CAPITAL STRUCTUREDECISIONS
Capital Structure rotors to tho proportion of dobt and oquity in tho tolal cupltal of tho Comparny, Thio daGOKO
S COncetned with the Debt Equity Mix. Thoro is a judicious combination of dobt and oquity, whvich mirnirnizns
the cost of capital and incroasos tho total valuo of tho fin (optimun capital otructuro), In practic0, n s
Oticut to design an optimum capital structuro. At tho most, ono can only attompt to dosign ong.
Factors affecting capital structuro
Protitability aspect - A good capital stucturo ohould contritbuto to tho profitability of tho cornpany.
The tBn-EPS analysis shows tho impact of varioun financlng options (dobt oquity rnix)
Vafious lovels of EBIT, A Company which has dobt in tho capital struoturo ls said to be trading on
on EP& at
Quity t the rotum on the invostment is groator than tho cost of dobt. This incroasos tho roturn
avalade to sharoholdors. Tho bonefit of trading on oquity la found even if Proference Capital is
used, but the benetit is groator if dobt is usod, duo to the fact that dobt is cheapor than Praforonco
Shares and due to the tax benofit rosulting frorm intorost paymonts on dobt. If however, the ratg of
tetun on investment is loss than the cost of dobt, tho uso of dobt in the capital structure will reducy
EPS It theretore stands to reason that thoro is a partlcular lovel of EBIT, at which the EPS would be
the same, whatover bo the mothod of financing used (indifforonco point EBIT)
Trading on equity is subject to the following limitation:
a) it is possible only when the rate of roturn and capital ornployed is more than the rate of
intetest on borrowed funds or dividend on prelorenco shares
b) Trading on equity is benoticial only for companios which have stability of earnings since
both, interest and preference dividend impose a recurring burden on the company.
c)Every rupee borrowed increases the risk and hence the rate of interest expected by
Sbbsequent lenders increase. Thus borrowings become costlier, which ultimately reduces
the profit available for equity shareholders.
2
Liquidity aspect It
may be possible that the company's EBIT is adequate to cover its
commitments arising out of debt obligations, but the firm may not have sufficient cagh to pay, as its
specific
intome is locked up in inventory, receivables, etc. In the absence of cash inflows, a Company which
s othenvise protiiaoiy souna, wouid in case ui úeiauii un intu diicuities (problorns rcouing rom
failure to pay interest and return the principal).
Control-t the Management is anxious to retain control of the organization, they would ike to have
more of debt and Preference shares, when additional capital is required, since by obtaining funds
from such sources, Management does not sacrifice control.
. Nature of the industry:
Fims whose sales fluctuate widely should employ less debt concumer durables.
Fms aeaingun non-durable consumergoods- items with inelastic.demand.can raly-more ondebt
Firmsoperating in aheary-cempetitive industry rely more on equity.
Public utilities (transport, electricity etc.) which are relatively free from competition can use more
debt.
Firms in the infancy stage of their life cycle, rely more on
equity. As the firm grows and reachess
maturity more debt can be employed.
Capital Market considerations - 1The type of securities investors are prepared to buy is an
inportant factor in determining the type of securities to be issued.
6. Maintaining flexibility Flexibility refers to the firm's ability to adjust its source of funds in either
-
direction- increase or decrease in response to changes in the need of funds. While designing thee
capital structure, the firm should not lose sight of the future impact on the present financial plan: E.g.
if the firm has exhausted its debt capacity, it may be forced to issue
Equity shares for future financing
on unfavorable terms due to too heavy debt. Hence the firm must
always
maintain some unused
debt capacity for future needs.
Fleribility should be there for not only obtaining funds, but also for refunding them. To provide for
desired flexibility the firm may include a clause which provides for repayment of the loan at the
discretion of the borrower. This can be oblained only at a higher cost for the funds borrowed. The
Finance Manager thus faces the task of a "risk-return trade off. He has to assure himself that he is
not buying flexibility at a higher cost than what is warranted by the gains achieved through flexibility.
