Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University Capital structure S.Vasantha

Executive Placement 2003 BIMSchool of Management Studies – Striving towards Excellence

Vels University www.velsuniv.org

Capital structureCapital structure

S.VasanthaS.Vasantha



Introduction Introduction

• Capital Structure is the proportion of debt, preference and Capital Structure is the proportion of debt, preference and equity capitals in the total financing of the firm’s assets.equity capitals in the total financing of the firm’s assets.

• The main objective of financial management is to The main objective of financial management is to maximize the value of the equity shares of the firm. maximize the value of the equity shares of the firm.

• Given this objective, the firm has to choose that financing Given this objective, the firm has to choose that financing mix/capital structure that results in maximizing the wealth mix/capital structure that results in maximizing the wealth of the equity shareholders.of the equity shareholders.

• Such a capital structure is called as the optimum capital Such a capital structure is called as the optimum capital structure. structure.

• At the optimum capital structure, the weighted average At the optimum capital structure, the weighted average cost of capital would be the minimum. cost of capital would be the minimum.

•



Cont….Cont….

• The capital structure decision influences the The capital structure decision influences the value of the firm through its cost of capital and value of the firm through its cost of capital and can affect the share of the earnings that pertain can affect the share of the earnings that pertain to the equity shareholders.to the equity shareholders.

• At the optimum capital structure, the weighted At the optimum capital structure, the weighted average cost of capital would be the minimum. average cost of capital would be the minimum.



Patterns of capital structurePatterns of capital structure

• Capital structure with equity shares onlyCapital structure with equity shares only• Capital structure with equity shares and Capital structure with equity shares and

preference sharespreference shares• Capital structure with equity shares and Capital structure with equity shares and

debenturesdebentures• Capital structure with equity shares, preference Capital structure with equity shares, preference

and debenturesand debentures• Choice of appropriate capital structure depends Choice of appropriate capital structure depends

on different factors like nature of business, on different factors like nature of business, regularity of earnings, conditions in money regularity of earnings, conditions in money markets, attitude of the investorsmarkets, attitude of the investors



Cont…Cont…

• Debt is the liability on which interest is paid to the Debt is the liability on which interest is paid to the borrowersborrowers

• Equity is the owners fundsEquity is the owners funds• a high proportion of debt content in the capital a high proportion of debt content in the capital

structure increases the risk and may lead to insolvencystructure increases the risk and may lead to insolvency• But raising funds through debt is cheaper as compared But raising funds through debt is cheaper as compared

to raising funds through shares to raising funds through shares • The main reason debt interest has tax benefits The main reason debt interest has tax benefits

whereas payment of dividend does not attract tax whereas payment of dividend does not attract tax benefitsbenefits

• This inturn increases the EPS of the company which is This inturn increases the EPS of the company which is the basic objective of the financial manager the basic objective of the financial manager



Debt/equity ratioDebt/equity ratio

• A measure of a company's financial leverage. A measure of a company's financial leverage. Debt/equity ratio is equal to long-term debt divided by Debt/equity ratio is equal to long-term debt divided by common shareholders' equity. common shareholders' equity.

• Investing in a company with a higher debt/equity ratio Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates, may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for due to the additional interest that has to be paid out for the debt.the debt.

• It is important to realize that if the ratio is greater than 1, It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed smaller than 1, assets are primarily financed through equity.through equity.



Financial leverageFinancial leverage

• The degree to which an investor or business is utilizing The degree to which an investor or business is utilizing borrowed money is called financial borrowed money is called financial leverage. Companies that are highly leveraged may leverage. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to be at risk of bankruptcy if they are unable to make payments on their debt; they may also be make payments on their debt; they may also be unable to find new lenders in the future.unable to find new lenders in the future.

• Financial leverage is not always bad, however; it Financial leverage is not always bad, however; it can increase the shareholders' return on can increase the shareholders' return on investment and often there are tax advantages investment and often there are tax advantages associated with borrowing.associated with borrowing.

