financial management 2

Unit IIFinancial ManagementCapital Structure Planning : capitalization Concept, Basis of capitalization, consequences and remedies of over and under capitalization,Determinants of Capital structure, Capital structure theories

Prepared by:- Dr. Waqar Ahmad

Asstt. Professor Allenhouse Business School

Capital Structureis the proportion of debt and preference and equity shares on a firm’s balance sheet. The term ‘structure’ means the arrangement of the various parts. So capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised.Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital, debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its business.

Capital Structure PlanningThe capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing.

“Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders”-P. Chandra..

Importance of Capital Structure:The importance or significance of Capital Structure

Value Maximization

Cost Minimization

Increase in Share Price

Investment Opportunity

Growth of the Country

Patterns of Capital Structure

Capital Structure Planning cont..

Capital structure is the mix of the long-term

sources of funds used by a firm. It is made up

of debt and equity securities and refers to

permanent financing of a firm. It is composed

of long-term debt, prefer ence share capital

and shareholders’ funds.

Factors Determining Capital Structure:

1. Risk of cash insolvency

2. Risk in variation of earnings

3. Cost of capital

4. Control

5. Trading on equity

6. Government policies

7. Size of the company

8. Needs of the investors

9. Flexibility

10.Period of finance

11. Nature of business

12. Legal requirements

13. Purpose of financing

14. Corporate taxation

15. Cash inflows

16. Provision for future

17. EBIT-EPS analysis

Capitalization Capitalization is an important constituent

of financial plan in common parlance, the

phrase ‘capitalization’ refers to total of all

kinds of long term securities at their par

values.

Basis of capitalizationOne of problems facing the financial manager is determination of value at which a firm should be capitalized because it have to raise funds accordingly there are two theories that contain guidelines with which the amount of capitalization can be surmised

1. Cost Theory of Capitalization

According to this theory capitalization of a firm is regarded as the

sum of cost actually incurred in setting of the business. A film

needs funds to acquire fixed assets, to defray promotional and

organizational expenses and to meet current asset requirements

of the enterprise sum of the costs of the above asset gives the

amount of capitalization of the firm, acquiring fixed assets and to

provide with necessary Working capital and to cover possible

initial losses, it will capitalized Under this method more emphasis

is laid on current investments. They are static in nature and do not

have any direct relationship with the future earning capacity.

This approach givens as the value of capital only at a particular

point of time Which Would not reflect the future changes.

2. Earning Theory of capitalization

According to this theory, firm should be capitalized on

the basis of its expected earning A firm’s profit is

seeking entity and hence its value is determiner

according to what it earns. The probable earning are

forecast and they are capitalized at a normal

representative rate of return.

Capitalization of a company as per the earning theory

can thus be determined with help following formula.

Capitalization = Annual Net Earnings X Capitalization

Rate

Consequences (or Effect of Over-Capitalisation)Consequences of Over-Capitalisation could be described, in the following Analytical Manner:(1) Consequences for the Company:

(i) An unsatisfactory rate of return on the equity leads to a poor market value of the company’s shares. There is thus, considerable loss of goodwill to the company.(ii) Investors’ confidence in the company is lost; as to them, the future of the company seems to be gloomy and uncertain.(iii) There is usually, unhealthy speculation, in the shares of an over-capitalised company; which, in turn, brings a bad name to the company.

(2) Consequences for the Members:(i) Members of the company are losers; as the dividend

payable to them is both reduced an uncertain, and

(ii) There is a capital loss to the members; as a result of the

poor market value of their shares.(3) Consequences for the Workers:

(i) Because of reduced profitability, workers might be

required to suffer a cut in their wages.

(ii) If an over-capitalised company is liquidated untimely due

to this financial disease; workers lose their employment.

(4) Consequences for the Society:(i) The poor functioning of an over-capitalised

company implies wastage of nation’s precious

economic resources; as the same amount of

resource might be profitably employed

elsewhere, to produce more.

(ii)Closure of an over-capitalised company hits the

society adversely; in terms of loss of production,

generation of unemployment, etc.

Remedies for Over-Capitalisation:The only effective remedy to cure over-capitalisation lies in implementing a scheme of a capital reduction.

