It is defined as the mix or proposition of a firm’s permanent long-term financing represented by debt, preference stock, and common stock equity.

Capital structure theory suggests that firms determine what is often referred to as a target debt ratio, which is based on various tradeoffs between the costs and benefits of debt versus equity.

The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital. Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure in terms of risk / reward payoff for shareholders. This is true for Fortune 500 companies and for small business owners trying to determine how much of their startup money should come from a bank loan without endangering the business

Let’s look at each in detail:

Equity Capital

This refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types: 1) contributed capital, which is the money that was originally invested in the business in exchange for shares of stock or ownership and 2) retained earnings, which represents profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion.

Many consider equity capital to be the most expensive type of capital a company can utilize because its “cost” is the return the firm must earn to attract investment. A speculative mining company that is looking for silver in a remote region of Africa may require a much higher return on equity to get investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.

Debt Capital

The debt capital in a company’s capital structure refers to borrowed money that is at work in the business. The safest type is generally considered long-term bonds because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime.

Other types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart and General Electric that amount to billions of dollars in 24-hour loans from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills. The cost of debt capital in the capital structure depends on the health of the company’s balance sheet – a triple AAA rated firm is going to be able to borrow at extremely low rates versus a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital.

Other Forms of Capital

There are actually other forms of capital, such as vendor financing where a company can sell goods before they have to pay the bill to the vendor, that can drastically increase return on equity but don’t cost the company anything. This was one of the secrets to Sam Walton’s success at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter & Gamble, in effect, using PG’s money to grow his retailer. In the case of an insurance company, the policyholder “float” represents money that doesn’t belong to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

SEEKING THE OPTIMAL CAPITAL STRUCTURE

Many middle class individuals believe that the goal in life is to be debt-free. When you reach the upper echelons of finance, however, that idea is almost anathema. Many of the most successful companies in the world base their capital structure on one simple consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure.

Of course, how much debt you take on comes down to how secure the revenues your business generates are – if you sell an indispensable product that people simply must have, the debt will be much lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom comes into play. The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher return products, and more.

To truly understand the idea of capital structure, you need to take a few moments to read Return on Equity: The DuPont Model to understand how the capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a doughnut shop or are considering investing in publicly traded stocks, it’s knowledge you simply must have.

Question on our minds: Can the total valuation of a company (debt+equity) and the cost of capital be affected by changing the financing mix. The imperfections in the market play a vital role in the valuation of a company. This data is of utmost importance to the suppliers of capital. Changes in the financing mix are assumed to occur by issuing debt and repurchasing common stock or by issuing common stock and retiring debt.

Example 1. Assume a company whose earnings are not expected to grow and which pays out all of its earnings to its shareholders in the form of dividends. All kinds of market imperfections are not considered in the current example, for simplicity in calculations.

We are concerned mainly with 3 different rates of return. The first is

The yield on company’s debt, ki = =

The second rate of return that we are concerned with is

ke = =

With our assumptions that the firms earnings are not expected to grow and which has a 100 percent dividend payout, the firm’s earning per price represents the market rate of discount that equates the present value of the perpetual stream of expected constant future dividends with the current market price of the common stock.

The third rate to be calculated is

ko = =

These 3 different rates of return affect the amount of financial leverage, which is the debt to equity ratio.

ko is defined as the overall capitalization rate of the firm. It is designed as the weighted average cost of capital, and can also be expressed as

ko = ki [] + ke []

Calculating A Company’s Capital Structure

Review your company’s most recent financial statements to find all of the capital components. Highlight all of the debt of the company and the equity (including common and preferred shares, capital contributions and retained earnings).

Add up the total debt and equity It will be equal to your company’s assets on the balance sheet because the debt and equity is what paid for those assets.

Your capital structure is the percentage that each funding source represents of your company’s total funding. Let’s look at an example. Let’s say you have the following capital components: bank loan $176,500, retained earnings $54,300, common stock $12,500. That makes your total capital $243,300. To calculate your capital structure, take the dollar amount of each capital source and divide it by the total capital. In the above example, the bank loan is 72.5%, retained earnings 22.3%, capital stock 5.2% for a total of 100%.

Monitor your company’s capital structure over time. Debt tends to be the most expensive source of capital and, over time, you will determine the most effective blend of debt versus equity financing for your particular situation. Calculating your actual capital structure will allow you to track how closely you are following your ideal capital structure.

