Capital structure and approaches to capital structure

ceiling bodily building and approaches to jacket crown organiseIt is defined as the meld or proposition of a homes permanent long-term financing represented by debt, preference stock, and common stock rightfulness.Capital structure theory suggests that steadfasts model what is often referred to as a target debt ratio, which is based on various tradeoffs between the exists and benefits of debt versus virtue.The term smashing structure refers to the percentage of gravid ( gold) at work in a business by type. Broadly speaking, at that place atomic number 18 dickens forms of upper persona integrity groovy and debt smashing. Each has its own benefits and drawbacks and a substantial part of wise corpo array stewardship and management is attempting to find the perfect upper-case letter structure in toll of risk / reward payoff for shargonholders. This is unfeigned for Fortune 500 companies and for small business owners trying to determine how much of their startup m unrivalledy should come from a bank loan without endangering the businessLets relish at each in detail integrity CapitalThis refers to money put up and owned by the sh atomic number 18holders (owners). Typically, fair play superior consists of two types 1) contributed expectant, which is the money that was originally invested in the business in exchange for sh ares of stock or ownership and 2) bear meshwork, which represents profits from past years that save been kept by the corporation and used to strengthen thebalance sheetor fund growth, acquisitions, or expansion.Many consider equity capital to be the most dear(predicate) type of capital a company can utilize because its live is the return the firm essential earn to attract investment. A speculative excavation company that is looking for silver in a remote region of Africa may require a much higherreturn on equityto get investors to purchase the stock than a firm such as Procter Gamble, which sells everything from t oothpaste and shampoo to detergent and beauty products.Debt CapitalThe debt capital in a companys capital structure refers to borrowed money that is at work in the business. The safest type is generally considered long-term bondsbecause the company has years, if non decades, to come up with the principal, while paying cheer lone(prenominal) in the mean measure. new(prenominal) types of debt capital can include short-term commercial paper utilized by giants such as Wal-Mart and General voltaic that amount to billions of dollars in 24-hour loans from the capital merchandises to meet day-to-day working capital requirements such as payrolland utility bills. The embody of debt capital in the capital structure depends on the health of the companys balance sheet a triple AAA measured firm is going to be able to borrow at exceedingly low rank versus a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital.Other Forms of CapitalThere are actually other forms of capital, such asvendor financingwhere a company can sell goods forwards they have to pay the bill to the vendor, that can drastically subjoin return on equity but dont hail the company anything. This was one of the secrets toSam Waltons success at Wal-Mart. He was often able to sell Tide detergent before having to pay the bill to Procter Gamble, in effect, using PGs money to grow his retailer. In the solecism of an insurance company, the policyholder float represents money that doesnt belong to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes mickle to the talent and discipline of managers.SEEKING THE OPTIMAL uppercase STRUCTUREMany middle class individuals believe that the goal in life is to be debt-free. When you chain the upper ech elons of finance, however, that idea is almost anathema. Many of the most successful companies in the world base their capital structure on one simple consideration the cost of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in shopping mall operations at 15%, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure.Of course, how much debt you take on comes down to how secure the revenues your business generates are if you sell an indispensable product that people simply must have, the debt pass on be much lower risk than if you operate a theme park in a tourist town at the height of a pick up mart. Again, this is where managerial talent, experience, and wisdom comes into play. The great managers have a knack for consistently lowering theirweighted average cost of capitalby increasing productivity, seeking out higher return products, and more.To truly understand the idea of capital struc ture, you need to take a few moments to read