Capital Structure Decisions

CCHAPTERHAPTER: 1.00: 1.00OORIENTATIONRIENTATION OFOF T THEHE T TERMERM

PPAPERAPER

1.1 INTRODUCTION

The term Paper tries to visualize “Capital Structure Decisions” and

represent the facts that include features of Capital structure,

determinants of capital structure, patterns or forms of capital

structure, types and theories of capital structure, theory of optimal

capital structure, risk associated with capital structure, external

assessment of capital structure and some assumption related to

capital structure.

The following sections in this chapter represent an orientation of the

Term Paper.

1.2 ORIGIN OF THE TERM PAPER

The students pursuing the MBA program at the Institute of Business

Administration, University of Rajshahi has prepared the Term Paper,

“Capital Structure Decisions” to fulfill the partial requirement of the

course, Financial Management (C-620).

1.3 OBJECTIVES OF THE TERM PAPER

The objectives of the Term Paper are portrayed below:

1.3.1 BROAD OBJECTIVE

To determine features of Capital structure,

To know about the determinants of capital structure

To evaluate the patterns or forms of capital structure

To identify the types and theories of capital structure

To analyze the theory of optimal capital structure

To determine the risk associated with capital structure

“Capital Structure Decisions” 2

To have an overview about external assessment of capital

structure

To know about the assumption related to capital structure.

1.3.2 SPECIFIC OBJECTIVE

Have the knowledge about how the capital structure

decisions.

1.4 SCOPE OF THE TERM PAPER

“Capital structure decisions” has been covered in this Term Paper.

Within a short time frame, the paper came to its existence with the

following highlighted facts:

Features of Capital structure,

Determinants of capital structure

Patterns or forms of capital structure

Types and theories of capital structure

Theory of optimal capital structure

Risk associated with capital structure

External assessment of capital structure

Assumption related to capital structure.

The Term paper provides itself as the conspicuous view of the capital

structure and open up the facts that leads to making decisions.

1.5 METHODOLOGY

The ultimate goal of the Term Paper is to discover the facts concerned

with capital structure decisions. So a well-planned research

methodology has been formulated to get a conspicuous view. In this

section, research processes that been followed while prepared the

Term Paper is been listed:


1.5.1 SOURCES OF INFORMATION:

Books on Financial Management

Articles published on capital structure both in the country

and all across the world

Search out different websites for data collection related to

capital structure decisions.

Lecture notes of the course Financial Management

1.5.2 JUSTIFICATION OF THE INFORMATION:

All the information have been examined and analyzed to

evaluate their justification.

Finally, input the appropriate information into the Term Paper.

1.6 LIMITATIONS

Limitations we had to face on preparing the Term Paper are portrayed

below:

In-experience on preparing this sort of Term Paper

In-available information related to the Term Paper

Improper knowledge on technological know how.

Language proficiency

Time constraints


CCHAPTERHAPTER: 2.00: 2.00OOVERVIEWVERVIEW OFOF F FINANCIALINANCIAL

MMANAGEMENTANAGEMENT


2.1 FINANCIAL MANAGEMENT

Finance can be defined as the art and science of managing

money. Finance is concerned with the process, institutions,

markets, and instruments involved in the transfer of money

among individuals, businesses, and governments.

On the other hand Financial Management is concerned with the

planning and controlling of resources. It is defined by the

functions of financial managers. Three (3) things should be

managed,

Investment Decision

Financing Decision

Managing Resources

Financial Services is the area of finance concerned with the

design and delivery of advice and financial products to


individuals, businesses, and government. Career opportunities

include banking, personal financial planning, investments, real

estate, and insurance.

2.2 GOAL OF THE FIRM

Actions of the financial manager should be taken to achieve the

objectives of the firm’s owners, its stockholders. Thus financial

managers need to know what the objectives of the firm’s are.

