Introduction

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. With the objective of maximizing the value
of the equity shares, the choice should be that pattern of using debt and equity in a proportion
that 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 will maximize 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 EPS.

Features of an Ideal Capital Structure

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

· Flexibility: It 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 moneys 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, no restrictions placed
on the assets usage or laying a restriction on early repayments. In other words, the finance
authorities should have the power to take decisions on the basis of the 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 are to be avoided however
attractive some investment proposals look. Some companies resort to issue of equity shares to
repay their debt for equity holders do not have a fixed rate of dividend.

Factors Affecting Capital Structure

Leverage: The use of fixed charges sources of funds such as preference shares, loans from
banks and financial institutions and debentures in the capital structure is known as “trading
on equity” or “financial leverage”. 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 SSI. 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. 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 a healthy ratio, but it is not always a hard and fast rule
that this standard is insisted upon. A ratio of 1.5:1 is considered good for a manufacturing
company while a ratio of 3:1 is good for heavy engineering companies. It is generally
perceived that lower the ratio, 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. 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, for 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
flows 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 after 2 years.

· Size of the company

· Dilution of control – The top management should have the entire flexibility to take
appropriate decisions at the right time. The capital structure planned should be one in this
direction.

· Floatation costs – 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 taken.

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. 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 pay-out 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 decline.

· 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 occurrence of transaction
costs.

· The life of the firm is indefinite.

Based on the above, we derive the following:

1. Debt capital being constant, Kd is the cost of debt which is the discount rate at which
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

2. 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.

3. 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.

4. The net operating income being constant, overall cost of capital is represented as K0 =
W1K1 + W2K2.

That is, K0 = (B/V)K1 + (S/V)K2 where B is the total market value of the debt, S market
value of equity and V total market value of the firm (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.

Net Income Approach

This theory is suggested by Durand and 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 WACC declines and market value of firm increases. The
NI approach is based on 3 assumptions – no taxes, cost of debt less than cost of equity and
use of debt does not change the risk perception of investors.

We know that K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

The following graphical representation of net income approach may help us understand this
better.
Net Operating Income Approach

This theory is again propounded by Durand and is totally opposite of the Net Income
Approach. He says 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 capitalization rate is the
same for all degrees of leverage.

As per the NOI approach the overall capitalization rate remains constant for all degrees of
leverage. The market values the firm as a whole and the split in the capitalization 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.

Cost of debt: The cost of debt has two parts – explicit cost and implicit cost. Explicit cost is
the given rate of interest. The firm is assumed to borrow irrespective of the degree of
leverage. This can mean that the increasing proportion of debt does not affect the financial
risk of lenders and they do not charge higher interest. Implicit cost is increase in Ke
attributable to Kd. Thus the advantage of use of debt is completely neutralized by the implicit
cost resulting in Ke and Kd being the same.

Graphically this is represented as:

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, Ko decreases till a certain level, remains

constant for moderate increases in leverage and rises beyond a certain point.

Graphically, we can represent these as under:

Miller and Modigliani Approach

Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a
reasonable limit and Ko being constant at all degrees of leverage. They state that the
relationship between leverage and cost of capital is elucidated as in NOI approach. The
assumptions for their analysis are:

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

· Investors behave rationally, that is, they choose that combination of risk and return that is
most advantageous to them.

· Homogeneity of investors risk perception, that is, all investors have the same perception of
business risk and returns.

· Taxes: There is no corporate or personal income tax.

· Dividend pay-out is 100%, that is, the firms do not retain earnings for future activities.

Basic propositions: The following three propositions can be derived based on the above
assumptions:

Proposition I: The market value of the firm is equal to the total market value of equity and
total market value of debt and is independent of the degree of leverage. It can be expressed
as:

Expected NOI

Expected overall capitalization rate

V + (S+D) which is equal to O/Ko which is equal to NOI/Ko

V + (S+D) = O/Ko = NOI/Ko

Where V is the market value of the firm,

S is the market value of the firm’s equity,

D is the market value of the debt,

O is the net operating income,

Ko is the capitalization rate of the risk class of the firm.

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. 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 identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalization rate)
applicable plus a premium.

Ke = Ko +[(Ko—Kd)D/S]

Proposition III: The average cost of capital is not affected by the financing decisions as
investment and financing decisions are independent.

Criticisms of MM Proposition

Risk perception: The assumption that risks are similar is wrong and the risk perceptions of
investors are personal 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 levered firm becomes bankrupt but an investor loses not only
his shares in a company but would also be liable to repay the money he 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 subject 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.

Taxes: When personal taxes are considered along with corporate taxes, the Miller and
Modigliani approach fails to explain the financing decision and firm’s value.

Agency costs: A firm requiring loan approach 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 pay-outs, limiting further issue of capital, limiting new investments or expansion
schemes etc.