Return on Equity The DuPont Modelto understand how the capital structure represents one of the three components in determining therate of returna company will earn on the money its owners have invested in it. Whether you own a doughnut shop or are considering investing in publicly traded stocks, its knowledge you simply must have.Question on our minds Can the perfect valuation of a company (debt+equity) and the cost of capital be affected by changing the financing mix. The imperfections in the market play a snappy role in the valuation of a company. This data is of utmost importance to the suppliers of capital. Changes in the financing mix are assumed to occur by issuing debt and repurchasing common stock or by issuing common stock and retiring debt.Example 1. Assume a company whose earnings are non expected to grow and which pays out all of its earnings to its shareholders in the form of dividends. All kinds of market imperfections ar e not considered in the current example, for simplicity in calculations.We are concerned mainly with 3 different rates of return. The first isThe yield on companys debt, ki = =The jiffy rate of return that we are concerned with iske = =With our assumptions that the firms earnings are not expected to grow and which has a 100 percent dividend payout, the firms earning per price represents the market rate of discount that equates the present protect of the perpetual stream of expected constant future dividends with the current market price of the common stock.The third rate to be calculated isko = =These 3 different rates of return affect the amount of financial supplement, which is the debt to equity ratio.ko is defined as the overall capitalization rate of the firm. It is designed as the weighted average cost of capital, and can also be expressed asko = ki + ke Calculating A Companys Capital bodily structureReview your companys most recent financial conjurements to find all o f the capital components. Highlight all of the debt of the company and the equity (including common and favored shares, capital contributions and retained earnings).Add up the total debt and equity It will be equal to your companys assets on the balance sheet because the debt and equity is what paid for those assets.Your capital structure is the percentage that each funding source represents of your companys total funding. Lets look at an example. Lets say you have the following capital components bank loan $176,500, retained earnings $54,300, common stock $12,500. That makes your total capital $243,300. To calculate your capital structure, take the dollar amount of each capital source and divide it by the total capital. In the above example, the bank loan is 72.5%, retained earnings 22.3%, capital stock 5.2% for a total of 100%.Monitor your companys capital structure over time. Debt tends to be the most expensive source of capital and, over time, you will determine the most effect ive blend of debt versus equity financing for your feature situation. Calculating your actual capital structure will allow you to track how closely you are following your ideal capital structure.Factors Affecting Capital StructureThe factors that affect the decisions taken regarding capital structure can be divided into three major typesInternal FactorsExternal FactorsGeneral FactorsINTERNAL FACTORSCost of CapitalThe cost of capital is the cost of the companys funds. It consists of debts and equity. When a company raises funds for its operations there are sure costs involved. When decisions regarding the capital structure are taken, managers curb that the earnings on the capital are more than this cost of capital. In general, the cost of borrowing capital is little than the cost of equity capital. This is because the interest rate on loans and borrowings is less than the dividend rates and also the dividends are a function of the companys profits and not expenditure.Risk FactorW hen decisions regarding capital structure are to be taken, the risk factors considerations are an important issue. If company raises its funds through debts, the risks involved are of two typesThe company has to repay the lenders in a fixed time period and at a fixed rate, whether or not the company makes profit or goes into loss.The borrowed capital is secured capital. Hence, if the company fails to make the payments, the lenders can take self-denial of the companys assets.If the company goes for funds through equity capital there are minimum risks. As the dividends are an appropriation of the companys profits, if it does not make any profit, it is not obliged to make the payments. In contrast to debt capital, here the company is not expected to