Factors Affecting Capital Structure

The factors that affect the decisions taken regarding capital structure can be divided into three major types:

Internal Factors

External Factors

General Factors

INTERNAL FACTORS

Cost of Capital

The cost of capital is the cost of the company’s funds. It consists of debts and equity. When a company raises funds for its operations there are certain costs involved. When decisions regarding the capital structure are taken, managers ensure that the earnings on the capital are more than this cost of capital. In general, the cost of borrowing capital is less than the cost of equity capital. This is because the interest rate on loans and borrowings is less than the dividend rates and also the dividends are a function of the company’s profits and not expenditure.

Risk Factor

When decisions regarding capital structure are to be taken, the risk factors considerations are an important issue. If company raises its funds through debts, the risks involved are of two types:

The company has to repay the lenders in a fixed time period and at a fixed rate, whether or not the company makes profit or goes into loss.

The borrowed capital is secured capital. Hence, if the company fails to make the payments, the lenders can take possession of the company’s assets.

If the company goes for funds through equity capital there are minimum risks. As the dividends are an appropriation of the company’s profits, if it does not make any profit, it is not obliged to make the payments. In contrast to debt capital, here the company is not expected to repay its equity capital. And also the equity capital is not secured.

Control Factor

When additional funds are to be raised, the control factors are very essential in deciding the capital structure of the company. When a company decides to issue further equity shares the control of the company may be at stake. Hence, it may not be acceptable to its shareholders and owners. This factor is not vital in case of debt financing, except when financing institutions stipulate the appointment of nominee directors in the Board of Directors of the company.

Objects of Capital Structure Planning

They are-

Maximize profit of the owners

Issue transferable securities

Issue further securities in a way that does not dilute the holdings of the present owners

EXTERNAL FACTORS

General Economic Conditions: If the economy is in the state of depression, equity funding is considered as it involves less risk. While, if the economy is booming and the interest rates are forecasted to fall, debt funding is given preference.

Interest Rate Levels: If the interest rates are high in the capital market, equity funding is preferred until the interest rate levels fall down.

Policy of Lending Institutions: If the terms and policies of the financing institutions are rigid and harsh, debt financing should be ignored and equity financing should be tapped.

Taxation Policy: The government has taxation policies which include corporate taxes as well as individual taxes. The government includes individual taxes on both borrowings as well as dividends. Also income tax deductions are offered on interests paid on borrowings. All these factors have to be considered while planning capital structure.

Statutory Risks: While planning Capital Structure, the statutory risks given by the Government and other statutes are to be considered.

GENERAL FACTORS

Constitution of the company: If the company is private limited, the control factors are essential while if the company is public limited, the cost factors are essential.

Characteristics of the company: Companies which are small and in the early stage have weak credit standings and bargaining capacity, hence they have to rely on equity financing. While big companies have strong credit standings and they can source their funds from borrowings with acceptable interest rates.

Stability of earnings: The companies which have stable earnings and the risks involved are less, go for debt funding as they can handle the high risk factors. While companies whose earnings are forecasted to be fluctuating, usually go for less risky equity funding.

Attitude of the Management: For a company with conservative management, the control factor is more important, while a company with a liberal management considers the cost factors to be more important.

Approaches to Capital Structure

Net Operating Income Approach

Traditional Approach

Net Income Approach

Modigliani Miller Approach

Net Operating Income Approach

David Durand proposed the net income approach to capital structure. This approach looks at the consequence of alterations in capital structure in terms of net operating income. Under this approach, on the basis of net operating income, the overall value of the firm is measured. Therefore this approach is identified as net operating income approach.

The NOI approach entails that:

Largely the value of the firm does not depend on the degree of leverage in capital structure and hence whatever may be the change in capital structure the overall value of the firm is not affected.

In the same way, the overall cost of capital is not affected by any change in the degree of leverage in capital structure. The overall cost of capital is independent of leverage.

Under the net income approach, the overall cost of capital is unaffected and remains constant irrespective of the change in the ratio of debts to equity capital when the cost of debt is less than that of equity capital whereas it is assumed the overall cost of capital must decrease with the increase in debts. How is this assumption justified? With the increase in the amount of debts the degree of risk of business increases. As a result the rate of equity over investment in equity shares thus on one hand the WACC decreases with the increase in the amount of debts; on the other hand cost of equity capital increases to the same tune. Therefore the benefit of leverage is mopped away and the overall cost of capital remains at the same level.

In other words there are two parts of the cost of capital.

Interest charges on debentures.

The increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts.

