Capital structure and approaches to capital structure

Capital mental synthesis and bettermentes to groovy bodily buildingIt is defined as the mix or hint of a strongs permanent long-term financing represented by debt, penchant banal, and common stock law.Capital bodily twist possibleness suggests that satisfyings determine what is very much referred to as a target debt balance, which is based on various tradeoffs surrounded by the exists and benefits of debt versus uprightness.The term outstanding building refers to the role of bang-up ( specie) at work in a note by display case. Broadly speaking, on that point argon deuce forms of large(p) equity not bad(p) and debt upper-case letter. Each has its witness benefits and drawbacks and a substantial part of wise corpo straddle stewardship and management is attempting to visit the perfect nifty structure in footing of try / returns deliveroff for sh ar reigners. This is received for Fortune 500 companies and for sm any(prenominal) business haveers onerous to determine how much of their startup money should come from a cuss loan without endangering the businessLets look at each in full stopEquity CapitalThis refers to money put up and owned by the shargonholders (owners). Typically, equity peachy consists of dickens types 1) contri thoed seat of government, which is the money that was originally invested in the business in ex sort for sh atomic subject 18s of stock or ownership and 2)retained shekels, which represents boodle from past years that af fuddled been kept by the company and apply to strengthen thebalance sheetor fund produce, acquisitions, or expansion.many conduct equity chief city to be the approximately expensive type of great(p) a company place utilize because its follow is the fade the unassailable must earn to attract investment. A speculative dig company that is looking for silver in a remote character of Africa may require a much high(prenominal) proceeds on equityto get investors to purchase the stock than a firm much(prenominal) as Procter Gamble, which swops everything from toothpaste and shampoo to detergent and beauty products.Debt CapitalThe debt not bad(p) in a companys dandy structure refers to borrowed money that is at work in the business. The safest type is generally considered long-term bondsbecause the company has years, if not decades, to come up with the principal, while pay offing affair totally in the meantime. early(a) types of debt capital crowd out include short-term commercial paper utilized by giants such(prenominal) as Wal-Mart and General Electric that amount to billions of dollars in 24-hour loans from the capital foodstuffs to meet day-to-day working capital requirements such as payroll departmentand utility bills. The address of debt capital in the capital structure seems on the health of the companys balance sheet a triple AAA straddled firm is going to be able to borrow at extremely grim sites versus a speculative co mpany with tons of debt, which may grow to pay 15% or to a greater extent in ex replace for debt capital.Other Forms of CapitalThere are actually other forms of capital, such asvendor financingwhere a company fire sell goods earlier they induct to pay the bill to the vendor, that can drastically add-on surrender on equity but dont be the company anything. This was one of the secrets tosurface-to-air missile Waltons success at Wal-Mart. He was often able to sell run detergent forwards having to pay the bill to Procter Gamble, in force-out, using PGs money to grow his retailer. In the case of an insurance company, the policyholder float represents money that doesnt run to the firm but that it gets to use and earn an investment on until it has to pay it out for accidents or medical bills, in the case of an auto insurer. The toll of other forms of capital in the capital structure varies outstandingly on a case-by-case basis and often comes down to the talent and sepa loca lize of managers.SEEKING THE OPTIMAL CAPITAL STRUCTUREMany middle track individuals believe that the goal in life is to be debt-free. When you reach the upper echelons of finance, however, that idea is almost anathema. Many of the most fortunate companies in the cosmos base their capital structure on one simple regard the damage of capital. If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider at least 40% to 50% in debt capital in your boilersuit capital structure.Of course, how much debt you repel on comes down to how near the revenues your business generates are if you sell an indispensable product that people plain must nourish, the debt forget be much lower risk than if you live on a theme park in a tourist townspeople at the height of a boom market placeplace. Again, this is where managerial talent, experience, and