Capital structure

Sidharth Tenpa Surender Vishal Kavya

INTRODUCTION

We may not know what a capital structure is or why you should even concern yourself with it, but the concept is extremely important because it can influence not only the return a company earns for its shareholders, but whether or not a firm survives in a recession or depression. Sit back, relax, and prepare to learn everything you ever wanted to know about investments and the capital structure of the companies

CAPITAL STRUCTURE WHAT IT IS AND WHY IT MATTERS

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 big 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.

Meaning:
Combination

of debt and equity that a firm uses to fund its long term financing. Capital structure of a company refers to the composition of its capitalization and it includes all long term capital sources i.e., loans, reserves, shares and bonds. Gerestenbeg

Choosing a Capital Structure

What

is the primary goal of financial managers?

Maximize stockholder wealth

We

want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC

Optimal capital structure

The

OCM can be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm OCM maximises the value of the company and hence the wealth of its owners and minimise the companys cost of capital

Following consideration should be kept in mind while maximizing the value of the firm:
If

ROI > the fixed cost of funds If debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax. The Capital structure should be flexible.

CAPITAL STRUCTURE THEORIES

Net Income Approach 2. Traditional Approach 3. Net Operating Income Approach 4. Modigliani And Miller Approach
1.

Net Income Approach

suggested by the David Durand.

Exist Direct relationship between capital structure and net

income The capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure

leads to a corresponding change in the overall cost of capital

as well as the total value of the firm.

According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm.

Net Operating Income Approach

Capital Structure decision is irrelevant to the

valuation of the firm.

The market value of the firm is not at all affected by the capital structure changes. According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as well as the overall cost of capital.

TRADITIONAL APPROACH
Up

to a certain point additional introduction of debt reduces the cost of capital and increases the value of the firm. But beyond a point if you borrow more debt the cost will increase and value will decrease.

Modigliani and Miller Approach

Modigliani and Miller approach states that the

financing decision of a firm does not affect the

market value of a firm in a perfect capital market.

In other words MM approach maintains that the

average cost of capital does not change with change

in the debt weighted equity mix or capital structures of the firm.

important assumptions:

There is a perfect capital market.

There are no retained earnings. There are no corporate taxes. The investors act rationally. The dividend payout ratio is 100%. The business consists of the same level of business risk.

Factors that influence Capital Structure Decisions

Business

Risk Company's Tax Exposure Management Style Financial Flexibility Growth Rate Market Condition

1.Business Risk Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit

more variability in its earnings. Since the sales of a retail apparel

company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its

responsibilities with the capital structure in both good times and bad.

Company's Tax Exposure Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

Management aggressive to

Style

Management The

styles more

range

from a

conservative.

conservative

management's approach is, the less inclined it is to use debt

to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share

(EPS).

Financial Flexibility This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales

are growing and earnings are strong. However, given a company's strong cash
flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.

The airline industry is a good example. In good times, the industry generates
significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top.

Growth Rate Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise. Market Condition Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.