OPTIMUM CAPITAL STRUCTURE

This approach suggests that whatever the degree of indebtedness of the company, market value remains constant. Despite the change in the ratio of debt to capital in the market value of its equity shares remains constant. This means that there is no optimal capital structure. Each capital structure is optimal in approach of net operating income

The market value of the firm is determined as follows: 

The value of equity can be determined by the following equation

and

 The Net Operating Income Approach is based on the following assumptions:

Example:

ABC Ltd., is expecting an earnings before interest & tax of Rs.1,80,00,000 and belongs to risk class of 10%. You are required to find out the value of firm % cost of equity capital if it employs 8% debt to the extent of 20%, 35% or 50% of the total financial requirement of Rs. 90000000.

Solution

Statement showing value of firm and cost of equity capital 

20% Debt

35% Debt

50% Debt

Earnings before interest & tax EBIT ($)

18000000

18000000

18000000

Overall cost of capital

10%

10%

10%

Value of firm (V) =

EBIT Cost of Capital{EBIT/Cost of Capital}

180000000

180000000

180000000

Value of 8% debt (D)

18000000 (20% Ã- 90000000)

31500000 (35% Ã- 90000000)

45000000 (50% Ã- 90000000)

Value of equity (V – D)

162000000

148500000

135000000

Net profit (EBIT – Interest)

16560000 (18000000 – 1440000)

15480000 (18000000 – 2520000)

14400000 (18000000 – 3600000)

(Cost of equity (Kc)

10.22%

10.42%

10.66%

(Net profit/value of equity) Ã- 100

(16560000/ 162000000)

( 15480000/ 148500000)

( 14400000/ 135000000)

 

It is apparent from the above computation that the overall cost of capital & value of firm; re-constant at different levels of debt i.e., at 20%, 35% and 50%. The benefit of debt content is offset by increase in the cost of equity. The overall cost of capital (k0) remains constant and can be verified as follows:

Overall Cost of Capital k0 = kd  (D/D+S) + Ke  (S/D+S)

 

20% Debt

K0 =  $4,00,000/$40,00,000  Ã-8% + $36,00,000/$40,00,000 X  10.22%

= 0.008 + 0.092

= 0.10 or 10%

35% Debt

K0 = $7,00,000/$40,00,000  Ã-8% + $33,00,000/$40,00,000 X  10.42%

= 0.014 + 0.0859

= 0.0999

Or 10%

50% Debt

K0 = $10,00,000/$40,00,000  Ã- 8% + $30,00,000/$40,00,000 X  10.66%

= 0.02 + 0.07995

= 0.0995 or 10%

Traditional Approach

Traditional approach is a middle-way approach between net operating income approach & the net income approach. According to this approach:

(1) A best capital structure does exist.

(2) Market value of the firm can be increased and average cost of capital can be reduced through a prudent manipulation of leverage.

(3) The cost of debt capital increases if debts are increases beyond a definite limit. This is because the greater the risk of business the higher the rate of interest the creditors would ask for.

The rate of equity capitalization will also increase with it. Thus there remains no benefit of leverage when debts are increased beyond a certain limit. The cost of capital also goes up.

Traditional Approach

Thus at a definite level of mixture of debts to equity capital, average cost of capital also increases. The capital structure is optimum at this level of the mix of debts to equity capital.

The effect of change in capital structure on the overall cost of capital can be divided into three stages as follows;

First stage

In the first stage the overall cost of capital falls and the value of the firm increases with the increase in leverage. This leverage has beneficial effect as debts as debts are less expensive. The cost of equity remains constant or increases negligibly. The proportion of risk is less in such a firm.

Second stage

A stage is reached when increase in leverage has no effect on the value or the cost of capital, of the firm. Neither the cost of capital falls nor the value of the firm rises. This is because the increase in the cost of equity due to the assed financial risk offsets the advantage of low cost debt. This is the stage wherein the value of the firm is maximum and cost of capital minimum.

Third stage

Beyond a definite limit of leverage the cost of capital increases with leverage and the value of the firm decreases with leverage. This is because with the increase in debts investors begin to realize the degree of financial risk and hence they desire to earn a higher rate of return on equity shares. The resultant increase in equity capitalization rate will more than offset the advantage of low-cost debt.

It follows that the cost of capital is a function of the degree of leverage. Hence, an optimum capital structure can be achieved by establishing an appropriate degree of leverage in capital structure.