wisdom comes into play. The great managers have a knack for c onsistently lowering theirweighted intermediate represent of capitalby increasing productivity, seeking out higher return products, and more.To truly understand the idea of capital structure, you need to piddle a few moments to read Return on Equity The DuPont ensampleto understand how the capital structure represents one of the three components in determine therate of returna company will earn on the money its owners have invested in it. Whether you own a doughnut workshop or are considering investing in publicly traded stocks, its drive inledge you barely must have.Question on our minds Can the make out valuation of a company (debt+equity) and the exist of capital be affected by ever-changing the financing mix. The imperfections in the market play a vital billet in the valuation of a company. This data is of utmost importance to the suppliers of capital. Changes in the financing mix are imitation to occur by put out debt and repurchasing common stock or by issuing commo n stock and retiring debt.Example 1. Assume a company whose simoleons are not anticipate to grow and which pays out all of its earnings to its per centumholders in the form of dividends. All kinds of market imperfections are not considered in the flow rate example, for simplicity in calculations.We are concerned mainly with 3 diverse rates of return. The first isThe yield on companys debt, ki = =The second rate of return that we are concerned with iske = =With our assumptions that the firms earnings are not expected to grow and which has a 100 percent dividend payout, the firms earning per price represents the market rate of discount that equates the present economic value of the perpetual stream of expected uniform future dividends with the current market price of the common stock.The third rate to be deliberate isko = =These 3 diametrical rates of return affect the amount of pecuniary supplement, which is the debt to equity ratio.ko is defined as the general capitaliza tion rate of the firm. It is determinationed as the weighted intermediate court of capital, and can as well be expressed asko = ki + ke Calculating A Companys Capital StructureReview your companys most recent financial statements to find all of the capital components. Highlight all of the debt of the company and the equity (including common and preferred make outs, capital contributions and retained earnings). conduce up the total debt and equity It will be equal to your companys assets on the balance sheet because the debt and equity is what paid for those assets.Your capital structure is the percentage that each funding source represents of your companys total funding. Lets look at an example. Lets declare you have the following capital components bank loan $176,500, retained earnings $54,300, common stock $12,500. That makes your total capital $243,300. To calculate your capital structure, waste the dollar amount of each capital source and divide it by the total capital. In the above example, the bank loan is 72.5%, retained earnings 22.3%, capital stock 5.2% for a total of 100%.Monitor your companys capital structure all over time. Debt tends to be the most expensive source of capital and, over time, you will determine the most effective blend of debt versus equity financing for your particular situation. Calculating your actual capital structure will allow you to track how closely you are following your ideal capital structure.Factors Affecting Capital StructureThe factors that affect the decisions taken regarding capital structure can be change integrity into three major typesInternal Factors outdoor(a) FactorsGeneral FactorsINTERNAL FACTORS live of CapitalThe cost of capital is the cost of the companys property. It consists of debts and equity. When a company raises funds for its operations there are plastered costs compound. When decisions regarding the capital structure are taken, managers ensure that the earnings on the capital are more than this cost of capital. In general, the cost of acquire capital is less than the cost of equity capital. This is because the interest rate on loans and borrowings is less than the dividend rates and also the dividends are a function of the companys wampum and not expenditure.Risk FactorWhen decisions regarding capital structure are to be taken, the risk factors considerations are an important issue. If company raises its funds through debts, the risks involved are of two typesThe company has to repay the lenders in a improve time period and at a fixed rate, whether or not the company makes derive or goes into loss.The borrowed capital is secured capital. Hence, if the company fails to make the payments, the lenders can take possession of the companys