Under the scheme of capital reduction, there might be:

(i) A reduction in the rate of interest payable on

debentures

(or other types of loans)

(ii) A reduction in rate of preference dividend.

(iii) A reduction in the paid-up value of shares-equity or

preference or both. For example a share of the paid-

up value of Rs.10 might be reduced to a share with a

paid-up value of Rs. 5 or Rs. 3.

Remedies for overcapitalizationRestructuring the firm is to be executed avoid the

situation of company becoming sick.It involves

1. Reduction of debt burden2. Negotiation with term lending institutions for reduction in interest obligation.3. Redemption of preference share through a scheme

of capital reduction.4. Reducing the face value and paid-up value of equity

shares.5. Initiating merger with well managed profit making companies interested in talking over ailing company.

UndercapitalizationUnder-capitalization is just the reverse of

over-capitalization.

A company is considered to be under-

capitalized when its actual capitalization is

lower than its proper capitalization as

warranted by its earning capacity.

Causes of under- capitalization1. Under estimation of future earnings of the time of

promotion of the company.2. Abnormal increase in earnings from new economic and

business environment.3. Under estimation of total funds requirements.4. Maintaining very high efficiency through improved

means of production of goods or rendering of services.5. Companies which are set up during recession start

making higher earning capacity as soon as the recession is over.

6. Use of low capitalized rate.7. Companies which follow conservative dividend policy

will achieve a process of gradually rising profits.8. Purchase of assets at exceptionally low prices during

recession.

Remedies of undercapitalization

• Splitting up at the shares – This will reduce the

dividend per share

• Issue of bonus share: this will reduce both the

dividend per share and earning per share.

• Both over-capitalization and under – capitalization

are detrimental to the interests of the society.

Determinants of Capital structure I. Financial Leverage or Trading

on Equity:

II. Growth and Stability of Sales

III. Cost of Capital

IV. Risk

V. Cash Flow

VI. Nature and Size of a Firm

VII. Capital Market

Conditions (Timing)

VIII.Control

IX. Flexibility

X. Requirement of

Investors

XI. Marketability:

XII. Inflation

XIII.Floatation Costs

XIV.Legal Considerations

Theories of Capital structure

A number of theories explain the

relationship between cost of capital,

Capital structure and value of the

firm. They are:

1. Net income approach (NIA)

2. Net operating income approach (NOIA)

3. Traditional approach (TA)

4. Modigliani-Miller approach (MMA)


A) Net Income Approach

(NI)

Capital Structure Theories – A) Net Income Approach (NI)

Net Income approach proposes that there is a definite relationship between capital structure and value of the firm.

The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm.

NI approach assumptions –oNI approach assumes that a continuous increase in debt does not affect the risk perception of investors.

oCost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]

oCorporate income taxes do not exist.


As per NI approach, higher use of debt capital will result in reduction of WACC. As a consequence, value of firm will be increased.Value of firm = Earnings

WACC Earnings (EBIT) being constant and WACC is reduced, the value of a firm will always increase.

Thus, as per NI approach, a firm will have maximum value at a point where WACC is minimum, i.e. when the firm is almost debt-financed.


ke

kokd

Debt

Cost

kd

ke, ko

As the proportion of debt (Kd) in capital structure increases, the WACC (Ko) reduces.

Calculate the value of Firm and WACC for the following capital structuresEBIT of a firm Rs. 200,000. Ke = 10%Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000

Kd = 6%

Particulars case 1 case 2 case 3EBIT 200,000 200,000 200,000 (-) Interest 30,000 42,000 12,000 EBT 170,000 158,000 188,000

Ke 10% 10% 10%Value of Equity 1,700,000 1,580,000 1,880,000 (EBT / Ke)

Value of Debt 500,000 700,000 200,000

Total Value of Firm 2,200,000 2,280,000 2,080,000

WACC 9.09% 8.77% 9.62%(EBIT / Value) * 100



B) Net Income Operating

Approach (NI)

Capital Structure Theories – B) Net Operating Income (NOI)

Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach.

As per NOI approach, value of a firm is not dependent upon its capital structure.

Assumptions – oWACC is always constant, and it depends on the business risk.

oValue of the firm is calculated using the overall cost of capital i.e. the WACC only.

oThe cost of debt (Kd) is constant.oCorporate income taxes do not exist.