Net Income Approach

This approach states that, the cost of debt and the cost of equity do not change with a change in the leverage ratio(when D/E changes), due to which it is observed that there is a weakening in the cost of capital as the leverage increases. The cost of capitalcan be calculated by the use Net income approach; weighted average of cost of capitalcan be explained by the following equation;

http://lh6.ggpht.com/cemismailsezer/R4_ZkNJ-ThI/AAAAAAAAADY/RZYaGVynnUw/image%5B5%5D

where:

Ko: average cost of capital

Kd: cost of debt

Ke: cost of equity

B: market value of debt

S: market value of equity

As we know that cost of debt is less than cost of equity (Kd

http://lh6.ggpht.com/cemismailsezer/R4_ZlNJ-TjI/AAAAAAAAADo/de5aDk2tbUo/image%5B8%5D

The Net Income Approach assembles the investment structure of the firm which has a major influence on the value of the firm. Therefore, the use of control will change both the worth of the organisation & cost of capital. Net Income is exploited in approaching the market value that firm possesses. In this analysis Ka decreases when the D/E ratio increases as the proportion of debt, cheaper source of finance, increase in the capital structure & vice versa.

Assumptions of net income approach

the perception of risk is not altered by the use of liability for the investors; as a result, the equity capitalisation rate i.e. ke, and the debt capitalisation rate kd, remain constant with changes in leverage

The debt capitalization rate is less than the equity capitalization rate

The corporate income taxes are not considered.

Numerical example:

Assume that a firm has an expected annual net operating income of Rs.2, 00, 000, an equity rate, ke, of 10% and Rs. 10, 00,000 of 6% debt.

The value of the firm according to NET INCOME approach:

Net Operating Income NOI 2, 00,000

Total cost of debt Interest= KdD, (10, 00,000 x .06) 60,000

Net Income Available to shareholders, NOI – I 1, 40,000

Therefore:

Market Value of Equity (Rs. 140,000/.10) 14, 00,000

Market value of debt D (Rs. 60,000/.06) 10, 00,000

Total 24, 00,000

Note: The cost of equity and debt are respectively 10% and 6% and are assumed to be constant under the Net Income Approach

Ko = Kd (D/V) + Ke (S/V)

= 0.06 (10, 00,000/24, 00,000) + 0.10 (14, 00,000/24, 00,000)

= 0.025 + 0.0583 = 0.0833 or 8.33%

Modigliani – Miller (MM) Approach

Assumptions of the MM Approach

Capital market is perfect. It is so when:

Information is freely available

Problem of asymmetric information does not exist

Transaction cost is nil

There is no bankruptcy cost

Securities are fully divisible

100% payout ratio

Investors and managers are rational

Managers act in interest of shareholders

Combination of risk and return is rationally chosen

Expectations are homogenous

Equivalent risk class

No taxes

Investors can borrow in personal A/C at same terms of firm.

Proposition I

Value of the form is equal to the expected operating income divided by discount rate appropriate to its risk class.

It is independent of capital structure i.e.

where,

V = Market Value of the Firm

D = Market Value of the debt

E = Market value of the equity

O = Expected Operating Income

r = Discount rate applicable to risk class to which firm belongs

Proposition I is almost similar to the Net Operating Income Approach. MM used arbitrage argument to prove this approach. MM argues that identical assets must sell for same price, irrespective of how they are financed.

Arbitrage Process

If the price of a product is unequal in two markets, traders buy it in the market where price is low and sell it in the market where price is high. This phenomenon is known as price differential or arbitrage. As a result of this process of arbitrage, price tends to decline in the high-priced market and price tends to rise in the low-priced market unit the differential is totally removed.

Modigliani and Miller explain their approach in terms of the same process of arbitrage. They hold that two firms, identical in all respects except leverage cannot have different market value. If two identical firms have different market values, arbitrage will take place until there is no difference in the market values of the two firms.

Example:

Let us suppose that there are two firms, P and Q belonging to the same group of homogenous risk.

Firm P is unlevered as its capital structure consists of equity capital only

Firm Q is levered as its capital structure includes 10% debentures of Rs.10,00,000

According to traditional approach, the market value of firm Q would be higher than that of firm P.

But according to M-M approach, this situation cannot persist for long. The market value of the equity share of firm Q is high but investment in it is more risky while the market value of the equity share of firm P is low but investment in it is safe.

Hence investors will sell out equity shares of firm Q and purchase equity shares of firm P. Consequently the market value of the equity shares of firm Q while fall, while the market value of the equity shares of firm P will rise. Through this process of arbitrage therefore, the market values of the firms P and Q will be equalized. This is true for all firms belonging to the same group. In equilibrium situation, the average cost of capital will be same for all firms in the group.

The opposite will happen if the market value of the firm P is higher than that of the firm Q. In this case investors will sell equity shares of P and buy those of Q. Consequently market values of these two firms will be equalised.

