Financial management 2

Capital structure, Capitalisation, Capital Structure Theories.

1. Unit II Financial Management Capital Structure Planning : capitalization Concept, Basis of capitalization, consequences and remedies of over and under capitalization, Determinants of Capital structure, Capital structure theories Prepared by:- Dr. Waqar Ahmad Asstt . Professor Allenhouse Business School

2. Capital Structure is the proportion of debt and preference and equity shares on a firm’s balance sheet. The term ‘structure’ means the arrangement of the various parts. So capital structure means the arrangement of capital from different sources so that the long-term funds needed for the business are raised. Thus, capital structure refers to the proportions or combinations of equity share capital, preference share capital, debentures, long-term loans, retained earnings and other long-term sources of funds in the total amount of capital which a firm should raise to run its business .

3. Capital Structure Planning The capital structure of a company is made up of debt and equity securities that comprise a firm’s financing of its assets. It is the permanent financing of a firm represented by long-term debt, preferred stock and net worth. So it relates to the arrangement of capital and excludes short-term borrowings. It denotes some degree of permanency as it excludes short-term sources of financing. “ Capital structure is essentially concerned with how the firm decides to divide its cash flows into two broad components, a fixed component that is earmarked to meet the obligations toward debt capital and a residual component that belongs to equity shareholders ”-P. Chandra. .

4. Importance of Capital Structure: The importance or significance of Capital Structure Value Maximization Cost Minimization Increase in Share Price Investment Opportunity Growth of the Country Patterns of Capital Structure

5. Capital Structure Planning cont.. Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, prefer­ence share capital and shareholders’ funds.

6. Factors Determining Capital Structure: Risk of cash insolvency Risk in variation of earnings Cost of capital Control Trading on equity Government policies Size of the company Needs of the investors 9. Flexibility 10.Period of finance 11. Nature of business 12. Legal requirements 13. Purpose of financing 14. Corporate taxation 15. Cash inflows 16. Provision for future 17. EBIT-EPS analysis

7. Capitalization Capitalization is an important constituent of financial plan in common parlance, the phrase ‘capitalization’ refers to total of all kinds of long term securities at their par values.

8. Basis of capitalization One of problems facing the financial manager is determination of value at which a firm should be capitalized because it have to raise funds accordingly there are two theories that contain guidelines with which the amount of capitalization can be surmised

9. Cost Theory of Capitalization According to this theory capitalization of a firm is regarded as the sum of cost actually incurred in setting of the business. A film needs funds to acquire fixed assets, to defray promotional and organizational expenses and to meet current asset requirements of the enterprise sum of the costs of the above asset gives the amount of capitalization of the firm, acquiring fixed assets and to provide with necessary Working capital and to cover possible initial losses, it will capitalized Under this method more emphasis is laid on current investments. They are static in nature and do not have any direct relationship with the future earning capacity. This approach givens as the value of capital only at a particular point of time Which Would not reflect the future changes.

10. Earning Theory of capitalization According to this theory, firm should be capitalized on the basis of its expected earning A firm’s profit is seeking entity and hence its value is determiner according to what it earns. The probable earning are forecast and they are capitalized at a normal representative rate of return. Capitalization of a company as per the earning theory can thus be determined with help following formula. Capitalization = Annual Net Earnings X Capitalization Rate

11. Consequences (or Effect of Over-Capitalisation ) Consequences of Over-Capitalisation could be described, in the following Analytical Manner: (1 ) Consequences for the Company: ( i ) An unsatisfactory rate of return on the equity leads to a poor market value of the company’s shares. There is thus, considerable loss of goodwill to the company. (ii) Investors ’ confidence in the company is lost; as to them, the future of the company seems to be gloomy and uncertain. (iii) There is usually, unhealthy speculation, in the shares of an over-capitalised company; which, in turn, brings a bad name to the company .

12. (2) Consequences for the Members: ( i ) Members of the company are losers; as the dividend payable to them is both reduced an uncertain, and There is a capital loss to the members; as a result of the poor market value of their shares. (3) Consequences for the Workers: ( i ) Because of reduced profitability, workers might be required to suffer a cut in their wages. (ii) If an over-capitalised company is liquidated untimely due to this financial disease; workers lose their employment.

