Optimal Capital Structure and Factors Determining Capital Mix

Form of Capital:
Capital Structure

Capitalization
Capital
Structure
Financial
Structure
Terminologies

Total amount of
(in )
issued by a company
Current Liabilities Current Assets
Debt
Preference Shares
Fixed Assets
Equity Shares
Retained Earnings
Balance Sheet

Balance Sheet
Current Liabilities Current Assets
Debt
Preference Shares
Fixed Assets
Equity Shares
Retained Earnings

Capital Structure =
Financial Current
Structure liabilities

Equity Share Capital
+ Retained Earnings
Debt + Preference
Share
Debt
FoundationExpansion
Horizontal
Vertical
Pyramid
Shaped
Inverted
Pyramid
Shaped

Importance of Capital
Structure:

 Level of EBIT which is just equal to pay the total financial charges.
 At this point EPS = 0.
 Critical point in planning capital structure of firm.
 If EBIT < financial break even point, then debt and preference share capital
should be reduced in capitalization.
 If EBIT> financial break even point more of fixed cost may be inducted in
capital structure.
Financial Break-Even Point

• Financial Break Even Point
= Fixed Interest Charges
When capital
structure consists
of debt and equity
share capital and
no preference
share capital
• Financial break even point=
I+ Dp
• (1-t)
• here, I = fixed interest charges
• Dp = preference dividend
• t = tax rate
When capital
structure consists
of equity share
capital, preference
share capital and
debt

Point of Indifference/ Range of Earnings
 It is EBIT level at which
EPS remains the same ;
irrespective of different alternatives of debt-equity mix.
 At this level of EBIT,
rate of return on capital employed = cost of debt.

 Calculation of Point of Indifference (algebraically):
(X-I1) (1-T) – PD = (X-I2) (1-T)- PD
S1 S2
WHERE, X = point of indifference,
I1 = interest under alternative financial plan 1,
T= tax rate,
S1 = no of equity shares under financial plan1,
S2 = no of equity shared under financial plan 2,
PD= preference dividend.

A project under consideration by your company requires a
capital investment of 60 lakhs. Interest on loan 10 % p.a
and tax rate 50%. Calculate point of indifference for the
project, if debt equity ratio is 2:1.

As debt equity ratio is 2:1. So, Company has two alternatives :
(i) Raising entire amount by issue of share capital and no debt.
(ii) Raising 40 lakh by way of debt and 20 lakh by issue of equity
share capital.
Calculation of point of indifference:
(X-I1) (1-T) – PD = (X-I2) (1-T)- PD
S 1 S2
I1 = 0 , I2 = 40* 10% = 4 , tax rate = 50 % or .5 , S1= 60, S2 = 20
now substitute the values,
(X-0) (1-0.5) – 0 = (X-4) (1-0.5) – 0
60 20
20 (.5X) = 60 (.5X-2)
10X = 30X-120
X=6
Thus, EBIT at point of indifference is 6 lakhs.

Graphically :
0
0.2
0.4
0.6
0.8
1
1.2
1 2 3 4 5 6 7 8 9 10
Plan 1
Plan 2
EPS(Rs.)
EBIT (Rs. In lakhs)
Indifference point

Point of indifference and
uncommitted earnings per share
Equivalency point for uncommitted EPS can be calculated as below:
(X-I1) (1-T) –PD-SF = (X-I2) (1-T)- PD- SF
S1 S2
where, X = Equivalency point or point of indifference
T= tax rate,
S1 = no of equity shares under financial plan1,
S2 = no of equity shared under financial plan 2,
PD= preference dividend.
SF= sinking fund obligations

Considerations to be kept in mind while
maximising value of firm:

Capital mix involves two types of risks:
1. Financial Risk
2. Non-Employment of Debt Capital
Risk (NEDC)

Financial Risk
• Debt causes financial
risk !
• The use of debt
financing is referred to
as financial leverage.
• Financial leverage
measures Financial
risk.
Sales
Operating (–) Variable costs
Leverage Contribution
(–) Fixed costs
EBIT / Profit
(–) Interest expense
Financial EBT
Leverage (–) Taxes
EAT
(-) Preference dividend
Earnings available for
equity Shareholders

Non-Employment of Debt Capital
(NEDC) Risk
 No advantage of Financial leverage.
 Loss of control by issue of more and more
Equity.
 Higher Floatation Cost.

Strike a balance (trade off) between
the financial risk
and
Risk of non-employment of debt capital
to increase
Firm’s Market Value.

