Financial Management Unit 7

Unit 7 Capital Structure

Structure:
7.1 Introduction
Objectives
7.2 Features of an Ideal Capital Structure
7.3 Factors Affecting Capital Structure
7.4 Theories of Capital Structure
Net income approach
Net operating income approach
Traditional approach
Miller and Modigliani approach
Basic propositions
Criticisms of MM proposition
7.5 Summary
7.6 Glossary
7.7 Terminal Questions
7.8 Answers
7.9 Case Study

7.1 Introduction
In the previous unit, you have learnt about operating leverage, financial
leverage, and total or combined leverage. In this unit, we will discuss the
features of ideal capital structure, factors affecting capital structure, and
theories of capital structure.
Finance is an important input for any type of business and is needed for
working capital and for permanent investment. The total funds employed in
a business are obtained from various sources as we have already seen in
the earlier units. A part of the funds are brought in by the owners and the
rest is borrowed from others – both individuals and institutions. While some
of the funds are permanently held in business, such as share capital and
reserves (owned funds), some others are held for a long period such as
long-term borrowings or debentures, and still some other funds are in the
nature of short-term borrowings. The entire composition of these funds
constitutes the overall financial structure of the firm.

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A firm needs to have such sources in the right proportion. Short-term funds
keep varying and hence, their proportions cannot be laid down in a rigid
manner. However, a more definite policy is required for the composition of
the long-term funds. This forms the capital structure of the firm.
Thus, the capital structure of a company refers to the mix of long-term
finances used by the firm. In short, it is the financing plan of the company.
More important areas of the policy are the debt-equity ratio and the dividend
decision. The latter affects the building up of retained earnings which is an
important component of long-term owned funds. Since the permanent or
long-term funds often occupy a large portion of total funds and involve long-
term policy decision, the term financial structure is often used to mean the
capital structure of the firm.
With the objective of maximising the value of the equity shares, the choice
should be that pattern of using of debt and equity in a proportion which will
lead towards achievement of the firm’s objective. The capital structure
should add value to the firm. Financing mix decisions are investment
decisions and have no impact on the operating earnings of the firm. Such
decisions influence the firm’s value through the earnings available to the
shareholders.
The value of a firm is dependent on its expected future earnings and the
required rate of return. The objective of any company is to have an ideal mix
of permanent sources of funds in a manner that it will maximise the
company’s market price. The proper mix of funds is referred to as optimal
capital structure. The capital structure decisions include debt-equity mix and
dividend decisions. Both these have an effect on the Earnings Per Share
(EPS).
Objectives:
After studying this unit, you should be able to:
 explain the features of an ideal capital structure
 name the factors affecting the capital structure
 discuss the various theories of capital structure

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7.2 Features of an Ideal Capital Structure

How do you choose a particular type of capital structure? The decision
regarding what type of capital structure a company should have is of critical
importance because of its potential impact on profitability and solvency.
Capital structure of the company should be such that the company derives
maximum benefits from it and is able to adjust it easily to changing
conditions. Companies aim to find an appropriate proportion of different
types of capital which will minimise the cost of capital and maximise the
market value.
Optimum or balanced capital structure means an ideal combination of
borrowed and owned capital that may attain the marginal goal, i.e.,
maximisation of market value per share or minimisation of cost of capital.
The market value will be maximised or the cost of capital will be minimised
when the real cost of each source of funds is the same. It is a formidable
task for the financial manager to determine the combination of the various
sources of long-term finance.
Thus, capital structure is usually planned keeping in view the interests of the
ordinary shareholders. The ordinary shareholders are the ultimate owners of
the company and have the right to elect the directors. While developing an
appropriate capital structure for his or her company, the financial manager
should aim at maximising the long-term market price of equity shares.
Figure 7.1 depicts the features of an ideal capital structure – profitability,
flexibility, control, and solvency.

Figure 7.1: Features of an Ideal Capital Structure

Let us now discuss these features in detail.

Profitability
The firm should make maximum use of leverage at a minimum cost.

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Flexibility
An ideal capital structure should be flexible enough to adapt to changing
conditions. It should be in a position to raise funds at the shortest possible
time and also repay the money it borrowed, if they appear to be expensive.
This is possible only if the company’s lenders have not put forth any
conditions like restricting the company from taking further loans, restricting
the usage of assets, or restricting early repayments. In other words, the
finance authorities should have the power to take decisions as
circumstances warrant.
Control
The structure should have minimum dilution of control.
Solvency
Use of excessive debt threatens the very existence of the company.
Additional debt involves huge repayments. Loans with high interest rates
must be avoided even if some investment proposals look attractive. Some
companies who resort to issue of equity shares to repay their debt for equity
holders do not have a fixed rate of dividend.

