Capital Structure

UNIT 10 CAPITAL STRUCTURE

Objectives
The objectives of this unit are to:

• Understand the importance of decisions regarding Capital Structure.

• Discuss the concept of an appropriate Capital Structure.
• Identify the factors that have bearing on determining the Capital
Structure.

Structure
10.1 Introduction
10.2 Concept of Capital Structure
10.3 Features of an Appropriate Capital Structure
10.4 Determinants of Capital Structure
10.5 Summary
10.6 Key Words
10.7 Self Assessment Questions/Exercises
10.8 Further Readings

10.1 INTRODUCTION
Finance is a critical input for any organisation, since it is required for both
working capital and long-term investment. The total funds used in a firm
come from a variety of sources. The owners contribute a portion of the
capital, while the rest is borrowed from individuals and institutions. While
some funds are maintained in the firm indefinitely, such as share capital and
reserves (owned funds), others are held for a long time, such as long-term
borrowings or debentures, while yet others are short-term borrowings mostly
used for working capital requirements. The total financial structure of the
company is made up of the complete composition of all of these funds.
You are well aware that the requirement for short-term funds fluctuate a lot.
As a result, the proportion of short-term financing is constantly changing.
The composition of long-term funds, referred to as capital structure, is
frequently governed by a set of rules. The debt-to-equity ratio and dividend
determination are two other important parts of policy. The latter has an
impact on the accumulation of retained earnings, which is a key component
of long-term funds. Because permanent or long-term funds account for a
significant amount of total funds and include long-term policy decisions, the
term financial structure is frequently used to refer to a company's capital
structure.
There are some long-term funding options that are commonly available to
corporate organisations. Share capital and long-term debt, including
debentures, are the key sources. The profit generated by operations can be
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Financing
Decisions retained in the business or distributed as a dividend. A reinvestment of the
owners' funds is the portion of profits retained in the firm. As a result, it is a
long-term fund source. All of these sources combine to form the firm's capital
structure.

10.2 CONCEPT OF CAPITAL STRUCTURE

The mix, or proportion, of different types of finance (debt and equity) to total
capitalization is referred to as capital structure. It is a measure of a company's
entire long-term investment. It includes funds raised by common and
preferred stock, bonds, debentures, and term loans from a variety of financial
institutions, among other things. Earned revenue and capital surpluses are
also considered.

Capital Structure Planning

The construction of a suitable capital structure in the context of each firm's
facts and circumstances is referred to as capital structure planning. Because
of the possible impact on profitability and solvency, the decision on what
type of capital structure a company should have is crucial. Small businesses
frequently do not plan their capital structure. Without any explicit planning,
the capital structure may develop in these businesses. These businesses may
prosper in the short term, but they will encounter significant challenges
sooner or later. The company's unplanned capital structure prevents it from
making efficient use of its funds.

As a result, a company's capital structure should be planned in such a way

that it maximises its benefits and allows it to react more quickly to changing
situations. Rather than following any scientific procedure to determine an
appropriate proportion of different types of capital that will reduce the cost of
capital while increasing market value, a company can simply copy the capital
structure of other similar companies or consult an institutional lender and
follow its advice.

Theoretically, a firm should build its capital structure so that the market value
of its shares is as high as possible. When the marginal cost of each source of
funds is the same, the value will be maximised. In general, the debate over
the best capital structure is purely theoretical. In actuality, determining an
optimal capital structure is a difficult endeavor, and we must go beyond
theory. As a result, there are likely to be major differences in capital structure
between industries and across enterprises within the same industry. A
company's capital structure selection is influenced by a number of things.

The judgement of the individual or group of individuals making the capital

structure decision is critical. If the decision makers disagree about the
importance of various criteria, two similar companies can have distinct
capital structures. These variables are psychologically complicated and
qualitative, and they do not always match the accepted theory. Since capital
markets are not flawless, decisions need to be made with limited information
and thus risk. You may have been interested in identifying some of the key
aspects that drive capital structure planning in practice. However, before we
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go into these details, let us have a look at the characteristics of a good capital Capital Structure

structure in the next part.

