Victoria International College, Ghorahi Dang By: Amit Chaudhary

NOTES OF CORPORATE FINANCE BBA 8th Semester

Concept of Capital Structure:

Companies use debts and equity to raise fund to meet their financial needs. They need fund to purchase

fixed assets like machinery, land building etc. They also need money to expand their business. Capital

structure refers to the composition of various long term sources of financing. Debts, preferred stocks and

equity are the long-term source of financing. It is the proportionate mix of, debts, preferred stocks and

equity, the long term source of financing. The best mix of these source of financing helps to minimize

firm’s weighted average cost of capital. Therefore, financial manager should try to maintain optimal

capital structure at which weighted average cost of capital is minimized and value of the firm is maximized.

Factors affecting capital structure:

Businesses can utilize different types of capital in order to expand or sustain their current operations.

Depending on the type of company, some businesses may take on more debt, while others may look for

asset-based capital with lower amounts of debt. In any case, all companies need to find a balance between

debt and asset capital for an optimal structure. Here are some factors that may influence capital structure

decisions:

Interest Coverage Ratio (ICR):

It refers to number of time companies’ earnings before interest and taxes (EBIT) cover the interest

payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities whereas lower ICR means less

borrowed fund securities.

Debt Service Coverage Ratio (DSCR):

It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but DSCR takes care of

return of interest as well as principal repayment.

If DSCR is high, then company can have more debt in capital structure as high DSCR indicates ability of

company to repay its debt but if DSCR is less then, company must avoid debt and depend upon equity

capital only.

Return on Investment:

Return on investment is another crucial factor which helps in deciding the capital structure. If return on

investment is more than rate of interest then company must prefer debt in its capital structure whereas

if return on investment is less than rate of interest to be paid on debt, then company should avoid debt

and rely on equity capital. This point is explained earlier also in financial gearing by giving examples.

Cost of Debt:

If firm can arrange borrowed fund at low rate of interest, then it will prefer more of debt as compared to

equity.

Tax Rate:

High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from income

before calculating tax whereas companies have to pay tax on dividend paid to shareholders. So high end

tax rate means prefer debt whereas at low tax rate we can prefer equity in capital structure.

Cost of Equity:

Another factor which helps in deciding capital structure is cost of equity. Owners or equity shareholders

expect a return on their investment i.e., earning per share. As far as debt is increasing earnings per share

(EPS), then we can include it in capital structure but when EPS starts decreasing with inclusion of debt

then we must depend upon equity share capital only.

Floatation Costs:

Floatation cost is the cost involved in the issue of shares or debentures. These costs include the cost of

advertisement, underwriting statutory fees etc. It is a major consideration for small companies but even

large companies cannot ignore this factor because along with cost there are many legal formalities to be

completed before entering into capital market. Issue of shares, debentures requires more formalities as

well as more floatation cost. Whereas there is less cost involved in raising capital by loans or advances.

Risk Consideration:

Financial risk refers to a position when a company is unable to meet its fixed financial charges such as

interest, preference dividend, payment to creditors etc. Apart from financial risk business has some

operating risk also. It depends upon operating cost; higher operating cost means higher business risk. The

total risk depends upon both financial as well as business risk.

If firm’s business risk is low, then it can raise more capital by issue of debt securities whereas at the time

of high business risk it should depend upon equity.

Regulatory Framework:

Issues of shares and debentures have to be done within the SEBI guidelines and for taking loans.

Companies have to follow the regulations of monetary policies. If SEBI guidelines are easy then companies

may prefer issue of securities for additional capital whereas if monetary policies are more flexible then

they may go for more of loans

MM Model under perfect market assumption:

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their

analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that

in perfect markets, it does not matter what capital structure a company uses to finance its operations.

They theorized that the market value of a firm is determined by its earning power and by the risk of its

underlying assets, and that its value is independent of the way it chooses to finance its investments or

distribute dividends.

The basic M&M proposition is based on the following key assumptions:

No taxes

No transaction costs

No bankruptcy costs

Equivalence in borrowing costs for both companies and investors

Symmetry of market information, meaning companies and investors have the same information

No effect of debt on a company's earnings before interest and taxes

Proposition 1st

The Modigliani Miller Proposition I Theory (MM I) states that under a certain market price process, in the

absence of taxes, no transaction costs, no asymmetric information and in an perfect market, the cost of

capital and the value of the firm are not affected by the changed in capital structure. The firm's value is

determined by its real assets, not by the securities it issues. In other words, capital structure decisions are

irrelevant as long as the firm's investment decisions are taken as given.

The assumptions of the MM theory are:

1. There is a perfect capital market. Capital markets are perfect when

- l investors are free to buy and sell securities

- l investors can trade without restrictions and can borrow or lend funds on the same terms as the

firm’s do

- l investors behave rationally

- l investors have an equal access to all relevant information

- l capital markets are efficient

- l no costs of financial distress and liquidation

- l there are no taxes

2. Firms can be classified into homogeneous business risk classes. All the firms in the same risk class will

have the same degree of financial risk.