7.3 Factors Affecting Capital Structure

Capital structure should be planned at the time a company is promoted.
The initial capital structure should be designed very carefully. The
management of the company should set a target capital structure, and the
subsequent financing decisions should be made with a view to achieve the
target capital structure.
Every time the funds have to be procured, the financial manager weighs the
pros and cons of various sources of finance and selects the most
advantageous sources keeping in view the target capital structure. Thus, the
capital structure decision is a continuous one and has to be taken whenever
a firm needs additional finance.
The major factor affecting the capital structure is leverage. There are also a
few other factors affecting them. All the factors are explained briefly here.

Leverage
The use of sources of funds that have a fixed cost attached to them, such as
preference shares, loans from banks and financial institutions, and
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debentures in the capital structure, is known as “trading on equity” or

“financial leverage”.
If the assets financed by debt yield a return greater than the cost of the debt,
the EPS will increase without an increase in the owner’s investment.
Similarly, the EPS will also increase if preference share capital is used to
acquire assets. But the leverage impact is felt more in case of debt because
of the following reasons:
 The cost of debt is usually lower than the cost of preference share
capital
 The interest paid on debt is a deductible charge from profits for
calculating the taxable income while dividend on preference shares is
not
The companies with high level of Earnings Before Interest and Taxes (EBIT)
can make profitable use of the high degree of leverage to increase return on
the shareholder’s equity.
Debt-equity ratio is another parameter that comes into play here. Debt-
equity ratio is an indicator of the relative contribution of creditors and
owners. The debt component includes both long-term and short-term debt,
and this is represented as debt/equity.
Creditors insist on a debt-equity ratio of 2:1 for medium-sized and large-
sized companies, while they insist on 3:1 ratio for Small Scale Industries
(SSI).
A debt-equity ratio of 2:1 indicates that for every 1 unit of equity, the
company can raise 2 units of debt. By normal standards, 2:1 is considered
as a healthy ratio, but it is not always a hard and fast rule that this standard
is insisted upon. A ratio of 5:1 is considered good for a manufacturing
company while a ratio of 3:1 is good for heavy engineering companies.
Generally, in debt-equity ratio, the lower the ratio, the higher is the element
of uncertainty in the minds of lenders. Increased use of leverage increases
commitments of the company (the outflows being in the nature of higher
interest and principal repayments), thereby increasing the risk of the equity
shareholders.

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The other factors to be considered before deciding on an ideal capital

structure are:
 Cost of capital – High cost funds should be avoided. However attractive
an investment proposition may look like, the profits earned may be eaten
away by interest repayments.
 Cash flow projections of the company – Decisions should be taken in
the light of cash flow projected for the next 3-5 years. The company
officials should not get carried away at the immediate results expected.
Consistent lesser profits are any way preferable than high profits in the
beginning and not being able to get any profits after 2 years.
 Dilution of control – The top management should have the flexibility to
take appropriate decisions at the right time. Fear of having to share
control and thus being interfered by others often delays the decision of
the closely held companies to go public. To avoid the risk of loss of
control, the companies may issue preference shares or raise debt
capital. An excessive amount of debt may also cause bankruptcy, which
means a complete loss of control. The capital structure planned should
be one in this direction.
 Floatation costs – Floatation costs are incurred when the funds are
raised. Generally, the cost of floating a debt is less than the cost of
floating an equity issue. A company desiring to increase its capital by
way of debt or equity will definitely incur floatation costs. Effectively, the
amount of money raised by any issue will be lower than the amount
expected because of the presence of floatation costs. Such costs should
be compared with the profits and right decisions should be taken.

Activity: List the possible sources of capital that a company might use.
Hint:
 Issue of equity shares in the domestic capital market.
 Issue of equity (depository shares) in the international capital market.
 Equity financing from financial institutions
 Private equity
 Issue of debentures in the domestic capital market.
 Issue of debentures to financial institutions

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 Long term loans from financial institutions

 Mortgage loans from financial institutions
 External Commercial borrowings/ Syndicated loans (i.e., debt capital
from international capital market)
 Issue of preference shares in the domestic capital market.
 Issue of preference shares to financial institutions

7.4 Theories of Capital Structure

As we are aware, equity and debt are the two important sources of long-
term sources of finance of a firm. The proportion of debt and equity in a
firm’s capital structure has to be independently decided case to case.
A proposal, though not being favourable to lenders, may be taken up if they
are convinced with the earning potential and long-term benefits.
What proportion of equity and debt should be taken up in the capital
structure of a firm? The answer is tricky and is based on the understanding
and interpretation of the relationship between the financial leverage and firm
valuation or financial leverage and cost of capital. Many theories have been
propounded to understand the relationship between financial leverage and
firm value.

