CorporaLe CaplLal SLrucLure

k 8 Sharma
CorporaLe CaplLal SLrucLure
W CorporaLe caplLal sLrucLure represenLs Lhe long
Lerm lnvesLmenL ln buslness ln Lhe form of debL
(borrowed funds) or equlLy (owners' funds)
W lannlng Lhe caplLal sLrucLure means decldlng Lhe
quanLum and composlLlon of long Lerm funds
requlred by a company ln Lerms of debL and
equlLy bonds loans ordlnary share caplLal
preference share caplLal reLalned earnlngs eLc
W SomeLlmes caplLal sLrucLure ls referred merely as
debL and equlLy composlLlon as debL and equlLy
are Lwo ma[or componenLs of caplLal sLrucLure
b[ecLlves of CaplLal SLrucLure ueclslons
W 1he caplLal sLrucLure declslons are crlLlcal Lo a company
ln Lhe sense LhaL Lhey affecL proflLablllLy and solvency
W 1he caplLal sLrucLure of Lhe company should Lherefore
be planned properly
1 lL derlves maxlmum advanLage of cosL of caplLal
2 lL ls able Lo ad[usL easlly Lo changlng markeL
condlLlons
3 1he long Lerm markeL value of lLs ordlnary shares ls
maxlmlsed
1he value of ordlnary share shall be maxlmum ln case
Lhe marglnal real cosL of funds from each of Lhe source
ls Lhe same
ueLermlnanLs of CaplLal SLrucLure
1 llnanclal Leverage
2 CosL of CaplLal
3 Cash llow
4 ConLrol
3 llexlblllLy
6 Slze of Company
7 MarkeLablllLy
8 lloaLaLlon CosLs
9 1axaLlon
llnanclal Leverage
W Maxlmum advanLage of leverage should be derlved ln caplLal sLrucLure
W use of flxed cosL funds such as debL and preference shares Lo flnance
asseLs of a company ls known as flnanclal leverage
W lf Lhe asseLs flnanced from debL and preference share caplLal yleld a
reLurn greaLer Lhan Lhe cosL of debL and preference share caplLal Lhe
earnlng per share shall lncrease wlLhouL an lncrease ln owners
lnvesLmenL
W Powever Lhe leverage lmpacL ls more ln case of debL Lo preference share
caplLal as
(a) Lhe cosL of debL ls usually lower Lhan Lhe cosL of preference share
caplLal and
(b) Lhe lnLeresL pald on debL ls a deducLlble charge from proflLs for
calculaLlng Lhe Laxable lncome whlle dlvldend on preference shares ls noL
W ne common meLhod of examlnlng Lhe lmpacL of leverage on
shareholders' earnlngs ls Lo analyse Lhe relaLlonshlp beLween earnlng per
share (LS) aL varlous posslble levels of L8l1 under alLernaLlve meLhods of
flnanclng 1hls ls explalned laLer
CosL of CaplLal
W 1he composlLe cosL of caplLal should be kepL as low as posslble
W ComposlLe cosL of caplLal conslsLs of cosL of equlLy plus Lhe cosL of debL
1hls represenLs Lhe mlnlmum expecLed reLurn on lnvesLmenL
W 1hough all consLlLuenLs of caplLal have a cosL Lhere ls preference for debL
ln Lhe composlLlon of caplLal sLrucLure parLlcularly when Lhe markeL
senLlmenL favours lL due Lo
1 lnLeresL on debL ls deducLlble from earnlngs as expendlLure for LaxaLlon
2 uebL lnsLrumenLs are easlly absorbed by lnsLlLuLlons
3 1he floaLaLlon cosL ln case of debL ls lower
4 uebL lnLroduces leverage ln caplLal sLrucLure
3 1here ls no danger of loss of conLrol for exlsLlng managemenL
6 lL ls useful ln mlnlmlslng Lhe cosL of caplLal when Lax raLes are rlslng
7 lL brlngs lmprovemenL ln reLurn on lnvesLmenL reLurn on equlLy eLc
* Powever a company can noL go on mlnlmlslng lLs over all cosL of caplLal
by employlng debL A polnL ls reached beyond whlch debL becomes more
expenslve because of lncreased rlsk Lo credlLors as well as shareholders
CosL of CaplLal
Lxamp|e 1 1he cosL of debL (afLer Lax) and Lhe equlLy aL varlous levels of debL equlLy
mlx are esLlmaLed as follows
_______________________________________________________________
ercenLage of uebL ln CosL of uebL CosL of equlLy
1oLal CaplLal Lmployed
_______________________________________________________________
0 10 13
20 10 13
40 12 16
30 13 18
60 14 20