repay its equity capital. And also the equity capital is not secured. go out FactorWhen additional funds are to be raised, the control factors are very essential in deciding the capital structure of the company. When a company decides to i ssue further equity shares the control of the company may be at stake. Hence, it may not be acceptable to its shareholders and owners. This factor is not vital in case of debt financing, except when financing institutions stipulate the appointment of nominee directors in the Board of Directors of the company.Objects of Capital Structure PlanningThey are-Maximize profit of the owners reward transferable securitiesIssue further securities in a way that does not dilute the holdings of the present ownersEXTERNAL FACTORSGeneral Economic Conditions If the economy is in the state of depression, equity funding is considered as it involves less risk. While, if the economy is booming and the interest rates are forecasted to fall, debt funding is given preference. care Rate Levels If the interest rates are high in the capital market, equity funding is preferred until the interest rate levels fall down.Policy of Lending Institutions If the terms and policies of the financing institutions are ri gid and harsh, debt financing should be ignored and equity financing should be tapped.Taxation Policy The government has taxation policies which include corporate taxes as sanitary as individual taxes. The government includes individual taxes on both borrowings as well as dividends. Also income tax deductions are offered on interests paid on borrowings. All these factors have to be considered while planning capital structure.Statutory Risks While planning Capital Structure, the statutory risks given by the Government and other statutes are to be considered.GENERAL FACTORSConstitution of the company If the company is private limited, the control factors are essential while if the company is public limited, the cost factors are essential.Characteristics of the company Companies which are small and in the early pegleg have weak credit standings and bargaining capacity, hence they have to rely on equity financing. While big companies have strong credit standings and they can source th eir funds from borrowings with acceptable interest rates.Stability of earnings The companies which have stable earnings and the risks involved are less, go for debt funding as they can handle the high risk factors. While companies whose earnings are forecasted to be fluctuating, usually go for less risky equity funding.Attitude of the Management For a company with conservative management, the control factor is more important, while a company with a liberal management considers the cost factors to be more important.Approaches to Capital Structure final Operating Income Approach tralatitious ApproachNet Income ApproachModigliani milling machine ApproachNet Operating Income ApproachDavid Durand proposed the lolly income approach to capital structure. This approach looks at the consequence of alterations in capital structure in terms of bread operating income. under this approach, on the basis of net operating income, the overall value of the firm is measured. Therefore this approach is identified as net operating income approach.The NOI approach entails thatLargely the value of the firm does not depend on the microscope stage of leverage in capital structure and hence any(prenominal) may be the change in capital structure the overall value of the firm is not affected.In the same way, the overall cost of capital is not affected by any change in the degree of leverage in capital structure. The overall cost of capital is independent of leverage.Under the net income approach, the overall cost of capital is unaffected and carcass constant irrespective of the change in the ratio of debts to equity capital when the cost of debt is less than that of equity capital whereas it is assumed the overall cost of capital must decrease with the increase in debts. How is this assumption justified? With the increase in the amount of debts the degree of risk of business increases. As a result the rate of equity over investment in equity shares thus on one hand the WACC decrease s with the increase in the amount of debts on the other hand cost of equity capital increases to the same tune. Therefore the benefit of leverage is mopped away and the overall cost of capital remains at the same level.In other words there are two parts of the cost of capital.Interest charges on debentures.The increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts.OPTIMUM CAPITAL STRUCTUREThis approach suggests that whatever the degree of indebtedness of