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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.

Financial Management - Chapter 3

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Page 1: Financial Management - Chapter 3

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.

Page 2: Financial Management - Chapter 3

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.

Page 3: Financial Management - Chapter 3

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.

Page 4: Financial Management - Chapter 3

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.

Page 5: Financial Management - Chapter 3

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

Page 6: Financial Management - Chapter 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)

Page 7: Financial Management - Chapter 3

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

Page 8: Financial Management - Chapter 3

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.

Page 9: Financial Management - Chapter 3

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

Page 10: Financial Management - Chapter 3

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)

Page 11: Financial Management - Chapter 3

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)

Page 12: Financial Management - Chapter 3

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.

Page 13: Financial Management - Chapter 3

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.

Page 14: Financial Management - Chapter 3

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.

Page 15: Financial Management - Chapter 3

(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.

Page 16: Financial Management - Chapter 3

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.

Page 17: Financial Management - Chapter 3

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.

Page 18: Financial Management - Chapter 3

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.