Financial Decisions:

An Overview UNIT 3 CAPITAL STRUCTURE DECISIONS

Objectives

The objectives of this unit are to:

• define and distinguish capital structure

• explain briefly the important Characteristics of various long term sources
of funds.
• dilate upon the criteria for determining pattern of capital structure.

• analyse EBIT-EPS and ROI-ROE relationship.

• examine critically theories of capital structure-decision
• identify the factors influencing capital structure decision

• evaluate the relevance of debt equity ratio in public enterprises.

Structure

3.1 Introduction

3.2 Conceptual Framework

3.3 Characteristics of Important long term sources of Funds

3.4 Criteria for determining pattern of Capital Structure

3.5 Risk and Capital Structure

3.5.1 EBIT – EPS Analysis

3.5.2 ROI – ROE Analysis

3.6 Theories of Capital Structure Decision

3.6.1 Net Income Approach

3.6.2 Net Operating Income Approach

3.6.3 M-M Approach

3.6.4 Traditional Approach

3.7 Factors Influencing Pattern of Capital Structure

3.8 Relevance of Debt-equity ratio in Public enterprises

3.9 Summary

3.10 Key words

3.11 Self Assessment Questions/Exercises

3.12 Further Readings

62
3.1 INTRODUCTION Capital Structure
Decisions

Planning the capital structure is one of the most complex areas of financial
decision making because of the inter-relationships among components of the
capital structure and also its relationship to risk, return and value of the firm.
For a student of finance, the term capital usually denotes the long-term funds
of the firm. Debt capital and ownership capital are the two basic components
of capital. Equity capital, as one of the components of capitalization,
comprises equity share capital and retained earnings. Preference share capital
is another distinguishing component of total capital. In this unit,
characteristics of important long-term sources of funds, EBIT-EPS analysis,
ROI-ROE analysis, factors influencing capital structure, theories of capital
structure decision, etc are narrated briefly. In the end, relevance of debt-
equity ratio in public enterprises is also discussed.

3.2 CONCEPTUAL FRAMEWORK

According to Gerstenberg, “ capital structure refers to the makeup of a firm’s

capitalization”. In other words, it represents the mix of different sources of
long-term funds. E.F. Brigham defines the term as the percentage share of
each type of capital used by the firm-Debt, preference share capital and
equity capital (equity share capital paid up plus retained earnings). According
to E.W.Walker, concept of capital structure includes the following:

• The proportion of long-term loans;

• The proportion of equity capital and

• The proportion of short-term obligations

• In general, the experts in finance define the term capital structure to
include only long-term debt and total Stockholders’ investment.

Financial structure means the composition of the entire left hand side
(liabilities side) of the balance sheet. Financial structure refers to all the
financial resources marshaled by the firm. It will include all forms of long as
well as short-term debts and equity.

Thus, practically speaking, there is no difference between the capital

structure (as defined by walker) and financial structure.

In brief,

Capital structure = proportions of all types of Long-Term capital

Financial structure = Proportions of all types of Long-Term and Short-Term
capital Capitalisation = Total Long-Term capital

63
Financial Decisions:
An Overview
3.3 CHARACTERISTICS OF IMPORTANT
LONG-TERM SOURCES OF FUNDS

The four major sources of Long-Term funds in a firm are equity(or ordinary)
shares preference shares, retained earnings and long term debt. Many
financial analysts and managers tend to think of preference shares as a
substitute of debt, as the amount of dividend to be paid is fixed. The
difference is that the preference dividend, unlike debt interest, is not a tax-
deductible expense. It does not have a fixed maturity date. Preference
shareholders have a prior claim to receive income from the firm’s earning
through dividends. Convertible debentures have the features of both debt
and equity capital.

The main focus in the discussion that follows is on deciding the mix of debt
and equity which a firm should employ in order to maximize shareholder
wealth. Because of the secondary position relative to debt, suppliers of equity
capital take greater risk and therefore, must be compensated with higher
expected returns. The distinguishing characteristics of debt, preference
share capital, equity share capital and Retained Earnings are summarized in
Table 3.1.

3.4 CRITERIA FOR DETERMINING PATTERN

OF CAPITAL STRUCTURE

While choosing a suitable pattern of capital structure for the firm, finance
manager should keep into consideration certain fundamental principles.
These principles are militant to each other. A prudent finance manager strikes
golden mean among them by giving proper weightage to them.

Table 3.1: Characteristics of Long-Term Sources of Funds

Debt Preference Share Capitals Equity share Retained
capital Earnings
Firm must pay Preference dividends are limited Money is Lower
back money in amount to rate specified in the raised by amount of
with interest. agreement. selling money for
ownership current
rights. dividends but
can increase
future
dividends.
Interest rate is Dividends are not legally required Value of the Shareholders
based on risk of to be paid. But dividend on share is forgo dividend
Principal and equity shares cannot be paid determined by income but
interest unless preference shareholders are investors. they do not
payments as paid dividend. Now payment of lose
perceived by dividend to preference ownership
lenders shareholders for a number of rights, if new
years gives them the voting equity shares
rights. are issued.
64
Amount of No maturity but usually callable Dividends are Funds are Capital Structure
money to be not internal No Decisions
repaid is contractually need for
specified by payable. No external
debt contract. maturity. involvement.