the company, market value remains constant. Despite the change in the ratio of debt to capital in the market value of its equity shares remains constant. This means that there is no optimal capital structure. Each capital structure is optimal in approach of net operating incomeThe market value of the firm is determined as followsThe value of equity can be determined by the following equationandThe Net Operating Income Approach is based on the following assumptionsE xampleABC Ltd., is expecting an earnings before interest tax of Rs.1,80,00,000 and belongs to risk class of 10%. You are required to find out the value of firm % cost of equity capital if it employs 8% debt to the extent of 20%, 35% or 50% of the total financial requirement of Rs. 90000000.SolutionStatement showing value of firm and cost of equity capital20% Debt35% Debt50% DebtEarnings before interest tax EBIT ($)180000001800000018000000Overall cost of capital10%10%10% time value of firm (V) =EBIT Cost of CapitalEBIT/Cost of Capital180000000180000000180000000 shelter of 8% debt (D)18000000 (20% - 90000000)31500000 (35% - 90000000)45000000 (50% - 90000000)Value of equity (V D)162000000148500000135000000Net profit (EBIT Interest)16560000 (18000000 1440000)15480000 (18000000 2520000)14400000 (18000000 3600000)(Cost of equity (Kc)10.22%10.42%10.66%(Net profit/value of equity) - 100(16560000/ 162000000)( 15480000/ 148500000)( 14400000/ 135000000)It is apparent from the above comp utation that the overall cost of capital value of firm re-constant at different levels of debt i.e., at 20%, 35% and 50%. The benefit of debt content is offset by increase in the cost of equity. The overall cost of capital (k0) remains constant and can be verified as followsOverall Cost of Capital k0 = kd (D/D+S) + Ke (S/D+S)20% DebtK0 = $4,00,000/$40,00,000 -8% + $36,00,000/$40,00,000 X 10.22%= 0.008 + 0.092= 0.10 or 10%35% DebtK0 = $7,00,000/$40,00,000 -8% + $33,00,000/$40,00,000 X 10.42%= 0.014 + 0.0859= 0.0999Or 10%50% DebtK0 = $10,00,000/$40,00,000 - 8% + $30,00,000/$40,00,000 X 10.66%= 0.02 + 0.07995= 0.0995 or 10%Traditional ApproachTraditional approach is amiddle-way approach between net operating income approach the net income approach. According to this approach(1) A bestcapital structuredoes exist.(2) foodstuff value of the firm can be increased and average cost of capital can be reduced through a prudent usage of leverage.(3) The cost of debt capital increases if debt s are increases beyond a definite limit. This is because the greater the riskof businessthe higher therate of interestthe creditors would ask for.The rate of equity capitalization will also increase with it. Thus there remains no benefit of leverage when debts are increased beyond a certain limit. The cost of capital also goes up.Traditional ApproachThus at a definite level of mixture of debts to equity capital, average cost of capital also increases. Thecapital structureis optimum at this level of the mix of debts to equity capital.The effect of change incapital structureon the overall cost of capital can be divided into three stages as followsFirst stageIn the first stage the overall cost of capital falls and the value of the firm increases with the increase in leverage. This leverage has beneficial effect as debts as debts are less expensive. The cost of equity remains constant or increases negligibly. The proportion of risk is less in such a firm.Second stageA stage is reached w hen increase in leverage has no effect on the value or the cost of capital, of the firm. Neither the cost of capital falls nor the value of the firm rises. This is because the increase in the cost of equity due to the assed financial risk offsets the advantage of low cost debt. This is the stage wherein the value of the firm is maximum and cost of capital minimum.Third stageBeyond a definite limit of leverage the cost of capital increases with leverage and the value of the firm decreases with leverage. This is because with the increase in debts investors begin to realize the degree of financial risk and hence they desire to earn a higher rate of return on equity shares. The resultant increase in equity capitalization rate will more than offset the advantage of low-cost debt.It follows that the cost of capital is a function of the degree of leverage. Hence, an optimumcapital structurecan be achieved by establishing an appropriate degree of leverage incapital structure.Net Income Appr oachThis approach states that, the cost of debt and the cost of equity do not change with a change in the leverage ratio(when D/E changes), due to which it is observed that there is a weakening in the cost of capital as the leverage