10.3 FEATURES OF AN APPROPRIATE

CAPITAL STRUCTURE
The capital structure is frequently designed with regular shareholders'
interests in mind. Ordinary shareholders are the company's ultimate owners
and have the power to choose the Directors of the company. The Finance
Manager should try to maximise the long-term market price of equity shares
while building a suitable capital structure for the organisation. In actuality,
there would be a range of appropriate capital structures for most companies
within an industry, with few changes in the market value of shares. For
example, a corporation may operate in an industry with a debt-to-total-capital
ratio of 60%. It is possible that shareholders, on average, do not mind if the
company operates within a 15% range of the industry's typical capital
structure. As a result, the optimum capital structure for the corporation is a
debt-to-total capital ratio of 45 to 75 percent. Subject to other considerations,
such as flexibility, solvency, and so on, the company's Management should
strive to find a capital structure towards the top of this range to maximise the
use of favourable leverage.
A sound appropriate capital structure should have the following features:
Profitability: Within the limits, the company's capital structure should be the
most advantageous. The most effective use of leverage at the lowest possible
cost should be pursued.
Solvency: Excessive debt puts a company's solvency in jeopardy. The debt
should only be utilised sparingly.
Flexibility: The capital structure should be adaptable to changing
circumstances. If a company's financial structure needs to be modified, it
should be possible to do so with minimal expense and delay. The corporation
should also be able to supply finances whenever it is needed to finance its
profitable activities.
To put it another way, we need to approach capital structuring with caution
from a solvency standpoint. The company's debt capacity, which is based on
its ability to generate future cash flows, must not be surpassed. It should have
adequate cash on hand to pay creditors' set charges (interest) on a regular
basis as well as the principal payment upon maturity.
The characteristics listed above are typical of an appropriate capital structure.
more special aspects may be reflected in a company's characteristics. Further,
the importance placed on each of these characteristics may differ from one
organisation to the next. For example, a company may place a higher value
on flexibility than on maintaining control, which is another desirable
attribute, while another company may place a higher value on solvency than
on any other criteria. Further, if circumstances change, the relative relevance
of these factors may shift.

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Financing
Decisions 10.4 DETERMINANTS OF CAPITAL
STRUCTURE
When a firm is promoted, the capital structure must be decided. The initial
capital structure should be properly planned. The company's Management
should establish a target capital structure, and subsequent finance decisions
should be made with the goal of achieving that capital structure. The Finance
Department Management must deal with the current capital structure once a
firm has been created and has been in operation for few years. The company
may require capital to continue to fund its operations. When funds are
needed, the Management assesses the advantages and disadvantages of
various sources of financing and chooses the most favourable sources while
keeping the intended capital structure in mind. As a result, the capital
structure choice is a constant one that must be made anytime a company
needs additional funding.

When deciding on a capital structure, the following factors should be

considered:

i) Leverage or Trading on Equity:

Financial leverage, also known as trading on equity, is the use of fixed-cost
sources of finance, such as debt and preference share capital, to fund assets of
a company. If the return on debt-financed assets exceeds the cost of debt,
earnings per share will rise without an increase in the owners' investment.
Similarly, if preference share capital is used to acquire assets, earnings per
share will rise. However, the impact of leverage is felt more in the case of
debt because (i) the cost of debt is typically lower than the cost of preference
share capital, and (ii) interest paid on debt is a deductible charge from profits
for calculating taxable income, whereas dividends on preference shares are
not.

Financial leverage is an important consideration when developing a

company's capital structure because of its impact on earnings per share.
Companies having a high level of Earnings Before Interest and Taxes (EBIT)
can profitably use a high degree of leverage to boost their shareholders'
equity return. The link between Earnings Per Share (EPS) at various possible
levels of EBIT under alternative ways of financing is a typical approach of
analysing the impact of leverage. The EBIT-EPS analysis is an important tool
in the toolbox of financial manager for gaining insight into the capital
structure design of the company. S/he can assess potential EBIT changes and
their impact on EPS under various financing arrangements.
For a recapitulation of the effects of financial leverage on earnings per share
(EPS) under various financing plans with different mixes of equity and fixed
return securities, an illustration is given below which demonstrates the effect
of financial leverage on EPS by considering three alternative financing plans:

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Illustration 10.1 Capital Structure

Plan A: No debt, all equity shares

Plan B: 50% debt @10%, 30% preference shares @12%, 20% equity shares
Plan C: 80% debt @10%, 20% equity shares

The face value of equity shares is Rs. 10.

