FINANCIAL MANAGEMENT

CAPITAL STRUCTURE
Capital Structure :refers to proportion of debt and equity used for financing business
operations.After determining the financial requirements, next financial decision is to decide
composition of capital structure. It involves deciding about how much funds to be raised from
each source of finance. In short, capital structure decision involves deciding the kinds of
securities to be issued and their relative proportion in the capital.

On the basis of ownership, sources of business finance are classified into two categories:

* Owners' Funds (Equity): They consist of equity share capital, preference share capital and
retained earnings (or reserves and surpluses).

* Borrowed Funds (Debt): They are in the form of loans, debentures, public deposits etc. These
may be borrowed from banks, other financial institutions, debenture holders and public.

Capital Structure is the mix between borrowed funds (debt) and owners' funds (equity).

Ratio of Debt and Equity in the capital structure is measured by the following formulas:

(i) Debt/Equity

(ii) Debt/(Debt + Equity) (When debt is taken as the proportion of total capital)

Some Noteworthy Points about Debt and Equity

* Nature: Debt is a borrowed fund, whereas equity represents owners' funds.

* Cost of Debt is lower than Cost of Equity: Since lenders earn on assured return and
repayment of capital, their risk is lower than risk of equity shareholders. As a result, lenders
require a lower rate of return as compared to equity shareholders.

* Further, interest paid on debt is a deductible expense for computation of tax liability,
whereas, dividends on equity are paid out of after-tax profits.

* Therefore, increased use of debt lowers the overall cost of capital if cost of equity remains
unaffected.

* Debt is more risky as compared to Equity: It happens because interest payment and return of
principal amount is obligatory for the business in case of debt. Any default in meeting these
commitments may force the business to go into liquidation. On the other hand, equity is
considered riskless as there is no such compulsion.

* So, increased use of debt increases the financial risk (risk of inability to meet fixed financial
charges) of a business.

After comparing debt and equity, it can be concluded that capital structure of a business
affects both the profitability and the financial risk. A capital structure is said to be optimal
when the proportion of debt and equity is such that it increases the value of equity shares.

The main objective of capital structure is to maximise the shareholders' wealth. This objective
can be achieved through 'Financial Leverage' or 'Trading on Equity'.

Financial Leverage or Trading on Equity

Financial leverage refers to the proportion of debt in the overall capital. It is computed as:

Debt/Equity

or

Debt/(Debt + Equity)

As the financial leverage increases, the cost of funds declines because of increased use of
cheaper debt, but the financial risk increases.

Trading on Equity raises the Return of Equity Shareholders

Trading on Equity means increase in profit earned by the equity shareholders due to the
presence of fixed financial charges. Financial Leverage or Trading on Equity raises the return
(Earning Per Share) of equity shareholders by making use of fixed cost securities (Debt) in the
capital structure. It happens because:

* Cost of debt is lower than cost of equity for a firm as lender's risk is lower than risk of
shareholder.

* Interest paid on debt is a deductible expense for computation of tax liability, whereas,
dividends are paid out of after-tax profits.

Therefore, increased use of debt increases the return of equity shareholders.

Factors Affecting the Choice of Capital Structure
Deciding about the capital structure of a firm involves determining the relative proportion of
various types of funds. This depends on various factors. The important factors which determine
the choice of capital structure are:

* Cash Flow Position: While deciding the capital structure, future cash flow position should be
kept in mind. Cash flows must not only cover fixed cash payment obligations but there must be
sufficient buffer also. A company must have enough cash; (i) to meet normal business
operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service
commitments i.e., payment of interest and repayment of principal.

* Interest Coverage Ratio (ICR): ICR refers to number of times earning before interest and tax
(EBIT) of a company covers the interest obligation. ICR is calculated as:

ICR = EBIT/Interest

ICR explains how many times EBIT can repay interest obligation. Higher ratio means company
can have more of debt as there is less risk in meeting the interest payment obligations. In case
of lower ratio, company should use less debt.

However, ICR is not an adequate measure as it does not consider the cash availability to meet
the repayment obligations. A firm may have a higher EBIT but low cash balance. Apart from
interest, repayment obligations are also relevant.

* Debt Service Coverage Ratio (DSCR): DSCR takes care of the drawback of ICR. The cash profits
generated by the operations are compared with the total cash required for the service of debt
and preference share capital. DSCR is calculated as:

DSCR = (Profit after tax + Depreciation + Interest + Non cash Expenses written off) /
(Preference dividend + Interest + Repayment obligation)

A higher DSCR indicates better ability to meet cash commitments. So, company can raise
more debt in case of higher DSCR. However, in case of lower DSCR, company should prefer
more of equity.

* Return on Investment (ROI): ROI is an important factor in designing an appropriate capital

structure. It is calculated as:

ROI = (EBIT / Total Investment) x 100

 If ROI is more than rate of interest to be paid on debt, then company should prefer more of
debt as compared to equity. However, if ROI is less than interest rate, then company should
avoid debt and rely more on equity capital. ROI helps in deciding the ratio of debt and equity to
enhance the EPS (Refer Examples 1 and 2 of Trading on Equity).

* Cost of Debt: Cost of debt directly influence the extent of debt to be used in the capital
structure. If the interest rate on debt is less, then more debt is preferred as compared to
equity. However, in case of higher cost of debt, company prefers more of equity.

* Tax Rate: Interest paid on debt is treated as an expense and helps in reducing taxable income
of the company, whereas, dividend is paid out of earnings available after tax. Sinceinterest is a
deductible expense, debt is preferred in case of higher tax rate. However, if tax rate is lower,
then equity is preferred.

* Cost of Equity: Shareholders expect a rate of return from equity, which is affected by use of
debt capital. Use of more debt in the capital structure raises the financial risk faced by
shareholders. Increase in risk also increases the desired rate of return. So, debt should be used
only to a level that also raises the cost of equity and share price may decrease inspite of
increased EPS.

* Floatation Costs: Floatation cost refers to the cost involved in issue of securities. For
example, underwriting commission, brokerage, stamp duty, listing charges, etc. The cost of
raising finance from various sources should be carefully estimated before making a choice.
Securities with minimum floatation costs should be preferred. For instance, floatation cost
involved in raising loan is less as compared to shares and debentures.

* Risk Consideration: Every business faces two kinds of risks:

(i) Business or Operating Risk, i.e. risk of inability to meet fixed operating costs (rent, salary,
insurance premium, etc).

(ii) Financial Risk, i.e. risk of inability to meet fixed financial charges (interest payment,
preference dividend and repayment obligations).

The total risk depends on both the business risk and the financial risk. If a firm's business risk
is lower, then company may face financial risk, i.e. more debt capital can be used. However, in
case of higher business risk, financial risk should be reduced by using less debt.

* Flexibility: If a firm uses excess debt in the capital structure, it restricts the firm's potential to
raise further debt. Therefore, to maintain flexibility, firm must maintain some borrowing power
for unforeseen circumstances.
 * Control: Issue of debt does not dilute the control of equity shareholders. So, if the existing
shareholders want to retain effective control, then more debt should be used. On the other
hand, a public issue of equity will reduce the control of existing shareholders. It may also
increase the chances of takeover, especially when current holding of existing shareholders is on
a lower side.

* Regulatory Framework: Every company has to follow the regulatory framework provided by
the law while deciding about the capital structure. Issue of shares and debentures has to be
done as per the guidelines issued by SEBI. Loans from banks and other financial institutions also
require fulfillment of various norms. Company generally prefers those sources of finance, which
have easy and less legal and regulatory requirements.

* Stock Market Conditions: The company should consider the market conditions and design its
capital structure accordingly. During boom period (Bullish Phase), people are ready to take risk
and invest in equity shares, even at a higher price. However, during depressed market
conditions (Bearish Phase), investors prefer debt, which carry fixed rate of return.

* Capital Structure of other Companies: The pattern of capital structure and debt-equity ratio
of other companies in the same industry act as guiding force while deciding the capital
structure. However, the company should not follow the industry norms blindly.

Example 1

Suppose Company X wants to raise some money for investment purposes. The relevant facts
about Company X are:

Total Funds to be raised = ₹ 30,00,000

Interest rate on Debt = 10%

Face Value of Equity shares = ₹ 10 each

Tax Rate = 30%

Earning before interest and Tax (EBIT) = ₹ 4,00,000

Company X can raise ₹ 30 lakhs by all equity capital or including some debt along with equity.
As discussed before, use of debt increases the returns of equity shareholders. To prove this, let
us consider three different situations:

Situation 1 When total funds are raised through Equity

i.e. Debt = Nil, and Equity = ₹ 30,00,000

Situation II When some part is raised through debt and balance from Equity

i.e. Debt = ₹ 10,00,000; and Equity = ₹ 20,00,000

Situation III When major part is raised through debt and some from Equity

i.e. Debt = ₹ 20,00,000; and Equity = ₹ 10,00,000

Let us now calculate EPS under the three situations:

PARTICULAR SITUATION I SITUATION II SITUATION III

EBIT 4,00,000 4,00,000 4,00,000
(-INTEREST) 0 1,00,000 2,00,000
(O*10%) (10,00,000*10%)INT (20,00,000*10%)
ON DEBT ON DEBT
EBT 4,00,000 3,00,000 2,00,000
(-TAX) 1,20,000 90,000 60,000
(4,00,000*30%) (3,00,000*30%) (2,00,000*30%)
EAT 2,80,000 2,10,000 1,40,000
R54

NO OF SHARES-30,00,000/10= 3,00,000

EPS= EAT/NO OF SHARES

= 2,80,000/3,00,000

=0.93

EPS OF SITUATION II

NO OF SHARES=20,00,000/10=2,00,000
30,00,000-10,00,000=20,00,000(EQUITY-DEBT)

EPS=2,10,000/2,00,000

=1.05

EPS OF SITUATION III

NO OF SHARES = 10,00,000/10=1,00,000

30,00,000-20,00,000=10,00,000

EPS=1,40,000/1,00,000=1.40
ROI of Example 1

ROI = (EBIT / Total Investment) x 100 = (4,00,000 / 30,00,000) x 100 = 13.33%

(EXAMPLE ONE ME JIS SITUATION ME SBSE ZADA DEBT THA (SITUATION III) USI KA EARNING
PER SHARE SBSE MAXIMUM THA…TO THAT MEANS DEBT FAVBOUBLE HAI IS COMPANY ME)

(KYU FAVOURABLE HAI COMPANY NE INVESTVEST HAI 13.33% AND INTEREST HAI 10% JO
COMPANY EASILY PAY OFF KR SKTI HAI)

Out of the three situations, capital structure under Situation III seems to be the best as it gives
the maximum EPS of ₹1.40. In this situation, Company has used the maximum debt (or
financial leverage) and the results are positive. EPS is minimum in Situation I, in which there is
no debt content. Hence, it brings us to a conclusion that use of more debt increases the returns
for equity shareholders.

ROI is 13.33%, whereas, cost of debt is just 10%. As ROI > Cost of debt, EPS will always rise with
increase in debt. With higher use of debt, this difference between ROI and cost of debt
increases the EPS. This is a situation of favourable financial leverage. In such cases, companies
often employ more of cheaper debt to enhance the EPS. Such practice is called Trading on
Equity. However, when ROI is less than the cost of debt, then equity shareholders lose by use of
more debt content in the capital structure.

Let us now consider the case of Company Y with the help of Example 2.

Example 2

All details are same as of Example 1, except that EBIT of Company Y is ₹ 2,00,000.

With EBIT of ₹ 2,00,000, ROI of Company Y will be:

ROI = (EBIT / Total Investment) x 100 = (2,00,000 / 30,00,000) x 100 = 6.67%

The cost of Debt is 10% and ROI is just 6.67%. As ROI < Cost of Debt, EPS should fall with
increase in debt.

Let us calculate EPS under the three situations to prove this:

PARTICULAR SITUATION I SITUATION II SITUATION III

EBIT 2,00,000 2,00,000 2,00,000
(-INTEREST) - 1,00,OOO 2,00,000
(10,00,000*10%) (20,00,000*10%)
EBT 2,00,000 1,00,000 ------------------
(-TAX) 60,000 30,000 -----------------
(2,00,000*30%) (1,00,000*30%)
EAT 1,40,000 70,000 ------------------

EPS OF SITUATION I

NO OF SHARES- 30,00,000/10=3,00,000

EPS-1,40,000/3,00,000=0.47

EPS OF SITUATION II

NO OF SHARES- 30,00,000-10,00,000(DEBT)=20,00,000

20,00,000/10=2,00,000

EPS-70,000/2,00,000=0.35

EPS OF SITUATION III

NO OF SHARES-30,00,000-20,00,000=10,00,000

10,00,000/10=1,00,000

EPS-0/1,00,000=0

ROI of Example 2

ROI = (EBIT / Total Investment) x 100 = (2,00,000 / 30,00,000) x 100 = 6.667%

The cost of Debt is 10% and ROI is just 6.67%. As ROI < Cost of Debt, EPS should fall with
increase in debt.

(EXAMPLE SECOND ME JIS SITUATION ME SBSE ZADA DEBT THA(SITUATION III) ISME TO EPS 0
HAI TO YE TO CONTATRY HO GYA…ISME COMPANY NE JO DEBT LIA VO COMPANY KE FAVOUR
ME NH AA RAHA BECAUSE ISKA RETURN ON INVESTMENT 6.67% HAI AND INTEREST 10% HAI
TO COMPANY 10% INTEREST COVER UP KAISE KREGI JB EARNING HE NHI HAI, SO IN THIS
SITUATON DEBT ISNT FAVOURABLE FOR COMPANY)

FINANCUAL MANAGEMENT CHAPTER ENDS HERE