_________________________________________________________________
ueLermlne Lhe opLlmal mlx of debL and equlLy for Lhe Company by calculaLlng Lhe
composlLe cosL of caplLal
ComposlLe CosL of CaplLal
_______________________________________________________________
CosL uebL CosL LqulLy roporLlon uebL roporLlon LqulLy ComposlLe CosL
kd () ke () p
1
p
2
kdp
1
+ kep
2
_______________________________________________________________
10 13 00 10 0 + 130 130
10 13 02 08 20 + 120 140
12 16 04 06 48 + 96 144
13 18 03 03 63 + 90 133
14 20 06 04 84 + 80 164
_______________________________________________________________
W lL may be observed LhaL aL Lhe mlx of 20 debL and 80 equlLy produces
Lhe mlnlmum composlLe cosL of caplLal le 14 Any oLher mlx of debL
and equlLy glves a hlgher over all cosL of caplLal
W 1hus Lhe opLlmal debL equlLy mlx for Lhe Company ls 2080 where Lhe
composlLe cosL of caplLal ls mlnlmum
Cash llows
W 1here cash flow should adequaLely cover Lhe requlremenL
of caplLal sLrucLure
W lL ls obllgaLory for a company Lo pay lnLeresL on debL and
reLurn Lhe prlnclpal amounL of debL lf a company ls noL
able Lo generaLe enough cash flows Lo meeL Lhls flxed
obllgaLlon of lnLeresL lL may have Lo face flnanclal
lnsolvency
W 1hus companles LhaL expecL larger and sLable cash lnflows
can employ a larger amounL of debL ln Lhelr caplLal
sLrucLure
W lL may be rlsky Lo employ funds creaLlng burden of flxed
charges for companles whose cash lnflows are unsLable or
unpredlcLable
ConLrol of LxlsLlng Shareholders
W ln deslgnlng caplLal sLrucLure someLlmes exlsLlng managemenL ls governed
by lLs deslre Lo conLlnue conLrol over Lhe Company 1he exlsLlng
managemenL may noL only deslre Lo be elecLed Lo Lhe board of dlrecLors
buL may also deslre Lo manage Lhe company wlLhouL any ouLslde
lnLerference
W 1he equlLy shareholders have legal rlghL Lo elecL dlrecLors of Lhe Company
When a company lssues new shares Lhere arlses a rlsk of loss of conLrol
1hls may noL be a very lmporLanL conslderaLlon ln case of a wldely held
company buL may be an lmporLanL lssue ln case of closely held companles
W Slnce holders of debL do noL have voLlng rlghL lL ls ofLen suggesLed LhaL a
company should use debL Lo avold Lhe loss of conLrol
W Powever when a company uses larger amounLs of debL Lhe flnanclers
may lmpose resLrlcLlons and curLall Lhe freedom of exlsLlng managemenL
Lo run Lhe buslness Lhe way Lhey llke
W Lxcesslve amounL of debL may even cause bankrupLcy whlch may mean
compleLe loss of conLrol
llexlblllLy ln CaplLal SLrucLure
W llexlblllLy slgnlfles a flrms ablllLy Lo adapL lLs caplLal sLrucLure
Lo Lhe changlng condlLlons
W 1he caplLal sLrucLure of a flrm ls consldered flexlble lf Lhe
company has no dlfflculLy ln changlng Lhe caplLallsaLlon and or
sources of funds whenever needed Lo ralse funds wlLhouL
undue delay and cosL Lo flnance proflLable lnvesLmenLs
W 1he Company should be also ln a poslLlon Lo redeem lLs
preference shares and debL whenever warranLed by
condlLlons
W 1he flnanclal plan of Lhe company should be flexlble Lo permlL
a change ln Lhe composlLlon of caplLal sLrucLure Lo subsLlLuLe
one source of funds by anoLher Lo economlse on Lhe use of
funds
Slze of Company
W 1he slze of company ls an lmporLanL conslderaLlon ln
deslgnlng caplLal sLrucLure as Lhe slze greaLly lnfluences Lhe
avallablllLy of funds from dlfferenL sources
W A small company may ofLen flnd lL dlfflculL Lo ralse long
Lerm debL or lL ls avallable aL a hlgher raLe of lnLeresL and
on lnconvenlenL Lerms 1he managemenL of small
companles under such condlLlons are noL able Lo run
buslness freely and many Llmes depend upon owners'
funds and reLalned earnlngs for meeLlng Lhelr long Lerm
funds' requlremenL
W A large company can obLaln debL aL easy Lerms can also
lssue equlLy shares preference shares debenLures bonds