Lenders can Usually no voting rights except as Voting rights Cost of

take action to per (2) above. can create issuing
get their money change in securities is
back ownership. avoided.

Lenders get Preference share-holders come Equity It is related to

preferred next, when lenders are paid in shareholders dividend
treatment in liquidation. get the residual policy
liquidation assets prorata decisions.
after lenders &
preference
shareholders
claims are met
in liquidation.
Interest preference Dividends are not tax- Equity
payments are deductable. dividends are
tax-deductable not tax-
deductable,

3.4.1 Cost Principle

According to this principle, ideal pattern of capital structure is one that tends
to minimize cost of financing and maximize the value per share. Cost of
capital is subject to interest rate at which payments have to be made to
suppliers of funds and tax status of such payments. Debt capital is cheaper
than equity capital from both the points of view. According to this, the use
of debt capital in the financing process is immensely helpful in raising
income of the company.

3.4.2 Risk Principle

This principle suggests that such a pattern of capital structure should be

designed so that the firm does not run the risk of bringing on a receivership
with all its difficulties and losses. Risk principle places relatively greater
reliance on common stock for financing capital requirements of the
corporation and forbids as far as possible the use of fixed income bearing
securities.

3.4.3 Control Principle

While designing sound capital structure for the firm and for that matter
choosing different types of securities, finance manager should also keep in
mind that controlling position of residual owners remains undisturbed. The
use of preferred stock as also bonds offers a means of raising capital without
65
Financial Decisions: jeopardizing control. Management desiring to retain control must raise funds
An Overview
through bonds and preference capital.

3.4.4 Flexibility Principle

According to flexibility principle, the management should strive for such

combinations of securities that enable it to maneuver sources of funds in
response to major changes in need for funds. Not only several alternatives are
open for assembling required funds but also bargaining position of the
corporation is strengthened while dealing with the suppliers of funds
(through bonds).

3.4.5 Timing Principle

Timing is always important in financing more particularly in a growing

concern. Maneuverability principle is sought to be adhered in choosing the
types of funds so as to enable the company to seize market opportunities and
minimize cost of raising capital and obtain substantial savings. Important
point that is to be kept in mind is to make the public offering of such
securities as are greatly in demand. Depending on business cycles, demand
of different types of securities oscillates. Equity share during boom is
always welcome.

Activity 1

1) What is capital structure? How is it different from financial structure?

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

2) Bring out in brief, characteristics of equity share capital

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

3) List out sources of long – term finance used by a company of India

origin.

............................................................................................................

............................................................................................................
66
 ............................................................................................................ Capital Structure
Decisions
............................................................................................................

4) Discuss the criteria for determining pattern of capital structure.

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

3.5 RISK AND CAPITAL STRUCTURE

A firm’s capital structure should be developed keeping in view risk focus

because the risk affects the value of the firm. Risk can be considered in
two ways:

a) The capital structure should be consistent with the business risk of the
firm, and

b) The capital structure results in a certain level of financial risk to the

firm.

Business risk is the relationship between the firm’s sales and its earnings
before interest and taxes (EBIT). In general, the greater the firm’s operating
leverage i.e. the use of fixed operating costs-the higher is the business risk.
In addition to operating leverage, revenue stability and cost stability also
affect the business risk of the firm. The revenue stability means the
variability of the firm’s sales revenues which depends on the demand and the
price of the firm’s products. Cost stability refers to the relative predictability
of input prices such as labour and material. The more predictable these
prices are the less is the business risk. Business risk varies among firms.
Whatever their lines of business, the business risk is not affected by capital
structure decisions. In fact, capital structure decisions are influenced by the
business risk. Firms with high business risks, tend to have less fixed
operating costs. Let us take an example to illustrate the implications of
business risk for capital structure decisions.

Example

Raj Cosmetics Ltd., engaged in the process of planning its capital structure,
has obtained estimates of sales and associated levels of EBIT. The sales
forecasting group feels that there is a 25 percent chance that sales will be Rs.
4,00,000 a 50 percent chance that sales will be Rs. 6,00,000 and 25 percent
the sales will total Rs. 8,00,000. These data are summarised Table 3.2.

67
Financial Decisions: Table 3.2: Estimated sales and Associated levels of EBIT
An Overview
(000)
Probability of Sales 0.25 0.50 0.25
Sales 400 600 800
-Variable operating costs (50% of Sales) 200 300 400
-Fixed Operating Costs 200 200 200
Earnings before interest and taxes (EBIT) —— 0 —— ——
100 200
—— —— ——

The EBIT data, i.e. Rs.0,100 or 200 thousands at probability levels of 25%,
50% and 25% respectively reflect the business risk of the firm and has to be
taken into consideration when designing a capital structure.

The firm’s capital structure affects the firm’s financial risk arising out of the
firm’s use of financial leverage which is reflected in the relationship between
EBIT and EPS. The more fixed cost financing, i.e. debt and preference
capital in the firm’s capital structure, the greater is the financial risk.
Suppliers of funds will raise the cost of funds if the financial risk increases
. Let us take an example to illustrate this point.

Raj Cosmetics Let. Is now considering seven – alternative capital structure.