Assumptions
The following are some common assumptions made:
 The firm has only two sources of funds, debt and ordinary shares
 There are no taxes, both corporate and personal
 The firm’s dividend payout ratio is 100%, that is, the firm pays off the
entire earnings to its equity holders and retained earnings are zero
 The investment decisions of a company are constant, that is, the firm
does not invest any further in its assets
 The operating profits/EBIT are not expected to increase or decrease
 All investors shall have identical subjective probability distribution of the
future expected EBIT
 A firm can change its capital structure at a short notice without the
incurrence of transaction costs
 The life of the firm is indefinite

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Based on the assumptions regarding the capital structure, we derive the

following formulae:
Cost of Debt
 Debt capital being constant, Kd is the cost of debt which is the discount
rate at which the discounted future constant interest payments are equal
to the market value of debt, that is,
Kd = I/B
where, I refers to total interest payments and B is the total market value
of debt.
Therefore value of the debt B = I/Kd
Cost of Equity
As mentioned above, it is assumed that there is a 100% dividend payout
and constant earnings. Such being the case, the cost of equity is the
discount rate at which the discounted future dividend/earnings are equal to
the market value of equity.
 Cost of equity capital Ke = (D1/P0) + g
where D1 is dividend after one year, P0 is the current market price and
g is the expected growth rate.
 Retained earnings being zero, g = br where r is the rate of return on
equity shares and b is the retention rate, therefore g is zero. Now we
know Ke = E1/P0 + g and g being zero, so Ke = NI/S where NI is the net
income to equity holders and S is market value of equity shares.
Firm Value
 The net operating income being constant, overall cost of capital is
represented as K0 = W1 K1 + W2 K2.
 That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the
debt, S is the market value of equity and V is the total market value of
the firm and can be given as (B+S).
The above equation can be expressed as [B/(B+S)]K1 + [S/(B+S)]K2, (K1
being the debt component and Ke being the equity component) which
can be expressed as:
K0 = I + NI/V or EBIT/V
or in other words, net operating income/market value of firm.

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In the following pages we will understand what happens when the financial
leverage changes and its impact on Kd, Ke, and K0.
7.4.1 Net income approach
Net Income (NI) approach is suggested by Durand. He is of the view that
capital structure decision is relevant to the valuation of the firm. Any change
in the financial leverage will have a corresponding change in the overall cost
of capital and also the total value of the firm. As the ratio of debt to equity
increases, the Weighted Average Cost of Capital (WACC) declines and
market value of firm increases. According to this approach, a firm can
minimise the overall WACC and maximise the value of a firm by increasing
the proportion of debt in its capital structure.
The NI approach is based on 3 assumptions. They are:
 no taxes
 the cost of debt is less than the cost of equity and remains constant
 use of debt does not change the risk perception of investors
We know that,
K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
Where, B is the market value of Debt and S, the market value of equity.
The following graphical representation of NI approach may help us
understand this better. Figure 7.2 depicts the NI approach.

Figure 7.2: Net Income Approach

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It can be understood from the given graphical representation that as the

market value of debt-to-equity ratio (B/S) increases, K0 decreases. This is
because the proportion of debt, the cheaper source of finance, increases in
the capital structure.

Solved Problem – 1
Given below are two firms, A and B, which are identical in all aspects
except the degree of leverage employed by them. What is the average cost
of capital of both firms? Table 7.1 depicts the details of firms A and B.
Table 7.1: Details of Firms A and B
Firm A Firm B
Net operating income EBIT Rs. 1, 00, 000 Rs. 1, 00, 000
Interest on debentures I Nil Rs. 25, 000
Equity earnings E Rs. 1, 00, 000 Rs. 75, 000
Cost of equity Ke 15% 15%
Cost of debentures Kd 10% 10%
Market value of equity S = E/Ke Rs. 6, 66, 667 Rs. 5,00, 000
Market value of debt B Nil Rs. 2, 50, 000
Total value of firm V Rs. 6, 66, 667 Rs. 7, 50, 000

Solution:
Average cost of capital of firm A is:
10% * 0/Rs. 666667 + 15% * 666667/666667 = 0 + 15 = 15%
Average cost of capital of firm B is:
10% * 25000/750000 + 15% * 533333/750000 = 3.34 + 10 = 13.4%
Interpretation:
The use of debt has caused the total value of the firm to increase and the
overall cost of capital to decrease.

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Solved Problem – 2
The net income approach may be illustrated with a numerical example.
There are two firms, A and B, similar in all aspects except in the degree of
leverage employed by them. Financial data for these firms are given
below: Calculate average cost of capital for both the firms.
Net Income approach
Amount (in Rs.) Firm A Firm B
Net operating income 10,000 10,000
Interest on debt 0 3,000
Equity earnings 10,000 7,000
Cost of equity capital 10% 10%
Cost of debt capital 6% 6%
Market value of equity 100,000 70,000
Market value of debt 0 50,000
Total value of firm 100,000 120,000
Average cost of capital for Firm A:
6% * 0/100,000 + 10% * 100,000/100,000 = 10%
Average cost of capital for firm B:
6% * 50,000/120,000 + 10% * 70,000/100,000 = 8.33%

