Capital Structure

Rishi Taparia

What is Capital Structure?

The means by which a firm is financed. A firm can finance operations through common and preferred stock, with retained earnings, or with debt. Usually a firm will use a combination of these financing instruments. The proportion of short and long-term debt is considered when analyzing capital structure. And, when people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk.

Factors influencing Capital Structure

Control Risk Income Tax Consideration Cost of Capital Investors attitude Trading on equity Flexibility Timing Legal provisions Growth rate Government Policy Marketability Company size

Optimal Capital Structure

The optimal capital structure is that where the company maximises the total value of the firm (V) by minimising the overall cost of capital (K). The total value of the firm (V) is Value of Equity (E) + Value of Debt (D) i.e. V=E+D The overall cost of Capital (Ko) = Ke + Kd But, its very difficult to have optimal capital structure therefore, there exists two approaches.

Two Approaches
Net Income Approach. Net Operating Income Approach.

Some basic definitions:

E = Market Value of Equity Shares D = Market Value of Debt V = Total Value of the firm (E +D) NOI = Net Operating Income (EBIT) I = Interest NI = Net Income (EBIT I)

Some formulas to remember:

Cost of Debt (Kd) = Interest / Value of Debt Value of Debt (V) = Interest / Kd Cost Equity Shares (Ke) = DPS / MPS + g Ke = NOI I NI / E VD WACC (Ko) = NOI / V Value of the firm (V) = NOI / Ko

Net Income Approach

The firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. The assumptions are: a) Use if debt does not change the risk perception of investors, as a result, Ke and Kd remailn constant. b) Kd< Ke c) No corporate taxes.

Illustration
A company has expected annual net operating income of Rs.100000, an equity rate (ke) of 10% and Rs.50000 6% debt. Compute value of the firm using NI approach. Considering everything same, the company assumed to have employed a debt of Rs.700000 instead of Rs. 500000, Compute the value of the firm using NI approach.

Net Operating Income Approach

According to NOI approach, the market value of the firm is not affected by the capital structure changes. V = NOI / Ko Assumptions: a) Split between debt & equity is not important. b) Ko is assumed to be constant. c) Kd is assumed to be constant. d) Corporate taxes do not exist.

Illustration
A company has annual net operating income of Rs.100000, an average cost of capital (Ko) of 10% and an initial debt of Rs.500000 at 6% rate of interest. Compute the value of firm and Cost of equity shares (Ke) using NOI approach. Everything remained same except the debt, which increased from Rs.500000 to Rs.700000. Compute the value of firm (V) and the cost of equity share capital (Ke).

Pecking Order Theory

The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced. Therefore firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory

Some Implications:
Internal equity may be better than external equity.
Financial slack is valuable. If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).