Stated in terms of debt ratio) i.e. Percentage of debt in the total capital) these
are 0,10,20,30,40,50, and 60, per cent. Assume that (1) the firm has no
current liabilities, (2) that its capital structure currently contains all equity
(25,000 equity shares are outstanding at Rs. 20 par value), and (3) the total
amount of capital remains constant at Rs.5,00,000.

Table 3.3: Capital Structure Associated with Alternative Debt Ratios

Debt Total Debt Equity (Rs. Equity Shares

Ratio% Assests (Rs. 000) 000) outstanding
(Rs.000) 4=2-3 (Numbers 000)
1 2 3 4 = 2–3 5 = (4 4 Rs. 20)
0 500 0 500 25.00
10 500 50 450 22.50
20 500 100 400 20.00
30 500 150 350 17.50

As debt increases, the interest rate also increase with the increase in financial
leverage (i.e. debt ratios). Hence, the total interest on all debt also increase
(as successive debenture issues carry higher interest rates) as shown in Table
3.4.

68
 Table 3.4: Interest amount at Various levels of Debt Capital Structure
Decisions
Capital Debt Interest Rate on Interest amount
Structure (Rs.000) all debt % (2) (Rs.000)
% of Debt 1 (1) (3 = 1*2)
0 0 0.0 0.00
10 50 9.0 4.50
20 100 9.5 9.50
30 150 10.0 15.00
40 200 11.0 22.00
50 250 13.5 33.75
60 300 15.5 49.50

3.5.1 EBIT-EPS Analysis for Capital Structure

Using the levels of EBIT in table 3.2, number of equity shares in the columns
5 of table 3.3. and interest values calculated in table 3.4, the calculation of
EPS for debt ratios of 0,30, and 60 percent respectively is shown in Table
3.5. the effective tax rate is assumed to be 40 percent.

Table 3.5: Calculation of EPS for alternative Debt ratio

Probability 0.25 0.50 0.25
When Debt ration =
Less Interest (Table 3.4) 0.00 100.00 200.00
0.00 0.00 0.00
Earnings after taxes —— —— ——
Less Taxes (0.40) 0.00 100.00 200.00
0.00 40.00 80.00
Earnings after taxes —— —— ——
EPS (25,000) shares (table 3.3) 0.00 60.00 120.00
0.00 2.40 4.80
When Debt ration = 30%
EBIT 0.00 100.00 200.00
Less Interest 15.00 15.00 15.00
—— —— ——
Earnings before taxes (15.00) 85.00 185.00
Less Taxes (0.40) (6.00) 34.00 74.00
—— —— ——
Earnings after taxes (9.00) 51.00 111.00
EPS (17,500 shares) (0.51) 2.91 6.34

When Debt ratio = 60%

EBIT 0.00 100.00 200.00
Less Interest 49.50 49.50 49.0
—— —— ——
Earnings before taxes (49.50) 50.50 150.50
Less Taxes (0.40) (19.80) (a) 20.20 60.20
—— —— ——
Earnings after taxes (29.70) 30.30 90.30
EPS (10,000 Shares) 2.97 3.03 9.03
69
Financial Decisions: Notes: a ) It is assumed that the firm received the tax benefits from its loss in
An Overview
the current period, as a result of carrying forward and setting off the loss
against in the following periods.

Following the same procedure as in Table 3.5, we may obtain EPS for other
debt ratios. Table 3.6 gives expected EPS at 50% probability level (to be
viewed as typical level ) for seven alternative debt ratios along with the
Standard deviation and co-efficient of variation of expected EPS.

Table 3.6: Expected EPS, Standard. Deviation and Co-efficient of variation

of EPS at 50% probability level for alternative debt ratios

Capital Expected Standard deviation Co-efficient of

structure debt EPS (Rs.) of EPS (Rs.) variation
ratio (%) (1) (2) (2) + (1) = (3)
0 2.40 1.70 0.71
10 2.55 1.88 0.74
20 2.72 2.13 0.78
30 2.91 2.42 0.83
40 3.12 2.83 0.91
50 3.18 3.39 1.07
60 3.03 4.24 1.40

Notes: The standard deviation () represents the square root of the sum of the
product of each deviation from the mean of expected value squared and the
associated probability of occurrence of each outcome. This is the most
common statistical measure of assets risk.

The co-efficient of variation is calculated by dividing the standard deviation

for an asset by its mean or expected value. The higher the co-efficient of
variation, the riskier is the asset.

Table 3.6 shows that as the firm’s financial leverage increases, its co-efficient
of variation of EPS also increases, signifying that the higher level of risk is
associated with higher levels of financial leverage.

The relative risk of the two of the capital structures at debt ratio=0% and
60% respectively is illustrated in Figure 3.1 by showing the subjective
probability distribution of

EPS associated with each of them. As the expected level of EPS increase
with increasing financial leverage, the risk also increases which is reflected in
the relative dispersion of each of the distributions. As the higher levels of
financial EPS increase. There are chances that there will be negative EPS
depending on the probabilities of occurrence of the expected results.

70
 Capital Structure
Decisions

Figure 3.1: A Graphic Presentation of Probability Distribution of EPS at Alternative Debt

Ratios.

The EBIT –EPS analysis helps in choosing the capital structure which
maximizes EPS over the expected range of EBIT. Since EBIT is one of the
major factors which affects the market value of the firm’s shares, EPS can as
well be used to measure the effect of various capital structure on
shareholders’ wealth. The relationship between EBIT and EPS of the firm
to analyse the effect of capital structure on results to the shareholders has
been graphically shown in Figure 3.2 where data from Table 3.7 are used.

