CAPITAL
CAPITAL
STRUCTURE
STRUCTURE
SUBJECT: FINANCIAL SUBJECT: FINANCIAL MANAGEMENT. MANAGEMENT. COLLEGECOLLEGE : : BHAVAN’S BHAVAN’S COLLEGE.COLLEGE. CLASS
CLASS : : T.Y. T.Y. B.M.S. B.M.S. (A).(A). GROUP
GROUP NO. NO. : : 77 ACADEMIC YEAR :
ACADEMIC YEAR : 2010-2012010-2011 (SEMESTER-V).1 (SEMESTER-V).
SUBMITTED TO : PROF. RIDDHI SHARMA SUBMITTED TO : PROF. RIDDHI SHARMA
SUBMITTED BY:
SUBMITTED BY:
ACKNOWLEDGEMENT:-S
Srr..n
no
o..
G
Grro
ou
up
p
Members
Members
Roll no.
Roll no.
1 1.. PPUURRNNIIMMA A ORORAASSKKAARR 3377 2 2.. MMEEEETTA A PPAADDAAYYA A 3388 3 3.. KKIIRRA A PPAANNCCHHAALL 3399 4 4.. NNAAVVIIN N PPAARRGGHHII 4400 5 5.. PPAARRIITTA A PPAATTEELL 4411 6 6.. PPOOOOJJAA PPAATTIILL 4422We the group members are thankful to
Prof. RIDDHI SHARMA of FINANCIAL
MANAGEMENT
for
giving
us
the
opportunity to prepare a project on
CAPITAL STRUCTURE.
It was a fruitful experience to work on it;
we learned various dimensions relating
to it. At the same time the project gave
us
an
exposure
to
the
various
complexities associated with it.
We are thankful to our professor for
constantly
supporting
us
and
encouraging us to work on this project
and helped us in the accomplishment of
exploratory as well as result-oriented
research studies.
INDEX:-MEANING OF CAPITAL
STRUCTURE:-Sr.n
o.
Particulars
Page.N
o.
1. Introduction TO capital structure 5.
2. Factors Determining Capital Structure
7.
3. Theories of capital structure 13.
5. Net Income Approach 14.
6. Net Operating Income Approach
18.
7. Traditional Position 20.
8. Miller & Modigliani Approach
apital structure refers to the mix of
sources from where the long term funds
required in a business may be raised, i.e.,
what should be the proportions of equity
share capital, preference share capital,
internal sources, debentures, and other
sources of funds in the total amount of capital
which an undertaking may raise for
establishing its business.
C
In planning the capital structure, the
following issues must be kept in mind:
1. There is no one definite model which can
be suggested/used as an ideal for all business
undertakings. This is because of the varying
circumstances of various business
undertakings. The capital structure depends
primarily on a number of factors like the
nature of industry, gestation period, certainty
with which the profits will accrue after the
undertakings goes into commercial
production and the likely quantum of return
on investment. It is, therefore, important to
understand that different types of capital
structure would be required for different
types of business undertakings.
2. Government policy is a major factor in
planning capital structure. For example, a
change in the lending policy of financial
the financial pattern. Similarly, the Rules and
Regulations for Capital market formulated by
SEBI affect the Capital structure decisions.
Similarly, monetary and fiscal policies of the
Government also affect the capital structure
decisions.
The finance managers of business concerns
are therefore required to plan capital
1.Factors determining
capital
structure:-1) Trading on Equity :
A company earns
the profits on its total capital (borrowed
and owned). On the borrowed capital
(including preference capital company
pays interest or dividend at a fixed rate. If
this fixed rate is lower than the general
rate of earnings of the company, the
equity shareholders will have an
advantage in the form of additional
profits. This may be referred to as trading
on equity.
2)
Desire to Control the Business:
Quite often, the promoters want to retain
the control of the affairs of the company.
They raise the capital from the public by
issuing different types of securities in
such a way as to retain the control of
whole of substantially the whole of the
affairs of the company with them. For this
purpose, they raise a large proportion of
funds by the issue debentures and
preference shares.
3)
Nature of Business:
A manufacturing
company may give a differing capital
structure from Trading, financing,
extractive or public utility concerns.
These, differences enable one type of
business to issue securities which are not
profitable to other business. So public
utility concern may enjoy advantages of
fixed interest securities like bonds and
debenture because of their monopoly and
stability of income. But, on the other
hand, manufacturing concerns do not
enjoy such advantages and rely to a
great extent on equity share capital.