The total amount of capital required to be raised is Rs. 2,00,000. The

company estimates its Earnings Before Interest and Taxes (EBIT) at Rs.
50,000 annually.

Table-10.1: Effect of Financial Leverage on EPS

Financing Plan (in Rs.)

A B C
Earnings Before Interest and Taxes (EBIT) 50,000 50,000 50,000
Interest - 10,000 16,000
Earnings before taxes 50,000 40,000 34,000
Income Tax (50%) 25,000 20,000 17,000
Earnings after taxes 25,000 20,000 17,000
Preference share dividend - 7,200 -
Earnings available on equity shares 25,000 12,800 17,000
No. of shares 20,000 4,000 4,000
Earnings per share (EPS) 1.25 3.20 4.25

Table-10.1 shows the impact of financial leverage (trading on equity). Plan

‘C’ is the most appealing from the perspective of shareholders since it has the
highest EPS of Rs. 4.25. When a corporation does not use any debt or fixed-
income instruments, it has the lowest EPS. You will notice that under plans
‘B’ and ‘C’, the proportion of fixed-income securities is the same (80
percent). However, Plan ‘C’, has a greater EPS because the dividend on the
preference share is not tax deductible, whereas interest is. If the EBIT
predictions prove to be true, shareholders will benefit the most if plan ‘C’ is
implemented.

The companies using appropriate amount of debt in its capital structure and
having stable cashflows will command a large premium in the market and
will be in high demand. The advantage in financial leverage comes from the
fact that, while the overall return (before taxes) on capital employed is 25%,
the returns on preference shares and debt are only 12% and 10%,
respectively. The savings from this discrepancy allow management to
increase the return on equity shares along with the fact that interest is a tax
deductible expense through which the overall cost of capital becomes lower
as compared to the firms financed fully by equity.

While leverage can boost earnings per share (EPS) in favourable

circumstances, it can also put shareholders' money at risk. Because of (a) the
adverse fluctuations in the cashflows and (b) higher probability of 223
Financing
Decisions insolvency, as financial risk rises when debt is used. If a company's capital
structure is devoid of debt, it can completely avoid financial risk. However, if
no debt is used in the capital structure, shareholders will miss out on the
benefits of increased EPS due to financial leverage. As a result, a company
should use debt only if the financial risk perceived by shareholders does not
outweigh the advantage of greater EPS.

ii) Cost of Capital

The costs of numerous sources of finances are a complicated topic that
requires its own approach. It goes without saying that lowering the cost of
capital is beneficial. As a result, if all other factors remain constant, cheaper
suppliers should be favored. The minimal return expected by a source of
money is the cost of that source of financing. The expected return is
determined by the level of risk that investors are willing to take. Shareholders
take on a higher level of risk than debt holders. The rate of interest is fixed in
the case of debt holders, and the corporation is legally obligated to pay
interest whether it earns profits or not.

The dividend rate is not defined for shareholders, and the Board of Directors
is under no legal responsibility to pay dividends even if the firm has produced
profits. Debt holders get their money back after a set amount of time, whereas
shareholders only receive their money back when the company is wound up.
This leads to the conclusion that debt is a less expensive source of capital
than equity. Interest costs are tax deductible, which lowers the cost of debt
even further. Although preferred share capital is less expensive than equity
capital, it is not as inexpensive as debt money. As a result, a corporation
should use debt to lower its overall cost of capital.