Proposition II

MM Proposition II states that the value of the firm depends on three things:

Required rate of return on the firm’s assets (ra)

Cost of debt of the firm (rd)

Debt/Equity ratio of the firm (D/E)

An increase in financial leverage increases expected Earnings per Share (EPS) but not share prices. Proposition II states that an expected rate of return of shareholders increases with financial leverage. Expected ROE is equal to expected rate of return on assets plus premium.

The formula for re is:

re = ra + (ra-rd)x(D/E)

Implications of Proposition II-

rd is independent of D/E and hence re increases with D/E.

The debt crosses an optimal level, the risk of default increases and expected return on debt rd increases.

Limitations of MM Approach-

Leverage irrelevance theory of MM is valid if perfect market assumption is correct but actually it is not so.

Firms are able to pay taxes and investors also pay taxes.

Bankruptcy cost can be very high.

Managers have their own preference of a type of finance.

Managers are better informed than shareholders i.e. asymmetry of information exists.

Personal leverage is not possible to be substitute of corporate leverage.

100% payout ratio is not possible normally.

Analysis of Companies

TVS Motors:

TVS Motors hold one of the top ten two wheeler manufacturer and number three positions in Indian market, with turnover of $1 billion in 2008-2009 and is the flagship division of TVS group which is of worth $4 billion. TVS Motors manufactures wide range of two wheelers ranging from two wheelers for domestic use to two wheelers for racing. Manufacturing units are located at

Housar and Mysore

Himachal Pradesh

Indonesia

Has production capacity of 2.5 million units per year with strength in design and development TVS has recently launched 7 new products. Till now TVS has sold more than 15 million two wheelers and has employed 40000. TVS motor is the only Indian company to win Deming award for quality control in 2002. TVS Network spans over 48 countries.

Particulars

2007-08 (in crores)

2008-09(in crores)

OPERATING INCOME

45.31

121.08

INTEREST ON DEBT( I)

11.47

64.61

EQUITY EARNING

33.84

56.47

COST OF EQUITY (Ke)

4.13%

4.21%

MARKET VALUE OF EQUITY

819.37

1341.33

COST OF DEBT (Kd)

1.72%

7.13%

MARKET VALUE OF DEBT

666.34

905.98

VALUE OF FIRM

1485.71

2247.31

COST OF CAPITAL (Ko)

3.05%

5.39%

WACC Calculation:

For 2007-08

WACC= weke + wdkd

We = E/(D+E)

Wd = D/(D+E) = 1/(1.84) x 0.413 + 0.84/(1.84) x 0.172

= 0.2284 +0.078 = 3.051%

For 2008-2009

WACC= weke + wdkd

We = E/(D+E)

Wd = D/(D+E) = 1/(2.11) x 4.21 + 1.11/(2.11) x 7.13

=1.995 +3.750

= 5.75%

Hero Honda:

Hero Honda Motors Limited is largest and most successful two wheeler manufacturers in India and it is India based. Hero Honda was a joint venture between Hero group and Honda of Japan till 2010 when Honda sold its entire stake to Hero. In 2008-09 Hero Honda sold 3.7 million bikes with 12% growth rate and captured 57% of Indian market’s share. Hero Honda Splendor is world’s largest selling motorcycle sold more than 1 million units in 2001-03.C:UsersAAdityaDesktopindex.jpg

In December 2010, the Board of Directors of the Hero Honda Group have decided to terminate the joint venture between Hero Group of India and Honda of Japan in a phased manner. The Hero Group of India would buy out the 26% stake of the Honda in JV Hero Honda. Under the joint venture Hero Group could not sell into international markets and the termination would mean that Hero Group can exploit global opportunities now. Since last 25 years the Hero Group relied on their Japanese partner Honda for R & D for new bike models. So there are concerns that the Hero Group might not be able to sustain the performance of the Joint Venture alone.

WACC calculation:

For 2007-08

WACC= weke + wdkd

We = E/(D+E)

Wd = D/(D+E) = 1/(1.07)x34.73%+0.07/(1.07) x 8.33% = 33%

For 2008-09

WACC= weke + wdkd

We = E/(D+E)

Wd = D/(D+E) = 1/(1.04)x32.41%+1.04/(1.04)x10.20% = 31.55%

Particulars

2007-08

(in crores)

2008-09

(in crores)

OPERATING INCOME

1201.96

1367.77

INTEREST ON DEBT( I)

13.76

13.47

EQUITY EARNING

1188.22

1354.3

COST OF EQUITY (Ke)

34.73%

32.41%

MARKET VALUE OF EQUITY

3421.25

4178.65

COST OF DEBT (Kd)

8.33%

10.20%

MARKET VALUE OF DEBT

165.18

132.05

VALUE OF F