Importance Of Capital Structure To A Firm Finance Essay

Importance Of with child(p) organize To A rigid finance Essay big(p) Structure of a comp whatever refers to the composition or make-up of its groovyization and it includes all long-term superior resources, viz. Loans, reserves, sh bes and bonds,-GestenbergIntroductionCapital Structure is one of the most complex areas of financial decision making beca intent of its interrelationship with other financial decision variables. Poor hood anatomical social organization decisions gutter result in mel natural depressioned greet of working detonator thereby write downing the Net Present comforts of projects and making more of them unimaginable. Effective neat social organisation decision discharge lower the hail of capital , thereby increasing the cherish of the incorruptible.It is particularly important for small business owners to determine a rank capital structure for their satisfyings, since capital is expensive for such(prenominal) small businesses. Capital struct ure decisions posit considering a variety of factors. In general, companies use debt more when they mode identify steady, constant sales levels, assets that have good returns for loans and a high development gait . On the other hand, companies that have poor credit ratings, conservative management, or high profitability rely on beauteousness capital preferably.Capital StructureCapital structure is a business finance term that describes the remainder of a familys capital, or ope symmetrynal money, which is obtained through debt and fairness orhybrid securities 1. Debt consists of loans and other types of credit that is to be repaid in the future, usually with post. Equity involves will power reside in a corporation in theformof common billet or preferred stock. Equity financing does non involve a charter obligation to re conduct the funds which is in contrast to debt financing,. Instead, impartiality investors are able to exercise some degree of control over the compan y as they become part-owners and partners in the business.The goal of a companys capital structure decision is to maximize the gains for the equity shareholders. The optimal capital structure is the one that maximizes the price of the stock and simultaneously minimizes the cost of capital thus striking a balance between risk and return. 2A tights major decision is its financial decisions which can be analyzed in the theory of Corporate Capital Structure that is based on a model developed by Dodd(1986) and is determined mainly by cost variables- equity, debt and failure risk and other potential variables such as growth are, profitability and run supplement.The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. Equity investors claim does not end until their stock is sold as compared to debt obligations which are limited to the loan repayment period, after which the lender has no further claim on the business. Debt fin ancing tends to be less expensive for small businesses over the long term, though more expensive over the unawares term, than equity financing. The major disadvantage is that it requires a small business to make regular monthly payments of principal and chase group. Due to such regular payments, young companies lots experience shortages in cash flow. Debt financings availability is frequently limited to established businesses which is a disadvantage associated with it. Since lenders primarily seek security for their funds, it can be delicate for unproven businesses to obtain loans.The main advantage of equity financing for small businesses is that there is no obligation to repay the money. The investors in equity financing often prove to be good sources of advice and contacts for small business owners. The main disadvantage of equity financing is that the founders must give up some control of the business. about sales of equity, such as initial public offerings, can be very c omplex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations.Features of a Capital StructureCapital structure is that level of debt-equity proportion where the grocery value per-share is maximum and the cost of capital is minimum.It should have the following featuresProfitability/Return Studies have shown that the relationship between debt-equity ratio and a sures profit delimitation is such that for a firm which prefers to finance its investments through self-finance are more profitable than firms which finance investment through borrowed capital, firms prefer competing with each other than co operational and firms use their investment in fixed assets as a strategic variable to affect profitability.3Solvency/Risk Capital Structure of a firm indicates how such(prenominal) the company is leveraged by comparing what it owes to creditors and investors to what it owns. It reveals the degree to which the companys management is willing to fund its operations with debt, rather than equity. Lenders are sensitive about this feature as a high debt-equity ratio will put their loans at risk of being unpaid.4Flexibility Flexibility is the ability to make decisions that the firm thinks are most apt eventide when others disagree. The level of flexibility the management can have depends on how the firm is financed. Debt offers little flexibility relative to equity. However, the flexibility offered by equity depends on the expiration to which shareholders are inclined to agree with managements strategic choices. The