Figures 3.2: A Graphic comparison of selected structures for Raj Cosmetics Ltd.

71
Financial Decisions: Table 3.7 : EBIT-EPS Coordinates (Selected Capital Structures)
An Overview

Capital structure debt ratio (%) EBIT

Rs.1,00 000 Rs.2,00,000
Earnings per share
0 2.40 4.80
30 2.91 6.34
60 303 9.03
Expected earnings before interest and taxes are assumed to be constant
because only the effect of financing costs such as interest and preference
dividends on equity shareholders’ earnings is to be analysed. Thus, the
business risk is assumed constant.
Graphically, the risk of each capital structure can be seen in the context of the
financial breakeven point. (i.e. EBIT-axis intercept). Below the x-axis,
negative EPS would result. The higher the financial breakeven point and the
steeper the slope of the capital structure line, the greater the financial risk.

The assessment of the capital structure can also be made by using ratios.
With increased financial leverage, the ability of the firm to service its debt
decreases. Thus, the times Earned Interest Ratio (i.e. EBIT divided by
interest) ratio also measures firm’s financial leverage and associated risk.
3.5.2 ROI-ROE Analysis
In the preceding section, we looked at the relationship between EBIT and
EPS. Pursuing a similar type of analysis, we may look at the relationship
between the ROI and ROE for different levels of financial leverage.

Example:
Raj Ltd., which requires an investment outlay of Rs. 200 lakhs, is considering
two capital structures propositions:

Capital Structure X Capital Structure Y

(Rs. in lakhs) (Rs. in lakhs)

Equity 200 Equity 100

Debt 0 Debt 100

Tax rate = 50 percent Cost of Debt = 12 percent

Based on the above information, the relationship between ROI and ROE
would be as shown in Table 3.8.

72
Table 3.8: Relationship between ROI and ROE under capital structures Capital Structure
Decisions
X and Y

Particulars ROI EBIT Int. Profit Profit Tax Return

before after on
tax tax Equity
Capital Structure 5% 10 0 10 5 5 2.5%
X
10% 20 0 20 10 10 5.0%
15% 30 0 30 15 15 7.5%
20% 40 0 40 20 20 10.0%
25% 50 0 50 25 25 12.5%
Capital Structure 5% 10 10 0 0 0 0.0%
Y
10% 20 10 10 5 5 5.0%
15% 30 10 20 10 10 10.0%
20% 40 10 30 15 15 15.0%
25% 50 10 40 20 20 20.5%

Return on Equity is equity earnings divided by Net worth. Looking at the

relationship between ROI and ROE, we find that

1) The ROI under capital structure X is higher than the ROE under capital
structure Y (ROI is less than the cost of Debt).

2) The indifference value of ROI is equal to the cost of Debt.

3) The ROE under capital structure X (ROI is more than the cost of
Debt).

Capital Structure

Decisions
Mathematically this relationship can be expressed as:
ROE = [ROI + (ROI-r) D/E] (1-t)
Where r = Cost of Debt D/E = Debt- Equity Ratio t = tax rate
Applying the above equation when D/E Ratio is 1, we may calculate the
value of ROE for two values of ROI namely, 15 percent and 20 percent.
ROI = 15% ROE = [15+(15-10) 1]0.5 = 10 %
ROI = 20% ROE = [20+(220-10) 1]0.5 = 15%
The results are the same as we see in Table 3.8.

Activity 2

1) Leverage decision is the same as capital structure decision. Do you

agree? Give one reason.

............................................................................................................
73
Financial Decisions: ............................................................................................................
An Overview
............................................................................................................

............................................................................................................

............................................................................................................

2) Distinguish between EBIT and EPS.

............................................................................................................
............................................................................................................

............................................................................................................

............................................................................................................
3) Collect the figures of any company and do the EBIT-EPS analysis by
making necessary assumptions.

............................................................................................................
............................................................................................................

............................................................................................................
............................................................................................................

4) With a real company example, make ROI-ROE analysis.

............................................................................................................

............................................................................................................

............................................................................................................
............................................................................................................

3.6 THEORIES OF CAPITAL STRUCTURE

A firm should try to maintain an optimum capital structure with a view to

maintaining financial stability. The optimum capital structure is obtained
when the market value per equity share is the maximum. In order to achieve
the goal of identifying an optimum debt-equity mix, it is necessary for the
finance manager to be familiar with the basic theories underlying the capital
structure of corporate enterprises.

1. N I Approach
2. NOI Approach
3. MM Approach
4. Traditional Approach
Common assumptions of the theories of capital structure decision are as
74 follows:
 i) Preference share capital is merged with debt. The firm employs only Capital Structure
Decisions
debt and equity capital.
ii) There are no corporate taxes.
iii) EBIT is not expected to grow.
iv) The firm’s total financing remains constant.
v) The business risk does not change with the growth of business
firm.
vi) All investors have the same subjective probability distribution of the
future expected earnings for a given firm.

3.6.1 Net Income (NI) Theory

According to this approach, capital structure decision is relevant to the

valuation of the firm in as much as change in the pattern of capitalization
brings about corresponding change in the overall cost of capital and total
value of the firm. This theory, also known as fixed ke theory, was propounded
by David Durand.