However, it must be understood that a corporation cannot continue to reduce

its overall cost of capital by using debt. Debt becomes more expensive
beyond a certain point because of the increasing risk of excessive debt to
creditors and shareholders. As the level of leverage rises, the risk to creditors
rises as well. Once the debt has reached a certain level, they may demand a
higher interest rate or refuse to lend to the company at all.
In addition, the enormous debt puts the stockholders' position in jeopardy. As
a result, the equity cost of capital rises. As a result, while debt lowers the
overall cost of capital up to a degree, beyond that point, the cost of capital
begins to rise, making it unfavorable to use debt further. As a result, there is a
mix of debt and equity that lowers the firm's average cost of capital while
increasing the market value of its stock.

The cost of retained earnings and the cost of a fresh issue of shares are
included in the cost of equity. The cost of debt is less than the cost of both of
these equity capital sources. The cost of retained earnings is less than the cost
of new issuance. Since the company does not have to pay personal taxes,
which are paid by shareholders on distributed earnings, the cost of retained
earnings is lower than the cost of new issues, and because, unlike new issues,
retained profits do not incur floatation charges. As a result, between these
two sources, retained earnings are preferable.
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When the leverage and cost of capital aspects are considered, it appears Capital Structure

appropriate for a company to use a higher amount of debt if its cashflows are
stable and do not fluctuate significantly and the cashflows are over and above
the required cashflows to service interest on debt and the principal
repayment. In fact, debt can be employed to bring the average cost of capital
down to zero. Together, these two parameters determine the maximum
amount of debt that can be used. Other considerations, however, should be
considered when determining a company's suitable financial structure.
Theoretically, a company's debt and equity balance should be such that its
overall cost of capital is as low as possible. Let us look at an illustration to
better understand this notion.
Illustration-10.2
A company is planning for an appropriate capital structure. The cost of debt
(after tax) and of equity capital at various levels of debt equity mix are
estimated as follows:
Debt as percentage of Cost of debt (%) Cost of equity (%)
total capital employed
0 10 15
20 10 15
40 12 16
50 13 18
60 14 20
Determine the optimal mix of debt and equity for the company by calculating
composite cost of capital?
For determining the optimal debt equity mix, we have to calculate the
composite cost of capital, i.e., Ko which is equal to Kip1+Kep2.

Where,
Ki = Cost of Debt
pl = Relative proportion of debt in the total capital of the firm
Ke = Cost of Equity
p2 = Relative proportion of equity in the total capital of the firm

Before we arrive at any conclusion, it would be desirable to prepare a table

showing all necessary information and calculations.

Table-10.2: Cost of Capital Calculations

Ki % Ke % pl p2 Kip1 + kep2 = Ko
10 15 0.0 1.00 0.0 + 15.0 = 15.0
10 15 0.2 0.8 2.0 + 12.0 = 14.0
12 16 0.4 0.6 4.8 + 9.6 = 14.4
13 18 0.5 0.5 6.5 + 9.0 = 15.5
14 20 0.6 0.4 8.4 + 8.0 = 16.4
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Financing
Decisions The best debt-to-equity ratio for a corporation is when the composite cost of
capital is the lowest. Table-10.2 shows that a 20 percent debt/80 percent
equity combination results in a minimum composite cost of capital of 14
percent. Any other debt-to-equity ratio results in a greater overall cost of
capital. A mix of 40% debt and 60% equity, with a Ko of 14.4 percent, comes
closest to the minimal cost of capital. As a result, it may be argued that a
capital structure consisting of 20% debt and 80% equity is ideal.

iii) Cash Flow

Conservatism is one of the characteristics of a healthy capital structure.
Conservatism does not imply the avoidance of debt or the use of a minimal
amount of debt. It has to do with determining the obligation for fixed charges,
as well as the use of produced debt or preferred capital in the capital
structure, in light of the company's ability to generate cash to cover these
fixed charges.