flexibility benefit of equity is high only when the share price is high.5Conservation/Capacity If a firm starts with a specific business risk, then the total risk associated with stock and debt is not affected by the capital structure. This is called conservation of risk. Risk is neither created nor destroyed.6 Debt dexterity involves the assessment of the amo unt of debt that the organization can repay in a timely manner without forfeiting its financial viability.7Control The capital structure of a firm shows when control is allocated to only shareholders and when to others like creditors, or the management team. Generally the shareholders trance control when the firms cash flow is sensitive. Also , debt value and firm value are negatively correlated when debtholders have veto power8Determinants of Capital StructureCapital structure of a firm is determined by various internal and remote factors. The macro variables of the economy are inflation rate, tax policy of government, capital market condition. The characteristics of an individual firm, termed as micro factors (internal), withal affect the capital structure of enterprises. This section presents how the micro-factors affect the capital structure of a firmSize of a Firm in that location is a positive relation between the capital structure and size of a firm. The larger the firms the more diversified they are. They have easy access to the capital market, receive high credit ratings for debt tailors, and pay lower interest rate on debt capital. Further, larger firms are less prone to unsuccessful person and this implies the less probability of bankruptcy and lower bankruptcy costs. Hence, the lower bankruptcy costs, the higher debt level.9Growth Rate There is a contradictory relation between the growth rate and capital structure. The equity controlled firms tend to invest sub-optimally to get wealth from the enterprises bondholders. They are more flexibility in their choice of future investment. Hence, growth rate is negatively related with long-term debt level.10Business Risk There is a negative relation between the capital structure and business risk. Lesser the stability of the lolly of the enterprises, the greater is the chance of business failure and the greater the exercising weight of bankruptcy costs on enterprise financing decisions. Hence, as bu siness risk increases, the debt level in capital structure of the enterprises should decrease.11Dividend Payout There is an wayward relation between the dividend payout ratio and debt level in capital structure. The low dividend payout ratio means increase in the equity base for debt capital and low probability of going into liquidation. As a result of low probability of bankruptcy, the bankruptcy cost is low. This implies high level of debt in the capital structure.12 operational leverage The use of fixed cost in production process also affects the capital structure. The high operating leverage-use of higher proportion of fixed cost in the total costs over a period of time-can magnify the variability in future earnings. There is a negative relation between operating leverage and debt level in capital structure. The higher operating leverage, the greater the chance of business failure and the greater will be the weight of bankruptcy costs on enterprise financing decisions.Industry Life Cycle Firms tend to adopt different financing strategies and a specific hierarchy of decision-making as they progress through the phases of their business life cycle. Debt is fundamental to business activities in the early stages, representing the first choice. However, in the maturity stage, firms re-balance their capital structure, substituting debt for internal capital.13 mark of Competition Debt ratios are minify as the scope of competition falls. For oligopolies, debt ratios show a significant and positive effect on prices.14Company Characteristics Variables of size and growth opportunity in total assets reveal a positive association with the leverage ratio, however, profitability, growth opportunities in plant, property and equipment, non-debt tax shields and tangibility reveal contrary relation with debt level.15Forms of Capital StructureCapital Structure can be of various formsHorizontal capital Structure The firm has no component of debt in the financial mix. Expansi on of the firm is through equity and retained earnings only.Vertical Capital Structures The base of the structure is a little amount of equity share capital which serves as the foundation for a super structure of preference share capital and debt.Pyramid Shaped Capital Structure fully grown proportion consisting of equity capital and retained earnings.Inverted Pyramid shaped Capital Structure Small component of equity capital, reasonable retained earnings and increasing component of debt.ReplacementModernizationExpansionDiversificationCapital Structure DecisionDesired Debt-Equity MixExisting Capital StructurePayout insurance policyEffect on ReturnEffect on RiskEffect on Cost of CapitalValue of FirmOptimum Capital StructureCapital Budgeting DecisionNeed for FundsCapital Structure Decision ProcessInternal FundsDebtExternal EquityDIFFERENT feelerES TO CAPITAL bodily structureWeighted Average Cost of CapitalIt is the expected rate of return on the market value of all the firms secur ities. Anything that increases the value of the firm also minimizes the WACC if operating income is constant.It is a calculation