and oLher flnanclal lnsLrumenLs Lo publlc for ralslng funds
MarkeLablllLy of SecurlLles
W MarkeLablllLy ls an lmporLanL conslderaLlon ln decldlng Lhe
Lype and Llme of securlLy lssues
W AL one Llme Lhe markeL may favour debL or bond whlle aL
anoLher Llme lL may readlly accepL ordlnary share lssues
W vlewlng markeL senLlmenL a company has Lo declde
wheLher Lo ralse funds Lhrough ordlnary shares or Lhrough
debL
W lf Lhe share markeL ls depressed a company may noL be
able Lo lssue ordlnary shares buL lL may lssue debL and walL
for Lhe lssue of ordlnary shares Llll Lhe markeL revlves
W uurlng boom perlod ln share markeL lL ls noL advlsable for
a company Lo lssue bonds 8aLher lL should keep Lhe debL
capaclLy unuLlllsed and lssue ordlnary shares Lo ralse funds
lloaLaLlon CosLs of lssue
W lloaLaLlon cosLs are lncurred when funds are ralsed and
lf Lhey are less Lhe over all cosL of caplLal ls also less
W Cenerally Lhe cosLs of floaLlng a debL lssue ls less Lhan
Lhe cosL of floaLlng an equlLy lssue 1hls may encourage
a company Lo use debL raLher Lhan Lo lssue equlLy
shares
W Powever lf Lhe equlLy caplLal ls lncreased by reLalnlng
Lhe earnlngs no floaLaLlon cosLs shall be lncurred
W lloaLaLlon cosL generally may noL be a very lmporLanL
lssue lnfluenclng caplLal sLrucLure of a large company
8uL an lmporLanL conslderaLlon ln small companles
1axaLlon
W 1ax ralses Lhe cosL and should be mlnlmlsed ln caplLal
sLrucLure plannlng
W 1ax ls levled on producLlon (exclse duLy) lmporLs (cusLoms
duLy) and on proflL of a company 1ax ls also levled some
Llmes on dlvldend pald by Lhe company ln addlLlon Lo
corporaLe Lax A company Lhus suffers double lncldence ln
Lax 1hls pushes Lhe cosL of equlLy upwards
W n Lhe oLher hand lnLeresL pald on debL ls a Lax deducLlble
1hls reduces Lhe cosL of debL 1hus prudenLly mlxlng debL
and equlLy Lhe composlLe cosL of caplLal can be conslderably
reduced
W 1he lmpacL of Lax ls felL noL only ln cosL of caplLal buL also ln
earnlng per share and cash lnflows whlch are reduced 1hus
LaxaLlon ls relevanL ln plannlng Lhe caplLal sLrucLure
CaplLal SLrucLure and leverage
W Leverage ls Lhe advanLage developed due Lo Lhe use of
flxed cosLs ln flnanclng Lhe long Lerm funds requlremenL ln
an enLerprlse
W uue Lo leverage lL ls posslble Lo mlnlmlse Lhe cosL of funds
and also maxlmlse Lhe reLurn Lo shareholders and Lhe value
of shareholders funds
W Powever leverage creaLes and enhances rlsk also Plgher
Lhe leverage hlgher Lhe rlsk
W Leverage can be of Lhree Lypes
1 peraLlng leverage
2 llnanclal leverage and
3 1oLal Leverage
peraLlng 8reak even olnL
W 1he level of operaLlon necessary Lo cover all operaLlng cosLs
Lhe varlable cosLs and Lhe flxed cosLs boLh ls known as
operaLlng break even
W AL Lhls polnL Lhe operaLlng proflL or earnlng before lnLeresL
and Laxes ls zero as Lhe LoLal operaLlng cosL ls equal Lo sales
revenue
W 8eyond Lhls level a flrm sLarLs maklng operaLlng proflL
W peraLlng leverage ls raLlo of conLrlbuLlon Lo earnlng before
lnLeresL and Lax
ConLrlbuLlon C ( vC)
peraLlng Leverage or
L8l1 C ( vC) lC
uegree of peraLlng Leverage
W #@e operat|ng |everage may be def|ned as te f|rm's ab|||ty to use f|xed
operat|ng costs to magn|fy te effect of cange |n sa|es on |ts earn|ng before
|nterest and taxes"
W Degree of operat|ng |everage rat|o between percentage cange |n L8I@ to
percentage cange |n sa|es recenue
W peraLlng leverage ls relaLed Lo operaLlng break even and as such senslLlve Lo
selllng prlce varlable cosLs and flxed cosLs A change ln Lhese affecLs operaLlng
earnlngs of an enLerprlse Plgher Lhe change greaLer would be flucLuaLlons ln
operaLlng proflL
W Change ln peraLlng roflL Change ln L8l1
uegree of peraLlng Leverage
Change ln Sales Change ln Sales
C ( vC)
uL aL 8ase Level C
C ( vC) lC
