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ASSIGNMENTSubmitted To:
Mr. Suleman
Submitted By:
UZMA SIDDIQUE
Topic:Capital Structure
MIU
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Definition of Capital Structure
The capital structure of a business is the mix of types of debt and equity the company
has on its balance sheet. Capital structure is sometimes referred to as a
company's debt to equity ratio. Debt and Equity has a different impact on earnings, cash
flow, balance sheet presentation, and taxes, Companys leverage, intensity, and a host
of other metrics by which businesses are measured. Finally, each financing option
brings a different type of relationship with the respective financing source.
Sources of debt financing include collateralized bonds, debentures, bank loan,
and lines of credit.
Sources of equity financing includes seeking capital from investors through the
issuance of shares these shares can be common or preferredIf the capital structure is mostly based on debt investors considered the firm more risky
as there are more chances of bankruptcy. Debt financing is cheaper than equity
financing but the increase leverage increases the risk and investors will demand high
expected return to take that risk.
Financing is one of the most important functions of the firms. Firms need finance to
extend their business and to accomplish other projects and operations. Firms can
finance themselves by two ways:
1. Internal Financing.
2. External Financing.
Types of financing
A companys capital structure describes the composition of its permanent or long-term
capital, which consist of a combination of debt and equity and hybrid securities. A good
proportion of equity as opposed to debt in a companys capital structure is an indication
of financial fitness.
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Three types of financing needs to be considered when we talk about financing
decisions:
1. Debt financing
2. Equity financing3. Hybrid financing
Debt financing
A company is said to take up debt financing, when it takes money from sources other
than its own
Debt financing is obtainined by borrowed funds for the company
Equity financing
Equity financing includes owners equity, venture capital, common equity, and warrants
Equity financing is obtaining funds for the company in exchange for ownership
Debt financing
Debt comes in two primary forms: senior and subordinated. Senior debt from a bank is
less expensive than subordinated debt but often has more extensive covenants that
provide the lender with certain remedies in the event the covenants are not satisfied .
Debt financing ranges from simple bank debt to commercial paper and corporate bonds.
It is a contractual arrangement between a company and an investor, whereby the
company pays a predetermined claim (or interest) that is not a function of its operating
performance, but which is treated in accounting standards as an expense for tax
purposes and is therefore tax-deductible. The debt has a fixed life and has a priority
claim on cash flows in both operating periods and bankruptcy. This is because interest
is paid before the claims to equity holders, and, if the company defaults on interest
payments, it will be declared bankrupt, its assets will be sold, and the amount owed to
debt holders will be paid before any payments are made to equity holders.Typically,
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debt financing also called asset based financing requires that some asset such as a
car, house, plant, machine, or land etc be used as a collateral.
A company consider itself too highly leveraged when it has much debt then equity may
find itself free from the actions restricted by its creditors and/or may have its profitability
hurt as a result of paying high interest cost on debt. During period of adverse economic
conditions the worst situation would be having trouble in meeting operational and debt
liabilities. A company in a highly competitive business, if have high debt, may find its
competitors taking advantage of its problems to grab more market share.
The debt-equity relationship varies according to industries involved, a companys line of
business and its stage of development.
Debt financing is supposed to be a good idea for short term expensive projects.
Suppose you get a pretty amazing project proposal, to be completed in a certain
amount of time, it is not always possible to raise all the money for it so fast. Debt capital
can help you complete the project. You can then sell it, get a lot more money than what
you took as debt, and pay off the loan and pocket the rest yourself. Your business
capital remains untouched.
Debt capital comes with an inherent risk. And an interest rate which can be quite high.
Usually you have to keep an asset as a security for the debt with your creditor. And in
case your plan bombs, and you are not able to generate the revenue you had budgeted,
you will not be able to pay off the debt and hence stand to lose the asset you pledged
If the financing is short term less then one year, the money is usually used to provide
working capital to finance inventory, account receivable, or the operations of the
business. The funds are typically rapid from the resulting sales and profits during the
year. Longterm debt lasting more then one year is frequently used to purchase some
assets such as a piece of machinery, land or building, with part of the value of asset
usually from 50 to 80 percent of the total value being used as a collateral for the long
term loan.