7. Timing of issuo Public offoring shoukd be mado at a timo whon tho stato of the oconomy as well
as the capital market is ideal to provide funds I tho Managoment fools that tho intorost rato will risa
in the tuture, it may use the benefit of dobt immodiatoly. If intorost ratos aro oxpoc d to fall in future,
borrowing may be postoned
Tax Planning under the income tax act, interest on borrowed funds is allowod as a deduction,
whereas, divisend paid is not deductible. Howover, paymont of dividond by the Company would
invohve a 10% tar on the amount paid.
Cost of raising finance through borrowing is deductible in the yoar it is incurred f however,
borrowng is made before commencement of business it has to be capitalizod.
Cost of issue of shares is allowed as a deduction over 5 years.
Legal framework - long term loans are available only on security of asseis. However, debentures
can be issued as secured or unsecured. It Debentures are issued redeemable after 18 month, credit
rating is required as per SEBI noms. Approval of SEBI is required for raising funds from the capital
market, whereas, no such approval is required if loans are borrowed from financial institutions.
10 Agency cost since equity shareholders control the firm's management and decision making. their
terests will dominate the interest of debenture holders. To protect their interests debenture holders
may incude certain conditions in the loan agreement, such as
a) their representative on the Board of Directors
b)appointment of Debenture Trustees
c)maximum dividend the Company can pay
intensive intemal control
Regular follow up and reporting
Conclusion:
There is no standard capita! structure (debt equity mix) which will be suitable for all the firms and all
situations. Some of the factors discussed above are conflicting in nature. The determination of the
most suitable debt equity mix is affected by characteristics of suitability, risk, control, flexibility and
timing. The relative weights assigned to these factors will vary widely from company to company
depending on the general economic conditions, the characteristics of the industry, tax implications
and the particular position of the company.
PROBLEMS ON FINANCING OPTIONS
1. A Ltd requires Rs.5,00,000 for construction of a new plant. It has identified the following three
financing options:
a) issue 50,000 equity shares at Rs.10 each.
b) Issue 25,000 equity shares at Rs.10 each and 2,500 10% debentures of Rs.100 each.
c) Issue 25,000 equity shares at Rs.10 each and 2,500 12% Preference shares of Rs.100o
each.
Assuming EBIT after construction is Rs.1,00,000 which alternative would you recommend? Tax
rate is 50%.
2. The eristing capital structure of X Ltd. is as follows:
Eguity shares of Rs.100 each Rs.40,00,000
Retained earnings Rs.10,00,000
9% Preference shares Rs.25,00,000
7% debentures Rs.25,00,000
The eisting rate of return on the company's capital employed is 12% and the tax rate 50%. The
company requires a sum of Rs.25,00,000 to finance its expansion program, for which it is
considering the follovwing options;
of Rs.25 per share.
a) lesue 20,000 equity shares at a pronium
b) lssue 10% Preference shares,
c)Issue 8% debentures
It is estimated that the Price Earnings Ratio (P/E) In the abovo throo financing options would ba
rocommend.
20, 17 and 16 reopectivcly, whlch option would you
t is estimated that tha Prica Earnings Ratio P/E)In the above threo financing options would be
20, 17 and 16 respectively, whlcl optlon would you recommend.
3. The following figures of K Ltd aro givon to you:
Rs
EBIT 23,00,000
Lessdebenture Interest 8% 80,000
Loan interest 11% 2,20,000 3.00.000
EBT 20,00,000
Less tax 10.00.000
EAT 10.00.000
Number of equity shares Rs.10 each 5,00,000
EPS 2
Market price per share 20
PEratio 10
The company has undistributed roservos of Rs.20,00,000. It is in need of Rs.30,00,000 to pay
off debentures and modemize the plant.Ithasldentified the following financial options:
a) Raise a term loan at 12%
b) Issue1,00,000 equity share al Rs.20 each and a 12% lerm loan for the balance.
The Company expects to increase lts rate of return by 2% as a result of modernization, but the
PE ratio is tikely to reduce to 8 If the entlre amount is raised to the term loan.
Advise the compàny.
A new project under consideration requires a capital outlay of Rs.300 lakhs. The requred funds
can be raised either fully by equlty shares of Rs.100 each or by the equity shares of the value
of Rs.200 lakhs and a 15% loan of Rs.100 lakhs. Assuming the tax rate is 50%, calcutate the
EBIT level at which investors would be indifferent to the two options.