1oLal 8evenue 1oLal varlable CosLs
uL aL 8ase level Sales 8evenue
1oLal 8evenue 1oLal varlable CosLs 1oLal llxed CosL
leaLures of peraLlng Leverage
1 lL depends upon Lhe naLure of flxed cosLs of an enLerprlse
2 1he operaLlng leverage can be hlgh or low Plgher Lhe operaLlng
leverage hlgher ls Lhe rlsk ln caplLal sLrucLure and vlce versa
3 1he degree of operaLlng leverage also affecLs earnlng before lnLeresL
and Lax (L8l1) Plgher Lhe degree of operaLlng leverage hlgher ls Lhe
earnlng before lnLeresL and Lax (L8l1) and vlce versa
4 1he operaLlng leverage can be poslLlve or negaLlve dependlng upon
whlch of Lhe Lwo sales revenue and varlable cosLs ls hlgher or
lower
lf Lhe sales revenue ls hlgher Lhan Lhe varlable cosLs Lhe operaLlng
leverage ls poslLlve whlch ls usually Lhe case ln mosL slLuaLlons
Powever ln case Lhe sales revenue ls lower Lhan Lhe varlable cosLs
Lhe operaLlve leverage ls negaLlve
3 1he polnL aL whlch Lhe operaLlng surplus or conLrlbuLlon ls equal Lo
flxed cosLs ls known as 8reak Lven olnL
peraLlng Leverage
W Lxamp|e 2 1he varlable cosL of a producL ls
n$30 per unlL and lLs selllng prlce ls n$30 per
unlL 1he flxed cosLs are n$3000 per year 1he
level of currenL producLlon ls 300 unlLs
Assumlng LhaL (a) Lhe producLlon can be
lncreased Lo 330 unlLs and (b) broughL down
Lo 230 unlLs deLermlne (l) conLrlbuLlon
margln (ll) L8l1 and (lll) degree of operaLlng
leverage aL Lhe Lhree operaLlng levels
peraLlng Leverage
resenL Level lncrease Lo uecrease Lo
300 unlLs (n$) 330 unlLs (n$) 230 unlLs (n$)
Sales 8evenue ([ n$30) 13000 17300 12300
Less varlable CosLs ([ n$30) 9000 10300 7300
______________________________________
ConLrlbuLlon 6000 7000 3000
Less llxed CosLs 3000 3000 3000
______________________________________
L8l1 1000 2000 nll
Change ln L8l1 () + 100 100
Change ln Sales 8evenue () +1667 1667
uegree of peraLlng Leverage (uL) 6 6 6
ConLrlbuLlon n$6000
uegree of peraLlng Leverage
L8l1 n$1000
Change ln L8l1() 100
uegree of peraLlng leverage
Change ln Sales () 1667
llnanclal Leverage
W #@e f|nanc|a| |everage |s a f|rm's ab|||ty to use f|xed f|nanc|ng costs to
magn|fy te effect of cange |n earn|ngs before |nterest and tax (L8I@% on
earn|ngs per sare (LS%"
W llnanclal leverage depends upon Lhe cholce of long Lerm funds wheLher
debL bearlng a flxed raLe of lnLeresL or preference shares wlLh dlvldend aL
flxed raLe or ordlnary shares wlLh varlable dlvldend raLe
W Plgher Lhe flnanclal leverage hlgher ls Lhe rlsk ln caplLal sLrucLure 1hus ln
case Lhe earnlngs of Lhe enLerprlse do noL grow ln Lhe same proporLlon as
Lhe lncrease ln flnanclng cosLs Lhere may be reducLlon ln funds avallable
for paymenL of dlvldend Lo ordlnary shareholders
W llnanclal leverage can be poslLlve or negaLlve dependlng upon Lhe
dlfference beLween earnlng before lnLeresL and Lax (L8l1) and cosL of flxed
cosL funds
W lf change ln cosL of flxed cosL funds ls lower Lhan change ln earnlng
before lnLeresL and Lax (L8l1) Lhe flnanclal leverage ls poslLlve whlch ls
Lhe case under normal clrcumsLances 8uL lf change ln cosL of flxed cosL
funds ls hlgher Lhan change ln earnlng before lnLeresL and Lax (L8l1) Lhe
flnanclal leverage ls negaLlve
llnanclal Leverage
W llnanclal leverage magnlfles Lhe volaLlllLy ln reLurns wheLher
measured by neL reLurn or reLurn on equlLy or reLurn per share
W 1he expecLed earnlng per share ls hlgher wlLh Lhe lncreaslng use of
flnanclal leverage 8uL due Lo varlablllLy Lhere ls hlgher rlsk ln case
of decllne ln proflLablllLy of flrm Lhe relaLlve decllne ln reLurn
accrulng Lo shareholders ls also hlgher
Change ln LS L8l1
uegree of llnanclal Leverage (ulL) or
Change ln L8l1 LA1
L8l1
ulL
1
L8l1 l u () 1ax
1 18
llnanclal Leverage
W Lxamp|e 3 1he caplLal sLrucLure of Lhe company
conslsLed of 10 bonds worLh n$30000 12