assets.If the company goes for funds through equity capital there are minimum risks. As the dividends are an appropriation of the companys profits, if it does not make any profit, it is not obliged to make the payments. In demar cation to debt capital, here the company is not expected to repay its equity capital. And also the equity capital is not secured.Control FactorWhen additional funds are to be raised, the obligate factors are very essential in deciding the capital structure of the company. When a company decides to issue bring forward equity shares the control of the company may be at stake. Hence, it may not be acceptable to its shareholders and owners. This factor is not vital in case of debt financing, except when financing institutions stipulate the appointment of nominee directors in the Board of Directors of the company.Objects of Capital Structure PlanningThey are-Maximize profit of the owners consequent transferable securitiesIssue further securities in a way that does not dilute the holdings of the present ownersEXTERNAL FACTORSGeneral Economic Conditions If the economy is in the state of depression, equity funding is considered as it involves less risk. While, if the economy is sound and the interest rates are forecasted to fall, debt funding is given preference.Interest wander Levels If the interest rates are high in the capital market, equity funding is preferred until the interest rate directs fall down.Policy of change Institutions If the terms and policies of the financing institutions are rigid and harsh, debt financing should be unheeded and equity financing should be tapped.Taxation Policy The regimen has tax policies which include merged taxes as well as individual taxes. The government includes individual taxes on both borrowings as well as dividends. similarly income tax deductions are offered on interests paid on borrowings. All these factors have to be considered while cookery capital structure.Statutory Risks While planning Capital Structure, the statutory risks given by the Government and other statutes are to be considered.GENERAL FACTORSConstitution of the company If the company is private seted, the control factors are essential while if the company is public limited, the cost factors are essential.Characteristics of the company Companies which are small and in the early detail have weak credit standings and bargaining capacity, indeed they have to rely on equity financing. While big companies have strong credit standings and they can source their funds from borrowings with acceptable interest rates.Stability of earnings The companies which have stable earnings and the risks involved are less, go for debt funding as they can batchle the high risk factors. While companies whose earnings are forecasted to be fluctuating, usually go for less godforsaken equity funding. lieu of the Management For a company with conservative management, the control factor is more important, while a company with a liberal management considers the cost factors to be more important. cash advancees to Capital Structure winnings operating(a) Income coverion conventional onslaught pay Income draw nearModigliani Miller ApproachNet ru n Income ApproachDavid Durand proposed the simoleons income approach to capital structure. This approach looks at the consequence of alterations in capital structure in terms of scratch operating income. Under this approach, on the basis of kale operating income, the overall value of the firm is measured. Therefore this approach is identified as net operating income approach.The NOI approach entails thatLargely the value of the firm does not depend on the degree of leverage in capital structure and hence whatever may be the change in capital structure the overall value of the firm is not affected.In the same way, the overall cost of capital is not affected by any change in the degree of leverage in capital structure. The overall cost of capital is independent of leverage.Under the net income approach, the overall cost of capital is unaffected and dust constant irrespective of the change in the ratio of debts to equity capital when the cost of debt is less than that of equity cap ital whereas it is assumed the overall cost of capital must decrease with the outgrowth in debts. How is this assumption justified? With the increase in the amount of debts the degree of risk of business increases. As a result the rate of equity over investment in equity shares thus on one hand the WACC decreases with the increase in the amount of debts on the other hand cost of equity capital increases to the same tune. Therefore the benefit of leverage is mopped forth and the overall cost of capital remains at the same level.In other words there are two parts of the cost of