CAPITAL STRUCTURE POLICY

INTRODUCTION
y The objective of a firm should be directed towards the

maximization of the firms value.

y The capital structure or financial leverage decision should be

examined from the point of its impact on the value of the firm.

Capital Structure Theories:

y Net operating income (NOI) approach. y Traditional approach and Net income (NI) approach. y MM hypothesis with and without corporate tax. y Millers hypothesis with corporate and personal taxes. y Trade-off theory: costs and benefits of leverage.

Net Income (NI) Approach

y 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. The effect of leverage on the cost of
capital under NI approach

MMs Proposition I: Key Assumptions

y Perfect capital markets y Homogeneous risk classes y Risk y No taxes y Full payout

MMs Proposition II
y Financial leverage causes two opposing effects: it increases the

shareholders return but it also increases their financial risk. Shareholders will increase the required rate of return (i.e., the cost of equity) on their investment to compensate for the financial risk. The higher the financial risk, the higher the shareholders required rate of return or the cost of equity. y The cost of equity for a levered firm should be higher than the opportunity cost of capital, ka; that is, the levered firms ke > ka. It should be equal to constant ka, plus a financial risk premium.

Net Operating Income (NOI) Approach

y According to NOI approach the value of the firm and

the weighted average cost of capital are independent of the firms 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. y MMs approach is a net operating income approach.

RELEVANCE OF CAPITAL STRUCTURE:

THE MM HYPOTHESIS UNDER CORPORATE TAXES
y MM show that the value of the firm will increase with debt

due to the deductibility of interest charges for tax computation, and the value of the levered firm will be higher than of the unlevered firm.

Example: Debt Advantage: Interest Tax Shields

y Suppose two firms L and U are identical in all respects except that firm L is levered

and firm U is unlevered. Firm U is an all-equity financed firm while firm L employs equity and Rs 5,000 debt at 10 per cent rate of interest. Both firms have an expected earning before interest and taxes (or net operating income) of Rs 2,500, pay corporate tax at 50 per cent and distribute 100 per cent earnings as dividends to shareholders.

y You may notice that the total income after corporate tax is Rs 1,250 for the

unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered firm Ls investors are ahead of the unlevered firm Us investors by Rs 250. You may also note that the tax liability of the levered firm L is Rs 250 less than the tax liability of the unlevered firm U. For firm L the tax savings has occurred on account of payment of interest to debt holders. Hence, this amount is the interest tax shield or tax advantage of debt of firm L: 0.5 (0.10 5,000) = 0.5 500 = Rs 250.Thus,

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Millers Model
y To establish an optimum capital structure both corporate and personal taxes paid

on operating income should be minimised. The personal tax rate is difficult to determine because of the differing tax status of investors, and that capital gains are only taxed when shares are sold.
y Merton miller proposed that the original MM proposition I holds in a world with

both corporate and personal taxes because he assumes the personal tax rate on equity income is zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax rate. At this point, there will be no net tax advantage to companies from issuing additional debt.
y It is now widely accepted that the effect of personal taxes is to lower the estimate

of the interest tax shield.

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Equity Capital Structure

(Rs.in Cr) Less : Calls in Arrears

Year 2011 2010 2009 2008 2007 2006 2005 2004 2003

Authorised

Issued Subscribed

Called Up

Forfeited

Paid Up

349.25 349.25 349.25 349.25 349.25 349.25 349.25 349.25 349.25

338.63 338.63 338.63 338.63 339.33 339.33 339.33 339.33 339.33

338.63 338.63 338.63 338.63 339.33 339.33 339.33 339.33 339.33

338.63 338.63 338.63 338.63 339.33 339.33 339.33 339.33 339.33

0.00 0.00 0.00 0.00 0.38 0.39 0.40 0.43 0.50

0.38 0.38 0.38 0.38 0.00 0.00 0.00 0.00 0.00

339.01 339.01 339.01 339.01 338.95 338.94 338.93 338.90 338.83

CAPITAL STRUCTURE PLANNING AND POLICY

y Theoretically, the financial manager should plan an optimum

capital structure for the company. The optimum capital structure is one that maximizes the market value of the firm. y The capital structure should be planned generally, keeping in view the interests of the equity shareholders and the financial requirements of a company. y While developing an appropriate capital structure for its company, the financial manager should inter alia aim at maximizing the long-term market price per share.

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Elements of Capital Structure

1. 2. 3. 4. 5. 6.

Capital mix Maturity and priority Terms and conditions Currency Financial innovations Financial market segments

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Framework for Capital Structure: The FRICT Analysis

y Flexibility y Risk y Income y Control y Timing

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APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE

EBITEPS approach for analyzing the impact of debt on EPS. 2. Valuation approach for determining the impact of debt on the shareholders value. 3. Cash flow approach for analyzing the firms ability to service debt.
1.

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EBIT-EPS Analysis
y The EBIT-EPS analysis is a first step in deciding about a firms capital

structure. y It suffers from certain limitations and does not provide unambiguous guide in determining the level of debt in practice.
y The major shortcomings of the EPS as a financing-decision criterion

are:
y It is based on arbitrary accounting assumptions and does not reflect the

economic profits. y It does not consider the time value of money. y It ignores the variability about the expected value of EPS, and hence, ignores risk.

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Valuation Approach
y The firm should employ debt to the point where the marginal benefits

and costs are equal. y This will be the point of maximum value of the firm and minimum weighted average cost of capital. y The difficulty with the valuation framework is that managers find it difficult to put into practice. y The most desirable capital structure is the one that creates the maximum value.

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Cash Flow Analysis

y Cash adequacy and solvency y In determining a firms target capital structure, a key issue is the firms ability to service its debt. The focus of this analysis is also on the risk of cash insolvencythe probability of running out of the cashgiven a particular amount of debt in the capital structure. This analysis is based on a thorough cash flow analysis and not on rules of thumb based on various coverage ratios. y Components of cash flow analysis y Operating cash flows y Non-operating cash flows y Financial cash flows

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Cash Flow Analysis Versus EBITEPS Analysis

y The cash flow analysis has the following advantages over EBIT

EPS analysis:
1.

2. 3. 4. 5.

It focuses on the liquidity and solvency of the firm over a long-period of time, even encompassing adverse circumstances. Thus, it evaluates the firms ability to meet fixed obligations. It goes beyond the analysis of profit and loss statement and also considers changes in the balance sheet items. It identifies discretionary cash flows. The firm can thus prepare an action plan to face adverse situations. It provides a list of potential financial flows which can be utilized under emergency. It is a long-term dynamic analysis and does not remain confined to a single period analysis.

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Practical Considerations in Determining Capital Structure

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Assets Growth Opportunities Debt and Non-debt Tax Shields Financial Flexibility and Operating Strategy Loan Covenants Financial Slack Sustainability and Feasibility Control Marketability and Timing Issue Costs Capacity of Raising Funds

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