Theories of Capital Structure
1. Net Income Approach
2. Net Operating Income Approach
3. The Traditional Approach
4. Modigliani and Miller Approach

PURPOSE OF STUDY
CAPITAL
STRUCTURE
VALUE OF
FIRM
COST OF
CAPITAL

1. NET INCOME APPROACH
ASSUMPTIONS:
1. COST OF DEBT < COST OF EQUITY
2. NO TAXES
3. RISK NOT INFLUENCED BY DEBT’S
USAGE

IMPLICATIONS
INCREASE IN FIRMS’ VALUE
PROPORTION OF
CHEAP SOURCE OF
FUNDS INCREASE
PROPORTION
OF DEBT
INCREASES

CONT…
DECREASE IN
FIRMS’VALUE
FINANCIAL
LEVERAGE IS
REDUCED
PROPORTION OF DEBT
FINANCING DECREASES

Calculation of THE TOTAL MARKET VALUE OF A FIRM
V = S + D
Where, V= Total market value of a firm
S= Market value of equity shares
Earnings available to equity shareholders (NI)
Equity Capitalization Rate
D = market value of debt
And, Overall Cost of Capital (Weighted Average Cost of Capital)
K0 = EBIT
V

A company expects a net income of Rs. 80,000. It has
Rs. 2,00,000, 8% debentures. The equity
capitalization rate of the company is 10%.
Calculate:
(a) the value of the firm & overall capitalization rate.
(b) If the debenture debt is increased to Rs 3,00,000,
what shall be the value of the firm & overall
capitalization rate?

Solution
Particulars
Net income
Less interest on 8% debentures of
Rs .2,00,000/3,00,000
Earnings available to equity shareholders
Equity capitalization rate
Market value of equity(s)
Market value of debentures(D)
Value of the firm (S+D)
Overall cost of capital
Rs
80,000
(16000)
64000
10%
6,40,000
2,00,000
8,40,000
(80,000/8,40,000)
X100
=9.52%.
Rs
80,000
(24000)
56,000
10%
5,60,000
3,00,000
8,60,000
(80,000/8,60,000)
X100
=9.30%

2. NET OPERATING INCOME
APPROACH
ASSUMPTIONS:
1. MARKET CAPITALISES VALUE OF FIRM AS A WHOLE
2. BUSINESS RISK REMAINS CONSTANT AT EVERY LEVEL
OF DEBT EQUITY MIX
3. NO CORPORATE TAXES

IMPLICATIONS
INCREASED USE OF
DEBT INCREASES
FINANCIAL RISK OF
THE EQUITY
SHAREHOLDERS.
COST OF EQUITY
INCREASES.
ADVANTAGE OF
USING CHEAP
SOURCE OF FUND
i.e., DEBT IS EXACTLY
OFFSET BY
INCREASED COST OF
EQUITY.
OVERALL COST OF
CAPITAL REMAINS
THE SAME.

Ascertainment of value of firm
 V= EBIT/KO
 V= Value of the firm
 EBIT= Net operating income or earnings
before interest & tax
 KO= Overall cost of capital
 S= V-D
 S= Market value of equity shares
 V= total market value of a firm
 D= market value of debt

A company expects a net operating income of
Rs.1,00,000. It has Rs 5,00,000 6% debentures. The
overall capitalization rate is 10%. Calculate the value
of the firm & cost of equity according to net
operating income approach. If the debenture debt is
increased to Rs 7,50,000. What will be the effect on
the value of the firm % the equity capitalization
rate?

Solution
PARTICULARS
Net operating income
Overall cost of capital (Ko)
Market value of the firm=
EBIT/Ko (100000x100/10)
Market value of the firm(v)
Less market value of
debentures (D)
Total market value of equity
Cost of equity=
(EBIT-I) x 100
(V-D)
RS
1,00,000
10%
10,00,000
10,00,000
(5,00,000)
5,00,000
(1,00,000-30,000) x 100
10,00,000-5,00,000
=14%.
RS
1,00,000
10%
10,00,000
10,00,000
(7,50,000)
2,50,000
(1,00,000-45000) x 100
10,00,000-7,50,000
=22%

3. Traditional approach
USE OF DEBT
INITIALLY
VALUE OF FIRM
INCREASES
COST OF CAPITAL
DECREASES
BUT..
INCREASED
USE OF DEBT
FINANCIAL
RISK OF EQUITY
SHAREHOLDER
S INCREASE
COST OF
EQUITY
INCREASES
OVERALL COST
OF CAPIAL
INCREASES
Implications:

Compute:
Market value of Firm, Value of shares, and Average cost of Capital
Particulars
Total investment
Equity capitalization rate
a. If the firm uses no debt
b. If the firm uses Rs 4,00,000 debentures
c. If the firm uses Rs 6,00,000 debentures
Rs.
2,00,000
10,00,000
10%
11%
13%
Assume that Rs. 4,00,000 debentures can be raised at 5% rate of interest
whereas Rs. 6,00,000 debentures can be raised at 6% rate of interest.