capital.Interest charges on debentures.The increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts.OPTIMUM CAPITAL STRUCTUREThis approach suggests that whatever the degree of financial obligation of the company, market value remains constant. Despite the change in the ratio of debt to capital in the market value of its equity shares remains c onstant. This instrument that there is no optimal capital structure. Each capital structure is optimal in approach of net operating incomeThe market value of the firm is determined as followsThe value of equity can be determined by the following equationandThe Net Operating Income Approach is based on the following assumptionsExampleABC Ltd., is expecting an earnings before interest tax of Rs.1,80,00,000 and belongs to risk pattern of 10%. You are inevitable to find out the value of firm % cost of equity capital if it employs 8% debt to the extent of 20%, 35% or 50% of the total financial requirement of Rs. 90000000.SolutionStatement showing value of firm and cost of equity capital20% Debt35% Debt50% Debt wage before interest tax EBIT ($)180000001800000018000000 boilers suit cost of capital10%10%10%Value of firm (V) =EBIT cost of CapitalEBIT/Cost of Capital180000000180000000180000000Value of 8% debt (D)18000000 (20% - 90000000)31500000 (35% - 90000000)45000000 (50% - 90000000) Value of equity (V D)162000000148500000135000000Net profit (EBIT Interest)16560000 (18000000 1440000)15480000 (18000000 2520000)14400000 (18000000 3600000)(Cost of equity (Kc)10.22%10.42%10.66%(Net profit/value of equity) - 100(16560000/ 162000000)( 15480000/ 148500000)( 14400000/ 135000000)It is apparent from the above tally that the overall cost of capital value of firm re-constant at different levels of debt i.e., at 20%, 35% and 50%. The benefit of debt content is depart by increase in the cost of equity. The overall cost of capital (k0) remains constant and can be verified as followsOverall Cost of Capital k0 = kd (D/D+S) + Ke (S/D+S)20% DebtK0 = $4,00,000/$40,00,000 -8% + $36,00,000/$40,00,000 X 10.22%= 0.008 + 0.092= 0.10 or 10%35% DebtK0 = $7,00,000/$40,00,000 -8% + $33,00,000/$40,00,000 X 10.42%= 0.014 + 0.0859= 0.0999Or 10%50% DebtK0 = $10,00,000/$40,00,000 - 8% + $30,00,000/$40,00,000 X 10.66%= 0.02 + 0.07995= 0.0995 or 10%Traditional ApproachTraditional approach is amiddle-way approach between net operating income approach the net income approach. According to this approach(1) A bestcapital structuredoes exist.(2) commercialize value of the firm can be increase and clean cost of capital can be reduced through a wise manipulation of leverage.(3) The cost of debt capital increases if debts are increases beyond a clear limit. This is because the greater the riskof businessthe higher therate of interestthe creditors would affect for.The rate of equity capitalization will also increase with it. and so there remains no benefit of leverage when debts are increased beyond a certain limit. The cost of capital also goes up.Traditional ApproachThus at a definite level of mixing of debts to equity capital, average cost of capital also increases. Thecapital structureis optimum at this level of the mix of debts to equity capital.The effect of change incapital structureon the overall cost of capital can be divided into three stages as followsFirst stageIn the first stage the overall cost of capital move and the value of the firm increases with the increase in leverage. This leverage has beneficial effect as debts as debts are less expensive. The cost of equity remains constant or increases negligibly. The proportion of risk is less in such a firm.Second stageA stage is reached when increase in leverage has no effect on the value or the cost of capital, of the firm. Neither the cost of capital falls nor the value of the firm rises. This is because the increase in the cost of equity due to the assed financial risk offsets the advantage of low cost debt. This is the stage wherein the value of the firm is maximum and cost of capital minimum.Third stageBeyond a definite limit of leverage the cost of capital increases with leverage and the value of the firm decreases with leverage. This is because with the increase in debts investors begin to realize the degree of financial risk and hence they desire to earn a higher rate of retu rn on equity shares. The resultant increase in equity capitalization rate will more than offset the advantage of low-cost debt.It follows that the cost of capital is a function of the degree of leverage. Hence, an optimumcapital structurecan be achieved by establishing an appropriate degree of leverage incapital structure.Net Income ApproachThis approach states that, the cost of debt and the cost of equity do not change with a change in the leverage ratio(when D/E