of a firms cost of capital in which each category of capital is proportionately weighted. All capital sources common stock, preferred stock, bonds and any other long-term debt are included in a WACC calculation.The WACC equationis the cost of each capital componentmultiplied by its proportional weight and then summingWACC = E/V * Re + D/V * Rd * (1- Tc)WhereRe = cost of equityRd = cost of debtE = market value of the firms equityD =market value of the firms debtV = E + DE/V = portionage of financing that is equityD/V = percentage of financing that is debtTc =corporate tax rateAssumptionsThere is no income tax, corporate or personal.The firm believes in paying all of its earnings and dividends. A 100% dividend payout ratio is assumed.Investors have identical probability distributions of operating income for each company.The operating income is not expected to grow or decline over time.A firm can change its capital structure instantaneously without incurring transaction costs.rd represents the cost of debtFor 100% dividend payout, re represents cost of equityV = D + E. ra is the overall capitalisation rate of the firm. It can also be expressed asra = rdD/(D+E) + reE/(D+E)NET INCOME APPROACHAccording to NI approach both(prenominal) the cost of debt and the cost of equity are autarkical of the capital structure they remain constant regardless of how much debt the firm uses. This means that, the average cost of capital declines and the firm value increases with debt. This happens because when D/E increases, rd which is lower than re, receives a higher weight in the calculation of ra.This approach has no basis in honesty the optimum capital structure would be 100 per cent debt financing under NI approach.This can be illustrated with the help of a numerical. There are 2 firms A and B similar in all aspects except in the degree of levera ge employed.Firm AFirm BOperating income(Rs.)10,00010,000 raise on debt(Rs.)03,000Equity Earnings(Rs.)10,0007,000Cost of equity capital10%10%Cost of debt capital6%6% merchandise Value of equity(Rs.)1,00,00070,000Market value of debt(Rs.)050,000Total value of the firm(Rs.)1,00,0001,20,000The average cost of capital for firm A is 10%.The average cost of capital for firm B is 8.66%NET OPERATING INCOMEIt is the opposite of NI Approach. According to NOI approach the value of the firm and the overall capitalization rate are independent of the firms capital structure.That is, ra and rd are constant for all degrees of leverage.Now, re = ra + (ra rd)(D/E)The market capitalizes the firm as a whole at a discount rate which is independent of the firms debt-equity ratio. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.An increase in the use of de bt funds which are cheaper is offset by an increase in the equity capitalization rate. This happens because equity investors seek higher compensation as they are exposed to greater risk from increase in the degree of leverage. They increase the capitalization rate re as the leverage increases.Numerically, this can be explained. Two firms A and B are similar in all aspects except the degree of leverage employed by them.Firm AFirm BOperating income(Rs.)10,00010,000Overall capitalization rate0.150.15Total market value66.66766,667Interest on debt(Rs.)1,0003,000Debt capitalization rate.10.10Market Value of debt(Rs.)10,00030,000Market value of equity(Rs.)56,66736,667Degree of leverage0.1760.818Equity Capitalization for Firm A= (9,000/56,667) = 15.9%Equity Capitalization for Firm B = (7,000/36,667) = 19.1%TRADITIONAL APPROACHThe traditional approach argues that moderate degree of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a destine is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.The principal implication of the traditional approach is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. At this level, the real marginal cost of debt and equity is the same.MODIGLIANI AND milling machine POSITIONSimilar to NOI ApproachValue of the firm is independent to its capital structure i.e. Independence of total valuation and the cost of capital of the firm from its capital structureNOI is purely conceptual, Doesnt provide operational justificationSupports NOI and provides behavioral justifications.AssumptionsCapital market is perfect(i)Investors are free to buy and sell(ii) Well inform market(iii) Firm investors can borrow on the same terms(iv) Rational behavior of investors(v) No transaction costHomogeneous risk conformationAll investors have the same expectations of the firms EBITNo Corporate TaxPreposition IThe value of a firm is capable to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure.16V= D + E = O/rWhere O is the expected operating income r is the discount rate applicable to risk class.MM invokes an arbitrage argument to prove the preposition. In equilibrium, identical assets sell for the same price, irrespective of how they are financed. This is also known as the law of conservation of value.Arbitrage ArgumentConsider two firms U and L, similar in all respects except in their capital structure. Firm U is unlevered, financed by equity alone and firm L is a levered firm.Firm AFirm BOperating income(Rs.)1,50,0001,50,000Interest060,000Equity Earnings1,50,00090,000Cost of equity0.150.16Market value of eq uity10,00,0005,62, calciferolCost of debt0.12Market value of debt05,00,000Market value of the firm10,00,00010,62, viosterolAverage cost of capital0.150.1412The value of the levered firm