4)
Purpose of Financing:
If funds are
raised for betterment expenditure, it is
quite apparent that it will add nothing to
the earning capacity of the company.
Such expenditure may be incurred either
out of funds raised by issue of shares or
still better out of retained earnings but, in
no case, out of borrowed funds. On the
other hand productive projects may be
financed out of borrowings also.
5)
Period of Finance:
Normally funds
which are required for a short time say
for 5 to 10 years should be arranged
through borrowing because these can
easily be repaid as soon as company’s
financial position improves. On the other
hand, if funds are required permanently
or for a fairly long time, issue of ordinary
shares should be preferred.
6)
Elasticity of capital structure:
The
capital structure should be as elastic as
possible so as to provide for expansion
for future development or to make it
feasible to reduce the capital when it is
not needed. Too much dependence on
debentures and preference shares from
the very beginning makes the capital
structure of the company rigid because of
payment of fixed interest or dividend.
These sources should be kept in reserve
for emergency or for expansion purposes.
7
) Nature of Investors:
Some investors
who prefer security of investment and
stability of income usually go in for
debentures. Preference shares will be
preferred by those who want a higher and
stable income with enough safety of
investment. Equity shares will be taken
up by those who are ready to take risks
for higher income and capital
appreciation. Those who want to acquire
control over the affairs of the company
like equity shares.
8)
Market Conditions:
Conditions of
capital market have an important bearing
on the capital structure of the company
because investor is very often influenced
by the general mood or sentiment of the
capital market although his own mood or
sentiments guide him to invest his funds.
For example, in times of depression,
income and will be willing to invest in
debenture and not in equity shares.
During boom period, when people have
plethora of funds, any type of security
can be sold easily hence equities can
have a better market. The management
while designing the capital structure of
the company must watch the mood or
sentiments of the capital market.
9 ) Legal restrictions
: every company
has to
comply the law of the country
regarding the issues of different types of
securities therefore, hands of the
management are tied by these legal
restrictions. For example in India, banking
companies are not allowed to issue any
type of securities except equity shares
under the Indian banking companies act.
within this overall frame work ,the
management should strive towards
capital structure.
10
)Policy of term financing
institutions :
If financial institutions
offer credit to the industry on strictly
restrictive terms and adopt harsh policy
of lending .they allow raising of fresh
capital by specific manner.
11)
stability of earning or
income :
The stability of capital
structure of a company very much
depends upon the possibilities of regular
and fixed income.
a) if company expects sufficient regular
income in future ,debenture should be
issued .
b) preference share may be issued if
company does not expect regular income
but it is hopefull that its average earnings
for a few years may be equal to or in
excess of the amount of dividend to be
paid on such preference shares.
c)if company does not expect any regular
income in future, it should never issue
any type of securities other then equity
shares .
12)
Trends in capital market :
Capital
markets conditions determine not only
the types of securities to be issued but
also the rate of interest on debenture
,fixed rates on dividends on preference
shares and the prices of equity shares .
13)
Cost of capital and availability of
funds:
14)
Tax benefit.
15)
Assets structure
: Assets structure
also influences one sources of financing
in different ways .firms with long lived
fixed assets,especially when demand foe
the output is relatively assured can use
long term debts.firm whose assets are
mostly receivable and inventory whose
vale is dependent on the continued
profitability of the individual firm can rely
less long term debt financing and more
on short term funds.
16)
Attitude and temperament of
management .
17)
leaders attitude :
Sometimes the
leaders attitude is also an important
determinant of capital structure.in the
majority of cases,the firms management
discussies its capital structure with
leaders and gives much weight to their
advice.but where management is the
confident of future,it may use leverage
beyond norms for the industry.
18)F
iscal incentives and tax
concessions :
incentives and tax
concessions being provided by the
government to various types of industrial
units like relaxation of security
margin,15% subsidy by the
government,of repayment period
extension beyond 10 years,gestation
the extent of 50% in application is made
for the promotion in backward areas also
affect the capital structure.
19)
Advance given by financing
agencies :S
uch agencies are
specialised in tendering expert financial
advice concerning the capital structure of
firms .their advice should be given due
weight and consideration in financial plan
of the concern.
Thus we see the determination of a
thorough consideration of a large number
of factors .there can be no ideal patern of
capital structure for all companies ebven
in the same industry .so each company
has to be studied as an individual case.