5. A Ltd. provides you with the following data
Rs.
EBIT 3,00,0000
LEdhontra
E8T
interest@12% 60.000
2,40.000
Less
EAT
ie 1.20.000
Number of equity shares Rs.10 each 40,000
EPS 3
Market price per share 30
P/E ratio 10
The Company has undistribufed reserves of Rs:6 lakhs, The Company needs Rs.2 lakhs for
expansion. This amount will eam the same rate on funds employed as at present(You are
infommed that a debt equity ratlo (debt/debtplus.equity) higher than 35% will reduce the P/E ratio
to 8 and raise the interest rate on addtlonalfunds borrdwed to 14%Advise the company if they
plan to raise the funds elther a) debt or (b)equity at Rs.10 premium.
The following data is given to you for year ending 31 March 2001.
6 Rs.
EBIT 18,00,000
Less: Interest debeDtures
on secured
15% p.a. (Oebenture Issued on 1/7/2000) 1.12.500
EBT 16,87,500
Less: Income tax 35% and dividend
Distribution tax 8.43,750
EAT 843,750
Number of equity shares Rs.10 each 1,00.000
8.44
EPS
Market price per share 109.70
3
The
Compamy has accumuiated reserves Rs. 1lakhs The Cornpany is examining a project
reguiring en investment of Rs. 10 lakhs which will eatn the sarne rate of return as on exisling
unds A debt eguity 1atio (debt
S% and the interesl on addiional
debtequity) higher than 60% will decrease the PIE ralio by
borrowing s will cost the Cornpany 300 basio points (i.e.3%)
more than the cument
borrowing on secursd debentures. Advise the Company If it plans to raise
tunds through (a) loans (b)
equily share issued at a premium of
Rs.90/-
ABCLdolans tc epand assets by 50% lo finance the expansion. It plans to choose betwaen
BAraght 12% dett issue and equity shares. Its Balance sheet and Profit and Loss a/c are as
follows
Balance Sheet:
Rs Rs.
Equlty capital (Rs.10) 100,00,000 Tolal assots 200,00,000
Retained earnings 60,00,000
11% debenture
Profit&Loss Ac:
40,00,000
2 000 Ooa
Rs
Saies G00,00,000
Less cost (excluding inlerest) 54000.00
EBIT 60,00,000
Les
EBT
interest on 11% Debenture 440.000Q
55,60,000
ess tax 50% 27.80000
EPS 2.78
PIE 7.5
tMarket price
ouia ba12% and the P/IE ratio would be 5. If equity is
used the shares can be sold at
Rs,12.50 per share and the PIEralio will be 75, tmes.
) Assuming the sales after expar.slon would be Rs.10 crores and the rate of EBIT on sale
would remain the same as at present; calculate the EPS and the
market price of the share
under the two options.
b)Also calculate the Indifferent point EBIT under the two options.
8 A LId. wants to implement
plans ere ldentified:
a
project for which Rs.30 lakhs is needed. The
folowing financing
PA
(Rs.) (Rs (Rs.)
Option :Equty shares (Rs.100) 30 lakhs 30 laKhs 30 lakhs
Option I1: Equty shares (Rs.100
15lakhs 20 lakhs
10 lakhs
12% Pref.shares (Rs.100) 10 lakhs
10 lakhs
10%Debentures(Rs.100) 15 lakhs 10 lakhs
Calculate the EBTI at the indifference point for each financing plan. Assume 50% tax.
R Ltd is curreny generatng of Rs.60
EBI
an lakhs. lts current
against an equal equity leve' Its interestrale on borrowings is 15%. borrowings
are Rs.120 lakhs
I is planning to Install a new machlne which will lnmprove the operating profit by/Rs.20 lakhs and
vill cost Rs.85 lakhs. The bankers have, specified hal the Debt
Equity Ratio cannot increase
beyond 11:1 and the interest coverage should be a least three times
(a) How much maxdnun can the company raise in this context?
(U) If the promoters are prepared to invest only Rs.30 lakhs in this poject, how much
incfemental operating protit would bg iquired trOin Uhe new project so that the bankers can
lend the batance fund required7
