Capital Structure
Capital
Capital refers to the wealth that the company uses for its establishment and
long-term management purpose.
Capital is one of the essential elements to start up a business.
Capital Structure refers to the combination or mixture of long-term sources of
capital which includes equity shares, preference shares, long term loans,
debentures, retained earnings.
It tries to establish a relationship between the owned capital and borrowed
capital.
Capital Structure - Definition
“The mix of a firm's permanent long-term financing
represented by debt and equity” – James Van Horne
“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
Assumptions of Capital Structure
Firm’s investment policy remains constant
A change in the capital structure will lead to
change in the firms value and earnings ability
Capital structure changes affect the allocation of
profit between the debt holders and equity
holders.
The cost of debt is always lesser than the cost of
equity
Objectives of Capital Structure
To generate maximum earnings
To
keep Weighted average cost of capital at
minimum level
To maximize value of firm
To maximize value of shares
Types of Capital Structure
100% Equity
Equity and preference shares
More Equity and lesser debt
Lesser equity and more debts
Different
proportions of equity, debt and
preference shares
100% Debt
Factors affecting capital structure
Cost of capital
Size of the company
Choice of investors
Degree of control / Dilution of control
Economic cycle – Boom, Recession
Nature of business
Period of financing
Trading on Equity/Leverage on equity
Taxation
Need for long term Finance
Modernisation,
Expansion,
Diversification,
SOURCES OF LONG TERM
FINANCE
Equity Capital
Authorised, Subscribed, Issued, and Paid up capital
Par/face value, Issue Price, Book value and Market
Value
Rights of equity shareholders
-Right to Income :PAT less preferred dividends
-Right to Control: voting rights
-Pre-emptive Right: for additional issues, rights
issue in the same proportion
-Right in liquidation: residual claim over assets
Pros and cons of equity Capital
Advantages Disadvantages
No fixed maturity, no obligation to Dilution of control of existing
redeem owners
High Cost: rate of return
No compulsion to pay dividends expected by equity holders
Provides leverage capacity higher than debtholders
Dividends tax exempt for investors
Dividends are not tax
deductible: hence cost is higher
Issue costs higher:
underwriting, brokerage, other
issue expenses
Higher servicing costs: hold
AGMs, post annual reports etc.
Internal Accruals
Consists of retained earnings and depreciation charges
Pros Cons
Readily available, no Quantum very limited
talking to outsiders High Opportunity costs:
Effectively additional dividends forgone by
equity capital, however equity holders
no issue costs Requires careful
No dilution of control attention to NPV of
No expansion in equity projects
base, hence no dilution
of EPS, BV per share etc.
Preference Capital
Is a hybrid form of financing, payment after debt but
before equity
Equity features:
-out of distributable profits
-not an obligatory payment
-dividends not tax deductible
Debt features:
-dividend rate is fixed
-capital is redeemable
-normally no right to vote
Can have other features like convertible, participating…..
Preference Capital
Pros Cons
No obligation to pay dividend, Expensive source since
no bankruptcy or legal action dividends not tax deductible
for non payment Though no legal consequences,
Financial distress of redemption liability to pay dividends
obligation not very high stands, can spoil company’s
image
Part of net worth, hence
increases its creditworthiness/ Can acquire voting rights in
leverage capacity some cases
No dilution of control Have claim prior to equity
No pledging of assets required holders
Term Loans
Provided by FIs/banks
Can be in domestic/foreign currency, liability on FC loans
translated to rupees for payment
Are typically secured against fixed assets/ hypothecation
of movable properties
Definite obligations on interest and principal repayment;
interest paid periodically;
Term Loans
Pros Cons
Interest on debt is tax deductible Entails fixed obligation for
Does not result in dilution of interest and principal, non
control payment can even lead to
bankruptcy/ legal action
Do not partake in value created
by the firm Debt contracts impose
restrictions on firm’s financial
Issue costs of debt is lower and operational flexibility
Interest cost is normally fixed, Increases financial leverage,
protection against high excess raises cost of equity to
unexpected inflation the firm
Has a disciplining effect on
management If inflation rate dips, cost of
debt higher than expected
Debentures
More flexible compared to term loans as they offer
variety of choices as regards maturity, interest rate,
security, repayment and other special features
Interest rate can be fixed/floating
Convertibility : Can be FCDs, NCDs, PCDs
Warrants : Can have warrants attached, detachable or
non detachable, detachable traded separately
Redemption: Bullet payment or redeemed in
instalments
Security: Secured or unsecured
Credit rating: Need to have a credit rating by a credit
rating agency
Trustee: Need to appoint a trustee to ensure
fulfilment of contractual obligations by company
Other forms of Finance
Leasing: asset leased out in lieu of lease rentals, title not transferred,
only economic use of assets given;
Hire Purchase: ownership transferred to the buyer after all the
installments paid up
Securitization: assets involving financial claims pooled and financial
instruments created, thus creating cash out of receivables
Government Subsidies: central and state govts offer cash subsidies to
units in backward areas, classified in three categories
Tax exemptions given for certain no. of years
Suppliers credit: available from suppliers of machinery, other fixed
assets, terms devised to defer payment, or pay in installments over a
period of time
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