Profit maximization

Wealth maximization

PROFIT MAXIMIZATION

To achieve this goal, the financial manager would take only those

actions that were expected to make major contribution to the firm’s

overall profits. Corporations commonly measure profits in terms of

earning per share (EPS). The objections of profit maximization are,

The concept is vague

It ignores time dimension of financial decision

It ignores the risk dimension of financial decision

Profit do not necessarily result in cash flows

available to the stockholders

WEALTH MAXIMIZATION

The goal of the firm, and therefore of all managers and employees is

to maximize the wealth of the owners for whom it is being operated.

The wealth of corporate owners is measured by the share price of the

stock. Maximizing shareholder wealth properly considers cash flows,

the timing of these cash flows, and the risk of these cash flows.

2.3 FINANCIAL INSTITUTIONS

Financial institutions serve as intermediaries by channeling the

savings of individuals, business and governments into loan or

investments. The key suppliers and demanders of funds are

individuals, businesses, and governments. In general, individuals are


net suppliers of funds, while businesses and governments are net

demanders of funds.

Firms have ongoing needs of funds. They can obtain funds through the

following ways,

Financial Institutions

Financial Market

Private Placement

2.4 FINANCIAL MARKETS

Financial markets are organized forums in which the suppliers and

demanders of various types of funds can make transaction. The two

key financial markets are the money market and the capital market

Transactions in short term marketable securities take place in the

money market while transactions in long-term securities take place in

the capital market. Whether subsequently traded in the money or

capital market, securities are first issued through the primary market.

The primary market is the only one in which a corporation or

government is directly involved in and receives the proceeds from the

transaction.

Once issued, securities then trade on the secondary markets such as

the New York Stock Exchange or NASDAQ.

THE MONEY MARKET

The money market exists as a result of the interaction between the

suppliers and demanders of short-term funds (those having a maturity

of a year or less). Most money market transactions are made in

marketable securities which are short-term debt instruments such as


T-bills and commercial paper. Money market transactions can be

executed directly or through an intermediary.

THE CAPITAL MARKET

The capital market is a market that enables suppliers and demanders

of long-term funds to make transactions. The key capital market

securities are bonds (long-term debt) and both common and preferred

stock (equity). Bonds are long-term debt instruments used by

businesses and government to raise large sums of money or capital.

Common stocks are units of ownership interest or equity in a

corporation.

The following figure will show how funds flow between financial

institutions and financial markets,

2.5 BASIC FORMS OF BUSINESS ORGANIZATION


Flow of funds for financial institutions and markets

Three most common legal forms of business organizations are the sole

proprietorship, the partnership and the corporation. Other specialized

forms of business organization also exist. Sole proprietorship is the

most numerous. However, corporations are overwhelmingly dominant

with respect to business receipts and net profits. The advantages and

disadvantages of different types of business are as follows

SOLE PROPRIETORSHIP

A sole proprietorship is a business own by one person who operates it

for his or her own profit. About 75% of all business farms are sole

proprietorships. The strengths and weaknesses are as follows,

STRENGTHS:• Low organizational cost• Income taxed once as personal income

• Independence• Secrecy• Ease of dissolution

WEAKNESSES:• Unlimited liability• Limited funding• Proprietor must be all• Difficult to develop staff career opportunities

• Lack of continuity on death of proprietor

PARTNERSHIP

A partnership consists of two or more owners doing business togather

for profit. Partnerships account for about 10% of all businesses and

they are typically larger that sole proprietorships. Finance, Insurance

and Real estate firms are the most common types of partnerships. The

written contract used to formally establish a business partnership.

STRENGTHS:• Improved funding sources• Increased managerial talent• Income split by partnership contract, taxed as personal income

WEAKNESSES:• Unlimited liability to all partners• Partnership dissolved upon death of partner

• Difficult to liquidate or transfer ownership


CORPORATION

A corporation is an artificial being created by law. Often called a

“legal entity”, a corporation has the powers of an individual in that it

sue and be sued, make and be party to contracts, and acquire property

in it own name. Although only about 15% of all businesses are

incorporated, the corporation is the dominant form of business

organizations in term of recipts and profits. The strengths and

weakness are as follows,

STRENGTHS:• Owners’ liability limited• Large capitalization possible, greater funding

• Ownership readily transferable• Indefinite life• Professional management

WEAKNESSES:• Higher tax rates• Expensive organization• Greater government regulation

• When publicly traded, lacks secrecy


CCHAPTERHAPTER: 3.00: 3.00

CCAPITALAPITAL S STRUCTURETRUCTURE D DECISIONSECISIONS


3.1 INTRODUCTION

Capital Structure is one of the most complex areas of financial

decision making because of its interrelationship with other

financial decision variables. Poor capital structure decisions can

result in a high cost of capital thereby lowering the NPVs of

projects and making more of them unacceptable. In practical

sense, a firm can probably more readily increase its value by

improving quality and reducing costs than by fine tuning its

capital structure. Effective capital structure decision can lower

the cost of capital, resulting in higher NPVs and more acceptable

projects, and thereby increasing the value of the firm.

A firm’s major decision is its financing decisions which are

analyzed in the theory of corporate capital structure and based

on the model developed by Dodd (1986), capital structure is

determined mainly by three agency costs variables- agency-

equity, agency-debt & bankruptcy risk and other potential

variables such as growth rate, profitability and operating

leverage.


The firm’s capital structure should result from balancing the

costs of certain relationships between firm related groups.

Sometime agent does not act in line with the set objectives of the

principal.

Shareholders are the owner of the firm. If shareholders

value increases they will be benefited and vice-versa.

Shareholders value maximization depends on managers

activities. But as a rational being, managers try to

maximize their own interest. As a result agency and equity

cost arises which tend to discourage the use of equity.

Debt holders have no voice on management issue.

Managers are accountable only to the firm. So, they are

trying to maximize the wealth of shareholders not debt

holders. So, conflict arises between managers and debt

holders. There is an agency-debt cost which discourages

the issuance of debt.

There is a possibility of bankruptcy if the firm taking more

debt capital. Because the greater the firms debt capital,

higher the possibility of default on interest and capital

repayment.

Three other potential determinants of capital structure are

also included in the model developed by Dodd. Firms

growing at higher rates should have higher debt ratios than

firms with lower growth rates. The relationship between

debt ratios and growth rate is expected to be positive.

Firms with higher profitability ratio may be expected to

have more equity than firms with lower ratios.

Management of companies with high operating leverage

may use lower levels of financial leverage i.e, debt.


3.2 CAPITAL STRUCTURES

Capital structure is the manner in which a firm’s assets are

financed; that is, the right-hand side of the balance sheet.

Capital structure is normally expressed as the percentage of

each type of capital used by the firm--debt, preferred stock, and

common equity.

Combination of capital is called capital structure. The firm may

use only equity, or only debt, or a combination of equity and

debt, or a combination of equity, debt, preference shares or may

use other similar combinations.

3.3 FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE

Capital structure is that level of debt-equity proportion where

the market value per share is maximum and the cost of capital is

minimum.

Appropriate capital structure should have the following features

Profitability / Return Solvency / Risk Flexibility Conservation / Capacity Control

3.4 DETERMINANTS OF CAPITAL STRUCTURE

Formation of Capital structure depends on many factors which

are normally called the determinants of Capital structure. The

determinants based on which capital structure were formed are

listed below,

Seasonal Variations


Tax benefit of Debt

Flexibility

Control

Industry Leverage Ratios

Agency Costs

Industry Life Cycle

Degree of Competition

Company Characteristics

Requirements of Investors

Timing of Public Issue

Legal Requirements

3.5 PATTERNS / FORMS OF CAPITAL STRUCTURE

Following are the forms of capital structure:

Complete equity share capital;

Different proportions of equity and preference share

capital;

Different proportions of equity and debenture (debt)

capital and

Different proportions of equity, preference and

debenture (debt) capital.

