnings No. of equity shares EPS(Equity earnings/No. 30000 10000 20000 8000 12000 4000 8000 2000 Rs. 4

Operating leverage
Operating leverage arises from the presence of fixed operating costs in the firms cost structure. The degree of operating leverage (DOL) measures operating leverage.

DOL = (at a given level of sales)

% change in PBIT % Change in Sales

Alternatively:

= Contribution PBIT DOL measures the business risk (operating risk) of the firm

DOL

FINANCIAL LEVERAGE
Financial leverage arises from the use of fixed cost

financing i.e.debt and preference share capital.

The degree of financial leverage

(DFL) measures

financial leverage.

DFL =

Percentage change in EPS Percentage change in PBIT

Alternatively:

PBIT PBT DFL measures financial risk of the firm i.e.sensitivity of shareholders returns to the financing mix

DFL =

Effects of financial leverage Example

Firm L Capital structure No debt 1. Rs.10,000 of 12%debt Equity-2000 shares 2.Equity-1000 shares @Rs.10 each @Rs.10 each
Rs.20,000 in assets 40% tax rate EBIT Rs.3000

Firm U

Rs.20,000 in assets 40% tax rate EBIT Rs.3000

Effect of leverage on EPS

If firm Us EBIT If firm Ls EBIT

increases by 20%, its EPS also increases by 20 % i.e.in same proportion as the DFL is 1

increases by 20%, its EPS increases by 33.33%(20*1.67) i.e. more than proportionate as compared to the increase in EBIT as the DFL for L is 1.67.

Total leverage
Total leverage refers to the combination of

operating leverage and financial leverage. The degree of total leverage (DTL) measures total leverage.(DOL x DFL) DTL = Percentage change in EPS Percentage change in sales Alternatively: DTL = Contribution PBT

Example
Particulars of a company: (Rs. L) EBIT : 1120 PBT 320 Fixed cost 700 What will be the % change in EPS if sales: (a) Increased by 10 % (b) Decreased by 20 %

Financial Break-even point

Financial break-even point is the level of EBIT at

which EPS is zero. Hence for a given financial plan it can be calculated as : Interest + (Pref. Div./(1-t)) Lower the level of financial BEP, lower is the financial risk involved

EBIT EPS ANALYSIS

The objective of capital structuring decision is to

maximise shareholders value.

Selection of alternative financing plans is done on

the basis of EPS i.e. the capital structure giving the highest EPS would be selected.
As interest on the debt is a fixed commitment ,

higher D/E ratio would give higher EPS when the profits are growing and vice-versa.

Example
Existing capital structure:

10,00,000 equity shares @Rs.10 each. Tax rate : 40 % Additional financing requirement : 50 L

Should it be through equity or issue of debentures at 10% interest when the new EBIT is expected to be Rs.30 L?

Indifference point b/w two plans

The EBIT indifference point between two

alternative financing plans can be obtained

by solving the following equation for EBIT*

(EBIT * I1) (1 t) =

(EBIT * I2) (1 t)

n1

n2

Capital structuring practice : Considerations

Preserving flexibility Tax advantage of debt Risk exposure Control implications of alternate financing

plans Corporate strategy Norms of lenders and credit rating agencies Judicious timing

CAPITAL STRUCTURE THEORIES

Capital structuring
One view point strongly supports close relationship

between leverage and value of the firm whereas the other holds that the debt-equity mix is irrelevant & has no impact on shareholders wealth. In theory the capital structure can affect the value of the firm by affecting either its earnings or the cost of capital or both. The theories depict the relationship between leverage and cost of capital from the stand point of valuation.

Capital structure theories

Net Income approach Net operating income approach Modigliani-Miller approach

Traditional approach

Assumptions
There are only two sources of funds used by a firm

perpetual debt and equity No corporate taxes The dividend pay-out ratio is 100 % The firms total assets remain constant. The firms total financing remains constant The operating profits are not expected to grow The firms business risk is assumed to be constant and is independent of its financial risk.

Important symbols used

S = total market value of equity B = total market value of debt V = total market value of the firm (S+B)

I = total interest payments

NI = net income available to equityholders

Cost of capital-basic definitions

Cost of debt (ki ) = I / B

Value of debt (B) = I/ki

Cost of equity capital = D/P = (EBIT I)/S

(As growth rate is assumed to be zero) Where D= net dividend P= current market price of shares

Cost of capital-basic definitions

WACC: Weighted average cost of capital Ko = (B/B+S)ki + (S/B+S)ke

The cost of equity can be derived from the above

WACC: Ke = Ko + (Ko Ki)B/S

Net income approach

Assumptions 1.No corporate taxes 2.Debts are cheaper than equity 3.The use of debts does not change the risk perspective of the investors i.e.there is not change in the cost of equity or debt due to change in leverage.

