CAPITAL STRUCTURE

INTRODUCTION: Capital structure refers to the composition or make-up of long term sources of funds such as equity shares, preference shares, debentures and long term loans. The capital structure of a company refers to a containation of the long-term finances used by the firm. The theory of capital structure is closely related to the firms cost of capital. The decision regarding the capital structure or the financial leverage or the financing wise is based on the objective of achieving the maximization of shareholders wealth. Capital structure decision is one the important decision that chief financial head of the company should take. He should plan optimum capital structure for the company, which will be advantageous to the company. The optimum capital structure is that increases the market value of firm. To design capital structure, we should consider the following two propositions: Wealth maximinization is attained. Best approximation to the optimal capital structure. Sources of long term fund: The capital of the company can be raised through shares. There are two types of shares which a company can issue. Preference share: The preference shares are market instrument issued by the companies to raise the capital. Preference shares have the characteristics of both equity shares and debentures. Fixed rate of dividends are paid to the preference share holder as incase of debentures, irrespective of the profits earned company is liable to pay interest to preference share holders. Equity shares: Equity shares are those shares which are ordinary in the course of company's business. They are also called as ordinary shares. These share holders do not enjoy preference regarding payment of dividend and repayment of capital. Equity shareholders are paid dividend out of the profits made by a company. Higher the profits, higher will be the dividend and lower the profits, lower will be the dividend.

Debentures:
A type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are documented in an indenture. Term Loans: These are raised through the bank and other financial institution for a fixed rate of interest. A term loan is a monetary loan that is repaid in regular payments over a set period of time. Term loans usually last between one and ten years, but May last as long as 30 years in some cases. A term loan usually involves an unfixed interest rate that will add additional balance to be repaid.

PROCESS OF CAPITAL STRUCTURE DECISIONS:

Capital budgeting decision

Long term sources of fund

Capital structure decision

Dividend decision

Debt equity

Existing capital structure

Effects on investors risk

Effects on cost of capital

Effects on earnings per share

Value of the firm

Features of capital structure: Return: The capital structure of the company should be advantageous subjects to other considerations; it should generate maximum returns to the shareholders without adding additional cost to them. Risk: The use of excessive debt threatens the solvency of the company. Debt can be used the point where there is no significance risk, it should be avoided. Flexibility: The capital structure should be flexible. It should be possible for the company to adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also possible for the company to provide funds whenever needed to finance its profitable activities. Capacity: The capital structure should be determined within the debt capacity of the company, and the capacity should not be exceeded. The capacity depends on the ability to generate future cash flows. They should have enough cash to pay the creditors fixed charges and principal sum. Control: The capital structure should involve minimum risk of loss of control of the company. The owners of closely held companies are particularly concerned about dilution of control. Factors Determining Capital Structure: Trading on Equity: The word equity denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to additional profits that equity shareholders earn because of issuance of debentures and preference shares. It is based on the thought that if the rate of dividend on preference capital and the rate of interest on borrowed capital is lower than the general rate of companys earnings, equity shareholders are at advantage which means a company should go for a judicious blend of preference shares, equity shares as well as debentures. Trading on equity becomes more important when expectations of shareholders are high. Degree of control: In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the companys management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

 Flexibility of financial plan: In an enterprise, the capital structure should be such that there is both contractions as well as relaxation in plans. Debentures and loans can be refunded back as the time requires. While equity capital cannot be refunded at any point which provides rigidity to plans. Therefore, in order to make the capital structure possible, the company should go for issue of debentures and other loans. Choice of investors: The companys policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. Capital market condition: In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the companys capital structure generally consists of debentures and loans. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. Period of financing: When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures. Cost of financing: In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debentures at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits. Stability of sales: An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases. Sizes of a company: Small size business firms capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.