3.6 CAPITAL STRUCTURE THEORY


Capital structure theory provides some insights into the value of

debt versus equity financing. Modern capital structure theory

began in 1958, when Modigliani and Miller proved, under a very

restrictive set of assumptions, that a firm’s value is unaffected by

its capital structure. There are 4 theories:

NI approach (net income approach)

NOI approach (net operating income approach)

MM approach (Modigliani-Millar Approach)

Traditional approach

NI APPROACH (NET INCOME APPROACH)

When you raise debt, leverage will increase. The overall values

of the firm will increase. Debt will have lower cost, so overall

cost of capital will reduce (it is better if the cost of capital

reduces).

V = S+ D

Where,

V = value of the firm, S = equity, D = debt

An increase in leverage will increase the value of the firm, it will

raise EPS, it will raise the market price of the shares and it will

reduce weighted average cost of capital, thus leverage is always

beneficial.


NOI APPROACH (NET OPERATING INCOME APPROACH)

Capital structure decision is irrelevant. If you raise debt, the cost

of equity will increase. The overall cost of capital will remain

constant in spite of leverage. Thus there is no advantage of

raising debt. As we raise the debt, the cost of equity increases in

the same proportion. The market discounts the firm, which is

leveraged. Thus capital structure decision has no relevance.

According to NOI approach the value of the firm and the

weighted average cost of capital are independent of the firm’s

capital structure. In the absence of taxes, an individual holding

all the debt and equity securities will receive the same cash

flows regardless of the capital structure and therefore, value of

the company is the same.

MM APPROACH WITHOUT TAX

The firm’s value is independent of its capital structure. With

personal leverage, shareholders can receive exactly the same

return, with the same risk, from a levered firm and an un-levered

firm. Thus, they will sell shares of the over-priced firm and buy

shares of the under-priced firm until the two values equate. This

is called arbitrage.

The cost of equity for a levered firm equals the constant overall

cost of capital plus a risk premium that equals the spread

between the overall cost of capital and the cost of debt

multiplied by the firm’s debt-equity ratio. For financial leverage

to be irrelevant, the overall cost of capital must remain constant,


regardless of the amount of debt employed. This implies that the

cost of equity must rise as financial risk increases.

MM APPROACH WITH TAX

Under current laws in most countries, debt has an important

advantage over equity: interest payments on debt are tax

deductible, whereas dividend payments and retained earnings

are not. Investors in a levered firm receive in the aggregate the

un-levered cash flow plus an amount equal to the tax deduction

on interest. Capitalizing the first component of cash flow at the

all-equity rate and the second at the cost of debt shows that the

value of the levered firm is equal to the value of the un-levered

firm plus the interest tax shield which is tax rate times the debt

(if the shield is fully usable).

It is assumed that the firm will borrow the same amount of debt

in perpetuity and will always be able to use the tax shield. Also,

it ignores bankruptcy and agency costs.

TRADITIONAL APPROACH

It says that with the use of debt, the overall cost of capital comes

down up to some extent and thereafter the overall cost of capital

increases. Thus there is an ideal point, up to which the overall


cost of capital will decrease with the help of increase in debt,

beyond which the use of debt is detrimental to the company.

3.7 THEORY OF OPTIMAL CAPITAL STRUCTURE

This theory states that we can have an optimum capital structure

– as we raise the debt, we can raise the value of the firm to some

extent. Thus level of debt can be increased up to some level.

That level is the ideal capital structure. Ultimate objective of

Finance manager is to raise the value of the firm and raise the

wealth – which is possible by an ideal capital structure.

3.8 TYPES OF CAPITAL

All of the items on the right-hand side of the firm’s balance

sheet, excluding current liabilities, are sources of capital. The

following simplified balance sheet illustrates the basic

breakdown of total capital into its two components, debt capital

and equity capital.

Balance Sheet


Current LiabilitiesLong term

Assets: Stockholder’s

equity Preferred stock Common stock

equity

Debt Capital

Equity Capital

Total Capital

3.9 DESIGN COST OF CAPITAL

Capital of a firm can be designed by considering the following

facts

It should minimize cost of capital

It should reduce risks

It should give required flexibility

It should provide required control to the owners

It should enable the company to have adequate

finance.

3.10 RISKS ASSOCIATED WITH CAPITAL STRUCTURE DECISIONS

Meaning of risk is variability in income. Business risk is the

situation, when the EBIT may vary due to change in capital

structure. It is influenced by the ratio of fixed cost in total cost. If

the ratio of fixed cost is higher, business risk is higher. Financial

risk is the variability in EPS due to change in capital structure. It

is caused due to leverage. If leverage is more, variability will be

more and thus financial risk will be more.

BUSINESS RISK


Business risk is the risk inherent in the operations of the firm,

prior to the financing decision. Thus, business risk is the

uncertainty inherent in a total risk sense, future operating

income, or earnings before interest and taxes (EBIT). Business

risk is caused by many factors. Two of the most important are

sales variability and operating leverage.

FINANCIAL RISK

Financial risk is the risk added by the use of debt financing. Debt

financing increases the variability of earnings before taxes (but

after interest); thus, along with business risk, it contributes to

the uncertainty of net income and earnings per share. Business

risk plus financial risk equals total corporate risk.

3.11 USE OF FINANCIAL LEVERAGE IN CAPITAL STRUCTURE

The use of the fixed-charges sources of funds, such as debt and

preference capital along with the owners’ equity in the capital

structure, is described as financial leverage or gearing or trading

on equity.

Operating leverage is the extent to which fixed costs are used in

a firm’s operations. If a high percentage of a firm’s total costs

are fixed costs, then the firm is said to have a high degree of

operating leverage. Operating leverage is a measure of one

element of business risk, but does not include the second major

element, sales variability.

Financial leverage is the extent to which fixed-income securities

(debt and preferred stock) are used in a firm’s capital structure.

If a high percentage of a firm’s capital structure is in the form of


debt and preferred stock, then the firm is said to have a high

degree of financial leverage.

The financial leverage employed by a company is intended to

earn more return on the fixed-charge funds than their costs. The

surplus (or deficit) will increase (or decrease) the return on the

owners’ equity. The rate of return on the owners’ equity is

levered above or below the rate of return on total assets.

Financial Leverage can be measured by

Debt ratio,

Debt-equity ratio and

Interest coverage.

The first two measures of financial leverage can be expressed

either in terms of book values or market values. These two

measures are also known as measures of capital gearing.

The third measure of financial leverage, commonly known as

coverage ratio. The reciprocal of interest coverage is a measure

of the firm’s income gearing


3.12 ASSUMPTION OF CAPITAL STRUCTURE THEORIES

Assumptions related to capital structure are as follows

There are only two sources of funds i.e.: debt and equity.

The total assets of the company are given and do no

change.

The total financing remains constant. The firm can change

the degree of leverage either by selling the shares and

retiring debt or by issuing debt and redeeming equity.

Operating profits (EBIT) are not expected to grow.

All the investors are assumed to have the same expectation

about the future profits.

Business risk is constant over time and assumed to be

independent of its capital structure and financial risk.

Corporate tax does not exist.

The company has infinite life.

Dividend payout ratio = 100%.


3.13 EXTERNAL ASSESSMENT OF CAPITAL STRUCTURE

Financial leverage results from the use of fixed-cost financing,

such as debt and preferred stock, to magnify return and risk. The

amount of leverage in the firm’s capital structure can affect its

value by affecting return and risk. Those outside the firm can

make a rough assessment of capital structure by using measures

found in the firm’s financial statements

Measures of the firm’s ability to meet contractual payments

associated with debt include the times interest earned ratio and

the fixed- payment coverage ratio. These ratios provide indirect

information on financial leverage.