•



operating leverageoperating leverage

• The percentage of fixed costs in a company's cost The percentage of fixed costs in a company's cost structure. Generally, the higher the operating leverage, structure. Generally, the higher the operating leverage, the more a company's income is affected by fluctuation the more a company's income is affected by fluctuation in sales volume. in sales volume.

• The higher income vs. sales ratio results from a smaller The higher income vs. sales ratio results from a smaller portion of variable costs, which means the portion of variable costs, which means the company does not have to pay as company does not have to pay as much additional money for each unit produced or sold.much additional money for each unit produced or sold.

• The more significant the volume of sales, the more The more significant the volume of sales, the more beneficial the investment in fixed costs becomes.beneficial the investment in fixed costs becomes.



Trading on equityTrading on equity

• Trading on equityTrading on equity is when a company incurs new is when a company incurs new debt (such as from bonds, loans, or preferred debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a stock) to acquire assets on which it can earn a return greater than the interest cost of the debt.return greater than the interest cost of the debt.

• If a company generates a profit through this If a company generates a profit through this financing technique then its shareholders earn a financing technique then its shareholders earn a greater return on their investments. In this case, greater return on their investments. In this case, trading on equity is successful. If, on the other trading on equity is successful. If, on the other hand, the company earns less than the cost of hand, the company earns less than the cost of the debt, then its shareholders earn a reduced the debt, then its shareholders earn a reduced return because of this activity.return because of this activity.



Advantages of Trading on equity Advantages of Trading on equity

• Trading on equity has two primary advantages:Trading on equity has two primary advantages:• Enhanced earningsEnhanced earnings. It may allow an entity to earn . It may allow an entity to earn

a disproportionate amount on its assets.a disproportionate amount on its assets.• Favorable tax treatmentFavorable tax treatment. In many tax . In many tax

jurisdictions, interest expense is tax deductible, jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.which reduces its net cost to the borrower.



Example of Trading on EquityExample of Trading on Equity

• Able Company uses $1,000,000 of its own cash to buy a Able Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual factory, which generates $150,000 of annual profits. The . The company is not using financial leverage at all, since it company is not using financial leverage at all, since it incurred no debt to buy the factory.incurred no debt to buy the factory.

• Baker Company uses $100,000 of its own cash and a loan Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy a similar factory, which also generates a of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using financial leverage to $150,000 annual profit. Baker is using financial leverage to generate a profit of $150,000 on a cash investment of generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its investment.$100,000, which is a 150% return on its investment.

• Baker's new factory has a bad year, and generates a loss of Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its original $300,000, which is triple the amount of its original investment.investment.

• Trading on equity is also known as Trading on equity is also known as financial financial leverageleverage, , investment leverageinvestment leverage, and , and operating operating leverageleverage..



Optimum capital structure - meaningOptimum capital structure - meaning

The best debt-to-equity ratio for a firm that The best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for maximizes its value. The optimal capital structure for a company is one which offers a balance between a company is one which offers a balance between the ideal debt-to-equity range and minimizes the the ideal debt-to-equity range and minimizes the firm's cost of capitalfirm's cost of capital

Optimum capital structure is obtained when the Optimum capital structure is obtained when the market value per equity share is the maximummarket value per equity share is the maximum

• Optimum capital structure defined as the relationship Optimum capital structure defined as the relationship between debt and equity securities when maximizes between debt and equity securities when maximizes the value of the company’s share in the stock the value of the company’s share in the stock exchange and minimizes the overall cost of capitalexchange and minimizes the overall cost of capital



Capital structure theoriesCapital structure theories

• In order to achieve the goal of identifying an In order to achieve the goal of identifying an optimum debt-equity mix , it is necessary for the optimum debt-equity mix , it is necessary for the finance manager to be conversant with basic finance manager to be conversant with basic theories of capital structuretheories of capital structure

• 4 major theories are4 major theories are• Net income approach Net income approach • Net operating income approachNet operating income approach• Modigilani –Miller approachModigilani –Miller approach• Traditional approachTraditional approach