7.4.2 Net operating income approach

Net Operating Income (NOI) approach is also propounded by Durand and is
totally opposite to the NI approach. Durand says that any change in
leverage will not lead to any change in the total value of the firm, market
price of shares, and overall cost of capital. The overall capitalisation rate
and the cost of debt is the same for all degrees of leverage.
We know that:
K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
As per the NOI approach, the overall capitalisation rate remains constant for
all degrees of leverage. The market values the firm as a whole and the split
in the capitalisation rates between debt and equity is not very significant.
The increase in the ratio of debt in the capital structure increases the
financial risk of equity shareholders and to compensate this, they expect a
higher return on their investments. Thus, K0 and Kd remaining constant for
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all degrees of leverage, the cost of equity is:

Ke = K0 +[ (K0 – Kd)(B/S)].

Cost of debt
The cost of debt has two parts. Figure 7.3 depicts the two parts of cost of
debt.

Figure 7.3: Cost of Debt

Let us now discuss these two parts in brief.

Explicit cost can be considered as the given rate of interest. The firm is
assumed to borrow irrespective of the degree of leverage. This can result to
a conclusion that the increasing proportion of debt does not affect the
financial risk of lenders, and they do not charge higher interest.
Implicit cost is the increase in Ke attributable to Kd. Thus the advantage of
use of debt is completely neutralised by the implicit cost resulting in Ke and
Kd being the same.
Figure 7.4 depicts the behaviour of Kd, Ke and K0, in response to changes in
B/S.

Figure 7.4: Graphical Representation of Debts

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Solved Problem – 3
Table 7.3 depicts the figures of two firms, X and Y, which are similar in all
aspects except the degree of leverage employed. Calculate the equity
capitalisation rates of the firms.
Table 7.3: Details of Firms X and Y
Firm X Firm Y
Net operating income EBIT Rs. 10000 Rs. 10000
Overall capitalisation rate K0 18% 18%
Total market value 55555 55555
V = EBIT/K0
Interest on debt I Rs. 1000 Rs. 2000
Debt capitalisation rate Kd 11% 11%
Market value of debt B= I/Kd Rs. 9091 Rs. 18181
Market value of equity S=V—B Rs. 46464 Rs. 37374
Leverage B/S 0.1956 0.2140

Solution:
The equity capitalisation rates are:
Ke = K0 +[ (K0 – Kd)(B/S)]
Firm X = 0.18 + [(0.18 – 0.11)(0.1956)] = 19.36%
Firm Y= 0.18 + [(0.18 – 0.11)(0.4865)] = 21.40%

Solved Problem – 4
Consider two firms, MA and CMA, which are similar in all aspects other
than the degree of leverage employed by them. Table 7.4 depicts the
financial data of both these firms. Calculate the equity capitalisation rates
of the firms.
Table 7.4: Details of Firms MA and CMA
Firms MA Firms CMA
Net operating income EBIT Rs. 20, 000 Rs. 20, 000
Overall capitalisation rate K0 19% 19%
Total market value 66, 666 66, 666
V = EBIT/K0
Interest on debt i Rs. 1, 500 Rs. 3, 000

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Debt capitalisation rate Kd 13% 13%

Market value of debt B = i/Kd Rs. 11, 538 Rs. 23, 077
Market value of equity S = V-B Rs. 55, 128 Rs. 43, 589
Leverage B/S 0.21 0.53

Solution:
The equity capitalisation rates are:
Ke = K0 +[ (K0 – Kd)(B/S)]
Firm MA = 0.19 + [(0.19 – 0.13)(0.21)] = 0.2026 = 20.26%
Firm CMA = 0.19 + [(0.19 – 0.13)(0.53)] = 0.2218 = 22.18%

7.4.3 Traditional approach

The traditional approach has the following propositions:
 Kd remains constant until a certain degree of leverage and thereafter
rises at an increasing rate
 Ke remains constant or rises gradually until a certain degree of leverage
and thereafter rises very sharply
 As a sequence to the above 2 propositions, K0 decreases till a certain
level, remains constant for moderate increases in leverage thereafter
and rises beyond a certain point
Figure 7.5 depicts the graphical representation based on the propositions
made on the traditional approach.

Figure 7.5: Propositions of Traditional Approach

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The approach primarily implies that the cost of capital is dependant on the
capital structure, and there is an optimal capital structure which minimises
the cost of capital. At this optimal capital structure, the real marginal cost of
debt and equity is the same. Before this point is reached, the real marginal
cost of debt is less than the real marginal cost of equity. After this point, the
real marginal cost of debt is more than the real marginal cost of equity.
7.4.4 Miller and Modigliani approach
Miller and Modigliani criticise traditional approach that the cost of equity
remains unaffected by leverage up to a reasonable limit and K0 remains
constant at all degrees of leverage. They state that the relationship between
leverage and cost of capital is elucidated as in NOI approach.
Table 7.6 depicts the assumptions regarding Miller and Modigliani (MM)
approach: perfect capital markets, rational behaviour, homogeneity, taxes,
and dividend payout.