Interest, preference dividends, and principal payments are all part of a

company's fixed expenses. If the company uses a lot of debt or preferred
capital, the fixed charges will be quite expensive. When a corporation
considers taking on more debt, it should consider how it will cover its fixed
charges in the future. Interest must be paid, and the principal amount of the
debt must be returned according to the timelines. A corporation may suffer
financial insolvency if it is unable to earn enough cash to pay its fixed
obligations. Companies that anticipate big and consistent cash inflows can
use a lot of debt in their capital structure. Employing fixed-fee sources of
finance for organisations whose cash inflows are variable or unpredictable is
a bit dangerous.

iv) Control
When it comes to capital structure design, the Management is sometimes
guided by its desire to maintain control over the company. The current
management team may not only seek to be elected to the Board of Directors,
but also to run the company without influence from outsiders.
Ordinary shareholders have the legal right to choose the company's Directors.
There is a risk of losing control if the corporation issues fresh shares. In the
case of a publicly traded corporation, this is not a significant factor to
consider. The stock of such a corporation is extensively distributed. The
majority of shareholders are uninterested in participating in the company's
management. They are unable to attend shareholder meetings due to a lack of
time and desire. They are solely concerned with dividends and share price
appreciation. By distributing shares widely and in tiny quantities, the risk of
losing control can almost be eliminated.
In the case of a closely held corporation, however, keeping control may be a
key factor. A single shareholder or a group of shareholders might buy all or
most of the new shares, thereby taking control of the firm. Fear of losing
control and so being hampered by others is a common reason for closely held
companies delaying their decision to go public. To avoid the risk of losing
control, companies may issue preference shares or raise debt capital.
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Because debt holders do not have voting rights, it is frequently proposed that Capital Structure

a corporation employs debt to avoid losing control. When a corporation

employs a considerable amount of debt, the debt holders place a lot of
constraints on it to safeguard their interests. These limitations limit the
management's ability to run their businesses. An excessive amount of debt
may also cause bankruptcy, which means a complete loss of control.

v) Flexibility
The ability of a company's financial structure to adjust to changing situations
is referred to as flexibility. A company's capital structure is flexible if
changing its capitalization or funding sources is not difficult. The corporation
should be able to raise funds without undue delay or expense whenever it is
needed to fund lucrative investments. When future conditions justify it, the
corporation should be able to redeem its preference capital or debt. The
company's financial plan should be adaptable enough to adjust the capital
structure's composition. It should keep itself in a position to switch from one
type of funding to another in order to save money.

vi) Size of the Company

The availability of funding from various sources is heavily influenced by the
size of a company. It might be difficult for a small business to obtain long-
term financing. If it is able to secure a long-term loan, it will be at a high
interest rate and with uncomfortable terms. The financial structures of Small
businesses are inflexible due to the highly restrictive covenants in their loan
agreements. As a result, Management is unable to conduct business freely.
Therefore, small businesses must rely on their own capital and retained
revenues to meet their long-term needs.
A large corporation has more leeway in deciding how to arrange its capital
structure. It can get low-interest loans and offer ordinary shares, preferred
shares, and debentures to the general public. A company should make the
best use of its size in planning the capital structure.
vii) Marketability
In this sense, marketability refers to a company's ability to sell or market a
security in a given timeframe, which is dependent on investors' willingness to
buy that security. Although marketability may not have an impact on the
original capital structure, it is an important factor to consider when selecting
to issue securities. The market may prefer debenture issues at one time while
accepting ordinary share issues at another. The corporation must determine
whether to raise financing through ordinary shares or debt due to shifting
market sentiments.
If the stock market is down, the corporation should issue debt instead of
ordinary shares and wait until the stock market recovers before issuing
regular shares. During a period of high stock market activity, the corporation
may be unable to successfully issue debentures. As a result, it should leave its
debt capacity unused and issue common stock to raise funds.

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Financing
Decisions viii) Floatation Costs
When money is raised, floatation charges are incurred. The cost of floating a
debt issuance is typically lower than the cost of floating an equity issuance.
This may persuade a corporation to issue debt rather than common stock.
There are no floating charges if the owner's capital is enhanced by keeping
the earnings. The floatation cost generally is not an important factor that
affects the capital structure of a company except in the case of small
companies.

Activity-10.1
a) What is the capital structure of a company made up of? Why does the
corporation have a certain capital structure and not another?
………..…………………………………………………………………
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b) Note the differences in the capital structures of any two companies and
find out the reasons for the differences.
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………..…………………………………………………………………

10.5 SUMMARY
The capital structure of a firm is the mix of long-term financing sources in its
total capitalization. