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Chapter III Capital Structure Planning
Capital structure refers to the mix of long term sources of funds like
debentures, term loans, preference capital and equity capital including
retained earnings.
When a business firm makes a capital investment, need arises for raising
funds.
A demand for raising funds generates a new capital structure when a decision
needs to be taken on the amount and modes of finance.
The financing decision involves an analysis of the existing capital structure
and the factors governing the proposed financing decision.
The use of debt along with the owners’ equity in the capital structure is
referred to as the financial leverage or trading on equity.
Quote: “As the supplier of debt (i.e., lender) has limited participation in the profits of
the company, the lender needs protection in earnings and protection in values
represented by owners’ equity” – Waterman Merwin H., in his article ‘Trading
on equity’ in Essays on Business Finance, published in 1953.
The debt-equity mix has implications for the shareholders in terms of their
earnings and risk, which in turn affects the cost of capital and the market
value of the firm.
Note: While making a capital structure decision, the dividend policy of the
company should also be considered.
II Determinants of capital structure
While deciding on an appropriate capital structure, various factors should be
considered. These factors include –
(i) The effect of leverage on EPS.
(ii) Cash flow ability to service debts.
(iii) Effect on debt ratios.
(iv) Effect on credit / security ratings.
(v) Timing of security issues.
(vi) Flexibility in future financing options.
(vii) Pecking order of financing.
(i) Effect of leverage on EPS
One method of examining the effect of leverage is to analyse the
relationship between EBIT and EPS.
EBIT – EPS analysis focuses on the EBIT indifference between financing
methods with respect to EPS. That is to say, the EBIT – EPS indifference
point is the level of EBIT where EPS will be the same for two (or more)
alternative methods of financing.
Illustration
Company A with long term capitalization of Rs.18 cr. comprising Rs.5 cr. in
debt bearing an average interest of 9% and Rs.13 cr. in equity proposes to
raise another Rs.5 cr. for funding expansion plans. The co. is looking at three
possible financing options –
(a) To issue 10 lac equity shares @ Rs.50 per share
(b) To avail loan @ 8% interest
(c) To issue 7.6% preference shares
The number of equity shares at present is 40 lacs and the EBIT is Rs.3 cr.
Assume corporate tax rate to be 40%. You may ignore dividend distribution
tax and advise the company on the best option.
Answer:
The first step for analysis is to determine EBIT break-even or indifference point
between various financing alternatives. For this purpose, EPS is calculated at
an assumed EBIT level. If we assume EBIT to be Rs.4 cr., EPS under the three
financing alternatives will be as per the following table:
Equity option Debt option Pref. capital option
( Rupees in crore)
Assumed EBIT 4.00 4.00 4.00
Interest on existing debt 0.45 0.45 0.45
Interest on new debt - 0.40 -__
PBT 3.55 3.15 3.55
Tax 1.42 1.26 1.42_
PAT 2.13 1.89 2.13
Pref. dividend - - 0.38_
Earnings available toEquity shareholders 2.13 1.89 1.75
No. of shares (in lacs) 50 40 40
EPS (in rupees) 4.26 4.73 4.38
Note: It can be observed that the EPS is higher under the debt alternative than under
the preference share option despite the fact that the interest rate on debt is
higher than the preference stock dividend rate. The reason is interest is tax
deductible while dividend is not.
Break Even or Indifference Analysis
Based on the above table, an indifference chart is constructed.
In the chart, EBIT is plotted on the horizontal axis and EPS on the vertical axis.
For each financing alternative, a straight line is drawn to reflect EPS for all
possible levels of EBIT.
For drawing a straight line, two points are required. The first point is the assumed
level of EBIT and the second point is the EBIT necessary to simply cover all fixed
financial costs for a particular financial plan.
For the equity shares alternative:
(i) EBIT required is Rs.45 lacs to cover interest on existing debt. At this level,
earnings available to equity shareholders is nil and hence EPS = 0.