Figure 7.6: Analysis of Miller and Modigliani Approach

Let us now discuss these assumptions in detail.

 Perfect capital markets – Securities can be freely traded, that is,
investors are free to buy and sell securities (both shares and debt
instruments), no hindrances on the borrowings, no presence of
transaction costs, securities are infinitely divisible, and availability of all
required information at all times.

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 Investors behave rationally – They choose the combination of risk and

return which is most advantageous to them.
 Homogeneity of investor’s risk perception – All investors have the
same perception of business risk and returns.
 Taxes – There is no corporate or personal income tax.
 Dividend payout is 100% – The firms do not retain earnings for future
activities.
7.4.4.1 Basic propositions
Three propositions can be derived based on the assumptions made on MM
approach:
Proposition I: The total market value of the firm, which is equal to the total
market value of equity and total market value of debt, is independent of the
degree of leverage. Therefore, the market value of the firm can be
expressed as:

Expected NOI/discount rate appropriate to its risk class

i.e., expected overall capitalisation rate

V = (S+B)

which is equal to O/k0

which is equal to NOI/k0

V = (S+B) = O/k0 = NOI/k0

Where V is the market value of the firm,

S is the market value of the firm’s equity,
B is the market value of the debt,
O is the net operating income,
k0 is the capitalisation rate of the risk class of the firm, i.e., the
discount rate applicable.

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Figure 7.7 depicts the graphical representation of proposition 1.

Figure 7.7: Representation of Proposition 1

The basic argument for proposition I is that equilibrium is restored in the

market by the arbitrage mechanism.
Arbitrage is the process of buying a security at lower price in one market
and selling it in another market at a higher price bringing about equilibrium.
This is a balancing act.
Miller and Modigliani perceive that the investors of a firm whose value is
higher will sell their shares and in return, buy shares of the firm whose value
is lower. They will earn the same return at lower outlay and lower perceived
risk. The MM hypothesis thus states that the total value of homogeneous
firms that differ only in leverage will not be different due to the arbitrage
operation.
Such behaviours are expected to increase the share prices whose shares
are being purchased and lowering the share prices of those share which are
being sold. This switching operation will continue till the market prices of
identical firms become equal or identical. Thus, the arbitrage process drives
the value of two homogeneous companies to equality that differs only in
leverage.
Proposition II: The expected yield on equity (ke) is equal to the discount
rate (capitalisation rate) applicable (k0) plus a premium. This premium is
equal to the debt-equity ratio times the difference between k0 and the yield
on debt, r.
This can be represented as below:
ke = k0 + [ (k0 – r) (B/S)]
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Proposition III: This proposition states the implication of the earlier

propositions for investment decision making.
It states that the average cost of capital is not affected by the financing
decisions as investment and financing decisions are independent.
7.4.4.2 Criticisms of MM proposition
There were many criticisms, on various grounds, over MM propositions.
Figure 7.8 depicts the criticisms of MM proposition.

Figure 7.8: Criticisms of MM Proposition

Let us now discuss these criticisms in detail.
Risk perception
The assumption that risks are similar is wrong. The risk perceptions of
investors/personal leverage and corporate leverage is different. The
presence of limited liability of firms in contrast to unlimited liability of
individuals puts firms and investors on a different footing.
All investors lose if a leveraged firm becomes bankrupt, but an investor
loses not only his or her shares in a company but would also be liable to
repay the money he or she borrowed.
Arbitrage process is one way of reducing risks. It is more risky to create
personal leverage and invest in unlevered firm than investing in levered
firms.
Convenience
Investors find personal leverage inconvenient. This is so because it is the
firm’s responsibility to observe corporate formalities and procedures
whereas it is the investor’s responsibility to take care of personal leverage.
Investors prefer the former rather than taking on the responsibility and thus
the perfect substitutability is subjected to question.
Transaction costs
Another cost that interferes in the system of balancing with arbitrage
process is the presence of transaction costs. Due to the presence of such
costs in buying and selling securities, it is necessary to invest a higher
amount to earn the same amount of return.

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Taxes
When personal taxes are considered along with corporate taxes, the MM
approach fails to explain the financing decision and the firm’s value.
Agency costs
A firm requiring loan approaches creditors and creditors may sometimes
impose protective covenants to protect their positions. Such restriction may
be in the nature of obtaining prior approval of creditors for further loans,
appointment of key persons, restriction on dividend payouts, limiting further
issue of capital, limiting new investments or expansion schemes, etc.