increases. The cost of capitalcan be calculated by the use Net income approach weighted average of cost of capitalcan be explained by the following equationhttp//lh6.ggpht.com/cemismailsezer/R4_ZkNJ-ThI/AAAAAAAAADY/RZYaGVynnUw/image%5B5%5DwhereKo average cost of capitalKd cost of debtKe cost of equityB market value of debtS market value of equityAs we know that cost of debt is less than cost of equity (Kdhttp//lh6.ggpht.com/cemismailsezer/R4_ZlNJ-TjI/AAAAAAAAADo/de5aDk2tbUo/image%5B8%5DThe Net Income Approach assembles the investment structure of the firm which has a major influence on the value of the firm. Therefore, the use of control will change both the worth of the organisation cost of capital. Net Income is exploited in approaching the market val ue that firm possesses. In this analysis Ka decreases when the D/E ratio increases as the proportion of debt, cheaper source of finance, increase in the capital structure vice versa.Assumptions of net income approachthe perception of risk is not altered by the use of liability for the investors as a result, the equity capitalisation rate i.e. ke, and the debt capitalisation rate kd, remain constant with changes in leverageThe debt capitalization rate is less than the equity capitalization rateThe corporate income taxes are not considered.Numerical exampleAssume that a firm has an expected annual net operating income of Rs.2, 00, 000, an equity rate, ke, of 10% and Rs. 10, 00,000 of 6% debt.The value of the firm according to NET INCOME approachNet Operating Income NOI 2, 00,000Total cost of debt Interest= KdD, (10, 00,000 x .06) 60,000Net Income Available to shareholders, NOI I 1, 40,000ThereforeMarket Value of Equity (Rs. 140,000/.10) 14, 00,000Market value of debt D (Rs. 60,000/. 06) 10, 00,000Total 24, 00,000Note The cost of equity and debt are respectively 10% and 6% and are assumed to be constant under the Net Income ApproachKo = Kd (D/V) + Ke (S/V)= 0.06 (10, 00,000/24, 00,000) + 0.10 (14, 00,000/24, 00,000)= 0.025 + 0.0583 = 0.0833 or 8.33%Modigliani Miller (MM) ApproachAssumptions of the MM ApproachCapital market is perfect. It is so whenInformation is freely availableProblem of asymmetric information does not existTransaction cost is nilThere is no bankruptcy costSecurities are amply divisible100% payout ratioInvestors and managers are rationalManagers act in interest of shareholdersCombination of risk and return is rationally chosenExpectations are homogenousEquivalent risk classNo taxesInvestors can borrow in personal A/C at same terms of firm. proposition IValue of the form is equal to the expected operating income divided by discount rate appropriate to its risk class.It is independent of capital structure i.e.where,V = Market Value of the FirmD = Market Value of the debtE = Market value of the equityO = Expected Operating Incomer = rebate rate applicable to risk class to which firm belongsProposition I is almost similar to the Net Operating Income Approach. MM used arbitrage communication channel to prove this approach. MM argues that identical assets must sell for same price, irrespective of how they are financed.Arbitrage ProcessIf the price of a product is unequal in two markets, traders buy it in the market where price is low and sell it in the market where price is high. This phenomenon is known as price differential or arbitrage. As a result of this process of arbitrage, price tends to decline in the high-priced market and price tends to rise in the low-priced market social unit the differential is totally removed.Modigliani and Miller explain their approach in terms of the same process of arbitrage. They hold that two firms, identical in all prise except leverage cannot have different market value. If two identi cal firms have different market values, arbitrage will take place until there is no difference in the market values of the two firms.ExampleLet us suppose that there are two firms, P and Q be to the same group of homogenous risk.Firm P is unlevered as its capital structure consists of equity capital onlyFirm Q is levered as its capital structure includes 10% debentures of Rs.10,00,000According to traditional approach, the market value of firm Q would be higher than that of firm P.But according to M-M approach, this situation cannot persist for long. The market value of the equity share of firm Q is high but investment in it is more risky while the market value of the equity share of firm P is low but investment in it is safe.Hence investors will sell out equity shares of firm Q and purchase equity shares of firm P. whence the market value of the equity shares of firm Q while fall, while the market value of the equity shares