Assumptions Assumptions

• There are two types of capital employed debt and There are two types of capital employed debt and equityequity

• No corporate taxesNo corporate taxes• Dividend pay out is 100%Dividend pay out is 100%• Investment decisions are constantInvestment decisions are constant• Firms total financing remains constantFirms total financing remains constant• EBIT are not expected to growEBIT are not expected to grow• Business risk remains constantBusiness risk remains constant• The firm has perpetual (everlasting) lifeThe firm has perpetual (everlasting) life



Net Income approachNet Income approach• Suggested by DurandSuggested by Durand• Here capital structure decision is relevant to the Here capital structure decision is relevant to the

valuation of the firmvaluation of the firm• It Means capital structure causes a corresponding It Means capital structure causes a corresponding

change in the overall cost of the firm and as well change in the overall cost of the firm and as well as the total value of the firmas the total value of the firm

• According to this approach higher debt content in According to this approach higher debt content in the capital structure will result in decline in the the capital structure will result in decline in the overall cost of the capital provided the cost of overall cost of the capital provided the cost of equity is greater than the cost of debt. This will equity is greater than the cost of debt. This will cause increase in the value of the firm and cause increase in the value of the firm and consequently increase in the value of equity consequently increase in the value of equity shares of the companyshares of the company



Leverage

Ke

Ko

Kd

It can be observed from the figure 5.1 that as the leverage increases, the cost of capital (Ko) declines because of the substitution of high cost equity with low cost debt.

Illustration 5.1



• It can be observed from the above figure that as It can be observed from the above figure that as the leverage increases, the cost of capital (Kthe leverage increases, the cost of capital (Koo) ) declinesdeclines



Basic assumptionsBasic assumptions

• No corporate taxesNo corporate taxes• Kd < KeKd < Ke• Debt does not change the risk perception of the investorsDebt does not change the risk perception of the investors• The value of the firm is ascertained as follows:The value of the firm is ascertained as follows:• V = S + BV = S + B• V= value of the firmV= value of the firm• S= market value of equityS= market value of equity• B= market value of debtB= market value of debt• Market value of equity can be fund as: S=NI/keMarket value of equity can be fund as: S=NI/ke• S= market value of equity, NI=earnings available for equity S= market value of equity, NI=earnings available for equity

shareholders ke=cost of equityshareholders ke=cost of equity



PROBLEM 1PROBLEM 1

1. X ltd is expecting an annual EBIT OF Rs.1,00,000. the 1. X ltd is expecting an annual EBIT OF Rs.1,00,000. the company has Rs.4,00,000 10% debentures. The cost company has Rs.4,00,000 10% debentures. The cost of equity capital rate is 12.5% You are required to of equity capital rate is 12.5% You are required to calculate the value of the firm and also state the calculate the value of the firm and also state the overall cost of capitaloverall cost of capital

In order to prove raising more debt increases the value In order to prove raising more debt increases the value of the firm and reduces the overall cost of capitalof the firm and reduces the overall cost of capital

2. X ltd is expecting an annual EBIT OF Rs.1,00,000. 2. X ltd is expecting an annual EBIT OF Rs.1,00,000. the company has Rs.4,00,000 10% debentures. The the company has Rs.4,00,000 10% debentures. The cost of equity capital rate is 12.5%. The company cost of equity capital rate is 12.5%. The company decides to raise Rs.1,00,000 by issue of 10% decides to raise Rs.1,00,000 by issue of 10% debentures and use the proceeds thereof to redeem debentures and use the proceeds thereof to redeem equity sharesequity shares



Net operating income approachNet operating income approach

• Also suggested by Durand Also suggested by Durand • Here the market value of the firm is not at all Here the market value of the firm is not at all

affected by the capital structure changesaffected by the capital structure changes• The value of the firm remains constant The value of the firm remains constant

irrespective of its degree of leverage. The market irrespective of its degree of leverage. The market value of the equity is obtained by deducting the value of the equity is obtained by deducting the market value of the debt from the total value of market value of the debt from the total value of the firm.the firm.