changes), due to which it is observed that there is a weakening in the cost of capital as the leverage increases. The cost of capitalcan be calculated by the use Net income approach weighted average of cost of capitalcan be explained by the following equationhttp//lh6.ggpht.com/cemismailsezer/R4_ZkNJ-ThI/AAAAAAAAADY/RZYaGVynnUw/image%5B5%5DwhereKo average cost of capitalKd cost of debtKe cost of equityB market value of debtS market value of equityAs we know that cost of debt is less than cost of equity (Kdhttp//lh6.ggpht.c om/cemismailsezer/R4_ZlNJ-TjI/AAAAAAAAADo/de5aDk2tbUo/image%5B8%5DThe Net Income Approach assembles the investment structure of the firm which has a major influence on the value of the firm. Therefore, the use of control will change both the value of the organisation cost of capital. Net Income is exploited in approaching the market value that firm possesses. In this analysis Ka decreases when the D/E ratio increases as the proportion of debt, cheaper source of finance, increase in the capital structure vice versa.Assumptions of net income approachthe perception of risk is not alter by the use of liability for the investors as a result, the equity capitalization rate i.e. ke, and the debt capitalisation rate kd, remain constant with changes in leverageThe debt capitalization rate is less than the equity capitalization rateThe corporate income taxes are not considered.Numerical exampleAssume that a firm has an expected annual net operating income of Rs.2, 00, 000, an equity rate , ke, of 10% and Rs. 10, 00,000 of 6% debt.The value of the firm according to NET INCOME approachNet Operating Income NOI 2, 00,000Total cost of debt Interest= KdD, (10, 00,000 x .06) 60,000Net Income Available to shareholders, NOI I 1, 40,000Therefore market place Value of Equity (Rs. 140,000/.10) 14, 00,000Market value of debt D (Rs. 60,000/.06) 10, 00,000Total 24, 00,000Note The cost of equity and debt are respectively 10% and 6% and are assumed to be constant under the Net Income ApproachKo = Kd (D/V) + Ke (S/V)= 0.06 (10, 00,000/24, 00,000) + 0.10 (14, 00,000/24, 00,000)= 0.025 + 0.0583 = 0.0833 or 8.33%Modigliani Miller (MM) ApproachAssumptions of the MM ApproachCapital market is perfect. It is so whenInformation is freely available paradox of asymmetric information does not existTransaction cost is vigourThere is no bankruptcy costSecurities are fully partible100% payout ratioInvestors and managers are rationalManagers act in interest of shareholdersCombination of risk an d return is rationally chosenExpectations are undiversifiedEquivalent risk classNo taxesInvestors can borrow in personal A/C at same terms of firm. offer IValue of the form is equal to the expected operating income divided by discount rate appropriate to its risk class.It is independent of capital structure i.e.where,V = Market Value of the heartyD = Market Value of the debtE = Market value of the equityO = anticipate Operating Incomer = Discount rate applicable to risk class to which firm belongsProposition I is almost similar to the Net Operating Income Approach. MM used arbitrage argument to prove this approach. MM argues that undistinguishable assets must sell for same price, irrespective of how they are financed.Arbitrage mathematical processIf the price of a product is unequal in two markets, traders debase it in the market where price is low and sell it in the market where price is high. This phenomenon is known as price differential or arbitrage. As a result of this pro cess of arbitrage, price tends to decline in the pricy market and price tends to rise in the low-priced market unit the differential is totally removed.Modigliani and Miller explain their approach in terms of the same process of arbitrage. They hold that two firms, identical in all respects except leverage cannot have different market value. If two identical firms have different market value, arbitrage will take place until there is no difference in the market values of the two firms.ExampleLet us suppose that there are two firms, P and Q belonging to the same group of homogenous risk.Firm P is unlevered as its capital structure consists of equity capital barelyFirm Q is levered as its capital structure includes 10% debentures of Rs.10,00,000According to traditional approach, the market value of firm Q would be higher than that of firm P. notwithstanding according to M-M approach, this situation cannot persist for long. The market value of the equity share of firm Q is high but i nvestment in it is more risky while the market value of the equity share of firm P is low but investment in it is safe.Hence investors will sell out equity shares of firm Q and purchase equity shares of firm P. whence the market value of the equity shares of firm Q while fall, while