13. (4) Consequences for the Society: ( i ) The poor functioning of an over-capitalised company implies wastage of nation’s precious economic resources; as the same amount of resource might be profitably employed elsewhere, to produce more. Closure of an over-capitalised company hits the society adversely; in terms of loss of production, generation of unemployment, etc.

14. Remedies for Over-Capitalisation: The only effective remedy to cure over-capitalisation lies in implementing a scheme of a capital reduction. Under the scheme of capital reduction, there might be: ( i ) A reduction in the rate of interest payable on debentures ( or other types of loans) (ii) A reduction in rate of preference dividend. (iii) A reduction in the paid-up value of shares-equity or preference or both. For example a share of the paid- up value of Rs.10 might be reduced to a share with a paid-up value of Rs. 5 or Rs. 3.

15. Remedies for overcapitalization Restructuring the firm is to be executed avoid the situation of company becoming sick. It involves 1. Reduction of debt burden 2. Negotiation with term lending institutions for reduction in interest obligation. 3. Redemption of preference share through a scheme of capital reduction. 4. Reducing the face value and paid-up value of equity shares. 5. Initiating merger with well managed profit making companies interested in talking over ailing company .

16. Undercapitalization Under-capitalization is just the reverse of over-capitalization. A company is considered to be under-capitalized when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity.

17. Causes of under- capitalization Under estimation of future earnings of the time of promotion of the company. Abnormal increase in earnings from new economic and business environment. Under estimation of total funds requirements. Maintaining very high efficiency through improved means of production of goods or rendering of services. Companies which are set up during recession start making higher earning capacity as soon as the recession is over. Use of low capitalized rate. Companies which follow conservative dividend policy will achieve a process of gradually rising profits. Purchase of assets at exceptionally low prices during recession .

18. Remedies of undercapitalization Splitting up at the shares – This will reduce the dividend per share Issue of bonus share: this will reduce both the dividend per share and earning per share. Both over-capitalization and under – capitalization are detrimental to the interests of the society.

19. Determinants of Capital structure Financial Leverage or Trading on Equity: Growth and Stability of Sales Cost of Capital Risk Cash Flow Nature and Size of a Firm Capital Market Conditions (Timing) Control Flexibility Requirement of Investors Marketability: Inflation Floatation Costs Legal Considerations

20. Theories of Capital structure A number of theories explain the relationship between cost of capital, Capital structure and value of the firm. They are: Net income approach (NIA) Net operating income approach (NOIA) Traditional approach (TA) Modigliani-Miller approach (MMA)

21. Theories of Capital structure A) Net Income Approach (NI)

22. Capital Structure Theories – A) Net Income Approach (NI) Net Income approach proposes that there is a definite relationship between capital structure and value of the firm. The capital structure of a firm influences its cost of capital (WACC), and thus directly affects the value of the firm. NI approach assumptions – NI approach assumes that a continuous increase in debt does not affect the risk perception of investors. Cost of debt ( K d ) is less than cost of equity ( K e ) [i.e. K d < K e ] Corporate income taxes do not exist.

23. Capital Structure Theories – A) Net Income Approach (NI) As per NI approach, higher use of debt capital will result in reduction of WACC. As a consequence, value of firm will be increased. Value of firm = Earnings WACC Earnings (EBIT) being constant and WACC is reduced, the value of a firm will always increase. Thus, as per NI approach, a firm will have maximum value at a point where WACC is minimum, i.e. when the firm is almost debt-financed.

24. Capital Structure Theories – A) Net Income Approach (NI) As the proportion of debt (K d ) in capital structure increases, the WACC (K o ) reduces.

