Synopsis-02

Capital Structure
1. Definition of Capital Structure

Capital structure refers to the mix of long term sources of funds, such as debentures, long
term debt, preference share capital and equity share capital including reserves and surpluses.
The appropriate capital structure maximizes the long term market price per share, also
keeping in view the financial requirements of a company.

A sound or appropriate capital structure should have the following features:

1. It should generate maximum returns to the shareholders.

2. There should not be the use of excessive debt to maintain long term solvency.
3. The capital structure should be flexible, to provide funds to finance its profitable
activities in future.
4. The capital structure should involve minimum risk of loss of control of the
company.

2. Considerations of Control and Size affect the Capital Structure Decision of the Firm

Capital structure decision is governed by desire of management to continue control over

the company. The ordinary (equity) shareholders elect the directors of the company. This
may result into dilution of control by present management or owner. In the case of widely-
held company, the shares of such company are widely scattered, and by issues of new
shares, there is a risk of dilution of control. The risk of loss of control can be reduced by
distribution of shares widely and in small lots.

The closely-held small company would like to maintain control. Because of fear of sharing
control and being interfered by others, the closely held company would like to raise debt
capital instead of equity issue. To avoid the risk of loss of control, small companies may
slow down their rate of growth or issue preference share capital or raise debt capital. A very
excessive debt capital can also cause serious liquidity problem, and render the company sick,
which means complete loss of control.

The size of company may influence its capacity and availability of funds from different
sources. A small company finds it difficult to raise long term debt or long term loan at
acceptable rate of interest and convenient terms. If small companies are able to approach
capital markets, the cost of issuing shares is generally more than larger companies.

3. Practical Considerations in Determining Capital Structure

1. Assets
2. Growth Opportunities
3. Debt and Non-debt Tax Shields

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 4. Financial Flexibility and Operating Strategy
5. Loan Covenants
6. Financial Slack
7. Sustainability and Feasibility
8. Control
9. Marketability and Timing
10. Issue Costs
11. Capacity of Raising Funds

4. Capital Structure Theories

 Net operating income (NOI) approach.

 Traditional approach and Net income (NI) approach.
 MM hypothesis with and without corporate tax.
 Miller’s hypothesis with corporate and personal taxes.
 Trade-off theory: costs and benefits of leverage.

4.1 Net Operating Income (NOI) Approach

According to NOI approach the value of the firm and the weighted average cost of capital are
independent of the firm’s capital structure. 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.

4.2 Net Income (NI) Approach

According to NI approach both the cost of debt and the cost of equity are independent of the
capital structure; they remain constant regardless of how much debt the firm uses. As a result,
the overall cost of capital declines and the firm value increases with debt. This approach has
no basis in reality; the optimum capital structure would be 100 per cent debt financing under
NI approach.

The effect of leverage on the cost of

capital under NI approach

Net Income ( NI)

Value of the Equity = Cost of Equity (Ke)

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 Interest
Value of the Debt = Cost of Debt (Kd )

Value of the Firm = Value of the Equity + Value of the Debt

Net Operating Income

Firms Cost of Capital = Value of the Firm

4.3 Traditional Approach

The traditional approach argues that moderate degree of debt can lower the firm’s 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 rise until a point is reached at which the advantage of lower
cost of debt is more than offset by more expensive equity.

Criticism of the Traditional View

 The contention of the traditional theory, that moderate amount of debt in ‘sound’
firms does not really add very much to the ‘riskiness’ of the shares, is not
defensible.
 There does not exist sufficient justification for the assumption that investors’
perception about risk of leverage is different at different levels of leverage.

4.4 MM Hypothesis

The Modigliani-Miller hypothesis is identical with the NOI approach. M-M approach
indicates that a firm's market value and the cost of capital remain invariant to the capital
structure changes, i.e., any combination of debt and equity is as good as any other. M-M
hypothesis indicates that securities are traded in perfect capital market situation, and
firms can be grouped into homogeneous risk classes. Further, it is also assumed that no
corporate income taxes exist, and firms distribute all net earnings to the shareholders.
If two identical firms, except for the degree of leverage, have different market values,
arbitrage will take place to enable investors to engage in personal or home-made leverage
as against the corporate leverage to restore equilibrium in the market.

5. Financial Distress

Financial distress arises when a firm is not able to meet its obligations to debt-holders. For
a given level of debt, financial distress occurs because of the business (operating) risk with
higher business risk, the probability of financial distress becomes greater. Determinants of
business risk are:

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  Operating leverage (fixed and variable costs)
 Cyclical variations
 Intensity of competition
 Price fluctuations
 Firm size and diversification
 Stages in the industry life cycle

Costs of Financial Distress

 Financial distress may ultimately force a company to insolvency. Direct costs of

financial distress include costs of insolvency.

 Financial distress, with or without insolvency, also has many indirect costs.
These costs relate to the actions of employees, managers, customers, suppliers and
shareholders.

Problem-01:

A firm is expecting a net operating income of Tk. 3,00,000 on a total investment of Tk. 10
lakh. The cost of equity capital (Ke) is 10 percent when there is no debt capital. If the firm
wants to raise fund from debt capital by issuing 8 percent debenture of Tk. 3 lakh, the cost of
equity capital would raise to 11 percent. If the firm wants to raise Tk. 6 lakh issuing 9 percent
debenture the cost of equity capital will be 12.5 percent.

Calculate the market value of the firm (V), value of the share (S), and overall cost of capital
(Ko) of the firm under Traditional approach.

Problem-02:

A company has a total capitalization of Tk. 1 core and normally earns Tk. 10 lakh (before
interest and taxes) in a year. As the financial manager, following information with regard to
the company is provided you.

Amount of debt Interest Rate Equity

i) Tk. 10 lakh 8% 12%
ii) Tk. 20 lakh 8% 12%
iii) Tk. 30 lakh 9% 13%
iv) Tk. 40 lakh 11% 15%
v) Tk. 50 lakh 12% 16%
vi) Tk. 60 lakh 13% 18%

Required:
According to Traditional Approach determine the optimum capital structure.

Problem-03:

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X Company has net operating income of Tk. 2,00,000 on an investment of Tk. 10,00,000 in
assets. It can raise debt at a 16 percent rate of interest. Assume taxes do not exist.
a. Using the Net income approach and an equity capitalization rate of 18 percent,
compute the total value of the firm and the weighted average cost of capital if the firm
has i) no debt, ii) Tk. 3,00,000 debt, iii) Tk. 6,00,000 debt.
b. Using the NOI approach and the overall capitalization rate of 12%, compute the total
value of the firm, value of the shares and the cost of equity if the firm has i) no debt,
ii) Tk. 3,00,000 debt, iii) Tk. 6,00,000 debt.

Problem-04

Following is the capital structure of ABC company:

12% Debt capital Tk. 30 lakhs

Common stock capital (80,000 shares) 128 lakhs
Total capital Tk. 158 lakhs

To finance an expansion program, the company needs additional capital of Tk. 40 lakhs.
There are three alternative methods of financing:

i. Through 14% debt financing;

ii. Through 12% preferred stock financing;
iii. Selling common stock shares of Tk. 160 per share.

Assuming 40% corporate tax rate and expected EBIT of Tk. 15 lakhs. Find out Earnings
per Share (EPS) of ABC Company under each alternative method of financing.

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