Net operating income approachNet operating income approach

• Capital structure decision has no impact on the Capital structure decision has no impact on the firm valuationfirm valuation

• The cost of debt is also constant at all levels of The cost of debt is also constant at all levels of leverage. In case a firm increases the leverage by leverage. In case a firm increases the leverage by employing more debt, it becomes more risky. The employing more debt, it becomes more risky. The advantage of using 'cheaper' debt financing will advantage of using 'cheaper' debt financing will be offset by higher cost of equity due to its be offset by higher cost of equity due to its 'increased riskiness.’ 'increased riskiness.’

• The same is graphically represented as follows.The same is graphically represented as follows.



Leverage

K e

Ko

Kd



AssumptionsAssumptions

• overall cost of capital remains constant for all overall cost of capital remains constant for all kinds of debt-equity mixkinds of debt-equity mix

• Use of debt increases the risk of shareholdersUse of debt increases the risk of shareholders• There is no corporate taxesThere is no corporate taxes• Formula for value of firm: V= EBIT v= value of Formula for value of firm: V= EBIT v= value of

firmfirm

------- k=overall cost ------- k=overall cost capcap

k k



Cont….Cont….

• Value of equity: the value of equity is residual Value of equity: the value of equity is residual value which is determined by deducted from total value which is determined by deducted from total value of the firmvalue of the firm

• S= V-B S= Value of equity, V= total value B= S= V-B S= Value of equity, V= total value B= value of debtvalue of debt

Problem: Problem:

XY Ltd has an EBIT of Rs.1,00,000. the cost of XY Ltd has an EBIT of Rs.1,00,000. the cost of debt is 10% and outstanding debt amount to debt is 10% and outstanding debt amount to Rs.4,00,000. presuming the overall cost of capital Rs.4,00,000. presuming the overall cost of capital is 12.5% calculate the total value of the firm and is 12.5% calculate the total value of the firm and the equity capitalization ratethe equity capitalization rate



Cont…Cont…

• If the firm raises the debt content for reducing the If the firm raises the debt content for reducing the equity content the total value of the firm would equity content the total value of the firm would remain unchanged. However the cost of equity remain unchanged. However the cost of equity capital might go up. This is done through problemcapital might go up. This is done through problem

Problem 2 Problem 2

XY ltd has an EBIT of Rs.1,00,000. the cost of debt XY ltd has an EBIT of Rs.1,00,000. the cost of debt is 10% and outstanding debt amount to is 10% and outstanding debt amount to Rs.4,00,000. presuming the overall cost of capital is Rs.4,00,000. presuming the overall cost of capital is 12.5%. The company decides to raise a sum of Rs.1 12.5%. The company decides to raise a sum of Rs.1 lakh through debt at 10% and uses the proceeds to lakh through debt at 10% and uses the proceeds to pay of equity shareholders. You are required to pay of equity shareholders. You are required to calculate the total value of the firm and Ke.calculate the total value of the firm and Ke.



Traditional approachTraditional approach

• The firm can attain optimality in capital structure The firm can attain optimality in capital structure through judicious use of leverage. The theory through judicious use of leverage. The theory postulates that the cost of debt (kpostulates that the cost of debt (kdd) remains ) remains constant up to a certain level of leverage and constant up to a certain level of leverage and rises gradually thereafter. rises gradually thereafter.

• The cost of equity rises at a slow pace up to a The cost of equity rises at a slow pace up to a certain degree of leverage and increases rapidly certain degree of leverage and increases rapidly thereafter. The cost of capital (kthereafter. The cost of capital (koo) initially ) initially declines due to moderate application of leverage.declines due to moderate application of leverage.



• After a certain degree of leverage, the increase in After a certain degree of leverage, the increase in the cost of equity is more than the benefits the cost of equity is more than the benefits obtained due to cheaper debt. At this point the obtained due to cheaper debt. At this point the cost of capital begins to rise. The rise in cost of cost of capital begins to rise. The rise in cost of capital becomes much more sharper, once the capital becomes much more sharper, once the cost of debt begins to rise.cost of debt begins to rise.

• The theory explains that the cost of capital is The theory explains that the cost of capital is dependent on the capital structure of the firm. dependent on the capital structure of the firm. The optimal capital structure is the one which The optimal capital structure is the one which minimizes the cost of capital. minimizes the cost of capital.



Leverage

K e

Ko

Kd



Modigliani Miller ApproachModigliani Miller Approach

• Prof. Franco Modigliani and Prof. Merton Miller Prof. Franco Modigliani and Prof. Merton Miller propound that the composition of the capital propound that the composition of the capital structure is an irrelevant factor in the market structure is an irrelevant factor in the market valuation of the firm. They have strongly attacked valuation of the firm. They have strongly attacked the traditional position that a firm has an optimal the traditional position that a firm has an optimal capital structurecapital structure



AssumptionsAssumptions

• The fundamental building block for MM The fundamental building block for MM hypothesis is that capital markets are perfect. hypothesis is that capital markets are perfect. There is a free flow of information in the market There is a free flow of information in the market which can be readily accessed by any investor. which can be readily accessed by any investor. There are no costs involved in obtaining the There are no costs involved in obtaining the information.information.

• The securities issued and traded in the market The securities issued and traded in the market are infinitely divisible.are infinitely divisible.

• There are no transaction costs like flotation costs, There are no transaction costs like flotation costs, underpricing of primary issues, brokerage, underpricing of primary issues, brokerage, transfer taxes, etc.transfer taxes, etc.



AssumptionsAssumptions • All the participants in the market are rational, i.e. All the participants in the market are rational, i.e.

they strive to maximize their profits or minimize they strive to maximize their profits or minimize their losses.their losses.

• All investors have homogenous expectations about All investors have homogenous expectations about the future earnings of all the firms in the market.the future earnings of all the firms in the market.

• Firms can be classified into 'equivalent return' Firms can be classified into 'equivalent return' classes. The firms in each have exactly the same classes. The firms in each have exactly the same profile of business risk. Hence the firms can be taken profile of business risk. Hence the firms can be taken as perfect substitutes for one another. All the firms as perfect substitutes for one another. All the firms within a specific class have a common capitalization within a specific class have a common capitalization rate.rate.

• There are no corporate taxes. This assumption was There are no corporate taxes. This assumption was later dropped.later dropped.



• Proposition IProposition I: The market valuation of a firm is : The market valuation of a firm is independent of its capital structure and is independent of its capital structure and is determined by capitalizing its expected return at determined by capitalizing its expected return at the rate appropriate to its classthe rate appropriate to its class

• Thus the cost of capital of a firm is independent Thus the cost of capital of a firm is independent of its capital structure.of its capital structure.

•



Proposition II:Proposition II:

• The expected yield on common stock (cost of equity) The expected yield on common stock (cost of equity) is equal to the sum of the capitalization rate for a is equal to the sum of the capitalization rate for a pure equity stream of that specific class and the pure equity stream of that specific class and the premium based on the financial risk. premium based on the financial risk.

• The implication of this, proposition is that the cost of The implication of this, proposition is that the cost of equity will be equal to the cost of capital in an all equity will be equal to the cost of capital in an all equity firm. As the company starts introducing equity firm. As the company starts introducing cheaper debt in its capital structure to reduce the cost cheaper debt in its capital structure to reduce the cost of capital, the financial risk of the firm increases. Due of capital, the financial risk of the firm increases. Due to increase in the financial risk, the equity holders to increase in the financial risk, the equity holders demand higher returns, which pushes up the cost of demand higher returns, which pushes up the cost of equity. Thus the benefits obtained by the use of equity. Thus the benefits obtained by the use of cheaper debt is exactly offset due to the rise in the cheaper debt is exactly offset due to the rise in the cost of equity. Thus the cost of capital remains a cost of equity. Thus the cost of capital remains a constant irrespective of the financing mixconstant irrespective of the financing mix