(ii) When EBIT is Rs.4 cr., EPS = Rs.4.26/-.
Similarly for the debt alternative:
(i) EBIT required is Rs.85 lacs to cover fixed charges (i.e., interest on existing
debt plus new interest) where EPS will be zero.
(ii) When EBIT is Rs.4 cr., EPS = Rs.4.73/-
For the preferred stock alternative:
(i) Dividend on preference shares is out of post tax profit. Hence, in pre-tax
terms, the earnings required to cover preference dividend payout will be
Preference dividend / (1-T) i.e., Rs.0.38 cr./ (1-0.4) which works out to
Rs.0.63 cr. Thus the EBIT required to cover the fixed costs (i.e., interest
on existing debt plus the preference dividend) is Rs.1.08 cr. At this level,
EPS = 0.
(ii) When EBIT is Rs.4 cr., EPS = Rs.4.38.
EBIT – EPS Indifference chart for the three financing alternatives
Pref Cap
Debt
Equity
EBIT (Rs. in cr.)
EPS
(Rs.)
2.45
3
4
5
4 5
1
2
3.6210 2 3
Findings
EBIT of Rs.2.45 cr. is the indifference point between debt and equity financing
options where EPS is the same. If EBIT is below this point, equity option will
provide higher EPS and above the point, EPS will be higher for the debt
alternative.
The indifference point between preference and equity share alternatives is at
the EBIT level of Rs.3.62 cr. If EBIT is below Rs.3.62 cr., equity option is
preferred as EPS is higher and vice versa.
Note: There is no indifference point between debt and preference share
options. The debt alternative dominates (is higher) for all levels of
EBIT by a constant EPS amount of Rs.0.35.
Mathematical formulation of Indifference Point
i.e. EBIT – C1 = EBIT – C2
S1 S2
Where - EBIT is the EBIT at the indifference point
C1 & C2 are the annual interest expenses & preferred stock dividend on pre-tax terms as applicable for the financial alternatives.
S1 & S2 are the number of equity shares after the financing decision under the two alternatives
EBIT – 0.45 = EBIT – 0.85 (EBIT indifference between equity &
0.5 0.4 debt alternatives)
Utility of EBIT – EPS analysis
EBIT – EPS analysis reveals the impact of different financing alternatives on
EPS.
Using the indifference point between two financing alternatives, existing and
expected levels of EBIT can be easily compared.
Higher the level of EBIT in relation to the indifference point, debt option is
preferable.
Conversely, lower the level of EBIT in relation to the indifference point, equity
financing is preferable.
When the current EBIT is slightly above the indifference point and where the
probability of earnings falling below the indifference point is high, debt
alternative is too risky. The risk attached to the use of leverage is referred to
as ‘financial risk’.
To sum up, the greater the level of EBIT and lower the probability of downside
fluctuation in earnings, stronger is the case for the debt option. In the opposite
scenario, debt alternative is too risky. Thus financial leverage highlights the
underlying business risk of the firm in relation to EPS. In other words, financial
leverage highlights the risk-return trade off that governs valuation.
Summary of the effect of leverage on EPS
EPS is one of the most widely used measures of a company’s performance.
If the objective is to maximize the EPS, the decision will be to have the
highest level of debt. However, the major shortcoming is that it ignores
risk (i.e., variability of earnings).
Financial risk is attached with the use of debt due to variability in earnings
and the threat of default for non-payment of fixed charges. Hence, by not
employing any debt, financial risk can be totally avoided. However, the
shareholders will be deprived of increased earnings.
Therefore, the use of debt should be to the extent that the perceived risk
does not exceed the benefit of increased EPS.
Firms having stability and growth in sales and profits have stable EPS and
can employ higher degree of leverage and they do not face difficulty in
meeting their fixed commitments.
Conversely, companies with declining sales / profits should guard against
the use of debt as they may face cash flow constraint in meeting their
fixed obligations.
It is therefore prudent to also analyze the cash flow ability of the firm to service
fixed charges while considering an appropriate capital structure.
II Cash flow ability to service debt
The optimum debt-equity mix depends on the company’s ability to service
debt without any threat of insolvency and operating flexibility.
The greater the quantum of debt with short-term maturities, the higher is the
fixed charges for the company.
The fixed charges will include principal and interest payments on debt. In the
case of other modes of financing like leasing and preference share options,
the fixed charges will be lease payments and preference dividends
respectively.
Where a company is unable to meet the fixed charges (with the exception of
preference dividends), it may result in default and ultimately insolvency.
The higher and more stable the expected future cash flows of a company, the
greater the debt capacity.
Debt capacity is the maximum amount of debt that a firm can adequately
service.
To gauge the debt capacity of a company, coverage ratios are worked out.
Coverage ratios relate the financial charges of a firm to its ability to service
them. Rating agencies extensively use these ratios to rate instruments.
The coverage ratios include –
(i) Interest Coverage Ratio (ICR)
The most widely used coverage ratio to gauge the ability of a company to
service the cost of debt is the interest coverage ratio.
This ratio is simply the ratio of EBIT for a particular reporting period to the
amount of interest charges for the period.
ICR = EBIT / Interest charges on debt
Interest Coverage Ratio serves as a measure of the firm’s ability to meet its
interest obligations.
Example: If a company has an EBIT of Rs.6 cr. during a financial year and
the interest payments on all debt obligations were Rs.1.5 cr., interest
coverage ratio is 4 times (i.e., 6/1.5). This would suggest that even if EBIT
drops by 75%, the company would still be able to cover its interest payments
out of its earnings.
A coverage ratio of just one only would indicate that the earnings are barely
sufficient to satisfy the interest payments.
Generalizations on what an appropriate interest coverage ratio are difficult
unless reference is made to the type of business in which a firm is engaged.
In a highly stable business and the firm’s performance is consistent, a
relatively low interest coverage ratio may be acceptable. However, in a highly
cyclical business or where the performance of the firm has not been
consistent, a lower interest coverage ratio may not be appropriate.
In general, the interest coverage ratio in the range of 3 to 4 is widely
considered as a comfortable position.
(ii) Debt Service Coverage Ratio (DSCR)
The interest coverage ratio indicates the ability of a company to service only
the interest cost.
The inability to meet the principal repayment also constitutes default. Hence,
a broader analysis would include evaluation of the firm’s ability to meet the
principal repayments on debts also. In other words, DSCR is computed for
gauging the full debt-service ability.
As principal repayments are not tax deductible, they are calculated in pre-tax
terms to be consistent with EBIT in the above equation.
In the previous example, if principal repayment was Rs.1 cr. per annum and
the tax rate is 40%, DSCR = 1.89 as given below:
The above situation would mean that even if EBIT falls by 47% (i.e.,
0.89/1.89), earnings would still be sufficient to service the debt (both interest
and principal).
DSCR = EBDIT
Interest + Principal Repayment (1-T)
DSCR = 6
1.5 + 1 (1 - 0.4)
A DSCR closer to 1 signifies that the risk is higher as the ability to pay both
interest and principal may get affected if there is a fall in the earnings.
Note: While lease financing is not debt per se, its impact on cash flows is
exactly the same as the payment of interest and principal on debt
obligations except that there is no distinction between interest and
principal and the entire lease rental is revenue in nature.
(iii) Cash flow coverage ratios
Some analysts consider cash flows instead of operating earnings in working
out the coverage ratios. These cash flow coverage ratios are computed for
interest as well as for interest and principal repayments.
Note: It is implicit that the amount equal to the tax benefit on depreciation is
invested to maintain the earnings for the company (without any
growth). Any investment beyond this level can contribute to growth.
Hence, a measure reflecting the amount required to cover certain
expenditure necessary to keep the business operating being utilized
for repayment of a debt is not a good measure for assessing the debt
servicing ability.