Factors affecting capital structure: There are two types of factors and they are internal and external factors affecting capital structure. Internal factors: Financial leverage Risk Growth and stability Retaining control Cost of capital Cash flows Flexibility Purpose of finance Asset structure

External factors: Conditions of the capital market Level of stock prices Taxation policy Availability of funds Level of business activity Level of interest rate Period of finance Legal requirements Cost of inflation Investors Nature of the industry Size of the company

Assumptions of capital structure: There are only two sources of funds i.e.: debt and equity. The total assets of the company are given and do not change. Investment decisions will be constant. 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. The company has infinite life. Dividend payout ratio = 100%.(No Retained Earnings)

THEORIES OF CAPITAL STRUCTURE Equity and debt capital are the two major sources of long-term funds for a firm. The theories on capital structure suggest the proportion of equity debt in the capital structure.
ASSUMPTIONS:
a) There are only two sources of funds, i.e., the equity and the debt, having a fixed interest. b) The total assets of the firm are given and there would be no change in the investment decisions of the firm. c) EBIT (Earnings Before Interest & Tax)/NOP (Net Operating Profits) of the firm are given and is expected to remain constant. d) Retention Ratio is NIL, i.e., total profits are distributed as dividends. [100% dividend pay-out ratio] e) The firm has a given business risk which is not affected by the financing wise. f) There is no corporate or personal tax. g) The investors have th same subjective probability distribtuion of expected operating profits of the firm. h) The capital structure can be altered without incurring transaction costs.

Net Income Theory This theory was propounded by David Durand and is also known as Fixed Ke Theory. According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach Assumptions of NI Theory: The Kd is cheaper than the Ke. Income tax has been ignored. The Kd and Ke remain constant

Net Operating Income Theory This theory was propounded by David Durand and is also known as Irrelevant Theory. According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firms capital structure. Overall cost of capital is independent of degree of leverage. 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. Assumptions of NOI Theory: The split of total capitalization between debt and equity is not essential or relevant. The equity shareholders and other investors i.e. the market capitalizes the value of the firm as a whole. The business risk at each level of debt-equity mix remains constant. Therefore, overall cost of capital also remains constant. The corporate income tax does not exist

Traditional approach Theory This theory was propounded by Ezra Solomon. Its a Midway between Two Extreme (NI & NOI Approach). According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital. This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand: First Stage: In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. Second Stage In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. Third Stage Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital. Modigliani- Miller (MM) Approach Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide operational justification for independence of the company's cost of capital. Basic Propositions of MM approach: At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.

 The cost of capital (Ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio. The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed Assumptions of MM approach: Capital markets are perfect. All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm. Within similar operating environments, the business risk is equal among all firms. 100% dividend payout ratio. An assumption of "no taxes" was there earlier, which has been removed. MM Approach Without Tax: Proposition I MMs Proposition I, states that the firms value is independent of its capital structure. The Total value of firm must be constant irrespective of the Degree of leverage (debt equity Ratio). With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm. This will continue till the market prices of identical firms become identical. This is called arbitrage. MM Approach without Tax: Proposition II 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 firms 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 Hypothesis with Corporate 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 unlevered 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 unlevered 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.

Limitation of MM theory: Investors would find the personal leverage inconvenient. The risk perception of corporate and personal leverage may be different. Arbitrage process cannot be smooth due the institutional restrictions. Arbitrage process would also be affected by the transaction costs. The corporate leverage and personal leverage are not perfect substitutes. Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.

Objectives of the Study: To learn the capital structure To study the factors determining capital structure To analyze the debt servicing capacity of the company Limitations of the Study It is based on the secondary data so reliability may not be accurate The study is limited to Roots Industries India Limited only and hence the findings cannot be generalized to other similar concerns.

RESEARCH METHODOLOGY
Research Methodology is a way to systematically solve the research problem. It may be understand as a science of studying how research is done scientifically. In it we study the various steps that are generally adopted by a research problem along with the logic behind them. RESEARCH DESIGN The research design applicable for the proposed study is descriptive. As the use of facts & information are already available and these to make a critical evaluation of the material. The formidable program is the preparation of the design of the research program that follows design of the research project, properly known as the Research design. Designs regarding what, where, when, which & how much, by what means concerning an inquiry or a research study constitute a research design. A research design is the arrangement of condition for collection and analysis of data in a manner that aims to combine relevance to the research purpose with economic in procedure. SOURCES OF DATA The study is entirely based on secondary data. The secondary data is actually the available data which is in the form of reports that would serve as a source for the study. The sources are companys annual report. Sample size The sample size is chosen on the basis of available data from ROOTS INDUSTRIES INDIA LIMITED. Among other auto components companies in TamilNadu, Roots Industries India Limited in order to ascertain the capital structure and probability performance any of number of years. RESEARCH TOOLS: The tools used in the analysis are different ratios. Its analyze capital structure position of the company.