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Subordinated Debt
Subordinated debt is a type of debt that typically has both debt and equity
characteristics and sits below senior debt in the capital structure. Since the risk
exposure is great than senior debt, mezzanine debt carries a higher interest rate and
some form of equity kicker (an equity interest in the company typically in the form of
stock or warrants) to drive acceptable riskadjusted returns. Subordinated debt typically
requires that some or all of the related interest costs be paid monthly or quarterly,
placing a potential drain on a growing companys cash flow. And, subordinated interest
rates are much higher than Senior debt, these payments can be significant. Accordingly,
subordinated debt is commonly used specifically for recapitalizations or acquisitions.
Equity Financing
Equity financing is the money that the owner of the business puts in himself/themselves.
And for the money that the owners put in the business, they get a share of the
ownership and the resulting business profits after interest payments and tax. The
money stays in the business and the owners (called shareholders) can receive their
money only on winding up or by selling their share to someone else.
Does not require collateral and offers the investor some form of ownership position inthe company. The investor share in the profit of the company, as well as any disposition
of its assets on a pro rate basis based on the percentage of the business owned.
Debt is permanent in the company, its claim is residual and does not create a tax
advantage from its payments as dividends are paid after interest and tax, it does not
have priority in bankruptcy, and it provides management control for the owner.
Key factors that favoring the one type of financing over another are the availability of
funds, the assets of the company, and the prevailing interest rates. Usually, a creditor
meets financial needs by employing a combination of debt and equity financing.
All companies will have some equity, as all companies are owned by some person or
institution. Although the owner may sometimes not be directly involved in the day-to-day
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management of the company, there is always equity involved that is provided by the
owner. The amount of equity involved will of course vary by natural by the nature and
size of the company In general, analysts use three different ratios to assess the
financial strength of a company's capital structure. The first two, the so-called debt and
debt/equity ratios, are popular measurements; however, it's the capitalization ratio that
delivers the key insights to evaluating a company's capital position.
The debt ratio compares total liabilities to total assets. Obviously, more of the
debt/equity ratiomeans less equity and, therefore, indicates a more leveraged position.
The problem with this measurement is that it is too broad in scope, which, as a
consequence, gives equal weight to operational and debt liabilities.
The same criticism can be applied to the debt/equity ratio, which compares total
liabilities to total shareholders' equity. Current and non-current operational liabilities,
particularly the latter, represent obligations that will be with the company forever. Also,
unlike debt, there are no fixed payments of principal or interest attached to operational
liabilities.
Advantages of Equity Financing:
In equity financing there is a defined range of exit dates.
In equity financing there is a broad level participation.
There is an active involvement as appropriate.
Funding amounts are based on expected future value.
Equity financing is a low risk financing.
The difference is of control equity holders have more control over the company
than the debt holders but this control remains only till the bankruptcy.
You can use your cash and that of your investors when you start up your
business for all the start-up costs, instead of making large loan payments to
banks or other organizations or individuals. You can get underway without the
burden of debt on your back..
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Depending on who your investors are, they may offer valuable business
assistance that you may not have. This can be important, especially in the early
days of a new firm. You may want to consider angel investors orventure capital
funding. Choose your investors wisely.
Disadvantages of Equity Financing:
Equity financing involves Higher Cost of Capital
In equity financing Interest Accrued, but not Paid
The business will run quite slowly and won't progress as much as it could, had it
taken debt financing.
Business lack credibility
Equity financing involve higher tax
Since your investors own a piece of your business, you are expected to act in
their best interests as well as your own, or you could open yourself up to a
lawsuit. In some cases, if you make your firm's securities available to just a few
investors, you may not have to get into a lot of paperwork, but if you open
yourself up to wide public trading, the paperwork may overwhelm you. You will
need to check with the Securities and Exchange Commission to see therequirements before you make decisions on how widely you want to open up
your business for investment.
Advantages of Debt Financing
Debt financing involve low cost of capital.
Interest are paid on periodic bases.
Debt financing involve fixed maturity date.
Debt financing involves broad observer.
Debt financing allows you to have control of your own destiny regarding your
business. You do not have investors or partners to answer to and you can make
all the decisions. You own all the profit you make.
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If you finance your business using debt, the interest you repay on your loan is
tax-deductible. This means that it shields part of your business income from
taxes and lowers your tax liability every year. Your interest is usually based on
the prime interest rate.
The lender(s) from whom you borrow money do not share in your profits. All you
have to do is make your loan payments in a timely manner.
You can apply for a Small Business Administration loan that has more favorable
terms for small businesses than traditional commercial bank loans.
In case of value debt are preferred over the equity as they company pay to the
debt holder first than the equity holders as they are the liability of the company.
Disadvantages of Debt Financing
The disadvantages of borrowing money for a small business may be great. You
may have large loan payments at precisely the time you need funds for start-up
costs. If you don't make loan payments on time to credit cards or commercial
banks, you can ruin your credit rating and make borrowing in the future difficult or
impossible. If you don't make your loan payments on time to family and friends,
you can strain those relationships.
Debt financing funding Amount Based on Current Cash Flow.
Debt financing involve little involvement.
Debt capital comes with an inherent risk.
Debt financing including a higher probability of bankruptcy, an increase in the
agency conflicts between managers and bondholders
Debt financing involves loss of future financial flexibility.
Debt financing involves the cost of information asymmetry.
For a new business, commercial banks may require you to pledge your personal assets
before they will give you a loan. If your business goes under, you will lose your personal
assets.
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Any time you use debt financing, you are running the risk ofbankruptcy. The more debt
financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to
determine how much debt your firm is in compared to its equity.
Which is best; debt or equity financing? It depends on the situation. Your financial
capital, potential investors, credit standing, business plan, tax situation, the tax situation
of your investors, and the type of business you plan to start all have an impact on that
decision. The mix of debt and equity financing that you use will determine your cost of
capital for your business.
Types of Capital Structure Theories.
There are six types of capital structure theories which are
Net income theory
Net operating income theory
Modigliani-Miller theorem
Trade-off theory
Pecking order theory
Traditional theory
Assumptions of Capital Structure Theories
The total assets of a company are given and do not change.
Total financing remain constant.
Operating profit not expected to grow.
Company has infinite life.
Corporate tax does not exist.
Dividend payout equal to 100%
Business risk is constant overtime.
Net Income Theory
Net Income theory was propounded by David Durand and is also known as Fixed Ke
Theory.This theory gives the idea for increasing market value of firm and decreasingoverall cost of capital. A firm can choose a degree of capital structure in which debt is
more than equity share capital. It will be helpful to increase the market value of firm and
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decrease the value of overall cost of capital. Debt is cheap source of finance because
its interest is deductible from net profit before taxes. Interest rates are lower than
dividend rates due to element of risk,
For example if you have equity debt mix is 50:50 but if you increase it as 30: 70, it will
increase the market value of firm and its positive effect on the value of per share.
High debt content mixture of equity debt mix ratio is also called financial leverage.
Increasing of financial leverage will be helpful to for maximize the firm's value.
Assumptions of Net Income Theory
The Kd is cheaper than the Ke. Income tax has been ignored. The Kd and Ke
remain constant.
There are no Taxes.
Cost of debt is less then cost of equity.
Use of debt does not change the perception of the investors.et O
Net Operating Income Theory
Net Operating Income Approach was suggested by Durand. This approach is of the
opposite view of Net Income approach. This approach suggests that the capital
structure decision of a firm is irrelevant and that any change in the leverage or debt will
not result in a change in the total value of the firm as well as the market price of its
shares. This approach also says that the overall cost of capital is independent of thedegree of leverage. At each and every level of capital structure, market value of firm
will be same.