The critical assumptions of this theory are

i) There are no corporate taxes.

ii) The debt content does not change risk perception of the investors.
iii) The cost of debt is less than the cost of equity.

The theory works like this.

“As the proposition of cheaper debt funds in the capital structure increases,
the weighted average cost of capital decreases and approaches the cost of
debt.

This theory recommends 100% debt financing is optimal capital structure.

The following are the strengths of NoI approach:

i) it tries to explain the effects of borrowings on overall cost of capital.

ii) It explains and emphasizes on favourable financial leverage.

iii) However, the theory ignores the risk consideration.

3.6.2 Net Operating Income (NoI) approach

This approach, also propounded by Durand, is just opposite of Net Income

(NI) approach. According to this approach overall cost of capital and value of
the firm are independent of capital structure decision and change in degree
of financial leverage does not bring about and change in value of the firm and
cost of capital.

The approach is based on the following assumptions:

75
Financial Decisions: i) The overall cost of capital (k0) remains constant for all degrees of debt
An Overview
equity mix or leverage.

ii) There are no corporate taxes.

iii) The market capitalizes the value of the firm as a whole.

iv) The advantage of debt is set off exactly by increase in the equity
capitalization rate.

Capital Structure

According to the NOI Approach, the value of a firm can be determined by

the following equation;

EBIT
V
KO

Where:
V = Value of firm;
KO = Overall cost of capital

EBIT = Earnings before interest and tax.

Thus, according to Net Operating Income (NOI) Approach, any capital

structure will be optimum.

The following are the strengths of NOI approach:

i) it emphasizes on the role of NOI in the determination of total value of
the firm,
ii) According to this theory, new investment proposals should be based on
NOI approach

This theory seems to ignore the behavioral aspect of financing function of

management.

3.6.3 Modigilian- Miller (MM) Theory

The Modigiliani-Miller (MM) approach is similar to the Net Operating

Income (NOI) approach. It supports the NOI approach providing behavioural
justification for the independence of the total valuation and the cost of
capital of the firm from its capital structure. In other worlds, MM approach
maintains that the weighted average cost of capital does not change with
change in the capital structure of the firm.

The following are the three basic propositions of the MM approach:

i) The overall cost of capital (KO) and the value of the firm (V) are
independent of the capital structure.

76 ii) The cost of equity (KE) is equal to capitalization rate of a pure equity
 stream plus a premium for the financial risk. Capital Structure
Decisions
iii) The cut-off rate for investment purposes is completely independent of
the way in which an investment is financed.

The MM approach is subject to the following assumptions:

1) Capital markets are perfect.

2) All firms within the same class will have the same degree of business
risk.
3) All investors have the same expectation of a firm’s net operating income
(EBIT).

4) The dividend pay-out ratio is 100%.

5) There are no corporate taxes. However, this assumption was removed
later.

The “arbitrage process” is the operational justification of MM hypothesis.

The term ‘Arbitrage’ refers to an act of buying an asset or security in one
market having lower price and selling it is another market at a higher
price. The consequence of such action is that the market price of the
securities of the two firms exactly similar in all respects except in their
capital structures can not for long remain different in different markets.
Thus, arbitrage process restores equilibrium in value of securities. This is
because in case the market value of the two firms which are equal in all
overvalued firm would sell their shares, borrow additional funds on personal
account and invest in the undervalued firm in order to obtain the same return
on smaller investment outlay. The use of debt by the investor for arbitrage is
termed as ‘home made’ or ‘personal leverage’.

The following are limitations of MM’s theory-

i) Rates of interest are not the same for the individuals and the firms.
ii) Transactional costs are involved.
iii) Homem ade leverage is not perfect substitute for corporate leverage.
iv) The effectiveness of arbitrage process is limited.

Since corporate taxes do exist, MM agreed in 1963 that the value of the firm
will increase and overall cost of capital will decline because of tax
deductibility of interest payments. A levered firm should have, therefore, a
greater market value as compared to an unlevered firm. The value of the
levered firm would exceed that of the unlevered firm by an amount equal
to the levered firm’s debt multiplied by the tax rate. The formula is-

Capital Structure
Decisions
Vi = Vu + Bt
77
Financial Decisions: Where :
An Overview
Vi = Value of levered firm

Vu = Value of an unlevered firm B = Amount of Debt and

t = Tax rate

3.6.4 Traditional Approach

The traditional theory assumes changes in Ke at different levels of debt

equity rate. It is the middle of the two extremes of NI and NOI.

Beyond a particular point of debt-equity mix, ke rises at an increasing rate.

There are three stages:-

Stage I– Introduction of debt-Net Income rises; cost of equity capital rises

because of risk but less than earnings rate leading to decline in overall cost
of capital and increase in Market value.

Stage II – Further Application of debt: cost of equity capital rises-net income

– debt cost increases – value same.

Stage III – Further Application of debt – cost of equity capital is very high –
value goes down.

Example
Raj Cosmetics Ltd. has estimated the following rates of return (Column (3) of
the Table 3.9. Table 3.9 also gives the seven capital structures from the
debt ratios ranging from 0% to 60% and expected EPS in Rs. (from Table
3.6).
From these data, it is possible to work out the expected share values in each
of the alternative capital structures. Calculations are set out in column 4 of
the Table 3.9.