3.14 FACTORS TO CONSIDER IN MAKING CAPITAL STRUCTURE DECISIONS

Concern Factor DescriptionBusiness

riskRevenue stability

Firms that have stable and

predictable

revenues can more safely undertake

highly

leveraged capital structures than

can firms

with volatile patterns of sales

revenue. Firms

with growing sales tend to benefit

from

added debt; they can reap the

positive

benefits of financial leverage, which

magnifies the effect of these

increase.

Cash flow When considering a new capital

structure,

the firm must focus on its ability to

generate

the cash flows necessary to meet

obligations. Cash forecasts


reflecting and

ability to service debts and

preferred stock

must support any shift in capital

structure.

Agency cost

Contractual obligation

A firm may be contractually

constrained

with respect to the type of funds

that it can

raise. Contractual constraints on

the sale of

additional stock ,as well as on the

ability to

distributes dividends on stock might

also

exist

Management Preferences

A firm will impose an internal

constraint on

the use of debt to limits its risk

exposure to

a level deemed acceptable to

management.

Control A management group concerned

about

control may prefer to issue debt

rather than

(voting) common stock. Generally,

in

closely held firms or firms

threatened by

takeover does control become a


major

concerned in the capital structure

decision.

Asymmetric

information

External risk assessment

The. The firm’s ability to raise funds

quickly and at favorable rates

depends on the external risk

assessments of lenders and bond

rates. The firm must consider the

impact of capital structure decisions

both on share value and on

published financial statements from

which lenders and bond raters.

Timing At the time when interest rates are

low, debt financing might be more

attractive; when interest rates high,

the sales of stock may be more

appealing.


CCHAPTERHAPTER: 4.00: 4.00FFINDINGSINDINGS ANDAND CCONCLUSIONONCLUSION


4.1 FINDINGS

Capital Structure makes a difference to the organizations overall

retained earning. Such measures have consistently promoted

business performance criteria such as profit, sales and

productivity.

The overall findings from this term paper are listed below,

Capital structure has a substantial impact on overall

profitability

Leverage has also some impact on capital structure

decision

When making capital structure decision firm consider

different types of risks

Tax rate makes a substantial impact over the profitability

of the farm when debt capital were use

If debt, common equity and preferred equity were used in

capital structure the firms profitably will increase


4.2 CONCLUSION

This paper uses a novel data set to explore the capital structure

decisions that firms make in their operations. In the vast

majority of cases, this is when the firms in question still are

being incubated in their founders’ homes or garages, before

outside employees have joined the firm in any numbers, and

certainly well before the firms in question would be attractive to

the types of funding sources that are the focus of most

discussions of early stage financing. Despite these firms being at

the very beginning of life, they rely to a surprising degree on

outside capital. Roughly 80 percent to 90 percent of most firms’

startup capital is made up in equal parts of owner equity and

bank debt. While a large fraction of this bank debt is owed by the

founder, rather than the firm, the fact that the debt is financed

through arm’s length relationships, and not through family and


friends networks, is worthy of further research. To be sure, our

findings underscore the importance of liquid credit markets for

the formation and success of young firms. If firms hold the key to

growth in economies, then surely economic growth hinges

critically on the smooth functioning of credit markets that enable

young firms to be formed, to grow, and to succeed.

REFERENCES

BOOKS

Lawrence J. Gitman (2009-2010) “Principles of Managerial Finance, 12 th Edition”,

Prentice-Hall India

WEBSITES

Md. Tauhidul Alam-10: 30 AM (25-06-09)

HTTP://WWW.ESNIPS.COM


OTHER

Lecture Notes of Financial Management


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Capital Structure Decisions