NOI propositions (i.e. school of thought) –

The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity (Ke)

A higher cost of equity (Ke) nullifies the advantages gained due to cheaper cost of debt (Kd )In other words, the finance mix is irrelevant and does not affect the value of the firm.


Cost of capital (Ko) is constant.

As the proportion of debt increases, (Ke) increases.

No effect on total cost of capital (WACC)

ke

ko

kd

Debt

Cost

Calculate the value of firm and cost of equity for the following capital structure -EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)

Particulars Option I Option II Option IIIEBIT 200,000 200,000 200,000

WACC (Ko) 10% 10% 10%

Value of the firm 2,000,000 2,000,000 2,000,000

Value of Debt @ 6 % 300,000 400,000 500,000

Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000

Interest @ 6 % 18,000 24,000 30,000

EBT (EBIT - interest) 182,000 176,000 170,000

Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%



C) Modigliani – Miller Model

(MM)

Capital Structure Theories – C) Modigliani – Miller Model (MM) MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm.

Further, the MM model adds a behavioural justification in favour of the NOI approach (personal leverage)

Assumptions –o Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible.

o Investors can borrow without restrictions at par with the firms.

o Investors are rational & informed of risk-return of all securities

o No corporate income tax, and no transaction costs.o 100 % dividend payout ratio, i.e. no profits retention

Capital Structure Theories – C) Modigliani – Miller Model (MM)

MM Model proposition –oValue of a firm is independent of the capital

structure.oValue of firm is equal to the capitalized value

of operating income (i.e. EBIT) by the appropriate rate (i.e. WACC).

oValue of Firm = Mkt. Value of Equity + Mkt. Value of Debt

= Expected EBIT Expected WACC


MM Model proposition –oAs per MM, identical firms (except capital

structure) will have the same level of earnings.

oAs per MM approach, if market values of identical firms are different, ‘arbitrage process’ will take place.

o In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.

Capital Structure Theories – C) Modigliani – Miller Model (MM)Levered Firm

• Value of levered firm = Rs. 110,000 • Equity Rs. 60,000 + Debt Rs. 50,000• Kd = 6 % , EBIT = Rs. 10,000, • Investor holds 10 % share capital

Un-Levered Firm• Value of un-levered firm = Rs. 100,000 (all

equity)• EBIT = Rs. 10,000 and investor holds 10 %

share capital


Return from Levered Firm:10 110,000 50 000 10% 60,000 6 000

10% 10,000 6% 50,000 1,000 300 700

Alternate Strategy:

1. Sell shares in : 10% 60,000 6,0002. Borrow (personal leverage):

Investment % , ,

Return

L

10% 50,000 5,000

3. Buy shares in : 10% 100,000 10,000Return from Alternate Strategy:

10,00010% 10,000 1,000

: Interest on personal borrowing 6% 5,000 300Net return 1,000 300 700Ca

U

InvestmentReturnLess

sh available 11,000 10,000 1,000


D) Traditional Approach

Capital Structure Theories – D) Traditional Approach

The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm.

Traditional approach (‘intermediate approach’) is a compromise between these two extreme approaches.

Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum.

As per this approach, a best possible mix of debt and equity will maximize the value of the firm.


The approach works in 3 stages – 1)Value of the firm increases with an

increase in borrowings (since Kd < Ke). As a result, the WACC reduces gradually. This phenomenon is up to a certain point.

2)At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize. Further increase in borrowings will not affect WACC and the value of firm will also stagnate.

3) Increase in debt beyond this point increases shareholders’ risk (financial risk) and hence Ke increases. Kd also rises due to higher debt, WACC increases & value of firm decreases.

Capital Structure Theories –D) Traditional Approach

ke

ko

kd

Debt

Cost Cost of capital

(Ko) is reduces initially.

At a point, it settles

But after this point, (Ko) increases, due to increase in the cost of equity. (Ke)

EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt tothe extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%. For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC

Particulars Presently case I case IIDebt component - 300,000 500,000 Rate of interest 0% 10% 12%EBIT 150,000 150,000 150,000 (-) Interest - 30,000 60,000 EBT 150,000 120,000 90,000 Cost of equity (Ke) 16% 17% 20%Value of Equity (EBT / Ke) 937,500 705,882 450,000 Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000 WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%


Thank You

financial management 2

Economy & Finance