Table 3.9: Calculation of Share Value Estimate Associated with Alternative

Capital Structures for Raj Cosmetics Ltd.

Capital Expected EPS Estimated required Estimated

structure debt (Rs.) (From rate of return Esti. Share Value
ratio (%) Table 3.6) by the Co.) (Rs.)
(1) (2) (3) (4)
0 2.40 0.115 20.87
10 2.55 0.117 21.79
20 2.72 0.121 22.48
30 2.91 0.125 23.28
40 3.12 0.140 22.29
50 3.18 0.165 19.27
60 3.03 0.190 15.95
78
Table 3.9 shows that the maximum share value occurs at the capital structure Capital Structure
Decisions
associated with the debt ratio of 30%. This is the optimal capital structure. It
is noticeable that EPS is maximized at 50% debt ratio, while the share value
is maximized at 30% debt ratio. This discrepancy arises because EPS
maximization approach does not consider the risk as reflected in required
rates of return.

In addition to the analysis of the EBIT-EPS, required rates of returns and

share value, certain other factors are also taken into account in determining
the capital structure for the firm. These are listed below:

• Adequacy of cash flow to service debt and preference shares

• Having stable and predictable revenues

• Limitations imposed by previous contractual obligations

• Management Preference and attitudes towards risk

• Assessment of the firm’s risk by financial institutions and other
agencies
• Capital market conditions and investor preferences

• Considerations of corporate control.

Activity 3

1) In what manner are the corporate taxes relevant to capital structure

decision?

............................................................................................................

............................................................................................................

............................................................................................................

2) Contrast traditional and M-M position regarding optimal capital

structure.

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

3) Name of single most important factor which determines the capital

structure of a company.

............................................................................................................

............................................................................................................

............................................................................................................ 79
Financial Decisions: 4) Try to know from Finance Manager of any two companies:
An Overview
i) What is their present capital structure?

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

ii) What are the factors which determine their capital structure?

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

iii) Do they intend to change their capital structure in the near future ? why?

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

5) Show arbitrage process with an example.

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

3.7 FACTORS INFLUENCING PATTERN OF

CAPITAL STRUCTURE

Following are the major factors which should be kept in view while
determining the capital structure of a company:

1) Size of Business

Smaller firms confront tremendous problems in assembling funds

because of their poor creditworthiness. Investors feel loath in investing
their money in securities of these firms. Lenders prescribe highly
80 restrictive terms in lending. In view of this, special attention should be
 paid to maneuverability principle. This is why common stock represents Capital Structure
Decisions
major portion of this capital in smaller concerns. Larger concerns have to
employ different types of securities to procure desired amount of funds
of reasonable cost because they find it very difficult to raise capital at
reasonable cost of demand for funds is restricted to a single source.

2) Form of Business Organisation

Control principle should be given higher weightage in private limited

companies where ownership is closely held in a few hands. This may not
be so imminent in the case of public limited companies whose
shareholders are large in number. In proprietorship or partnership form
of organisation, control is undoubtedly an important consideration
because control is concentrated in a proprietor or a few partners.

3) Nature of Enterprise

Business enterprises which have stability in their earnings or which

enjoy monopoly regarding their products may go for debentures or
preference shares since they will have adequate profits to meet the
recurring cost of interest/fixed dividend. This is true in case of public
utility concerns. On the other hand, companies which do not have this
advantage should rely on equity share capital to a greater extent for
raising their funds. This is, particularly, true in case of manufacturing
enterprises.

4) Stability of earnings

With greater stability in sales and earnings, a company can insist on the
fixed obligation debt with less risk. But a company with irregular income
will not choose to burden itself with fixed charge. Such company
should depend upon the sale of stock to raise capital.

5) Age of Company

Younger companies generally find it difficult to raise capital in the initial

years because of greater uncertainty involved in them and also because
they are not known to suppliers of funds. It would therefore, be
worthwhile for such companies’ accord to higher weightage to
maneuverability factor. In a sharper contrast to this, established
companies with good earnings record are always in comfortable position
to raise capital from whatever sources they like. Leverage principle
should be insisted upon in such concerns.

6) Purpose of Financing

In case funds are required for some directly, productive purposes the
company can afford to raise the funds by issue of debentures. On the
other hand, if the funds are required for non-productive purposes,
81
Financial Decisions: providing more welfare facilities to the employees the company should
An Overview
raise the funds by issue of equity shares.

7) Market Sentiments

Times of boom investors generally want to have absolute safety. In such

cases, it will be appropriate to raise funds by issue of debentures. At
other periods, people may be interested in earnings high speculative
incomes; at such times, it will be appropriate to raise funds by issue of
equity shares.

8) Credit Standing

A company with high credit standing has greater ability to adjust sources
of funds upwards or downwards in response to major changes in need
for funds than one with poor credit standing. In the former case, the
management should pay greater attention to maneuverability factor.

9) Period of Finance

The period for which finance is required also affects the determination
of capital structure of companies. In case, funds are required, say, for 5
to 10 years, it will be appropriate to raise them by issue of debentures.
However, if the funds are required more or less permanently, it will be
appropriate to raise them by issue of equity shares.