Taxation and other imperfections cast a shadow on the leverage irrelevance

theorem of MM and imply that the cost of capital is affected by financial
leverage. The effect of taxation is to reduce the cost of capital as financial
leverage increases. Alternatively, it implies that the value of the firm
increases with financial leverage.
Bankruptcy and agency costs, however, tend to increase the cost of capital
as financial leverage increases. In other words, these imperfections detract
from the value of the firm as financial leverage increases.

Self Assessment Questions

1. Financing decisions are ________ and have no impact on the
_______ of the firm.
2. The value of the firm is dependent on its _____ and the ________.
3. ______ and _________ are two important sources of long-term
sources of finance of a firm.
4. As the ratio of debt-to-equity increases, the ________ declines and
______ of the firm increases.
5. As per the NOI approach, the ___________ remains constant for all
degrees of leverage.
6. ___ is the process of buying a security at a lower price in one market
and selling it in another market at a higher price bringing about ____.
7. The criticisms over Miller and Modigliani approach are ______,
__________, _________, _________, and_________.
8. Define Arbitrage.
9. The features of an ideal capital structure are _______, __________,
________, and __________.
10. The Miller and Modigliani approach fails to explain ______ decisions
and _____ value.
7.5 Summary
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Let us recapitulate the important concepts discussed in this unit:

 The capital structure of a company refers to the mix of long-term
finances used by the firm. In short, it is the financing plan of the
company.
 The proportion of equity and debt in the capital structure of a firm is
based on the understanding and interpretation of the relationship
between the financial leverage and firm valuation or financial leverage
and cost of capital.
 Many theories have been propounded to understand the relationship
between financial leverage and firm value.
 NI approach indicates that any change in the financial leverage will have
a corresponding change in the overall cost of capital and also the total
value of the firm.
 NOI approach states that any change in leverage will not lead to any
change in the total value of the firm, market price of shares, and overall
cost of capital. The overall capitalisation rate and the cost of debt is the
same for all degrees of leverage.
 Traditional approach implies that the cost of capital is dependant on the
capital structure, and there is an optimal capital structure which
minimises the cost of capital.
 MM approach states that the financial leverage does not have any
impact on the value of the firm.

7.6 Glossary
Arbitrage: The process of buying a security at a lower price in one market
and selling it in another market at a higher price bringing about equilibrium.

7.7 Terminal Questions

1. What are the assumptions of MM approach?
2. The following data is available with respect to 2 firms. What is the
average cost of capital? Table 7.5 depicts the data of a company.
Table 7.5: Data of a Company

Firm A Firm B
Net operating income Rs. 5,00,000 Rs. 5,00,000

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Interest on debt Nil Rs. 50,000

Equity earnings Rs. 5,00,000 Rs. 4,50,000
Cost of equity capital 15% 15%
Cost of debt Nil 10%
Market value of equity shares Rs. 20,00,000 Rs. 14,00,000
Market value of debt Nil Rs. 4,00,000
Total value of firm Rs. 20,00,000 Rs. 18,00,000

3. Two companies are identical in all aspects except in the debt-equity

profile. Company X has 14% debentures worth Rs. 25,00,000 whereas
company Y does not have any debt. Both companies earn 20% before
interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax
rate of 40% and cost of equity capital to be 22%, find out the value of the
companies X and Y using NOI approach?
4. The market values of debt and equity of a firm are Rs. 10 crore and Rs.
20 crore respectively, and their respective costs are 12% and 14%. The
overall capital is 13.33%. Assuming that the company has a 100%
dividend payout ratio and there are no taxes, calculate the net operating
income of the firm.
5. If a company has equity worth Rs. 300 lakh, debentures worth Rs. 400
lakh, and term loan worth Rs. 50 lakh, calculate the WACC.

7.8 Answers

Self Assessment Questions

1. Investment decisions, operating earnings
2. Expected future earnings, required rate of return
3. Equity debt
4. WACC, market value
5. Overall capitalisation rate
6. Arbitrage, equilibrium
7. Risk perception, convenience, transaction costs, taxes and agency
costs.
8. Arbitrage is the process of buying a security at lower price in one
market and selling it in another market at a higher price bringing about
equilibrium. Thus arbitrage process is a balancing act.
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9. Profitability, flexibility, control, and solvency.

10. Financing, firm’s

Terminal Questions
1. Assumptions of Miller and Modigliani (MM) approach: perfect capital
markets, rational behaviour, homogeneity, taxes, and dividend payout.
Refer to 7.4.4
2. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
3. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
4. Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
5. WACC = W e Ke + W p Kp +W r Kr + W d Kd + W t Kt
Hint : we =0.4; W d = 0.533; wt = 0.067

7.9 Case Study: “Capital Structure of Indian Corporate:

Changing Trends
In the review article, “Capital Structure of Indian Corporate:
Changing Trends” in ASIAN Journal of Management Research,
Mr. Ashok Kumar Panigrahi, examines the changing trend of the capital
structure financing pattern of Indian companies during pre and post
liberalised era as well as in the recent past. Following are excerpts from the
publishing. Interested students can read the entire article on
http://ipublishing.co.in/ajmrvol1no1/EIJMRS1023.pdf
Introduction
Capital structure is the combination of debt and equity that funds an
organisation's strategic plan. The "right" capital structure supports strategic
financial goals while optimising flexibility and minimising cost. Capital
structure management can be approached by answering the question,
what is the appropriate amount, mix, structure, and cost of debt and
equity to support the organisation's strategic financial goals? The proper
and strategic management of capital structure ensures access to the capital
needed to fund future growth and enhance financial performance. The key
benefits of effective capital structure management are increased capital
access, added flexibility, and lower overall cost of capital.