Cash flow adequacy
For determining the company’s debt policy, cash flows may be analyzed
over a longer time period.
CF Coverage Ratios
CF Coverage of Interest CF coverage of Interest + Principal
EBDIT EBDIT Interest Interest + Principal
(1-T)
The period over which cash flows are analyzed should cover various
phases mainly adverse.
Cash budgets with an element of probability for a range of possible
outcomes will aid the cash flow analysis.
In the analysis, not only the expected earnings are considered but also
cash flows from purchase / sale of assets.
Given the probabilities of particular cash flow sequences, the quantum of
debt that the company can take on without running out of cash to meet
the interest charges and principal repayment is determined.
Donaldson Approach (Gordon Donaldson – Corporate Debt Capacity, 1961)
To assess the cash adequacy, Donaldson advocates examining cash flows
under recessionary conditions. These conditions may or may not be the
most adverse. However, in keeping with the spirit of his proposal, a
company should evaluate its cash flows under adverse circumstances.
Donaldson defines the net cash balance in a recession as follows:
CBr = CBo + NCFr
Where CBo = Cash balance at the start of recession
NCFr = the net cash flow during recession
By combining the cash balance at the beginning with the probability
distribution of recession cash flows, the probability distribution of cash
balances during the recession i.e., CBr is determined.
Based on the above, debt capacity (i.e., the quantum of debt which can be
serviced comfortably) is ascertained in the following manner:
(i) Calculate fixed charges associated with incremental debt.
(ii) Determine for each additional debt, the likelihood of being out
of cash based on the probability distribution of cash balances
during recession.
(iii) To set tolerance limits for the probability of being out of cash.
For example, if a company is considering a 15% debt for Rs.20 cr., the annual
fixed charges work out to Rs.3 cr.
CBr (-) Rs.3 cr. = probability distribution of CB after Rs.20 cr. debt.
If the probability of being out of cash with incremental debt is negligible, debt
can be incurred.
Note: In case of cash inadequacy (i.e., lack of cash after all necessary
expenditure), the company needs to take stock of its resources, which can be
utilised to meet the cash flow requirements. The available alternatives may
range from sale of investments to fixed assets.
III Effect on debt ratios
Debt ratios indicate the extent to which the firm is financed by debt.
In the case of any proposed debt alternative, the incremental debt is
simply added to the existing debts and the combined amount is taken for
calculation of the debt ratios.
The revised debt ratio needs to be compared with
(i) past ratios in a trend analysis
(ii) the industry average.
The comparison will bring out if the company’s proposed capital structure
is significantly out of line with that of similar companies in the market
place.
Where in the proposed capital structure, debt is much higher, the
company can face any of the following two situations:
(i) Cost of capital going up as risk perception changes (or)
(ii) Justify the higher debt equity ratio as not being riskier in
case companies in the industry are too conservative.
Note: As investment analysts and creditors tend to evaluate companies
by the industry, the company needs to justify its position if its
capital structure is noticeably out of line in either direction
- Van Horne
Debt Ratios:
To aid in the analysis of long-term liquidity of a company (i.e., ability to
meet long term obligations), several debt ratios are computed and
analyzed. As already indicated, debt ratios reflect the relative proportion
of debt funds employed by a company in its business.
(i) Debt Equity Ratio (Generally referred to as Long-term debt
to networth ratio)
Debt equity ratio = Long term debt / shareholders’ funds
Note: As this is not a relatively a conservative ratio, this has not been
advocated by James C Van Horne. However, this ratio is
generally adopted in practice.
(ii) Debt Equity Ratio (as is defined by various authors and
computed by analysts)
Debt equity ratio = Total debt / Net worth
Note: Total debt will include short term liabilities
(iii) Long term debt to total capitalization
Formula - Long term debt / capital employed
- Capital employed includes networth plus long-term debts
Note: Debt ratios vary according to the nature of business and
volatility of cash flows. For example, a basic utility company
like Power Company has stable cash flows and hence can have
a higher debt equity ratio than a machine tool company whose
cash flows are far less stable.