is higher than that of the unlevered firm. Such, a situation, argue MM, cannot persist because equity investors would do well to sell their equity in firm L and invest in firm U with personal leverage. For example, if an investor owns 10% equity in firm L, he wouldSell his equity in firm L for Rs. 56,250Borrow Rs. 50,000, an amount equal to 10% of Ls debt at an interest rate of 12%.Buy 10% of firm Us equity for 1,00,000.His income remains the same.Old income from investment in firm LNew income from investment in firm U10% firms equity income9,00015,00012% interest on loan of Rs. 50,000(6,000)9,0009,000When investors sell their equity in firm L and buy the equity in firm U, the marker value of firm L tends to decline and the market value of firm U tends to rise. This process continues until the market value of both the firms become equal. As a result, the cost of capital for both the firms becomes the same.Preposition IIFirm A100% equityFirm B50-50%ratioExpected earnings per share (Rs.)45Price per share(Rs.)2020Expected return to equity shareholders20%25%An increase in financial leverage increases the expected earnings per share but not the share price. This is because the change in the expected earnings is offset by a corresponding change in the return required by shareholders.We know, re = ra + (ra-rd)(D/E)Preposition II states that The expected return on equity is equal to the expected rate of return on assets, plus a premium. The premium is equal to the debt-equity ratio times the difference between the expected return on assets and the expected return on debt.The general implications are that for low levels of debt, the firms debt is considered risk-free. This means that rd is independent of D/E and hence re increases linearly with D/E. As the debt reaches a threshold limit , the risk of default increases and the return on debt rd rises. To compensate this , the rate of increase in re decreases. This happens because, beyond the threshold level, a portion of the firms business risk is borne by the suppliers of the debt capital.WACC WarningsSometimes the objective in financing is not maximize overall market value but to minimize the WACC. If MMs proposition 1 holds true then they are equivalent objectives. However, if they dont, then the capital structure that maximizes the value of the firm also minimizes its WACC.Warning 1 Shareholders want management to increase the firms value. They are more interested in being than in owning a firm with low WACC.Warning 2 Since shareholders demand higher expected rates of return than bondholders, therefore debt is the cheaper capital source, so WACC can be reduced by borrowing more. However, this extra borrowing leads the stockholders to demand a still higher expected rate of return.17Criticisms of MM TheoryFirms ar e liable to pay taxes on their income.Bankruptcy costs are quite high.Agency costs exist because of conflict of interest between managers and shareholders.Managers have a preference for a certain sequence of financing.Personal leverage and corporate are not perfect substitutes.TRADE-OFF THEORY OF CAPITAL social systemIt states that a company chooses how much debt finance and equity finance to use by balancing the costs and benefits. It states that there is an advantage to financing with debt which is thetax benefits of debtand there is a cost of financing with debt which is the costs of financial distress includingbankruptcy costs of debtand non-bankruptcy costs. A firm that isoptimizes its overall value focuses on the trade-off when choosing how much debt and equity to use for financing. be OF FINANCIAL DISTRESSDifferent firms and different industries will have different magnitudes of costs if they encounter financial distress. With some firms, distress will result in both custome rs and suppliers fleeing. With other firms, the fact that a firm is close to bankruptcy will not affect customers. When a firm experiences financial distress some(prenominal) things can happen.Arguments between shareholders and creditors delay the liquidation of assets. Bankruptcy cases take years to settle and during this period machineries and equipments rust and become obsolete.Assets sold under distress conditions, channel a price lesser than their economic value.The legal and administrative costs associated with bankruptcy are quite high.Managers may lower the quality of goods, give unacceptable customer service, ignore welfare in a bid to survive in the short run.BANKRUPTCY COSTS OF DEBTThese the increased costs of financing withdebtinstead ofequitythat result in a higherprobabilityofbankruptcy. The fact that bankruptcy is generally a costly process and not just a transfer ofownershipimplies that these costs negatively affect the totalvalueof the firm. These costs can be tho ught of as a financial cost, because as the probability of bankruptcy increases the financial costs increases.PECKING ORDER THEORYORPECKING ORDER MODELItstates that companiesprioritizetheir sources of financing according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted,debtis issued, and when it is not sensible to issue any more debt, equity is issued. This theory prefers internal financing when available and maintains that businesses adhere to ahierarchyof financing sources and, and debt is preferred over equity if outer financing is required.AGENCY COSTIt is aneconomicconcept that relates to the cost incurred by an organizations associated with