3. All investors have the same view for the investment, profits and dividends in the future; they have

the same expectation of a firm's net operating income.

4. The dividend payout ratio is 100%, which means there are no retained earnings.

Proposition 2nd

The Modigliani Miller Proposition II Theory (MM II) defines cost of equity is a linear function of the firm's

debt/equity ratio. According to them, for any firm in a given risk class, the cost of equity is equal to the

constant average cost of capital plus a premium for the financial risk, which is equal to debt/equity ratio

times the spread between average cost and cost of debt. Also Modigliani and Miller (1963) recognized the

importance of the existence of corporate taxes. Accordingly, they agreed that the value of the firm will

increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges.

Thus, the value of corporation can be achieved by maximizing debt component in the capital structure.

This theory of capital structure for the study provided an important and analytical framework.

The revised capital structure of the MM Proposition II, pointed out that the existence of tax shield in a

perfect capital market conditions cannot be reached, in an imperfect financial market, the capital

structure changes will affect the company's value. Therefore, the value and cost of capital of corporation

with the capital structure changes in different leverage, the value of the levered firm will exceed the value

of the unlevered firm.

MM Proposition theory suggests that the higher the debt ratio is more favorable to corporate, but though

borrowing adds an interest tax shield it may lead to costs of financial distress. Financial distress occurs

when promises to creditors are broken or honored with difficulty. Financial distress may lead to

bankruptcy. The tradeoff theory of capital structure theory in MM based on the added risk of bankruptcy

and further improves the capital structure theory, to make it more practical significance.

Proposition 3rd

The Modigliani Miller Proposition III Theory (MM III) defines that in presence of tax the company can

increase its company’s value and decrease WACC by issuing debt capital. Because it can enjoy the tax

saving benefit from debt capital. According to this proposition the value of levered firm is equal to the

value of unlevered firm plus tax saving benefit. Symbolically,

Value of levered firm (VL) = Value of Unlevered firm (VU) + Benefit from tax saving

Concept of right offering:

Right offering refers to the offering of common stock to investors who currently

hold shares which entitle them to buy subsequent issues at a discount from the offering price.

New stock (share) issue offered to existing stockholders (shareholders) in proportion to

their current stock/shareholding, for a specified period and at a specified (usually discounted) price.

Its objective is to afford them the opportunity to maintain their percentage of ownership of the firm.

Effect of right offering in the market price of shares:

As you know that the company offer right shares at discount price i.e. lower than the market price of

stock. Due to the offering share at discount price the market price of stock decrease. It can be clear from

following example:

For example, ABC company has 100000 shares outstanding. And market price per share is NRP 200. Now

the company want to issue right shares to its existing shareholders at a discount price of NRP 175.

Shares PPS Value

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Outstanding shares 100000 shares NPR 200 per share NPR 20000000

Right offering 100000 shares NRP 170 per share NPR 17000000

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Total 200000 shares NRP 37000000

Price per share after right offering,

Price per share (PPS) = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘

𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔⁄

= 37000000200000⁄

= NRP 185

Here Market price of share decrease to NRP 185 from NRP 200 after issuing right share. Therefore,

issuance of right share leads to decrease in market price per share.

Financial distress:

A condition where a company cannot meet or has difficulty paying off its financial obligations

to its creditors. The chance of financial distress increases when a firm has high fixed

costs, illiquid assets, or revenues that are sensitive to economic downturns.

A company under financial distress can incur costs related to the situation, such as more

expensive financing, opportunity costs of projects and less productive employees. The firm's cost of

borrowing additional capital will usually increase, making it more difficult and expensive to raise the much

needed funds. In an effort to satisfy short-term obligations, management might pass on profitable longer-

term projects. Employees of a distressed firm usually have lower morale and higher stress caused by the

increased chance of bankruptcy, which would force them out of their jobs. Such workers can be less

productive when under such a burden.

Resolving financial distress:

1. Pay your taxes first. It is essential that you keep your taxes current. The Internal Revenue Service can

hold you personally liable for unpaid taxes. Make especially sure that taxes withheld from employees'

salaries are paid on time. Keep in mind that even if your tax payments are late, the IRS has a policy that

may reduce or eliminate penalties. This requires that you keep meticulous records of business expenses,

and that these records prove that you cut out all unnecessary expenditures AND made tax payments to

the IRS your number one business priority.

2. Update your business records and financial statements. This will give you a clearer picture of where you

really stand and will allow you to set priorities appropriately.

3. Don't comingle personal funds with business funds. When businesses are in financial trouble, owners

often seek to keep them afloat with personal loans to the business, the use of personal charge cards, or

the use of other personal assets. Comingling personal and business funds opens up the possibility that

creditors will seek to "pierce the veil" between you and your business. If they are successful, you become

personally liable for the business debts. Although "piercing the veil" is most often thought of in relation

to corporations, it is also a creditor's strategy in collecting the debts of limited liability companies and

other business structures that protect the owners from personal liability.