Net income approach

As per this approach by Durand capital structure

decision is relevant to the valuation of the firm. Higher the degree of leverage lower will be the WACC and higher will be the market price of shares and so the value of the firm Conversely lower the degree of leverage higher will be the WACC and lower will be the market price of shares and so the value of the firm

Calculation of value of the firm-NI approach

Firm A Firm B Firm C

EBIT
Less: Interest Cost of equity capital Cost of debt

10,000
0

10,000
3000 7000

10,000
6000 4000 10 % 6%

Net income(Equity earnings) 10,000

10 % 10 % 6% 6%

Market value of equity (NI/cost of equity) Market value of debt

Total value of the firm

1,00,000 70,000
50,000

40,000
1,00,000

1,00,000 1,20,000 1,40,000

Net operating income approach

As per this approach ,the capital structure decision of

a firm is irrelevant i.e. any change in leverage will not lead to any change in the total value of the firm ,the market price of shares or the overall cost of capital ,based on the following propositions

Net operating Income approachExplanation

1.The value of equity is determined by deducting value of debt from the total value of the firm 2.So,the equity capitalisation rate increases with increase in leverage due to increased risk perceived by the equity shareholders. 3.Hence the use of cheaper source of finance i.e.debt is exactly neutralised by the increase in equity capitalisation rate as: Ke = Ko + (Ko Ki)B/S

4.Thus,the overall cost of capital remains unchanged.

5. As there is no change in the total value of the firm irrespective of the degree of leverage,NOI proposes that there is no optimum capital structure as such.

Calculation of value of the firm-NOI approach Firm A Firm B Firm C

EBIT Overall capitalisation rate
Total market value

10,000 10 %

10,000 10 %

10,000 10 %

1,00,000 1,00,000 1,00,000 0 6% 1,00,000 10% 1200 6% 20000 80000 11% 3,000 6% 50,000 50,000 14%

Interest on debt Cost of debt Market value of debt Market value of equity Cost of equity
(equity earning/market

Modigliani-Miller Approach
This approach is similar to NOI approach i.e.it

supports the proposition that the capital structuring decision has no relevance in determining the overall cost of capital This theory is ,however,better than NOI as it provides operational justification for the constant overall cost of capital.

MM approach - Assumptions
Perfect capital markets All investors have same expectation about the NOI of

a firm Firms within an industry have the same amount of business risk The dividend pay-out ratio is 100 % No corporate taxes.(This is removed later).

MM-Propositions (Without taxes)

Proposition I: The value of the firm is equal to its expected

operating income divided by the discount rate appropriate to its risk class and hence is independent of its capital structure. MM uses arbitrage argument i.e.buying a security in a market where the price is low and selling it in the market with a high price.

Contd.
This investor behaviour tends to increase the share

prices of the firm whose shares are being purchased and lower the price of the firm whose shares are being sold. This process continues till the market prices of the two identical firms become the same.

Arbitrage mechanism
As the value of equity is higher in firm L,investor

holding 10% share in it will: Sell his equity in firm L for Rs.6667. Buy 10% equity in firm U after borrowing Rs.4000 @5% on personal account. By doing this he would be earning more income than before as explained below:

U Rs. Total capital employed Equity capital Debt Rate of interest on debt Net operating income Debt interest Market value of debt(@ 5 %) Equity earnings 10,000

L Rs.

100000 100000 100000 60,000 40,000 5% 10,000 10,000 2,000 40,000 8,000

Equity capitalisation rate

Market value of Equity Total Market value

10%
100000

12%
66667

100000 106667

Average cost of capital

D/E ratio

10%
0

9.38%
60%

Arbitrage mechanism
Dividend income earned from firm L before this

action = dividend =10%*8000=Rs.800 His total income after the action= Surplus amt. = 667 (6667+4000-10000) +Dividend from U = + 1000 -Interest(4000*5%) = - 200 1467

Arbitrage mechanism
When investors sell their equity in firm L and buy

equity in firm U,the market value of L would decline and that of U would increase. This process continues till the market values of both the firms are equal. As a result the cost of capital for both the firms becomes the same.

MM-Propositions
Proposition II: An increase in financial leverage increases the

expected earnings per share but not the share price. This is because the change in the expected earnings is offset by corresponding change in return required by the shareholders as Market value = Expected earnings / Expected return on assets

CRITICISMS OF MM THEORY Firms and investors pay taxes Bankruptcy costs can be high Agency costs exist Managers tend to prefer a certain sequence of financing Informational asymmetry exists

Personal and corporate leverage are not perfect substitutes

MM Theory:With taxes
With presence of corporate taxes debt financing is

advantageous. This is because interest on debt is a tax-deductible expenditure whereas dividend on equity is not. Hence value of a levered firm is given as: V(L)=V(u) + tcD = EBIT(1-tc) + tcB ------------k where k is the risk-free overall capitalisation rate

Traditional position
The cost of debt is constant upto a certain degree of

leverage but rises at an increasing rate thereafter. The cost of equity remains more or less constant upto a certain degree of leverage ,rising sharply thereafter As a result of the above behaviour with an increase in the level of leverage: The average cost of capital decreases upto a certain point Is more or less constant for moderate increase in leverage thereafter but Rises beyond a certain point

Trade-off theory
As per this theory,the optimal debt-equity ratio

depends on balancing the tax advantage of using debt with the additional distress and agency cost involved. The optimum D/E ratio for a profitable,stable firm would be higher than the optimal D/E ratio for an unprofitable firm with risky assets.

Signaling Theory There is a pecking order of financing which goes as

follows:

Internal finance (retained earnings)

Debt finance External equity finance Given the pecking order of financing, there is no welldefined target debt-equity ratio, as there are two kinds of equity, internal and external. While the internal equity is at the top of the pecking order, the external equity is at the bottom.