problems such as divergentmanagement-shareholder objectives andinformation asymmetry. The information asymmetry causes the agency problems of deterrent example hazard andadverse selection. Agency costs mainly a rise repayable to divergence of control, separation of ownership and control and the different objectives the managers consider.KINDS OF ANALYSIS FOR CHOOSING THE CAPITAL STRUCTURE supplement AnalysisEBIT EPS AnalysisROI ROE AnalysisRatio AnalysisCash Flow AnalysisComparative AnalysisCapital Structure Policies in PracticeWe will see a few in detail.LEVERAGE ANALYSIS Leverage arises from the public of Fixed Costs.There are two kinds of LeverageOperating Leverage arises from the firms Fixed Operating costs such as salaries, depreciation, insurance, property taxes, and advertising outlays.Financial Leverage arises from the firms Fixed Financing Costs such as Interest on Debt.SalesSales500 units600 unitsRevenues500,000600,000Variable operating costs250,000300,000Fixed operating costs200,000200,000Earnings ahead interest and taxes50,000100,000Operating leverage arises from the existence of fixed operating expenses.When a firm has fixed operating expenses, 1 percent change in unit sa les leads to more than 1 percent change in EBIT.Consider the case of a firm, XYZ Limited which is currently selling a product at Rs universal gravitational constant per unit. Its variable costs are Rs 500 per unit and its fixed operating costs are Rs 200,000. The earnings in the beginning interest and taxes at two levels of sales, viz., 500 units and 600 units, is shown belowIn the above example, a 20 percent increase in unit sales leads to a 100 percent increase in profit in the beginning interest and taxes, thanks to the existence of fixed operating costs. Hence, fixed operating costs magnify the impact of changes in revenues. This the magnification flora in the cabbage direction as well.Degree of Operating LeverageIt refers to the sensitiveness of PBIT (or EBIT) to changes in unit sales or Sales.Picture1.pngIt measures the effect of change in sales revenue on the level of PBIT.Financial leverage emanates from the existence of fixed interest expenses.The use of fixed-charges s ources of funds, such as debt and preference capital, along with owners equity in the capital structure is known as financial leverage (or gearing or trading on equity). When a firm has fixed interest expenses, 1 percent change in profit before interest in taxes (PBIT) leads to more than 1 percent change in profit before tax (or profit after tax or earnings per share).Consider the case of XYZ Limited, which currently has an PBIT of Rs 50,000. Its fixed interest expenses are Rs 30,000 and its tax rate is 50 percent. It has 10,000 shares outstanding. The profit before tax, profit after tax, and earnings per share for XYZ Limited at two levels of PBIT, viz., Rs 50,000 and Rs 60,000 are shown belowCase A Case BProfit before interest and taxes 50,000 60,000Interest expense 30,000 30,000Profit before tax 20,000 30,000Tax 10,000 15,000Profit after tax 10,000 15,000Earnings per share 1 1.50In the above example a 20 percent increase in PBIT leads to a 50 percent increase in profit before tax es (or PAT or EPS), thanks to the existence of fixed interest expenses. Hence, fixed interest expense magnifies the impact of changes in PBIT. The magnification works in the reverse direction as well.Degree of Financial LeverageIt refers to the sensitivity of PBT (or PAT or EPS) to changes in PBIT.The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity.Combined leverage, or total leverage, arises from the existence of fixed operating costs and interest expenses. Due to the existence of these fixed costs, 1 percent change in unit sales, leads to more than 1 percent change in PBT (or PAT or EPS).Consider the case of XYZ Limited, which currently has revenues of Rs 500,000. (Rs 500 units are sold at Rs 1,000 per unit). Its variable costs are Rs 500 per unit and its fixed operating costs are Rs 200,000. Its fixed interest expenses are Rs 30 ,000 and its tax rate is 50 percent. It has 10,000 shares outstanding. The financial profile of the company at two levels of sales viz. 500 units (the current level) and 600 units (a level 20 percent higher than the current level) is shown below.Sales Sales600 units 500 unitsRevenues 500,000 600,000Variable operating costs 250,000 300,000Fixed operating costs 200,000 200,000PBIT 50,000 100,000Interest 30,000 30,000Profit before tax 20,000 70,000Tax 10,000 35,000Profit after tax 10,000 35,000Earnings per share 1 3.5In the above example, a 20 percent increase in unit sales leads to a 250 percent increase in earnings per share, due to the existence of fixed operating costs and interest expenses.Also, fixed costs magnify the impact of changes in unit sales.Degree of Combined LeverageIt refers to the sensitivity of PBT (or PAT or EPS) to changes in unit sales or sales.PBIT-EPS AnalysisEPS is sensitive to changes in PBIT under different financing alternatives.whereEPS = earnings per share ,EBIT = earnings before interest and taxes,I = the interest burden,t = the tax rate, andn= the number of equity shares.Break-Even PBIT LevelConsider the following data for ABC Limited.Existing Capital Structure 1 million equity shares of Rs. 10 eachTax Rate 50 percentABC Limited plans to raise additional capital of Rs. 10 million for financing an expansion project. In this context, it is evaluating two alternative fina