reference Shares of n$30000 and 10000
ordlnary shares of n$10 each worLh n$100000
1he earnlng before lnLeresL and Lax (L8l1) of Lhe
company ls n$30000 1he Lax raLe ls 30
ueLermlne (l) Larnlng per share (LS) (ll) uegree
of flnanclal leverage (ulL) and (lll) effecL on LS
ln Lhe presenL and when Lhe L8l1 (a) lncreases Lo
n$73000 and (b) decreases Lo n$23000
llnanclal Leverage
LxlsLlng L8l1 uecrease Lo lncrease Lo
n$30000 n$23000 n$73000
_________________________________________________________________
Larnlng 8efore lnLeresL 1ax (L8l1) 30000 23000 73000
Less lnLeresL on 8onds 3000 3000 3000
________________________________
Larnlng afLer lnLeresL (LAl) 43000 20000 70000
Less 1ax [ 30 22300 10000 33000
_______________________________
LA1 buL 8efore ref ulvldend 22300 10000 33000
Less ref ulvldend [ 12 6000 6000 6000
_______________________________
Larnlng AfLer 1ax (LA1) 16300 4000 29000
_______________________________
Larnlng er Share (LS) 163 040 290
uegree of llnanclal Leverage (ulL) 303 623 2386
_________________________________________________________________
|nanc|a| Leverage and Cperat|ng Leverage
W 1he operaLlng leverage and Lhe flnanclal leverage boLh are
measures of rlsk ln an enLerprlse 8oLh affecL Lhe reLurn on
lnvesLmenL Powever Lwo are dlfferenL ln Lhe followlng
respecLs
1 peraLlng leverage ls creaLed by Lhe cholce of varlable and
flxed cosLs ln Lhe operaLlng sLrucLure whlle flnanclal leverage
ls creaLed by Lhe cholce of consLlLuenLs of caplLal sLrucLure
2 8oLh concepLs are based on opLlmum use of flxed
componenLs of Lhe cosLs peraLlng leverage ls based on
opLlmum uLlllsaLlon of flxed operaLlng cosLs and flnanclal
leverage ls based on opLlmum uLlllsaLlon of flxed flnanclal
cosLs
3 8oLh leverage produce slmllar cholce and has slmllar
lmpllcaLlons for Lhe shareholders ln Lerms of effecL on level of
rlsk ln caplLal sLrucLure and reLurn for Lhe shareholders
ComposlLe Leverage
W ComposlLe leverage ls a measure of senslLlvlLy of a flrm's earnlngs per
share Lo a change ln Lhe flrm's sales
W 1he degree of composlLe leverage ls percenLage change ln earnlngs per
share over Lhe percenLage change ln ouLpuL (or sales revenue)
W uegree of ComposlLe Leverage uL x ulL
Change ln LS
uegree of 1oLal Leverage (u1L)
Change ln ouLpuL or Sales 8evenue
Change ln L8l1 Change ln LS
x
Change ln Sales Change ln L8l1
C ( vC)
(1 18)
u
C ( vC) lC l
(1 18)
L8l1 + lC

u
L8l1 l () (1 18)
(1 18)
ComposlLe Leverage
Lxamp|e 4 1he sale of a company ls 100000
unlLs aL n$2 per unlL 1he varlable cosLs are n$1
per unlL and flxed cosLs are n$30000 1he caplLal
sLrucLure of Lhe company conslsLs of debL
n$200000 [ 10 and equlLy n$100000 1he
raLe of corporaLe Lax ls 30
ueLermlne (a) operaLlng leverage (b) flnanclal
leverage and (c) composlLe leverage (l) ln
presenL when Lhere ls (ll) lncrease of 30 ln Lhe
sale and (lll) decrease of 30 ln Lhe sale
peraLlng llnanclal and ComposlLe
Leverage
LxlsLlng + 30 30
CuanLlLy of Sale (unlLs) 100000 130000 30000
________________________________
Sales 8evenue (n$) [ n$2 pu 200000 300000 100000
Less varlable CosLs (n$) [ n$1 pu 100000 130000 30000
________________________________
ConLrlbuLlon (n$) 100000 130000 30000
Less llxed CosLs (n$) 30000 30000 30000
_________________________________
Larnlng 8efore lnLeresL 1ax (L8l1)(n$)30000 100000 nll
Less lnLeresL (n$) [ 10 pa 20000 20000 20000
__________________________________
Larnlng 8efore 1ax (L81) (n$) 30000 80000 20000
Less 1ax (n$) [ 30 13000 40000 nll
_________________________________
Larnlng AfLer 1ax (LA1) (n$) 13000 40000 20000
peraLlng llnanclal and ComposlLe
Leverage
ConLrlbuLlon n$100000
Cperat|ng Leverage 2
Larnlng 8efore lnLeresL 1ax n$30000
Larnlng 8efore lnLeresL 1ax n$30000
|nanc|a| Leverage 333
Larnlng AfLer 1ax n$13000