Proposition IIIProposition III

The investment and financing decisions of a firm The investment and financing decisions of a firm are independent of each other. A firm should are independent of each other. A firm should exploit an investment opportunity, if and only if, exploit an investment opportunity, if and only if, the rate of return on the investment is greater the rate of return on the investment is greater than the cost of capital- Thus the cut-off point for than the cost of capital- Thus the cut-off point for investment by the firm should in all cases be the investment by the firm should in all cases be the capitalization rate for that class. Regardless of capitalization rate for that class. Regardless of the financing mix, the marginal cost of capital will the financing mix, the marginal cost of capital will be equal to the average cost of capital.be equal to the average cost of capital.



Factors determining capital structureFactors determining capital structure

• Type of Asset FinancedType of Asset Financed: Ideally short-term : Ideally short-term liabilities should be used to create short-term liabilities should be used to create short-term assets and long-term liabilities for long-term assets and long-term liabilities for long-term assets. Otherwise a mismatch develops between assets. Otherwise a mismatch develops between the time to extinguish the liability and the assets the time to extinguish the liability and the assets generation of returns. This mismatch may generation of returns. This mismatch may introduce elements of risks like interest rate introduce elements of risks like interest rate movements and market receptivity at the time of movements and market receptivity at the time of refinancing.refinancing.



• Nature of the IndustryNature of the Industry: A firm generally relies : A firm generally relies more on long-term debt and equity if its capital more on long-term debt and equity if its capital intensity is high. All short-term assets need not intensity is high. All short-term assets need not be financed by short-term debt. In a non-seasonal be financed by short-term debt. In a non-seasonal and non-cyclical business, investments in current and non-cyclical business, investments in current assets assume the characteristics of fixed assets assets assume the characteristics of fixed assets and hence need to be financed by long-term and hence need to be financed by long-term liabilities. If the business is seasonal in nature, liabilities. If the business is seasonal in nature, the funding needs at seasonal peaks may be the funding needs at seasonal peaks may be financed by short-term debt. The risk of financial financed by short-term debt. The risk of financial leverage increases for businesses subject to large leverage increases for businesses subject to large cyclical variations. These businesses need capital cyclical variations. These businesses need capital structures that can buffer the risks associated structures that can buffer the risks associated with such swings.with such swings.



• Degree of CompetitionDegree of Competition: A business : A business characterized by intense competition and low characterized by intense competition and low entry barriers faces greater risk of earnings entry barriers faces greater risk of earnings fluctuations. The risks of fluctuating earnings can fluctuations. The risks of fluctuating earnings can be partially hedged by placing more weightage be partially hedged by placing more weightage for equity financing. Reductions in the levels of for equity financing. Reductions in the levels of competition and higher entry barriers decrease competition and higher entry barriers decrease the volatility of the earnings stream and present the volatility of the earnings stream and present an opportunity to safely and profitably increase an opportunity to safely and profitably increase the financial leverage.the financial leverage.

•



• ObsolescenceObsolescence: The key factors that lead to : The key factors that lead to technological obsolescence should be identified technological obsolescence should be identified and properly assessed. Obsolescence can occur in and properly assessed. Obsolescence can occur in products, manufacturing processes, material products, manufacturing processes, material components and even marketing. Financial components and even marketing. Financial maneuverability is at a premium during times of maneuverability is at a premium during times of crisis triggered by obsolescence. Excessive crisis triggered by obsolescence. Excessive leverage can limit the firm's ability to respond to leverage can limit the firm's ability to respond to such crisis. If the chances of obsolescence are such crisis. If the chances of obsolescence are high, the capital structure should be built high, the capital structure should be built conservatively.conservatively.

