What is Capital Structure? Optimum, Factors Affecting, Theories

What is Capital Structure?

Financial management aims at maximising the wealth of shareholders. All financial choices in any company should be made keeping this goal in mind. When a corporation has to raise long-term money, the finance manager must choose a combination of sources of capital with the lowest overall cost of capital (i.e., the firm’s value/shareholder wealth is at its highest). The word “capital structure” refers to the combination of long-term financing sources.

Various types of securities make up the capital structure. It consists of a mix of long-term sources such as equities, preference shares, debentures, long-term loans and retained earnings. The term capital structure refers to the combination of long-term funding sources such as stock, preference share capital and debt capital.

The choice of an appropriate capital structure is an important financial management decision since it is linked to the firm’s worth. The capital structure of a corporation refers to the firm’s long-term debt and equity funding. According to Gerestenbeg, Capital Structure of a corporation refers to the structure or make up of its capitalisation and it encompasses all long-term capital resources.

Optimum Capital Structure

When a company’s capital structure is optimal, it combines equity and debt in such a way that the firm’s wealth or shareholder value is maximised. The cost of capital is lowest and the market price per share is highest with this capital structure. It is tough to determine the best debt and equity mix for a capital structure because it is difficult to quantify a drop in the market value of equity shares owing to increased risk from a high debt content capital structure. As a result, “suitable capital structure” is a more practical expression than “optimum capital structure” in practice.

Some important features of an appropriate capital structure are as follows:

  • Profitability: The most profitable capital structure is one that aims to reduce financing costs while increasing earnings per equity share.

  • Flexibility: The capital structure of the firm should allow it to raise funds whenever it is required.

  • Conservatism: The amount of debt in the capital structure should not exceed a company’s ability to bear it.

  • Solvency: The capital structure should be such that the company does not face insolvency or liquidity crisis.

  • Control: The capital structure should be designed in such a way that there is little chance of losing control of the firm.

The optimal capital structure is one in which the Weighted Average Cost of Capital is the lowest and the firm’s value is the highest. In other words, the capital structure that leads to the firm’s maximum value is known as the optimal capital structure.

The two major features of an optimal capital structure are:

  • Maximise the value of the firm
  • Minimise the overall cost of capital

Forms of Capital Structure

The capital structure pattern varies across companies and the availability of finance. Normally, the following forms of capital structure are popular in practice.

  • Equity shares only
  • Equity shares and preference shares only
  • Equity shares and debentures only
  • Equity shares, preference shares and debentures

Factors Affecting Capital Structure

The proportions of various forms of funds must be determined when deciding on a company’s capital structure. This is dependent on a number of factors. Debt, for example, must be serviced on a regular basis. A business is required to pay interest and refund the principle. In addition, a firm that plans to expand debt must have enough cash on hand to cover additional outflows that would result from the additional debt. Let us discuss major considerations that influence capital structure selection.

Tax Benefit of Debt

Using debt helps to lower a company’s tax liability because the interest paid towards tax is allowed as a deduction from profits earned by an organisation. Interest payments can be deducted from revenues to arrive at taxable income under tax regulations. A firm pays fewer taxes if its taxable revenue is moderate. Dividends paid to equity investors, on the other hand, are not tax deductible and must be paid from the net revenue after tax. As a result, tax savings assist a company’s debt financing costs to be reduced even more, which is a benefit that equity financing lacks.

Industry Leverage Ratios

A leverage ratio is a financial metrics that are examined by stakeholders. This ratio helps in determining how much capital is raised from debt (loans) and evaluates a company’s capacity to satisfy its financial commitments. The leverage ratio is essential because organisations employ a combination of stock and debt to fund their operations, and knowing how much debt a firm has can help to determine if it will be able to pay-off its loans when due.

Some of the important features of leverage ratio are:

  • A leverage ratio is one of numerous financial metrics used to evaluate a company’s capacity to satisfy its financial obligations.

  • The debt-to-equity ratio, equity multiplier, degree of financial leverage, are common leverage ratios.

  • Banks are regulated in terms of how much leverage they can have.

Trading on Equity

To arrange funds for acquiring company’s assets, the use of fixed cost sources like debt and preference share capital is called trading on equity or financial leverage. If the return on assets acquired from the debt funds is greater than the cost of debt, the earnings per share will increase. The income will also increase by the use of preference share capital but it will increase more by the use of debt funds because interest is allowed as an expense from the taxable income. Because of its effect on the earnings per share, financial leverage is an important factor in planning the capital structure.

Cash Flow Position

While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.

Debt Service Coverage Ratio-DSCR

This ratio removes the weakness of ICR. This shows the cash flow position of the company. This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.

Size of Business

Small businesses have to face great difficulty in raising long-term finance. If, it is at all able to get long-term loan, it has to accept unreasonable conditions and has high rate of interest. Such restrictive conditions make the capital structure inflexible for small companies and management cannot freely run the business.

Degree of Competition

If in an industry, the degree for competition is high, such companies in that industry should use greater degree of share capital as compared to the debt capital. On the other hand, the industries in which the degree of competition is not so high, have a tendency of stable income and, therefore, they can use more debt.

Credit Standing

The companies whose credit standing is better from the viewpoint of investors and creditors, are able to raise funds on convenient terms. But in case the credit standing is not good, the financing decision becomes limited.


Theory of Capital Structure

In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. There are several competing capital structure theories, each of which explores the relationship between debt financing, equity financing, and the market value of the firm slightly differently. The capital structure theories explain a firm’s capital structure decision and explain when and why a company chooses debt over equity to fund its operations.

Some theory argues that capital structure can affect the overall cost of capital and the value of firm. These theories include NI approach, Traditional Approach, etc. On the other hand, some theories put forward the argument that capital structure is irrelevant in determination of value of firm. These theories include NOI approach, Modigliani & Miller approach, etc. Let us understand various theories of capital structure.

Net Income (NI) Approach

According to this approach, the cost of debt and the cost of equity do not change with a change in the leverage ratio. As a result, the average cost of capital declines as the leverage ratio increases. This is because when the leverage ratio increases, the cost of debt, which is lower than the cost of equity, gets a higher weightage in the calculation of the cost of capital.

As per NI approach, when the degree of leverage fluctuates, the cost of debt capital, Kd, and the cost of equity capital, Ke , stay unchanged.

Total capital employed = D+E = S

Since Kd and Ke remain constant with regard to leverage, Ko , the average cost of capital decreases as leverage grows.

This occurs because, as the degree of leverage grows, Kd, which is smaller to Ke , is given a bigger weight in the Ko computation. This can also be illustrated by a graph shown in Figure:

Because you assume that the cost of debt and equity capital remains constant regardless of leverage, Ko seems to decrease as the share of debt in the capital increases. It is important to note that you are discussing the market value of debt and the market value of equity. You frequently confuse these with book values of debt and equity.

For example: Expected EBIT of the firm is ₹2,00,000. The cost of equity (i.e., capitalisation rate) is 10%. Find out the value of Firm and overall cost of capital if degree of leverage is:

₹ 2,00,000

₹ 5,00,000

₹ 7,00,000

Debenture interest rate is 6%.

Statement Showing the Value of Firm and Overall Cost of Capital WACC

Degree of Leverage.
Debenture Capital2,00,0005,00,0007,00,000
EBIT2,00,0002,00,0002,00,000
Less int. @ 6%12,00030,00042,000
Net Profit (i.e., earning available for equity share holder)1,88,0001,70,0001,58,000
Equity capitalisation rate e.g., Ke10%10%10%
Therefore, value of equity (e.g., 1,88,000/10%)18,80,00017,00,0007,00,000
Value of debt (D)2,00,0005,00,0007,00,000
Therefore, value of the firm (V)20,80,00022,00,00022,80,000
WACC,
EBIT × 100
Value of firm
2,00,000 × 100
20,80,000
2,00,000 × 100
22,00,000
2,00,000 × 100
22,80,000
= 9.6%= 9%= 8.7%

Conclusion

Firm is able to increase its value and to decrease it’s (WACC) increasing the debt proportion in the capital structure. The NI approach, though easy to understand, ignores perhaps the most important aspects of leverage that the market price depends upon the risk, which varies in direct relation to the changing proportion of debt in capital structure.

Net Operating Income (NOI) Approach

In contrast to the net income approach, the NOI approach states that the cost of capital for the whole firm remains constant, irrespective of the leverage employed in the firm. With the cost of debt and the cost of capital constant, you can say that the cost of equity capital changes with the leverage to compensate for the additional level of risk. According to the net operating incomeapproach; for all degrees of leverage, the overall capitalisation rate remains constant and the cost of debt remains same.

Given this and manipulating the equation of the firm’s total cost of capital, you can express the cost of equity as:

This is illustrated below in Figure: Cost of Capital

For example: ABC Ltd., having an EBIT of ₹1,50,000 is contemplating to redeem a part of the capital by introducing debt financing.

Presently, it is a 100% equity firm with equity capitalisation rate, Ke, of 16%. The firm is to redeem the capital by introducing debt financing up to ₹3,00,000 i.e., 30% of total funds or up to ₹5,00,000 i.e., 50% of the total funds. It is expected that for the debt financing up to 30%, the rate of interest will be 10% and the equity capitalisation will increase up to 17%. However, if the firm opts for 50% debt financing, then interest will be payable at the rate of 12% and the equity capitalisation rate will be 20%.

Find out the value of the firm and its overall cost of capital under different levels of debt financing.

Solution: On the basis of the information given, the total funds of the firm is ₹10,00,000 (whole of which is provided by the equity capital) out of which 30% or 50% i.e., ₹3,00,000 or ₹5,00,000 may be replaced by the issue of debt bearing interest at 10% or 12% respectively.

The value of the firm and its WACC maybe ascertained as follows:

0% Debt30% Debt50% Debt
Total Debt3,00,0005,00,000
Rate of interest10%12%
EBIT1,50,0001,50,0001,50,000
Interest30,00060,000
Profit before tax1,50,0001,20,00090,000
Equity capitalisation rate0.160.170.20
Value of equity E9,37,5007,05,8824,50,000
Value of debt3,00,0005,00,000
Total Value9,37,50010,05,8829,50,000
Overall cost of capital (EBIT) Total value of firm0.160.1490.158

The example shows that with the increase in leverage from 0% to 30%, the firm is able to reduce its WACC from 16% to 14.9% and the value of the firm increases from ₹9,37,500 to ₹10,05,882. This happens as the benefits of employing cheaper debt are available and the cost of equity does not rise too much.

However, thereafter, when the leverage is increased further to 50%, the cost of debt as well as the cost of equity, both, rises to 12% and 20% respectively. The equity investors have increased the equity capitalisation rate to 20% as they are now finding the firm to be more risky (as a result of 50% leverage). The increase in cost of debt and the equity capitalisation rate has increased the cost of equity, hence as a result, the value of the firm has reduced from ₹10,05,882 to ₹9,50,000 and Ko has increased from 14.9% to 15.8%.

Traditional Approach

This approach is midway between the NI and the NOI approach. The main propositions of this approach are:

  • The cost of debt remains almost constant up to a certain degree of leverage but rises thereafter, at an increasing rate.

  • The cost of equity remains more or less constant or rises gradually up to a certain degree of leverage and rises sharply thereafter.

  • The cost of capital due to, the behaviour of the cost of debt and cost of equity, decreases up to a certain point and remains more or less constant for moderate increases in leverage, thereafter, rises beyond that level at an increasing rate.

The figure given below describes the traditional Viewpoint on the Relationship between Leverage, Cost of Capital and Value of the form

For example:

Compute the market value of the firm, value of shares and the average cost of capital from the following information:

ParticularAmount
Net opening income2,00,000
Total investment10,00,000
Equity capitalisation rate
(a) If the firm uses no debt10%
(b) If the firm uses ₹4,00,000 debentures11%
(c) If the firm uses ₹6,00,000 debentures13%

Assume that ₹4,00,000 debentures can be raised at 5% rate of interest whereas ₹6,00,000 debentures can be raised at 6% rate of interest.