THEORIES OF CAPITAL
STRUCTURE:
2. NET OPERATING INCOME
APPROACH
3. TRADITIONAL APPROACH.
4. MILLER AND MODGLIANI
APPROACH.
NET INCOME
APROACH:-Net income approach stats that a firm can
minimize the weighted average cost of capital and increased the value of the firm as well as the
market price of equity shares by using debt
financing to the maximum possible extend. This theory states that a firm can increase its value and reduces the overall cost of capital by increasing the proportion of debt in its capital structure. Net
income approach is based on the following assumption.
1. The cost of debt is less than the cost of equity.
2. There are no taxes.
3. The risk perception of the investors is not charged by this use of debt.
The increase in the debt financing in the capital structures decreases the proportion of equity capital and this results in decreases in the
weighted average cost of capital resulting in an
increase in the value of the firm. The cost of debt is less than the cost of equity because of two
reasons:
• Debt involves less risk then equity. • Interest being – deductible expenses.
According to this approach net income i.e.
expected profit after tax (profit to shareholders) is estimable, based on expectation of shareholders. Hence, Ke can be estimated. Based on this value of Ke, we can calculate Ko. This Ke is independent
variable and Ko is a dependent variable.
The equation for this approach is same as:
Ko = WeKe + WdKd
We know that equity is costlier sources of capital. Debt is relatively cheaper. This is because lenders take less risk. They get their interest payment
Hence equity, being a costlier sources; should be used less. Debt being a cheaper source; should be used more in proportion. Average cost will be less when we use more proportion of debt.
We can summarize this approach as fallows: As per net income approach:
Ko = WdKd + WeKe
a. Expected return on equity is estimable using appropriate estimation of
shareholders, which is Ke.
b. Cost of debt is estimable using rate of interest and tax rate, which is Kd.
c. Overall cost Ko is calculated based on weighted average of Ke and Kd.
d. Thus, Ko is dependent variable and Ke and Kd are independent variables.
e. In this case, cost and proportion of equity as well as debt is estimated. This is used to calculate overall cost of capital i.e.
weighted average cost of capital Ko.
In this case, cost and proportion of equity as well as debt is estimated. This is used to calculate
overall cost of capital i.e. weighted average cost of capital Ko.
This approach is called as net income approach. This is because Ke depends upon net income
available to shareholders i.e. PAT is estimable.
According to this approach Ko declines as debts: equity ratio Dm/Em increases. This is because as
Dm/Em increases, the proportion of the cheaper
capital i.e. debt (Kd) increases. It is graphically represented as fallows:
From this graph it is clear that as leverage i.e. Dm/Em increases, Ko decreases. This is because
cheaper capital viz. Debt, in proportion, increases.
Net Operating Income
Approach:-Cost of equity is estimatedsbn based on
expectations of shareholders. Such estimation is always debatable. Another argument is that the net operating income i.e. PBIT is better estimable for a proposed new venture. So total return on
investment is known i.e. Ko is estimable and wil remain constant irrespective of debt: equity
proportion or capital structure. Using Ko, we can estimate the return available to equity
shareholders and check whether it is in the
acceptable range.This approach is called as Net Operating Income Approach.
This approach assumes overall cost of capital i.e. Ko and cost of debt Kd to be constant. Ke is
variable. Hence the equation: Ko= Wd Kd + We
Ke
This is now rearranged as : Ke= Ko + (Ko -Kd) × (Dm/Em)
We can summarise this approach as follows: As per net operating income approach:
Ke = Ko + (Ko - Kd) × (Dm/De)
Expected return on total investment is estimable which is Ko
Cost of debt is estimable using rate of interest and tax rate, which is Kd
Return available to shareholders Ke is calculated based on Ko and Kd
Thus, Ke is a dependent variable and Ko and Kd are independent variables.
In this case cost and proportion of equity as well as debt is estimated. This is used to calculate return on equity i.e. Ke
This approach is called as Net Operating Income approach. This is because Ko depends upon net income on total investment i.e. PBIT is estimable. In this approach, as overall cost Ko is treated as
constant. So return on equity increases as leverage Dm/Em increases. The implied meaning of this is that the market discounts the leverage risk in price of equity and expectations (the opportunity cost) of equity increases. This may be graphically represented as follows:
(Leverage level)
It may be observed from the graph that Ke
Traditional Approach
Theory:- This approach is similar to Net Income Approach.. According to this, the value of firm can be
increased initially or the cost of capital can be decreased by using more debt as the debt is a
cheaper source of funds then equity. Thus optimum capital structure can be reached by a proper debt-equity mix.
Optimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.
Thus as per the traditional approach the cost of capital is a function of financial leverage and the value of firm can be affected by the judicious mix of debt and equity in capital structure. The increase of financial leverage upto a point favorably affects the value of firm. At this point the capital structure is optimal & the overall cost of capital will be the least.
There are two type of
risks-Business risk – risks-Business risk includes factors such as market fluctuations, availability of materials etc. and it will always be there more or less of risks.
Financial risks- Financial risk keeps on increasing after a certain stage as more and more debt
This theory states that there is a correlation
between the weighted average cost of the debt and equity ratio. The relation between the two when
presented graphically takes the form of a U-shaped curve. Cost of capital will be very high if the debt-equity ratio is zero. When debt is injected into the capital structure step- by- step the weighted
average cost of capital will progressively come down only up to the lowest (optimum) point and then the cost of capital will go up with the further introduction of debt , since the debenture holders have to be offered a higher rate of interest.
MILLER AND MODIGLIANI
POSITION:-According to this approach the total cost of capital of particular firm is independent of its
methods and level of financing. Modigliani and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words, a change in the debt equity mix does not affect the cost of capital. They gave a simple argument in support of their
approach. They argued that according to the
traditional approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, they argued, is determined from the level of shareholder’s expectations. Now, if
shareholders expect 16% from a particular company, they do take into account the debt
equity ratio and they expect 16^ merely because they find that 16% covers the particular risk which this company entails. Suppose, further that the
debt content in the capital structure of this
company increases; this means that in the eyes of shareholders, the risk of the company increases, since debt is a more risky mode of finance. Hence, shareholders will now start expecting a higher rate of return from the shares of the company. Hence, each change in the debt equity mix is automatically offset by a change in the expectations of the
shareholders from the equity share capital. This is because a change in the debt equity ratio changes the risk element of the company, which in turn
changes the expectations of the shareholders from the particular shares of the company. Modigliani and Miller, therefore, argued that financial leverage has nothing to do with the overall cost of capital
and the overall cost of capital of a company is equal to the capitalization rate of pure equity
stream of its class of risk. Hence, financial leverage has no impact on share market prices nor on the cost of capital.
Modigliani and Miller make the
following
propositions:-1. The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by
capitalizing the expected stream of operating
earnings at a discount rate considered appropriate for its risk class.
2. The cost of equity (K e) is equal to capitalization
rate of pure equity stream plus a premium for
financial risk. The financial risk increases with more debt content in the capital structure. As a result, K e
increases in a manner to offset exactly the use of less expensive source of funds.
3. The cut off rate for investment purpose is
completely independent of the way in which the investment is financed.
ASSUMPTIONS OF MODIGLIANI & MILLER
APPROACH:-1. The capital markets are assumed to be perfect. This means that investors are free to buy and sell
securities. They are well informed about the risk-return on all type of securities. These are no
transaction costs. The investors behave rationally. They can borrow without restrictions on the same
terms as the firms do.
2. The firms can be classified into ‘homogeneous risk class’. They belongs to this class if their
expected earnings is having identical risk characteristics.
3. All investors have the same expectations from a firm’s net operating income (EBIT) which are
necessary to evaluate the value of a firm.
4. The dividend payment ratio is 100%. In other words, there are no retained earnings.
5. There are no corporate taxes. However this assumption has been removed later.
Modigliani and Miller agree that while companies in different industries face different risks which will result in their earnings being capitalized at
different rates, it is not
possible for these companies to affect their market values, and therefore their overall capitalization rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in
company’s capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate
leverage. This is illustrated below:
Suppose there are two companies A & B in the same risk class. Company A is financed by equity and company B has a capital structure which
includes debt. If market price of share of company B is higher than company A, market participants would take advantage of difference by selling
equity shares of company B, borrowing money to equate there personal leverage to the degree of corporate leverage in company B, and use these funds to invest in company A. The sale of Company B share will bring down its price until the market value of company B debt and equity equals the
market value of the company financed only by equity capital.
Advantages:
• In practice, it’s fair to say that none of the
assumptions are met in the real world, but what the theorem teaches is that capital
structure is important because one or more of the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure.
Disadvantages:
• Modigliani and Miller’s theorem, which justifies
almost unlimited financial leverage, has been used to boost economic and financial
activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those
which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratios.
CONCLUSION:- Thus capital structure is the financing mix of the firm.