10) Legal Requirements

Companies Act, Banking Co. Act etc. influence the capital structure
considerations. The relative weightage assigned to each of these factors
will vary widely from company to company depending upon the
characteristics of the company, the general economic conditions and the
circumstances under which the company is operating. Companies issue
debentures and preference shares to enlarge the earnings on equity
shares, while equity shares are issued to serve as a cushion to absorb
the shocks of business cycles and to afford flexibility. Of course, greater
the operating risk, the less debt the firm can use, hence, in spite of the
fact that the debt is cheaper the company should use it with caution.

11) Tax Considerations

The existing taxation provision makes debt more advantageous in

relation to stock capital in as much as interest on bonds is a tax
deductible expense whereas dividend is subject to tax. In view of
prevailing corporate tax rates in India, the management would wish to
raise degree of financial leverage by placing greater reliance on
borrowing.

82
3.8 RELEVANCE OF DEBT – EQUITY RATIO Capital Structure
Decisions
IN PUBLIC ENTERPRISES

It is generally argued that the practical significance of the debt-equity ratio is

limited in the case of public enterprises in many countries because most of
the loans are derived from the government itself or from public sector
financial institutions. The government as the owner as well as the lender, has
access to all the information it needs about the financial health of the
enterprise and does not need to refer to any favourable ratio to derive
confidence before making loans to it. Even when the public enterprises are
allowed to borrow from private banks or from foreign financial institutions,
there is a government guarantee in one form or another that the loans will be
removed and lightened by adoption of an appropriate policy measures.

Since all this has the effect of making institutional arrangements for sharing
risk and thus reducing the disadvantages of debt, a case could be made for
justifying higher debt-equity ratios for public enterprises. A few observations
in this regard are made as under :

a) Since not all of the public enterprise are wholly owned and financed
(through loans) by government and there are many joint ventures, so that
institutional arrangements for diluting risks are not always available to
these enterprises, it has to be appreciated that in real life, public
enterprises have to face the bias of the lending agencies (local or foreign)
towards this measure of the strength of their capital structure.

b) In most of the countries public enterprises ministries e.g. planning and

finance, for a critical scrutiny and appraisal of their proposals. In any
case, the government owned financial institutions can be should be
expected to raise points also at the risk of further lending to an
enterprise, the debt-equity ratio of whose capital structure is not in line
with the normal or which does not appear to be quite sound in context
of its financial prospects. Many of the worthwhile plans of investment in
public enterprises, whether for replacement and rehabilitation of existing
assets or for expansion and diversification, require significant amounts of
foreign exchange. If these resources are arranged from foreign lending
agencies like the world Bank/IDA, the creditors make it a point to
specify adherence to a range of ‘healthy’ debt-equity ratios (and also to a
conservative dividend disbursement policy) till their loans are repaid.

c) It is also desirable from the enterprise’s own point of view to see that a
sufficiently high proportion of equity is maintained in its capital structure
because it should enable it some freedom of action in the matter of
retaining its earnings for its “self-financed” projects or for financing a
part of its working capital, provided, of course, that it is in the happy
position of making profits. In the case of other enterprises which operate
83
Financial Decisions: at a loss (whether because of government imposed pricing policies or
An Overview
because of their inefficiencies), there is usually a demand for concerting
at least a part of their loan capital into equity capital. When such
proposals are being formulated and examined, the question of a
reasonable or proper debt-equity ratio for the type of enterprises under
consideration is raised sooner or later.

d) With an inappropriately high debt-equity ratio, the initial cost of a

project/ manufacturing facility put up by a public enterprise has the
effect of increasing the fixed costs of operation through the capitalization
of interest during construction. This is likely to place the enterprise in a
disadvantageous position vis-à-vis its competitions and can lead to a
vicious cycle of accumulation of losses, under utilization of capacity,
low morale of workers and management inefficiencies, short-term (and
strategically unsuitable) solutions and further losses. Having once been
trapped in this situation, it is difficult indeed for the enterprise to
extricate itself and rehabilitate its capital structure, particularly when the
Government department’s ministries are not very prompt in analyzing
the causes of these problems and providing the requisite reliefs.

e) There cannot be must argument with the proposition that, in long run, the
equity portion of a public enterprise must not be regarded as a device of
cash convenience and as a no-cost input, because it certainly has an
opportunity cost for the economy as a whole. Public enterprises have, as
a general rule, to operate under pricing and operating policies dictated
by their owner government’s socio-economic (and political) objectives.
Debt- equity ratio is one device by which the enterprise can be
considered to have been compensated for its expenses/losses on meeting
these additional obligations.

f) If a certain range of debt-equity ratios is adopted for enterprise in a

particular sector of the economy, it can result in fixing a concessional
rate of interest/return on the capital mix (loan at market rate plus equity
at zero percent).

It may, thus, be concluded that the view that the practical significance of the
debt-equity ratio is limited in the case of public enterprise is not based on a
complete appreciation of all the factors in which these enterprises have to
operate in many developing countries. While the private sector analogy in
this respect may have to be qualified suitably when applied to the public
enterprise situation in a particular country, it will remain a useful indicator,
both with the administrative ministers and with the enterprise managements,
to assess the strength of their capital structures.

84
Activity 4 Capital Structure
Decisions
1) Bring out five factors that influence capital structure.

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

2) “Debt Equity Ratio is not relevant for public enterprises” Comment.