Solution
Less int.
Earnings available to
eq. Sh.Holders
Eq. Capitalization rate
Market value of shares
Market value of debt
Market value of firm
Average cost of
Capital =EBIT/v
(a) No debt
2,00,000
-
2,00,000
10%
20,00,000
-
20,00,000
2,00,000/20,00,000X
100
=10%
(b) Rs 4,00,000 5%
debentures
2,00,000
(20,000)
1,80,000
11%
16,36,363
4,00,000
20,36,363
2,00,000/20,36,363X1
00
=9.8%
(c) Rs. 6,00,000
6% debentures
2,00,000
(36,000)
1,64,000
13%
12,61,538
6,00,000
18,61,538
2,00,000/18,61,5
38X100
=10.7%

4. Modigliani & Miller Approach
(IN THE ABSENCE OF TAXES)
ASSUMPTIONS:
THERE ARE NO CORPORATE TAXES
THERE IS A PERFECT MARKET
INVESTORS ACT RATIONALLY
THE EXPECTED EARNINGS OF ALL THE FIRMS HAVE IDENTICAL
RISK CHARACTERSTICS
ALL EARNINGS ARE DISTIBUTED TO THE SHAREHOLDERS

Implications
 Cost of capital not influenced by changes in
capital structure
 Debt-equity mix is irrelevant in
determination of market value of firm

(B) WHEN TAXES ARE ASSUMED TO EXIST
USE OF DEBT
COST OF
CAPITAL
DECREASE
ACHIEVEMENT
OF OPTIMAL
CAPITAL
STRUCTURE
Implication:

The mix of debt, preferred stock, and common
stock the firm plans to use over the long-run
to finance its operations.

Features of a Optimal
Capital Mix
• Optimum capital structure is also referred as “
appropriate capital structure” and “sound capital
structure”
• Capacity of a FIRM
• Possible use of LEVERAGE
• FLEXIBLE
• Avoid Business RISK
• MINIMISE the cost of Financing and MAXIMISE
earning per share

Factors determining capital
structure

A company is considering 4 different plans to
finance its total project cost of Rs 5,00,000
Plan I Plan II Plan III Plan IV
Equity(Rs. 10
per share)
8% Preference
Shares
Debt (8%
Debenture)
5,00,000
-
-
5,00,000
2,50,000
2,50,000
-
5,00,000
2,50,000
-
2,50,000
5,00,000
2,50,000
1,00,000
1,50,000
5,00,000

Plan I Plan II Plan III Plan IV
EBIT 1,00,000 1,00,000 1,00,000 1,00,000
Less: Interest
on Debentures
EBT
-
1,00,000
-
1,00,000
20,000
80,000
12,000
88,000
Less: Tax @50%
Earning after
Interest and
Tax
Less:
Preference
Dividend
50,000
50,000
NIL
50,000
50,000
20,000
40,000
40,000
NIL
44,000
44,000
8,000
Earning available
for
eq.Shareholders
(A)
50,000 30,000 40,000 36,000
No. of Equity
Shares(B)
50,000 25,000 25,000 25,000
EPS(A/B) 50,000/50,000
= Rs.1per share
30,000/25,000
=Rs.1.20per share
40,000/25,000
=Rs.1.60per share
36,000/25,000
=Rs.1.44per share

PRINCIPLES OF CAPITAL
STRUCTURE
COST
PRINCIPLE
RISK
PRINCIPLE
TIMING
PRINCIPLE
FLEXIBILITY
PRINCIPLE
CONTROL
PRINCIPLE

CAPITAL GEARING
• The term "capital gearing" or "leverage" normally refers to the proportion
of relationship between equity share capital including reserves and
surpluses to preference share capital and other fixed interest bearing
funds or loans.
• It is the proportion between the fixed interest or dividend bearing funds
and non fixed interest or dividend bearing funds.
• Equity share capital includes equity share capital and all reserves and
surpluses items that belong to shareholders. Fixed interest bearing funds
includes debentures, preference share capital and other long-term loans.