IV Effect on credit rating
While deciding the capital structure, the effect of a financing alternative on
its security rating needs to be considered.
Security ratings serve as a measure of the default risk of a borrower.
The rating agency evaluates and rates specific debt instruments like
debentures, deposits, commercial papers etc.
Grades are assigned by rating agencies taking into consideration a
number of factors such as trends in coverage & liquidity ratios, profitability
ratios, the company’s business risk perception in the past and the
expected risk profile, present and likely future capital requirements and
the most important of all, the cash flow ability to service both interest and
principal payments.
The ratings are given at the time of issuance of specific instruments and
are updated throughout the life of the instrument.
The cost of the debt depends on the rating.
Where an additional debt lowers a company’s security rating from an
‘investment grade’ to a ‘speculative grade’ category, the decision to take
on an additional debt needs re-examination.
It is therefore necessary to consider the effect on the rating while
determining an appropriate capital structure.
V Timing Security Issues
The question of how to time an issue appropriately is as important as the
decision to raise funds through debt or equity.
In view of financing being composite (combination of multiple sources), it is
difficult for a company to maintain strict proportions of debt / equity in its
capital structure.
Frequently, a decision needs to be taken on the order of financing i.e., raising
funds through issuance of equity shares first and later with a debt issue or
vice versa.
A decision on the alternative methods of financing based on timing is mainly
due to the general market conditions and the company’s forecast of the future
market scenario.
Where future is uncertain, the optimal financing sequence over a medium
term may be determined. The sequence would be timed to take advantage of
the known future changes in the financial market. This decision is based on
management’s best estimate of the future.
VI Flexibility of future financing plans
Flexibility means that the current financing decision will keep future financing
options open for a company.
It is admitted that a company cannot raise funds through debt continuously
without building its equity base. Where a company takes on substantial debt
and things take a turn for the worse, it may be forced to issue shares on
unfavourable terms in the future.
To preserve flexibility in tapping capital markets, it is better to have unused
debt capacity to meet any sudden and unpredictable fund requirements.
Where a company has the financial flexibility, not only can it raise funds
without undue delay and cost whenever opportunities arise for profitable
investments but can also substitute one form of financing with another
depending on the future conditions.
Thus financial flexibility means a company’s ability to adapt its capital
structure to the changing conditions.
Financial flexibility depends predominantly on two factors viz.,
(i) Loan covenants i.e., option for early retirement of loans with
less or no penalty and
(ii) The financial slack. i.e., excess resources at the company’s
disposal.
Financial slack includes unused debt capacity such as unutilized lines of
credit, excess liquid assets and also other untapped resources.
Note: Basically, financial flexibility depends a lot on the company’s unused
debt capacity. Higher the debt capacity and larger the unutilized
portion, greater will be the degree of financial flexibility.
VII Behavioral aspect of capital structure planning
The behavioral explanation of why certain companies finance the way they
do is based on a preference order which is technically referred to as
‘pecking order’ of financing.
Usually, the order in which different sources are desired to be tapped
would be as follows:
(i) Internal financing of investment opportunities – Reason -
(a) To avoid outside scrutiny by suppliers of capital
(b) Absence of floatation costs for retained earnings
(ii) Straight debt is generally the second preference. Reason -
i. Lesser floatation costs
ii. Debt is beneficial for equity shareholders as it brings down
the cost of capital.
(iii) Next in preference is the preference shares option as it has certain
features of debt.
(iv) Hybrid securities like convertible bonds.
(v) Finally the equity option - Reason -
(a) Investors are generally intrusive
(b) Relatively costlier when compared to the other modes &
(c) Higher floatation costs.
Conclusion
Despite the pecking order hypothesis, James C Van Horne strongly advocates
that financing decisions should be based on rigorous analysis embracing
valuation. In other words, capital structuring planning should generally be
made keeping in view the interests of the equity shareholders.
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