............................................................................................................

............................................................................................................

............................................................................................................

............................................................................................................

3.9 SUMMARY

A firm’s capital structure is determined by the mix of long-term debt and

equity it uses in financing its operations. Financial structure means the
composition of the entire left hand side of the balance sheet. The basic
differences in debt (including preference shares) and equity capital are in
respect of the voting rights, the claims on income and assets, and the tax
treatment. Timing, flexibility, cost, risk and control principles are the criteria
for determining patter of capital structure.

A firm’s capital structure should be consistent with its business risk and
result in an acceptable financial risk. The EBIT-EPS analysis can be used to
evaluate various capital structure in the light of the degree of financial risk
and the returns to the equity shareholders. The EBIT-EPS analysis shows
how the desirable capital structure gives the maximum EPS.

The mathematical relationship between ROI is [(ROE + ROI – r) D/E] (1-t)

NI and NOI theories of capital structures are extreme. The MM analysis

suggests that the optimal capital structure does not matter and that as
much debt as possible should be used because the interest is tax-deductible.
The MM hypothesis is criticized because of its unreal assumptions. Tax
adjustment makes it more realistic.

The traditional approach to capital structure indicates that the optimal capital
structure for the firm is one in which the overall cost of capital is minimized
and the share value is maximized.

The cost of debt increases beyond a certain level of leverage.

85
Financial Decisions: Certain qualitative considerations such as cash flow, corporate control,
An Overview
contractual obligations, management’s risk tolerance, etc. are taken into
consideration while determining the capital structure.

The practical significance of Debt-Equity ratio for public enterprises is

limited and has different perspectives.

3.10 KEYWORDS

Capital Structure is the proportions of all types of long-term capital.

Financial Structure is the proportions of all types of long-term and short-term
capital.

EBIT = Earnings before Interest and taxes.

EPS = Earnings per share

NI Approach says more usage of debt will enhance the value of the firm.

NOI Approach says that the total value of the firm remains constant
irrespective of the debt-equity mix. Arbitrage refers to an act of buying a
security in one market having lower price and selling it in another market at a
higher price. The consequence of such action is that the market price of the
securities will become the same.

3.11 SELF ASSESSMENT

QUESTIONS/EXERCISES

1) What is a firm’s capital structure? How is it different from financial

structure?

2) Under the traditional approach to capital structure, what happens to the

cost of debt and cost of equity as the firm’s financial leverage
increases?

3) Explain ROI-ROE analysis.

4) Explain the EBIT-EPS approach to the capital structure. Are maximizing

value and maximizing EPS the same?

5) Khosla Ltd. had made the following forecast of sales, with the associated
probability of occurrence.

Sales Rs. Probability

2,00,000 0.20
3,00,000 0.60

4,00,000 0.20

86
The company has fixed operating costs of Rs.1,00,000 per year and variable Capital Structure
Decisions
operating costs represent 40% of sales. The existing capital structure consists
of 25,000 equity shares of Rs. 10 each. The market place has assigned the
following discount rates to risky earnings per share.

Co-efficient of variation of EPS Estimated Required Returns %

.43 15
.47 16
.51 17
.56 18
.60 22
.64 24

The company is considering changing its capital structure by increasing debt

in the capital structure vis-à-vis capital. Different debt ratios are considered,
given here with the estimate of the required interest rate on all debt.

Debt Ratio Interest on all debt

20% 10%
40% 12%
60% 14%

The tax rate is 40% percent.

a) Calculate the expected earnings per share, the standard deviation of EPS
and the co-efficient of variation of EPS for the three proposed capital
structures.
b) Determine the optimal capital structure, assuming (i) maximization of
EPS and (ii) maximization of share value.
c) Construct a graph showing relationship in (b).
6) Critically examine various theories of capital structure.
7) Narrate the factors influencing capital structure.
8) Explain the criteria for determining pattern of capital structure.
9) Discuss the relevance of debt-equity ratio for Indian Public
Enterprises.
10) Assume the figures of an Indian company and examine the relevance of
MM’s theory of capital structure.

3.12 FURTHER READINGS

Banerjee, B. (2015). Fundamentals of financial management. India: Phi
learning.

Bates, T., Gillan, S. L., Parrino, R., Kidwell, D. S. (2017). Fundamentals of

Corporate Finance. United Kingdom: Wiley.
87
Financial Decisions: Chandra, P. (2014). Fundamentals of Financial Management. India: Tata
An Overview McGraw-Hill Education.

Gitman Lawerence J. 1985, Principles of Managerial Finance Fourth

Edition. Haper & Row Publishers, Singapore, New York.
Maheshwari, S.N. 1996, Financial Management – Principles and Practices,
Sultan Chan & Sons, New Delhi.

Myers, S. C., Brealey, R. A., Allen, F. (2020). Principles of Corporate

Finance. United Kingdom: McGraw-Hill Education.

Pandey, I. M. (2015). Financial Management. India: Vikas Publishing House

Pvt Limited.

Ross, S. A. (2018). Corporate Finance. United Kingdom: McGraw-Hill

Education.
Vernimmen, P., Le Fur, Y., Quiry, P. (2022). Corporate Finance: Theory and
Practice. Germany: Wiley.

88