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A company considered too highly leveraged (too much debt versus equity)
may find its freedom of action restricted by its creditors and/or may have its
profitability hurt as a result of paying high interest costs.
Theoretically, the financial manager should plan an optimum capital
structure for his/her company. The optimum capital structure is obtained
when the market value per share is at maximum. Since a number of factors
influence the capital structure decision of a company, the judgment of
the person making the capital structure decision plays a crucial part.
Two similar companies can have different capital structures if the decision
makers differ in their judgment of the significance of various factors.
Liberalisation of economy
The government of India started the economic liberalisation policy in 1991.
Even though the power at the centre has changed hands, the pace of
the reforms has never slackened till date. Before 1991, changes
within the industrial sector in the country were modest to say the least. Post
1991, a major restructuring has taken place with the emergence of more
technologically advanced segments among industrial companies.
Nowadays, more small-scale and medium-scale enterprises contribute
significantly to the economy.
By the mid 90s, the private capital had surpassed the public capital.
The management system had shifted from the traditional family based
system to a system of qualified and professional managers. One of the most
significant effects of the liberalisation era has been the emergence of
a strong, affluent, and buoyant middle class with significant purchasing
power, and this has been the engine that has driven the economy since.
Capital structure of Indian corporate before liberalisation
Studies on capital structure of Indian industries are inconclusive and often
conflicting. A study by Sharma and Rao (1968) on 30 engineering firms for 3
years concludes that debt due to its tax deductibility is a prominent
determinant of the cost of capital. A study by I. M. Pandey (1981) on cotton
textiles, chemicals, and engineering and electricity generations lends
support to the traditional approach. Bhatt (1980) in his paper concludes
that the leverage ratio is very much influenced by business risks measured
in terms of variability in earnings, profitability, debt service capacity, and
dividend payout ratio. I. M. Pandey (1984) in another study found

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that during 1973-81 about 80% of the assets of the companies sampled
were financed by external debt and current liabilities. Large-sized
companies were more levered though a large number of small firms also
courted more debt capital. Leverage did not exhibit a definite relationship
with growth and profitability, although all the three variables moved in the
same direction. He also found that a majority of the profitability and growth-
oriented companies were within the narrow bands of leverage.
Before 1980s, Indian financial managers courted debt due to its low cost,
tax advantages, and the complicated procedures to be observed in
garnering equity capital. The substitutability of short-term debt for long-term
loan was another attraction. However, with the waves of liberalisation,
privatisation, and globalisation sweeping the capital market in recent years,
the corporate world has started wooing equity capital in a big way. The
arrival of a matrix of new financial instruments such as commercial papers,
asset securitisation, factoring and forfeiting services, and the market related
interest rate structure and their stringent conditions for lending, force
modern enterprises to court equity finance.
Of different sources, bank credit has been working since long as a major
source of working capital in India and abroad. Long-term borrowings like
debenture, institutional loan, and government loan have also contributed to
working capital financing, since a part of current assets is usually
covered by long-term funds. Another viable source of working capital is
trade credit, which is considered to be a formality free, security free,
and interest free source of finance.
Impact of liberalisation on capital structure of Indian corporate
Until the early nineties, corporate financial management in India was
a relatively drab and placid activity. There were not many important financial
decisions to be made for the simple reason that firms were given very
little freedom in the choice of key financial policies. The government
regulated the price at which firms could issue equity, the rate of interest
which they could offer on their bonds, and the debt-equity ratio that was
permissible in different industries. Moreover, most of the debt and
a significant part of the equity were provided by public sector institutions.
The liberalisation changed all of this. The corporate sector was exposed to
international competition and subsidised finance gave way to a regime of