Solution:

Computation of market value of firm, Value of share & the average cost of capital

(a) No debt(b) ₹4,00,000 5% debentures(b) ₹6,00,000 6% debentures
Net opening Income2,00,0002,00,0002,00,000
Less: Interest i.e., cost of debt20,00036,000
Earning available to equity shareholder20,0001,80,0001,64,000
Equity capitalisation rate10%11%13%
Market value of share2,00,000 × (100/10) 20,00,0001,80,000 × (100/11) 16,36,3631,64,000 × (100/13) 12,61,538
Market value of debt (debenture)4,00,0006,00,000
Market value of firm20,00,00020,36,36318,61,538
Average cost of capital
= Earning
Value of firm
or
EBIT
V
2,00,000
20,00,000 ×
100 = 10%
2,00,000 × 100
20,36,363
= 9.8%
2,00,000 × 100
18,61,538
= 10.7%

Comments:

It is clear from the above that if debt of ₹4,00,000 is used the value of the firm increases and the overall cost of capital decreases. But, if more debt is used to finance in place of equity, i.e., ₹6,00,000 debentures, the value of the firm decreases and the overall cost of capital increases.

Modigliani-miller (MM) Approach

Franco Modigliani and Merton Miller developed one of the most startling ideas of contemporary financial management in 1958, namely the Modigliani Miller (MM) approach which concludes that a firm’s worth is determined by the stream of its future earnings and the debt-equity combination has no bearing on its worth.

In a nutshell, they came to the conclusion that a company’s worth is determined by its assets, independent of how those assets are funded. This discovery had widespread ramifications such that the members of the Financial Management Association voted the paper to have had the greatest influence on financial management of any published work.

Assumption

Capital markets are perfect. This means,

  • Investors are free to buy and sell securities.

  • Inventors can borrow and lend money on the same terms on which a firm can borrow and lend.

  • There are no transaction costs.

  • They behave rationally.

  • Firms can be classified into homogenous risk categories. All the fi rms within the same class will have the same degree of business risks.

  • All the investors have the same expectations from a firm’s NOI with which to evaluate the value of the firm.

Modigliani and Miller started with a fairly stringent set of assumptions in their article, including flawless capital markets which imply zero taxes. Then, they utilised an arbitrage proof to show that capital structure does not matter. If debt financing increased the business’s worth more than equity financing, investors who owned shares in a leveraged (debt-financed) business may improve their income by selling those shares and using the profits, plus borrowed funds, to acquire shares in an unleveraged (all equity-financed) business, according to their assumptions.

The simultaneous selling of leveraged firm shares and the simultaneous acquisition of unleveraged company shares would bring the stock prices to the point where the two business valuations would be similar. As a result, according to the MM Hypothesis, a company’s stock price is unrelated to its debt and equity funding mix. The net operating income stance has been restated and enlarged by Modigliani and Miller in terms of three key assertions.

These are as follows:

Proposition I

A company’s entire market value is equal to its projected operational income (EBIT when Tax = 0) divided by the risk-based discount rate. It does not matter how much leverage you have.

The subscript L denotes a leveraged business, while the subscript U denotes an unleveraged business. Because the V (Value of the Business) established by the preceding equation is a constant, the value of the firm under the MM model is independent of its leverage when there are no taxes. This means that a business’s weighted average cost of capital is fully unaffected by its capital structure and that the WACC for any business, regardless of the amount of debt it employs, is identical to the cost of equity for an unleveraged business with no debt.

Proposition II

The predicted equity yield, Ke equals Ko plus a premium. This premium is calculated by multiplying the debt-to-equity ratio by the difference between Ko and the debt yield, Kd. This means that when a company’s debt usage grows, so does its cost of equity.

Proposition III

The way in which an investment is financed has no effect on the cutoff rate for investment decision making for a business in a particular risk class. Because the average cost of capital is unaffected by the financing decision, it emphasises the idea that investment and financing decisions are separate.

For example: Two companies, X Ltd. and Y Ltd., are identical in every way except that X Ltd. is a leveraged company with a 10% debt of ₹30,000 in its capital structure. Y Ltd., on the other hand, is a non-leveraged company that has exclusively raised funds through equity financing. Both companies have the same EBIT of ₹10,000 and a 20% equity capitalisation rate (Ke). Under these parameters, the total value and the WACC of both the firms may be ascertained as follows:

X ltd.Y ltd.
EBIT10,00,00010,00,000
Interest-3,00,000
Net profit7,00,00010,00,000
Equity capitalisation rate20%20%
Value of equity35,00,00050,00,000
+ Value of debt30,00,000NIL
Value of firm65,00,00050,00,000
WACC EBIT × 100
V
15.3820%