ConLrlbuLlon n$100000
Compos|te Leverage
Larnlng AfLer 1ax n$13000
AlLernaLlvely
Compos|te Leverage peraLlng Leverage x llnanclal Leverage
2 x 333
LssenLlal leaLures of CaplLal SLrucLure
1 rof|tab|||ty 1he caplLal sLrucLure of Lhe company should produce hlgher
proflLablllLy 1hls can be posslble when wlLhln Lhe glven consLralnLs maxlmum use
of leverage and lower cosL funds
2 So|vency 1he debL should be used [udlclously as excesslve use of debL may
LhreaLen solvency of Lhe company
3 |ex|b|||ty 1he caplLal sLrucLure should be flexlble Lo meeL Lhe changlng condlLlons
and requlremenLs of buslness lL should be posslble for Lhe company Lo adapL lLs
caplLal sLrucLure wlLh mlnlmum cosL and Llme lf warranLed by changed slLuaLlon
and ralse funds whenever needed Lo flnance proflLable acLlvlLles
4 Capac|ty 1he caplLal sLrucLure should be based on Lhe conslderaLlon of debL
capaclLy of Lhe company 1he debL capaclLy depends upon Lhe capaclLy Lo
generaLe cash flows ln fuLure Lo pay Lhe prlnclpal amounL and lnLeresL Lhere on
S Contro| 1he caplLal of exlsLlng managemenL should lnvolve mlnlmum rlsk wlLh
lncrease ln equlLy 1o avold LhreaL Lo managemenL conLrol debL raLher Lhan equlLy
should be preferred lssue of rlghL shares or use of free reserves for lssue of bonus
shares LhaL does noL pose any problem for conLrol may be preferred
Leverage 1he proporLlon of debL and equlLy known as leverage LhaL deLermlnes
Lhe level of rlsk ln caplLal sLrucLure be malnLalned aL lndusLry level Lo malnLaln Lhe
poslLlon of company ln Lhe same rlsk class as Lhe lndusLry
pLlmal CaplLal SLrucLure
W 1here has been a conLroversy wheLher Lhere ls an opLlmal caplLal sLrucLure?
W uavld uurand ls glven Lhe credlL for ldenLlflcaLlon Lwo exLreme caplLal sLrucLure
Lheorles vlz neL lncome (nl) Approach and neL peraLlng lncome (nl)
Approach
1 Net Income (NI% Approac
Accord|ng to NI Approac a f|rm |s ab|e to |ncrease |ts tota| va|uat|on (Vo% and
|ower |ts cost of cap|ta| (ko% as |t |ncreases te degree of f|nanc|a| |everage
(Vd]Vo% @e opt|mum cap|ta| structure |s a compos|t|on at w|c cost of cap|ta|
|s te |owest and te va|ue of te f|rm |s te |gest At tat comb|nat|on |n te
cap|ta| structure of a company te market pr|ce of te sare |s max|m|sed
As per Lhe nl Approach a flrm can lower lLs cosL of caplLal conLlnually by uslng
debL and Lhus lncrease lLs LoLal valuaLlon Powever wlLh more and more use of
debL a reducLlon ln Lhe cosL of caplLal and lncrease ln Lhe value of Lhe flrm wlll be
posslble when
(a) cosL of debL (kd) ls less Lhan Lhe cosL of equlLy (ke) and lL remalns consLanL
(b) Lhe flrms rlsk percepLlon ls noL changed le lL does noL become lncreaslngly
more rlsky ln Lhe percepLlon of lnvesLors and credlLors as Lhe degree of leverage ls
lncreased
ln addlLlon lL ls also assumed LhaL Lhere wlll be no lncrease ln corporaLe Lax
pLlmal CaplLal SLrucLure
2 Net Cperat|ng Income Approac
@e Net Cperat|ng Income (NCI% Approac |s based on te assumpt|ons tat te
over a|| cost of cap|ta| (ko% does not vary w|t |everage lL ls consLanL for all
degrees of leverage 1he advanLage accrulng from Lhe lncreaslng use of debL
supposedly cheaper ln LoLal caplLal ls off seL exacLly by lncrease ln Lhe cosL of
equlLy (ke) 1hus Lhe welghLed average cosL of caplLal (ke + kd) remalns
unchanged for all degrees of leverage
1he markeL caplLallses Lhe value of Lhe flrm as a whole 1he spllL beLween debL
and equlLy ls noL lmporLanL 1he value of Lhe flrm (vo) ls deLermlned by
caplLallslng Lhe neL operaLlng lncome (L8l1) aL overall cosL of caplLal (ko) Pence
value of flrm (vo) ls L8l1/ko As L8l1 and ko boLh are consLanL and lndependenL
of Lhe leverage Lhe value of Lhe flrm (vo) does noL change as leverage ls changed
1he value of equlLy (ve) ls deLermlned as a resldual by subLracLlng Lhe value of
