Capital Structure

Presented By Pooja

Topics
What is capital structure?
Why is it important? What does capital structure consist of ? What is business risk and financial risk? What are the theories of capital structure?

What is an optimum capital structure?

Summary
2

What is Capital Structure?

Balance Sheet Current Current Assets Liabilities
Debt Preference shares Ordinary shares
3

Fixed Assets

Financial Structure

What is Capital Structure?

Balance Sheet Current Current Assets Liabilities
Debt Preference shares Ordinary shares
4

Fixed Assets

Capital Structure

Definition
Capital structure of a company refers to the make-up of its capitalization and it includes all long-term capital resources, viz., shares, loans, reserves and bonds. - Gerstenberg

Format of Capital Structure

Option 1 xxxx EBIT=-------x funds employed xx Less: Interest on Debentures xxxx Net Profit Before Tax Less: Tax @ ______% xx Net Profit After Tax xxxx Number of Equity share xx EPS=NPAT/Number of Equity share xx PE Ratio xx Market Price=EPS x PE Ratio xx Particulars
PLANS

Option 2 xxxx xx xxxx xx xxxx xx xx xx xx

Option 3 xxxx xx xxxx xx xxxx xx xx xx xx

6

Why is it important?

Capital Structure consists of:

1. Owned Funds: It belongs to the proprietors It includes share capital, free reserves and surplus. 2. Borrowed Funds: It consists of long-term borrowings from outside sources. It consists of debentures, bonds and long-term loans provided by banks and term lending institutions.

Equity share capital

Risk bearing capital of the company Shares which do not enjoy special rights in respect of payment of dividend and repayment of capital. Rate of dividend fluctuates depending upon the availability of profits

Advantages
1. It represents a permanent source of finance 2. It does not carry any fixed burden 3. It enhances the creditworthiness of the firm

Disadvantages
1. Its cost is very high 2. Issue of equity to outsiders causes dilution of control
10

Preference Shares
Shares which enjoy priorities in the payment of dividend as well as in the repayment of capital Preference shareholders are entitled to receive a fixed rate of dividend Preference shareholder is paid back the capital before any payment is made to the equity shareholders.
11

Types of preference shares

Types of preference shares

Participating/ Non-participating

Redeemable/ Irredeemable

Cumulative/ Non-cumulative

Convertible/ Non-convertible

Surplus profit Fixed Dividend

Can be converted Dividend gets carried Returnable into equity share over next year Non-Returnable Cannot be converted Dividend lapses into ordinary share
12

Advantages
Preferential rights Arrears of Unpaid dividend payable Gives flexibility to the company Redeemable and Convertible Shares

Disadvantages
Fixed dividend No control
13

Debentures
Money received by the issue of debentures is a loan Debenture is a security issued by a company against the debt. Debenture holders are the creditors of the company Interest on debentures has to be paid even if the company makes losses Debenture holders have no voting rights No dilution of control Less risky for shareholders

14

Advantages
Regular fixed income Safety and security of investment Liquidity- easy sale in stock exchange Conversion into shares

Disadvantages
No control Fixed returns
15

Term Loans
3 categories based on Pay back period: Short term Loans Medium term Loans Long term Loans

16

Advantages
Cost lower than share capital No dilution of control Backed by security

Disadvantages
No voting rights Repayment is obligatory
17

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 =

18

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)

19

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.

20

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).

21

Weighted Average Cost of Capital

USED IN CAPITAL BUDGETING DECISIONS TO CALCULATE NPV EXPECTED RETURN ON PORTFOLIO OF ALL COMPANYS SECURITIES rA = (D/D+E)rD + (E/D+E)rE EXAMPLE: FIRM HAS 2 MILLION DEBT CURRENT BORROWING RATE, rD= 8% 100,000 SHARES PRICED AT 30 PER SHARE EXPECTED RATE OF RETURN ON SHARES, rE = 15% D=2M, E=100,000 x 30= 3M, V = D+E=2+3 = 5M WACC = (D/D+E)rD + (E/D+E)rE = (2/5).08 + (3/5).15 =.122 OR 12.2%

22

What are the theories of capital structure?

Net Income Theory of Capital Structure
Financial leverage is beneficial

Net Operating Income Theory of Capital Structure

Financial leverage is irrelevant

Traditional Theory of Capital Structure

There exists an optimal capital structure

Modigliani and Miller

23

Net Income Theory

Capital Cost

rE rA rD

Financial Leverage

Stock Price

Po

Financial Leverage
24

Net Income Theory of Capital Structure

No matter how modest or excessive the firms use of debt financing, both its cost of debt capital, rD, and cost of equity capital, rE, remain CONSTANT The weighted average cost of capital, rA, and the firms share price, Po, ARE affected by the firms use of financial leverage Since the cost of debt is lower than the cost of equity, greater use of debt reduces the weighted average cost of capital, ie the firms stock value increases with increase in financial leverage
25

Net Operating Income Theory rE

Capital Costs

rA rD

Financial Leverage

Stock Price

Po

Financial Leverage

Net Operating Income (NOI) Theory

The firms market value is unaffected by its capital structure As financial leverage increases cheaper debt, rD, is substituted for more expensive equity However, the firms cost of equity, rE, will gradually rise in line with the increasing use of debt The value of the firms equity is therefore unaffected by the increase in financial leverage Suggests that capital structure is irrelevant

27

Traditional Theory
rE

rA
Capital Costs

rD

Financial Leverage
28

Traditional Theory
Intermediate Position At moderate levels of financial leverage investors dont notice the risk of borrowing This results in a decrease in the weighted average cost of capital, rA The probability that the firm will not be able to meet its financial obligations increases as more and more debt is employed Thus investors wake up when debt is excessive and eventually at some point the expected cost of default outweighs the advantage of debt
29

Modigliani & Millers theory

Modigliani was awarded the 1985 Nobel price in Economics for this and other contributions. This approach says that there is not any relationship between capital structure and cost of capital Value of firm and cost of capital is fully affected from investor's expectations.

30

What is an optimum capital structure?

An optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value Essentials of optimum capital structure
Flexibility
Solvency Efficiency Simplicity Control
31

Summary
A firms capital structure is the proportion of a firms long-term funding provided by long-term debt and equity. Capital structure influences a firms cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk. Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.
32

Thank you

33