of firm P will rise. Through this process of arbitrage th erefore, the market values of the firms P and Q will be equalized. This is true for all firms belonging to the same group. In equilibrium situation, the average cost of capital will be same for all firms in the group.The opposite will happen if the market value of the firm P is higher than that of the firm Q. In this case investors will sell equity shares of P and buy those of Q. Consequently market values of these two firms will be equalised.Proposition IIMM Proposition II states that the value of the firm depends on three thingsRequiredrateof return on the firms assets (ra)Cost of debt of the firm (rd)Debt/Equity ratio of the firm (D/E)An increase in financial leverage increases expected Earnings per Share (EPS) but not share prices. Proposition II states that an expected rate of return of shareholders increases with financial leverage. Expected ROE is equal to expected rate of return on assets plus premium.The formula for re isre = ra + (ra-rd)x(D/E)Implications of Proposition II -rd is independent of D/E and hence re increases with D/E.The debt crosses an optimal level, the risk of default increases and expected return on debt rd increases.Limitations of MM Approach-Leverage irrelevance theory of MM is valid if perfect market assumption is correct but actually it is not so.Firms are able to pay taxes and investors also pay taxes.Bankruptcy cost can be very high.Managers have their own preference of a type of finance.Managers are better informed than shareholders i.e. asymmetry of information exists.Personal leverage is not possible to be substitute of corporate leverage.100% payout ratio is not possible normally.Analysis of CompaniesTVS MotorsTVS Motors hold one of the top ten two wheeler manufacturer and number three positions in Indian market, with turnover of $1 billion in 2008-2009 and is the flagship division of TVS group which is of worth $4 billion. TVS Motors manufactures full range of two wheelers ranging from two wheelers for domestic use to two wheelers for racing. Manufacturing units are located atHousar and MysoreHimachal PradeshIndonesiaHas production capacity of 2.5 million units per year with strength in design and development TVS has recently launched 7 new products. Till now TVS has interchange more than 15 million two wheelers and has employed 40000. TVS motor is the only Indian company to win Deming award for quality control in 2002. TVS Network spans over 48 countries.Particulars2007-08 (in crores)2008-09(in crores) direct INCOME45.31121.08INTEREST ON DEBT( I)11.4764.61EQUITY EARNING33.8456.47 salute OF EQUITY (Ke)4.13%4.21%MARKET VALUE OF EQUITY819.371341.33COST OF DEBT (Kd)1.72%7.13%MARKET VALUE OF DEBT666.34905.98VALUE OF FIRM1485.712247.31COST OF CAPITAL (Ko)3.05%5.39%WACC CalculationFor 2007-08WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(1.84) x 0.413 + 0.84/(1.84) x 0.172= 0.2284 +0.078 = 3.051%For 2008-2009WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(2.11) x 4.21 + 1.11/(2.11) x 7.13=1.995 +3.750= 5.7 5%Hero HondaHero Honda Motors Limited is largest and most successful two wheeler manufacturers in India and it is India based. Hero Honda was a joint venture between Hero group and Honda of Japan till 2010 when Honda sold its entire stake to Hero. In 2008-09 Hero Honda sold 3.7 million bikes with 12% growth rate and captured 57% of Indian markets share. Hero Honda Splendor is worlds largest selling motorcycle sold more than 1 million units in 2001-03.CUsersAAdityaDesktopindex.jpgIn December 2010, the Board of Directors of the Hero Honda sort have decided to terminate the joint venture between Hero multitude of India and Honda of Japan in a phased manner. The Hero Group of India would buy out the 26% stake of the Honda in JV Hero Honda. Under the joint venture Hero Group could not sell into international markets and the termination would mean that Hero Group can exploit global opportunities now. Since last 25 years the Hero Group relied on their Japanese partner Honda for R D for new bike models. So there are concerns that the Hero Group might not be able to sustain the performance of the Joint Venture alone.WACC calculationFor 2007-08WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(1.07)x34.73%+0.07/(1.07) x 8.33% = 33%For 2008-09WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(1.04)x32.41%+1.04/(1.04)x10.20% = 31.55%Particulars2007-08(in crores)2008-09(in crores)OPERATING INCOME1201.961367.77INTEREST ON DEBT( I)13.7613.47EQUITY EARNING1188.221354.3COST OF EQUITY (Ke)34.73%32.41%MARKET VALUE OF EQUITY3421.254178.65COST OF DEBT (Kd)8.33%10.20%MARKET VALUE OF DEBT165.18132.05VALUE OF F