debL (vd) from Lhe consLanL value of Lhe flrm (vo) 1hus value of equlLy (ve) ls
vo vd
1he cosL of debL (kd) ls consLanL Lhe cosL of equlLy (ke) ls (L8l1 l)/ ve 1he use
of debL lncreases Lhe rlsk Lo shareholders 1hls ralses Lhe cosL of equlLy or Lhe
caplLallsaLlon raLe
Under te NCI Approac te cost of equ|ty (ke% |ncreases but te cost of debt
(kd% te we|gted average cost of cap|ta| (ko% and te tota| va|ue of te f|rm (Vo%
a|| rema|n constant as f|nanc|a| |everage |s canged 1hls approach lmplles LhaL
Lhere ls no one opLlmum caplLal sLrucLure slnce Lhe cosL of caplLal (ko) can noL be
changed Lhrough leverage A|| cap|ta| structures are opt|ma| for te market pr|ce
per sare rema|n constant w|t cange |n |everage @us cap|ta| structure
becomes a matter of |nd|fference to te |nvestor
pLlmal CaplLal SLrucuLre
3 Mod|g||an| and M|||er Approac
ln 1938 lranco Modlgllanl and MerLon P Mlller developed a LheoreLlcal
argumenL and demonsLraLed algebralcally LhaL assumlng perfecL markeL condlLlons
te cap|ta| structure of a f|rm does not affect |ts va|ue 1he assumpLlons are as
under
1 @e cap|ta| market |s perfect lL lmplles among oLher Lhlngs LhaL (a) Lhere are no
LransacLlon cosLs and (b) lndlvldual lnvesLors can borrow aL Lhe same raLe of
lnLeresL as Lhe corporaLlons
2 All presenL and prospecLlve lnvesLors have ldenLlcal esLlmaLes of each flrms
average fuLure pro[ecL L8l1 le |nvestors ave omogeneous expectat|ons
3 A|| f|rms can be c|ass|f|ed |n to omogeneous r|sk c|asses Slnce Lhe flrms ln a
glven class are equally rlsky Lhelr expecLed fuLure earnlngs are caplLallsed aL Lhe
same raLe @us a|| f|rms |n a g|ven r|sk c|ass ave te same expected and
requ|red rate of return
4 @e d|v|dend pay out rat|o |s 100 per cent le flrms dlsLrlbuLe all neL earnlngs
Lo shareholders
S @ere |s no corporate tax 1hls assumpLlon ls removed aL a laLer sLage
W owever oter researcers |nc|ud|ng M M w|t |ess restr|ct|ve assumpt|ons
observed tat ba|anc|ng te costs and benef|ts of debt f|nanc|ng |t |s poss|b|e to
determ|ne a cap|ta| structure tat resu|ts |n max|m|s|ng te va|ue of f|rm
pLlmal CaplLal SLrucLure
W It |s genera||y be||eved tat te va|ue of f|rm |s max|m|sed wen te cost
of cap|ta| |s m|n|m|sed 1hls can be expressed as under
L8l1 x (1 1) nA1 LA1
v
ka ka ka
Where L8l1 Larnlng before lnLeresL and Lax
nA1 neL operaLlng proflL afLer Lax
LA1 Larnlng afLer Lax
1 8aLe of Lax
ka WelghLed average cosL of caplLal
W lL ls also suggesLed LhaL uslng L8l1 LS approach Lhe value can be
esLlmaLed uslng Lhe followlng relaLlonshlp
LS
value per share (p
0
)
ra
Where ra LxpecLed raLe of reLurn
pLlmal CaplLal SLrucLure
Lxamp|e S 1he caplLal sLrucLure of a company
wlLh asseL level $300 conslsLs of 300 equlLy
shares of $10 each and no debL Assumlng
L8l1 aL $100 and Lax aL 30 flnd LS and
value per share aL 0 10 20 30 40
30 and 60 debL levels lf debL ls expecLed
Lo be avallable aL 0 90 93 100
110 133 and 163 per annum aL Lhe
above levels respecLlvely
pLlmal CaplLal SLrucLure
uebL lnLeresL LqulLy uebL lnLeresL LAl 1ax LA1 LS
Level 8aLe $ $ $ $ $ $ $
0 0 300 00 00 10000 3000 3000 100
10 900 430 30 430 9330 4773 4730 106
20 930 400 100 930 9030 4323 4323 113
30 1000 330 130 1300 8300 4230 4230 1214
40 1100 300 200 2200 7800 3900 3900 13
30* 1330 230 230 3373 6623 33123 33123 132S*
60 1630 200 300 4930 3030 2300 2300 123
* AL 30 debL level Lhe LS ls maxlmum
AsslgnmenL
1 ueflne caplLal sLrucLure Lxplaln Lhe facLors Lo be borne
ln mlnd whlle deslgnlng caplLal sLrucLure of a flrm?
2 Pow Lhe approprlaLe comblnaLlon of operaLlng and
flnanclal leverage ln a corporaLe caplLal sLrucLure ls
deLermlned? Lxplaln wlLh example
3 ueflne operaLlng and flnanclal leverage Pow Lhe
degree of operaLlng leverage and flnanclal leverage ls
measured?