4. Don't hide your debts. If you are attempting to get new income into the business through outside loans,

you need to be honest about the business's condition. Hiding debts and other financial circumstances is

fraud. Not only will you find yourself personally liable for the loan, you could also face criminal charges.

5. Avoid making preferential payments to your creditors. If you have to file bankruptcy, all payments that

your business made for at least the prior year will be scrutinized. If the court finds that certain payments

were made preferentially, it can order that those payments be returned. Payments that you can make

without worrying about preferences include salaries, rent, payroll, retirement plan contributions,

insurance premiums, utilities, and vendor payments.

6. Use caution in transferring business assets. Creditors know how to discover where your property went.

The company car must remain the company car. Giving it or selling it for a fraction of what it is worth to

Uncle Joe is a fraudulent transaction. Don't even consider hiding business property or income from a

court.

7. Make plans to continue or obtain insurance coverage. This includes health, life, automobile, and any

other insurance that you may have through the business.

8. Protect your bank account. Determine whether your outstanding business loans give the lender the

right to take funds from your account without notice when you fall behind on payments. You may wish to

move your business account to another bank. Remember that your number one goal is to keep up with

tax payments. If your lender empties your account, the check you just wrote to the IRS will bounce.

9. Set priorities. Make a list of creditors that must be paid for you to continue operating until you can close

the business on the most favorable terms. Conducting an asset sale and winding up business affairs takes

time.

10. Consider bankruptcy immediately. Don't throw good money after bad! If nothing can be gained by

adding additional capital, don't do it. Straight bankruptcy (Chapter 7) and reorganization (Chapter 13) are

serious acts that will negatively affect your credit rating for years. At the same time, both options allow

you to get beyond the financial troubles and provide the opportunity to start over. Although Chapter 7, in

theory, gives you a completely clean slate, it is also more damaging to your credit history. Chapter 13

allows you to pay off your debts over time and is less harmful to your credit history, but it may not be

practical if your debts are high and your future income is not enough to meet these debts while supporting

yourself and your family.

Concept of Nepal Stock Exchange (NEPSE)

Nepal Stock Exchange, in short NEPSE, is established under the company act, operating under Securities

Exchange Act, 1983. The basic objective of NEPSE is to impart free marketability and liquidity to the

government and corporate securities by facilitating transactions in its trading floor through member, market

intermediaries, such as broker, market makers etc. NEPSE opened its trading floor on 13th January

1994. Government of Nepal, Nepal Rastra Bank, Nepal Industrial Development corporation and members

are the shareholders of NEPSE.

The history of securities market began with the floatation of shares by Biratnagar Jute Mills Ltd. and Nepal

Bank Ltd. in 1937. Introduction of the Company Act in 1964, the first issuance of Government Bond in 1964

and the establishment of Securities Exchange Center Ltd. in 1976 were other significant development

relating to capital markets.

Securities Exchange Center was established with an objective of facilitating and promoting the growth of

capital markets. Before conversion into stock exchange it was the only capital markets institution

undertaking the job of brokering, underwriting, managing public issue, market making for government bonds

and other financial services. Nepal Government, under a program initiated to reform capital markets

converted Securities Exchange Center into Nepal Stock Exchange in 1993.

Members of NEPSE are permitted to act as intermediaries in buying and selling of government bonds and

listed corporate securities. At present, there are 50 member brokers and 2 market makers, who operate on

the trading floor as per the Securities Exchange Act, 1983, rules and bye-laws.

Besides this, NEPSE has also granted membership to issue and sales manager securities trader (Dealer).

Issue and sales manager works as manager to the issue and underwriter for public issue of securities

whereas securities trader (Dealer) works as individual portfolio manager.

The tenure of the membership is one year. The license should be renewed within 3 months after the closure

of the fiscal year. If not, it can be done within another three months by paying 25% penalty.

Initial public offering:

An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise

money by issuing either debt or equity. If the company has never issued equity to the public, it's known

as an IPO. A large-scale company generally raises funds through public offering. In public offering the

investment banker acts as a middleman who brings together suppliers and users of long term funds in

capital market. The investment bankers buy securities from the company at lower price and resell them

to investors at a higher price. Difference between buying and selling price i.e. ‘Spread’ is commission to

the underwriter.

Difference between right offering and initial public offering:

Right Offering Initial Public Offering

Right offering refers to the issuance of right share for the existing shareholders at discounted price on pro-rata basis. In right offering the company can reduce the flotation cost by eliminating underwriting commission. It is only for the existing shareholders not for public.

Initial public offering refers to the issuance of new share to the general public. In initial public offering the company should pay commission to the underwriter for working as an agent while issuing shares to the general public. Public as well as existing shareholders also can buy shares in IPO.

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Paudel, R. B., Baral, K. J., Gautam, R. R., Rana, S. B. (2011). FINANCIAL MANAGEMENT. Kathmandu: Asmita

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