HOW TO CALCULATE
Formula of capital gearing
ratio:-
[Capital Gearing Ratio = Equity
Share Capital / Fixed Interest
Bearing Funds]

EXAMPLE
1992 1993
EQUITY SHARE
CAPITAL
5,00,000 4,00,000
RESERVES AND
SURPLUSES
3,00,OOO 2,00,000
LONG TERM
LOANS
2,50,000 3,00,000
6%
DEBENTURES
2,50,000 4,00,000

CALCULATI
ON
 Capital Gearing Ratio
 1992 = (500,000 + 300,000) / (250,000 + 250,000)
= 8 : 5 (Low Gear)
1993 = (400,000 + 200,000) / (300,000 +400,000)
=6 : 7 (High Gear)
 It may be noted that gearing is an inverse ratio to the
equity share capital.
 Highly Geared------------Low Equity Share Capital
 Low Geared---------------High Equity Share Capital

SIGNIFICANCE
Capital gearing ratio is important to the
company and the prospective investors. It
must be carefully planned as it affects the
company's capacity to maintain a uniform
dividend policy during difficult trading
periods. It reveals the suitability of company's
capitalization.

REASONS FOR CHANGE IN CAPITAL
STRUCTURE :-
To restore balance in financial plan
To simplify the capital structure
To suit investors needs
To fund current liabilities
To write-off the debts

To capitalise retained earnings
To clear default on fixed cost
structures
To fund accumulated dividends
To facilitate merger and expansion
To meet legal requirements

1.)
A company can
adjust its capital
structure as
according to
needs.
So as to maintain
a balance in
financial plan and
ease out the
tension and strain
Restoring
balance in
financial
plan

2.) Simplify the capital structure

3.)To suit the need of investors
To make the investment more
attractive especially when the
shares are limited
due to wide fluctuations in
market
the company may change
capitalisation to suit the needs of
investors.

4.)To fund current liabilities
There may be need of converting
short term obligations into long
term obligations
Or vice versa
When the market conditions are
favorable

5.)To write off deficit
A company may need to re-organize its
capital by reducing book value of its
liabilities and assets to its real values
As when the book value of assets are over-
valued
Or when there are accumulated losses
So as to make company legally payable for
dividends to its shareholders

6.)To capitalise retained earnings
To avoid over-
capitalisation
Maintain a balance
between preference
shares and equity
shares and equity
shares and
debentures
Company may
capitalise retained
earnings by issuing
bonus shares out of
it

7.)To clear defaults on fixed cost
securities:-
When the company is
not in a position to
pay interest on
debentures or to
repay them on
maturity
It may offer them
certain
securities(equity
shares, preference
shares or new
debentures)
to clear default

8.)To fund accumulated dividend
When its time to pay fixed dividends to its preference
shareholders
Or when the preference shares are due for redemption
And the company do not have sufficient funds
The company may prefer to issue new shares in lieu

9.)To facilitate merger and expansion
To facilitate merger and
expansion
Companies may be required to
re adjust its capital structure

10.)To meet legal requirements
To meet the legal requirements
It is necessitated to meet the changes in
various legal requirements
As and when took place

Financial Distress and Capital Structure
• Financial risk increases when firm uses more debt;
it may not be able to pat fixed interest and runs into bankruptcy.
• Firms using more equity don't face this problem.
• Use of debt provides tax benefit but bankruptcy costs work
against the advantage.
• When firm raises debt, suppliers put restrictions in agreement
resulting to less freedom of decision making by management
called agency cost.

• This theory was suggested by DONALDSON in 1961.
• It was modified by MYERS in 1984.
According to Donaldson,
o Firm has well defined order of preference for raising finance.
o When firm need funds it will rely on internally generated funds.
o This order of preference is so defined because internally
generated funds have no issue costs.

Theory
presumptions
Cost of
internally
generated
funds is
lowest.
Raising of debt
is cheaper
source of
finance.
Raising of debt
through term
loan is cheaper
than issuing
bonds.
Issue of new
equity capital
involves heavy
issue cost.
Servicing of
debt capital is
relatively less
as compared to
equity

Proposes
of pecking
order
theory
Dividend policy is
stickily
There is
preference for
internally
generated funds
to external
financing
If external
financing is
needed, debt is
preferred to
equity
Issue of new
equity for raising
additional funds
is considered as
a last resort

According to modified pecking order
theory,
o Order of preference for raising funds arises because of
asymmetric information between market and firm.
o Firm may prefer internal funds and then raising of debt
as compared to issue of new equity share capital.

Optimal Capital Structure and Factors Determining Capital Mix

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