The value of the Equity may be found by deducting the value of debt from the total value
ofthefirmi.e.,V = EBIT/k
And E = V- D
And the cost of equity capital, ke , is
k e = EBIT - Int. / V- D
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Features of Net Operating Income Approach:
At all degrees of debt, the overall capitalization rate would remain constant. For a
given level of Earnings before Interest and Taxes (EBIT), the value of a firm
would be equal to EBIT/overall capitalization rate.
The value of equity of a firm can be determined by subtracting the value of debt
from the total value of the firm. This can be denoted as follows:
Value of Equity = Total value of the firm - Value of debt
Cost of equity increases with every increase in debt and the weighted average
cost of capital (WACC) remains constant.
Disadvantages of Net Operating Income Approach
It lack behavioral significance.
Example:
Let us assume that a firm has an EBIT level of $50,000, cost of debt 10%, the total
value of debt $200,000 and the WACC is 12.5%. Let us find out the total value of the
firm and the cost of equity capital (the equity capitalization rate).
Solution:
EBIT = $50,000
WACC (overall capitalization rate) = 12.5%
Therefore, total market value of the firm = EBIT/Ko $50,000/12.5% $400,000
Total value of debt =$200,000
Therefore, total value of equity = Total market value - Value of debt
$400,000 - $200,000 $200,000
Cost of equity capital = Earnings available to equity holders/Total market value of equity
shares
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Earnings available to equity holders = EBIT - Interest on debt
$50,000 - (10% on $200,000) $30,000
Therefore, cost of equity capital = $30,000/$200,000 15%
Verification of WACC:
10% x ($200,000/$400,000) + 15% x ($200,000/$400,000) 12.5%
Effect of change in Capital structure (to prove irrelevance)
Let us now assume that the leverage increases from $200,000 to $300,000 in the firm's
capital structure. The firm also uses the proceeds to re-purchase its equity stock so that
the market value of the firm remains the same at $400,000.
EBIT = $50,000
WACC = 12.5% (overall capitalization rate)
Total market value of the firm = $50,000/12.5% $400,000
Less: Total market value of debt $300,000
Therefore, market value of equity = $400,000 - $300,000 $100,000
Equity-capitalization rate = ($50,000 - [10% on $300,000)/$100,000 20%
Overall cost of capital = 10% x $300,000/$400,000 + 20% x $100,000/$400,000
12.5%
The above example proves that a change in the leverage does not affect the total value
of the firm, the market price of the shares as well as the overall cost of capital.
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Modigliani Millar Approach
Modigliani Millar approach, popularly known as the MM approach is similar to the Net
operating income approach. The MM approach favors the Net operating income
approach and agrees with the fact that the cost of capital is independent of the degree
of leverage and at any mix of debt-equity proportions. The significance of this MM
approach is that it provides operational or behavioral justification for constant cost of
capital at any degree of leverage. Whereas, the net operating income approach does
not provide operational justification for independence of the company's cost of capital.
M&M position which is the same as the net operating approach is based on the notion
that there is a conservation of investment value no matter how you divide the
investment value pie between debt and equity claims, the total pie stays the same.
therefore leverage is said to be irrelevant. Behavioral support for the M&M position is
based on the arbitrage process.
Assumptions of MM approach:
Capital markets are perfect.
All investors have the same expectation of the company's net operating income
for the purpose of evaluating the value of the firm.Within similar operating environments, the business risk is equal among all firms.
100% dividend payout ratio.
An assumption of "no taxes" was there earlier, which has been removed.
Limitations of MM hypothesis:
Investors would find the personal leverage inconvenient.
The risk perception of corporate and personal leverage may be different.Arbitrage process cannot be smooth due the institutional restrictions.
Arbitrage process would also be affected by the transaction costs.
The corporate leverage and personal leverage are not perfect substitutes.
Corporate taxes do exist. However, the assumption of "no taxes" has been
removed later.