25. Capital Structure Theories – A) Net Income Approach (NI)

26. Theories of Capital structure B) Net Income Operating Approach (NI)

27. Capital Structure Theories – B) Net Operating Income (NOI) Net Operating Income (NOI) approach is the exact opposite of the Net Income (NI) approach. As per NOI approach, value of a firm is not dependent upon its capital structure. Assumptions – WACC is always constant, and it depends on the business risk. Value of the firm is calculated using the overall cost of capital i.e. the WACC only. The cost of debt (K d ) is constant. Corporate income taxes do not exist .

28. Capital Structure Theories – B) Net Operating Income (NOI) NOI propositions (i.e. school of thought) – The use of higher debt component (borrowing) in the capital structure increases the risk of shareholders. Increase in shareholders’ risk causes the equity capitalization rate to increase, i.e. higher cost of equity (K e ) A higher cost of equity (K e ) nullifies the advantages gained due to cheaper cost of debt (K d ) In other words, the finance mix is irrelevant and does not affect the value of the firm.

29. Capital Structure Theories – B) Net Operating Income (NOI) Cost of capital (K o ) is constant. As the proportion of debt increases, (K e ) increases. No effect on total cost of capital (WACC)

30. Capital Structure Theories – B) Net Operating Income (NOI)

31. Theories of Capital structure C) Modigliani – Miller Model (MM)

32. Capital Structure Theories – C) Modigliani – Miller Model (MM) MM approach supports the NOI approach, i.e. the capital structure (debt-equity mix) has no effect on value of a firm. Further, the MM model adds a behavioural justification in favour of the NOI approach (personal leverage) Assumptions – Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are infinitely divisible. Investors can borrow without restrictions at par with the firms. Investors are rational & informed of risk-return of all securities No corporate income tax, and no transaction costs. 100 % dividend payout ratio, i.e. no profits retention

33. Capital Structure Theories – C) Modigliani – Miller Model (MM) MM Model proposition – Value of a firm is independent of the capital structure. Value of firm is equal to the capitalized value of operating income (i.e. EBIT ) by the appropriate rate (i.e. WACC ). Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt = Expected EBIT Expected WACC

34. Capital Structure Theories – C) Modigliani – Miller Model (MM) MM Model proposition – As per MM, identical firms (except capital structure) will have the same level of earnings. As per MM approach, if market values of identical firms are different, ‘ arbitrage process ’ will take place. In this process, investors will switch their securities between identical firms (from levered firms to un-levered firms) and receive the same returns from both firms.

35. Capital Structure Theories – C) Modigliani – Miller Model (MM) Levered Firm Value of levered firm = Rs. 110,000 Equity Rs. 60,000 + Debt Rs. 50,000 K d = 6 % , EBIT = Rs. 10,000, Investor holds 10 % share capital Un-Levered Firm Value of un-levered firm = Rs. 100,000 (all equity) EBIT = Rs. 10,000 and investor holds 10 % share capital

36. Capital Structure Theories – C) Modigliani – Miller Model (MM)

37. Theories of Capital structure D) Traditional Approach

38. Capital Structure Theories – D) Traditional Approach The NI approach and NOI approach hold extreme views on the relationship between capital structure, cost of capital and the value of a firm. Traditional approach ( ‘intermediate approach’ ) is a compromise between these two extreme approaches. Traditional approach confirms the existence of an optimal capital structure; where WACC is minimum and value is the firm is maximum. As per this approach, a best possible mix of debt and equity will maximize the value of the firm.

39. Capital Structure Theories – D) Traditional Approach The approach works in 3 stages – Value of the firm increases with an increase in borrowings (since K d < K e ). As a result, the WACC reduces gradually. This phenomenon is up to a certain point. At the end of this phenomenon, reduction in WACC ceases and it tends to stabilize. Further increase in borrowings will not affect WACC and the value of firm will also stagnate. Increase in debt beyond this point increases shareholders’ risk ( financial risk ) and hence K e increases. K d also rises due to higher debt, WACC increases & value of firm decreases.

40. Capital Structure Theories – D) Traditional Approach Cost of capital (K o ) is reduces initially. At a point, it settles But after this point, (K o ) increases, due to increase in the cost of equity. (K e )

41. Capital Structure Theories – D) Traditional Approach

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