•



• Product Life CycleProduct Life Cycle: At the venture stage, the : At the venture stage, the risks are high. Therefore equity, being risk risks are high. Therefore equity, being risk capital, is usually the primary source of finance. capital, is usually the primary source of finance. The venture cannot assume additional risks The venture cannot assume additional risks associated with financial leverage. During the associated with financial leverage. During the growth stage, the risk of failure decreases and growth stage, the risk of failure decreases and the emphasis shifts to financing growth. Rapid the emphasis shifts to financing growth. Rapid growth generally signals significant investment growth generally signals significant investment needs and requires huge sums of capital to fuel needs and requires huge sums of capital to fuel growth. This may entail large doses of debt and growth. This may entail large doses of debt and periodic induction of additional equity capital. As periodic induction of additional equity capital. As growth slows, seasonality and cyclically become growth slows, seasonality and cyclically become more apparent. As the business reaches maturity more apparent. As the business reaches maturity stage, leverage is likely to decline as cash flows stage, leverage is likely to decline as cash flows accelerate.accelerate.



Financial PolicyFinancial Policy: Designing an optimum capital : Designing an optimum capital structure should be done in response to overall structure should be done in response to overall financial policy of the firm. The management may financial policy of the firm. The management may have evolved certain financial policies like have evolved certain financial policies like maximum debt equity ratio, predetermined maximum debt equity ratio, predetermined dividend payout, minimum debt service coverage dividend payout, minimum debt service coverage level, etc. Designing of capital structure will level, etc. Designing of capital structure will become subservient to such constraints and the become subservient to such constraints and the solution provided may be suboptimal.solution provided may be suboptimal.



Past and Current Capital StructurePast and Current Capital Structure: The : The proposed capital structure is often determined by proposed capital structure is often determined by past events. Prior financing decisions, past events. Prior financing decisions, acquisitions, investment decisions, etc. create acquisitions, investment decisions, etc. create conditions which may be difficult to change in the conditions which may be difficult to change in the short run. However, in the medium- to long-term, short run. However, in the medium- to long-term, capital structure can be changed by issuing or capital structure can be changed by issuing or retiring debt, issuing equity, equity buy-backs retiring debt, issuing equity, equity buy-backs (when permitted), securitization, altering dividend (when permitted), securitization, altering dividend policies, changing asset turnover, etc.policies, changing asset turnover, etc.



• Corporate ControlCorporate Control: Firms, which are vulnerable : Firms, which are vulnerable to takeover, are averse to further issuance of to takeover, are averse to further issuance of equity as it can result in the dilution of the equity as it can result in the dilution of the ownership stake. Such firms place an excessive ownership stake. Such firms place an excessive reliance on debt and retained earnings. Firms reliance on debt and retained earnings. Firms with 'strong' management (having controlling with 'strong' management (having controlling stake) are unlikely to have reservations over stake) are unlikely to have reservations over further issue of equity.further issue of equity.

•



• Credit RatingCredit Rating: The market assigns a great deal of : The market assigns a great deal of weightage to the credit rating of a firm. Hence obtaining weightage to the credit rating of a firm. Hence obtaining and maintaining a target rating has become imperative for and maintaining a target rating has become imperative for most firms. Rating agencies maintain constant watch to most firms. Rating agencies maintain constant watch to identify any signs of deterioration in the creditworthiness of identify any signs of deterioration in the creditworthiness of the company. The market reacts negatively to any the company. The market reacts negatively to any downgrading of the rating of a firm. This may result in a downgrading of the rating of a firm. This may result in a denial of access to capital either due to the provision of any denial of access to capital either due to the provision of any law / regulations (companies below a certain rating cannot law / regulations (companies below a certain rating cannot issue CPs) or by the market forces (investors may not issue CPs) or by the market forces (investors may not subscribe to debt with low ratings). The possibility of subscribe to debt with low ratings). The possibility of downgrading of rating due to the increase in leverage downgrading of rating due to the increase in leverage should be factored in while making capital structure should be factored in while making capital structure decisions.decisions.

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Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University Capital structure S.Vasantha