the market value of the equity shares of firm P will rise. Through this process of arbitrage therefore, the market values of the firms P and Q will be equalized. This is true for all firms belonging to the same group. In equilibrium situation, the average cost of capital will be same for all firms in the group.The antagonist will happen if the market value of the firm P is higher than that of the firm Q. In this case investors will sell equity shares of P and buy those of Q. Consequently market values of these two firms will be equalised.Proposition IIMM Proposition II states that the value of the firm depends on three thingsRequiredrateof return on the firms assets (ra)Cost of debt of the firm (rd)Deb t/Equity ratio of the firm (D/E)An increase in financial leverage increases expected Earnings per Share (EPS) but not share prices. Proposition II states that an expected rate of return of shareholders increases with financial leverage. anticipate ROE is equal to expected rate of return on assets plus premium.The formula for re isre = ra + (ra-rd)x(D/E)Implications of Proposition II-rd is independent of D/E and hence re increases with D/E.The debt crosses an optimal level, the risk of omission increases and expected return on debt rd increases.Limitations of MM Approach-Leverage irrelevance theory of MM is valid if perfect market assumption is correct but actually it is not so.Firms are able to pay taxes and investors also pay taxes.Bankruptcy cost can be very high.Managers have their own preference of a type of finance.Managers are better informed than shareholders i.e. unbalance of information exists.Personal leverage is not possible to be fill in of corporate leverage.100% pa yout ratio is not possible normally.Analysis of CompaniesTVS MotorsTVS Motors hold one of the top ten two wheeler manufacturer and number three positions in Indian market, with turnover of $1 billion in 2008-2009 and is the flagship division of TVS group which is of worth $4 billion. TVS Motors manufactures wide range of two wheelers ranging from two wheelers for domestic use to two wheelers for racing. Manufacturing units are located atHousar and MysoreHimachal PradeshIndonesiaHas production capacity of 2.5 million units per year with strength in design and development TVS has recently launched 7 sunrise(prenominal) products. Till now TVS has sell more than 15 million two wheelers and has employed 40000. TVS motor is the only Indian company to win Deming award for quality control in 2002. TVS Network spans over 48 countries.Particulars2007-08 (in crores)2008-09(in crores)OPERATING INCOME45.31121.08INTEREST ON DEBT( I)11.4764.61 fair-mindedness EARNING33.8456.47 personify OF EQUITY (Ke)4.13%4.21% food market measure OF EQUITY819.371341.33COST OF DEBT (Kd)1.72%7.13%MARKET VALUE OF DEBT666.34905.98VALUE OF FIRM1485.712247.31COST OF CAPITAL (Ko)3.05%5.39%WACC CalculationFor 2007-08WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(1.84) x 0.413 + 0.84/(1.84) x 0.172= 0.2284 +0.078 = 3.051%For 2008-2009WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(2.11) x 4.21 + 1.11/(2.11) x 7.13=1.995 +3.750= 5.75% gunman HondaHero Honda Motors Limited is largest and most successful two wheeler manufacturers in India and it is India based. Hero Honda was a give voice peril between Hero group and Honda of Japan till 2010 when Honda sold its holy stake to Hero. In 2008-09 Hero Honda sold 3.7 million bikes with 12% growth rate and captured 57% of Indian markets share. Hero Honda Splendor is worlds largest selling motorcycle sold more than 1 million units in 2001-03.CUsersAAdityaDesktopindex.jpgIn celestial latitude 2010, the Board of Directors of the Hero Honda gathering have d ecided to terminate the joint venture between Hero free radical of India and Honda of Japan in a phased manner. The Hero Group of India would buy out the 26% stake of the Honda in JV Hero Honda. Under the joint venture Hero Group could not sell into international markets and the termination would mean that Hero Group can exploit global opportunities now. Since last 25 years the Hero Group relied on their Japanese partner Honda for R D for new bike models. So there are concerns that the Hero Group tycoon not be able to sustain the performance of the Joint endanger alone.WACC calculationFor 2007-08WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(1.07)x34.73%+0.07/(1.07) x 8.33% = 33%For 2008-09WACC= weke + wdkdWe = E/(D+E)Wd = D/(D+E) = 1/(1.04)x32.41%+1.04/(1.04)x10.20% = 31.55%Particulars2007-08(in crores)2008-09(in crores)OPERATING INCOME1201.961367.77INTEREST ON DEBT( I)13.7613.47EQUITY EARNING1188.221354.3COST OF EQUITY (Ke)34.73%32.41%MARKET VALUE OF EQUITY3421.254178.65COST O F DEBT (Kd)8.33%10.20%MARKET VALUE OF DEBT165.18132.05VALUE OF F