4 ueflne 'degree of flnanclal leverage' and explaln why lL
ls consldered a measure of rlsk
3 WhaL are operaLlng leverage flnanclal leverage and
LoLal leverage? Lxplaln relaLlon ln Lhree wlLh examples
AsslgnmenL
1 A flrm ls conslderlng expanslon of lLs asseLs by n$3 mllllon 1he lnvesLmenL
can be flnanced elLher by a bond lssue carrylng a 10 lnLeresL or by a new
lssue of equlLy shares whlch can be sold aL n$20 per share 1he flrm
presenLly has 400000 shares and n$6000000 bonds aL 8 1ax raLe ls
33
(a) CalculaLe Lhe LS for each alLernaLlve aL L8l1 levels of n$1 mllllon n$2
mllllon n$3 mllllon and n$4 mllllon respecLlvely
(b) WhaL can be concluded from Lhls analysls regardlng Lhe cholce
beLween bonds and sLock?
2 A Company ls conslderlng Lhree flnanclal plans (l) all equlLy (ll) 60 equlLy
and 40 debL and (lll) 40 equlLy and 60 debL 1oLal funds requlred are
n$300000 Larnlngs before lnLeresL ls expecLed Lo be n$80000 Shares
can be sold aL n$20 each uebL ls avallable from a prlvaLe source aL
lnLeresL up Lo and lncludlng n$60000 aL 8 above n$60000 and up Lo
n$130000 aL 12 and over n$130000 aL 18 CompuLe earnlngs per
share for each plan Assume Lax raLe aL 33
AsslgnmenL
3 A company requlres n$2000000 for a new facLory expecLed Lo yleld an annual
L8l1 of n$330000 ln chooslng Lhe flnanclal plan Lhe company's ob[ecLlve ls
maxlmlslng Lhe LS 1he company ls conslderlng Lhree alLernaLlves
(a) borrow n$1000000 and lssue shares of n$1000000 (b) borrow n$800000
and lssue shares of n$1200000 and (c) borrow n$300000 and lssue shares for
n$1300000 1he face value as well as markeL value of one ordlnary share ls n$23
1he cosL of debL ls 10 per annum 1he raLe of corporaLe Lax ls 30 SLaLe whlch
of Lhe Lhree flnanclal plans Lhe company should follow Lo ralse flnances
4 Crey roducLs has flxed operaLlng cosLs of $380000 varlable operaLlng cosLs of $16
per unlL and a selllng prlce of $6330 per unlL
(a) CalculaLe Lhe operaLlng break even polnL ln unlLs (b) CalculaLe Lhe flrm's L8l1
aL 9000 10000 and 11000 unlLs respecLlvely (c) WlLh 10000 unlLs as base whaL
are Lhe percenLage changes ln unlLs sold and L8l1 as sales move from Lhe base Lo
Lhe oLher sales levels used ln b? (d) use Lhe percenLage compuLed ln parL c Lo
deLermlne Lhe degree of operaLlng leverage (uL) use Lhe formula for degree of
operaLlng leverage Lo deLermlne Lhe uL aL 10000 unlLs
AsslgnmenL
3 SouLhland lndusLrles has $60000 of 16 annual lnLeresL bonds
ouLsLandlng 1300 shares of preferred sLock paylng an annual
dlvldend of $3 per share and 4000 shares of common sLock
ouLsLandlng Assumlng LhaL Lhe flrm has a 40 Lax raLe compuLe
earnlng per share (LS) for (a) $24600 (b) $30600 and (c) $33000
levels of L8l1
6 norLhwesLern Savlngs and Loan has a currenL caplLal sLrucLure
conslsLlng of $230000 of 16 annual lnLeresL debL and 2000
shares of common sLock 1he flrm pays Laxes aL Lhe raLe of 40 (a)
uslng L8l1 values of $80000 and $120000 deLermlne Lhe
assoclaLed earnlngs per share (LS) (b) uslng $80000 of L8l1 as
base calculaLe Lhe degree of flnanclal leverage and (c) rework parLs
a and b assumlng LhaL Lhe flrm has $100000 of 16 annual lnLeresL
debL and 3000 shares of common sLock
AsslgnmenL
7 layMore 1oys produces lnflaLable beach balls selllng 400000 balls
per year Lach ball produced has a varlable operaLlng cosL of $084
and sells for $100 llxed operaLlng cosLs are $28000 1he flrm has
annual lnLeresL charges of $6000 preferred dlvldend of $2000
and a 40 Lax raLe CalculaLe (a) Lhe operaLlng breakeven polnL ln
unlLs (b) Lhe degree of operaLlng leverage (uL) (c) Lhe degree of
flnanclal leverage (ulL) and (d) Lhe degree of LoLal leverage (u1L)
8 CharLer LnLerprlses currenLly has $1 mllllon ln LoLal asseLs and ls
LoLally equlLy flnanced lL ls conLemplaLlng a change ln lLs caplLal
sLrucLure CompuLe Lhe amounL of debL and equlLy LhaL would be
ouLsLandlng lf Lhe flrm were Lo shlfL Lo each of Lhe followlng debL
raLlos 10 20 30 40 30 60 and 90 when Lhe amounL
of LoLal asseLs do noL change ls Lhere a llmlL Lo debL raLlo's value?
W .5<A