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high real interest rates. Consequently, the post-liberalised era has started
observing the following changes in the sources of Industrial finance:
 Domestic capital formation – It was envisioned that increased capital
formation would contribute for more industrial output and a 'virtuous
circle' of growth. Gross Capital Formation (GCF) is estimated across
three types of assets, viz, construction, machinery, and equipment.
The GCF, adjusted for errors and omissions, is termed as aggregate
investment or Gross Domestic Capital Formation (GDCF). A
positive association is hypothesised between the capital formation
and the industrial production.
 Foreign direct investment – A few decades ago, many countries
considered FDI as the source of economic imperialism, but things are
quite different now. The argument is that FDI contribute to the growth of
host economies in many ways. For example, physical capital formation,
technology transfer, human formation, stimulation of productivity,
augmentation of output, promotion of foreign trade, and improvement of
competitiveness of indigenous entrepreneurs.
As part of the economic reforms introduced in 1991, in the wake of
a sharp external payments crisis, policies relating to foreign investment
and foreign technology agreements were radically changed.
 Primary issues in the capital market - With the liberalisation of the
Indian economy since 1991, the government has provided a number of
additional fiscal and other incentives to foster capital market
development. The magnitude of growth has been rapid and vivid in terms
of fund mobilised, the amount of market capitalisation, and the
expansion of investor population. The Indian market was opened up for
investment by the Foreign Institutional Investors (FIIs) in September
1992, and the Indian companies were allowed to raise resources abroad
through Global Depository Receipts (GDR) and Foreign Currency
Convertible Bonds (FCCB).
 Bank credit – Banks are the dominant financial intermediaries in
developing countries including India. Bank credit is considered as an
important source of industrial finance. The dependence on bank for
finance could vary according to the size of the companies. The small-
scale industrial units have increased their dependence on banks for
loans because they have virtually no access to the capital markets.

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The financial sector reforms, based on working committee reports were

mainly aimed to provide credit to the industrial sector by reducing
the cash reserve ratio and statutory liquidity ratio. The liberalisation
policy also called for increased efficiency of commercial banks by
encouraging them to compete in the market. The public sector banks
were given autonomy to frame their policies including interest rate
fixation. It may be noted that the bank credit to the industrial sector has
not increased during the post-reform period in spite of the various
attempts.
Capital structure of Indian corporate after liberalisation
Capital structure management has been impacted by a number of
developments discussed above. Some of the important implications of
these changes for short-term financial management in the Indian corporate
sector are:
a) Creditworthiness – The abolition of the notion of maximum permissible
bank finance has given banks greater freedom and responsibility for
assessing credit needs and creditworthiness.
b) Choice – Top notch corporate borrowers are seeing a plethora of
choices. The disintegration of the consortium system, the entry of term
lending institutions into working capital finance, and the emergence of
money market borrowing options gives them the opportunity to
shop around for the best possible deal.
c) Maturity profile – The greater concern for interest rate risk makes
choice of debt maturity more important than before. Short-term
borrowings expose borrowers to rollover risk and interest rate risk.
d) Cash management – Companies now have to decide on the optimal
amount of cash or near-cash that they need to hold and also on how
to deploy the cash. Deployment, in turn, involves decisions
about maturity, credit risk, and liquidity.

Capital structure of Indian companies in the recent past

 Indian corporate employs substantial amount of debt in their capital
structure in terms of the debt-equity ratio as well as total debt to total
assets ratio.

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 The corporate enterprises in India seem to prefer long-term borrowings

over short-term borrowings.
 As a result of debt-dominated capital structure, the Indian corporate
is exposed to a very high degree of total risk. It is reflected in high
degree of operating leverage and financial leverage. Consequently, it is
subject to a high cost of financial distress which includes a broad
spectrum of problems ranging from relatively minor liquidity shortages to
extreme cases of bankruptcy.
 Retained earnings are the most favoured source of finance.
 Loan from financial institutions and private placement of debt are the
next most widely used sources of finance.
 The hybrid securities are the least popular source of finance amongst
corporates in India.
 Equity capital as a source of fund is not preferred across the board.
 To sum up, nature of the industry to which the firm belongs to, its size,
age, and location plays a major role in the determination of the capital
structure of the private sector firms of Indian corporate.
[Source: ASIAN JOURNAL OF MANAGEMENT RESEARCH,
Online Open Access publishing platform for Management Research –
Capital Structure of Indian Corporate: Changing Trends by
Ashok Kumar Panigrahi
Discussion Questions:
1. How do you think the trend of capital structures across the Indian
corporates affect the economy as a whole?
(Hint: factors affecting capital structure)
2. The author, in his study, has found that corporates are increasingly going
in for debt-dominant structures. Why do you think that is?
(Hint: debt is cheap)
3. There are various approaches that examine the relationship between
financial leverage and a firm’s value. We have seen the important ones,
the NI approach, the NOI approach, the traditional approach, and the
MM approach. If you were to argue in support of any one of these in the
background of the Indian scenario, which one would you pick and why?
(Hint: Theories of Capital Structure)

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(http://ipublishing.co.in/ajmrvol1no1/EIJMRS1023.pdf)]

Reference:
 Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.
 Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition

E-Reference:
 http://ipublishing.co.in/ajmrvol1no1/EIJMRS1023.pdf retrieved on
11/12/2011
 Egyankosh.ac.in
 Igidr.ac.in

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