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Trade-Off Theory
Miller & Modigliani showed (with unrealistic assumptions) that shareholder value would
be maximized with nearly 100% debt.
Doesnt hold in the real world because interest rates rise as leverage rises, and
because expected taxes go down as debt rises, and bankruptcy costs rise as leverage
rises.
The trade off theory also recognize that capital raised by firms is constituted by both
debts and equity, however the theory states that there is an advantage of financing
through debts due to tax benefit of the debts, however some costs arises as a result of
debt costs and bankrupt costs and non bankrupt costs, the theory also states that the
marginal benefit of debts declines as the level of debts decrease and at the same time
the marginal cost of debts increases as debts increase, therefore a rational firm will
optimize by the trade off point to determine the level of debts and equity to finance its
operations, the theory also states that as the debt equity ratio increases (D/E) then
there is a tradeoff between bankruptcy and tax shield and this as a result causes an
optimal capital structure for the firm
FirmVa
lue
M&M's original proposition
Zero Leverage
Value reduced by bankruptcy costs
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Traditional Approach
The Net Income theory and Net Operating Income theory stand in extreme forms.
Traditional approach stands in the midway between these two theories. Traditional
theory was advocated by financial experts Ezta Solomon and Fred Weston. According
to this theory a proper and right combination of the use of debt and equity will always
lead to market value enhancement of the firm. This approach accepts that the equity
shareholders perceive financial risk and expect premiums for the risks undertaken. This
theory also states that after a level of debt in the capital structure, the cost of equity
capital increases.
The traditional approach to capital structure and valuation assume that there is an
optimal capital structure and that management can increase the total value of the firm
through the judicious use of financial leverage.
Example:
Let us consider an example where a company has 20% debt and 80% equity in its
capital structure. The cost of debt for the company is 10% and the cost of equity is 14%.
According to the traditional approach the overall cost of capital would be:
WACC = (Weight of debt x cost of debt) + (Weight of equity x cost of equity)
(20% x 10%) + (80% x 14%)
2+ 11.2 13.2%
If the company wants to raise the debt portion in the capital structure to be 60%, the
cost of debt as well as equity would increase due to the increased risk of the company.
Let us assume that the cost of debt rises to 10% and the cost of equity to 15%. After
this scenario, the overall cost of capital would be:
WACC = (60% x 10%) + (40% x 15%)
6 + 6 12%
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In the above case, although the debt-equity ratio has increased, as well as their
respective costs, the overall cost of capital has not increased, but has decreased. The
reason is that debt involves lower cost and is a cheaper source of finance when
compared to equity. The increase in specific costs as well the debt-equity ratio has not
offset the advantages involved in raising capital by a cheaper source, namely debt.
Now, let us assume that the company raises its debt percentage to 80%, thereby
pushing down the equity portion to 20%. Due to the increased and over debt content in
the capital structure, the firm has acquired greater risk. Because of this fact, let us say
that the cost of debt rises to 15% and the cost of equity to 20%. In this scenario, the
overall cost of capital would be:
WACC = (80% x 15%) + (20% x 20%)
12 + 4 16%
This decision has increased the company's overall cost of capital to 16%.
The above example illustrates that using the cheaper source of funds, namely debt,
does not always lower the overall cost of capital. It provides advantages to some extent
and beyond that reasonable level, it increases the company's risk as well the overall
cost of capital. These factors must be considered by the company before raising finance
via debt.
Pecking Order Theory
The pecking order theory which was developed by Myers in 1984 states that firms will
finance through a hierarchy of finance options, therefore this theory supports the fact
that debts are preferred by firms than equity, the firm will finance itself internally, and
then finance itself using debts and when these debts are depleted then the firm will
finance through equity through sales of stock. Therefore equity financing is as a last
option to the firm, the firm prefers to finance through a hierarchy of financing whereby
they will finance through available funds, when these funds are used up the firm will
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acquire debts and finally when this is exhausted they will decide on to finance through
equity.