Comments

Though the EBIT is the same, the firm’s valuation and WACC are different. MM argue that this position cannot last for long, and that the two firms’ values will eventually converge through an arbitrage process, as outlined in the following paragraphs. Mr. A is holding 10% equity shares in X Ltd. The value of his loading is ₹3,50,000 i.e., 10% of ₹35,00,000. Further, he is entitled for ₹70,000 incomes (i.e., 10% of total profits of ₹7,00,000). In order to earn more income, he disposes off his holding in X Ltd. for ₹3,50,000 and buys 10% holding in Y Ltd.

For this purpose, he adopts following steps.

Step 1:

In order to buy 10% holding in Y Ltd, he requires total funds of ₹5,00,000, whereas his proceeds are only ₹3,50,000. Therefore, he borrows ₹3,00,000 loan @ 10% i.e. (10% of Debt of X Ltd). Thus, he substitutes personal loan for corporate loan.

Step 2:

Mr. A now has total funds of6,50,000
Sale proceeds3,50,000
10% personal loan3,00,000
Total6,50,000
Less: Invest in shares of Y Ltd shares– 5,00,000
Surplus funds (which he invests in some other securities say at 10%)1,50,000

Step 3:

Mr. A will earn more through arbitrage process.
Profits available to A from Y Ltd. (10% of 10,00,000)1,00,000
Less: interest on borrowing (10% 300,00,000)– 30,000
+ Interest income on some other investment (150000 × 10%)+ 15,000
Total income after Arbitrage Process85,000

Conclusion

According to the MM model, this possibility to gain additional revenue through the arbitrage process will attract a large number of investors. The progressive increase in sales of shares of leveraged firm X Ltd. will drive down its prices, while the tendency to buy shares of unlevered firm Y Ltd. will drive up its prices. These selling and purchasing activities will continue until the two firms’ market values are equal. The worth of the leveraged and unleveled firms, as well as their cost of capital, are the same at this point. As a result, the overall cost of capital is independent of financial leverage.]

Arbitrage

The term arbitrage refers to the act of buying a security in the market, where the price is less and simultaneously selling it in another market where the price is more, to take advantage of the difference in price prevailing in two different markets. The operational justification for the MM hypothesis is the “Arbitrage Argument”. The term arbitrage refers to the act of buying a security in the market, where the price is less and simultaneously selling it in another market where the price is more, to take advantage of the difference in price prevailing in two different markets.

Homemade Leverage

Homemade leverage is used by an individual investor to artificially adjust the leverage of a company. An individual investing in a company with no leverage can recreate the effect of leverage using homemade leverage, which includes taking out personal loans on the investment. However, differences in the tax rate between the corporation and the individual will likely disrupt the ability of the investor to construct the leveraging scenario accurately.

For Example: Assume that there are two firm L and U which are identical in all the respects except that, the firm L has 10% ₹5,00,000 debentures. The EBIT of both the firms are ₹80,000. The cost of equity of the firm L is higher at 16% and firm U is lower at 12.5%. The total market values of the firm are computed as below.

ParticularFIRM LFIRM U
EBIT80,00080,000
Less: Interest50,000
Earnings available to ESH (NI)30,00080,000
Cost of equity (Ke)0.160.125
Market value of equity shares (S = NI/Ke)1,87,5006,40,000
Market value of debt5,00,000
Total value of the firm6,87,5006,40,000
K0 = EBIT/V11.63%12.5%

Thus, the total value of the firm which employed debt is more than the value of the other firm. According to MM, this previous arbitrage would start and continue till the equilibrium is restored.

MM Hypothesis With Taxes

MM hypothesis of irrelevance of capital structure mainly holds true because it assumes that the corporate taxes are absent. Thus, the levered and unlevered firms stand on the same footing. But, in reality this is not the case. Firms do have to pay corporate taxes and as we know that the interest paid on debentures is tax deductible.

Hence, it becomes more profitable for a firm to have leverage (debt) as it saves taxes and thus the value of such a firm increases. Thus, in the presence of corporate taxes, MM hypothesize that the value of a firm increases as the leverage increases. How proposition 1 of MM’s hypothesis works in the presence of corporate taxes?

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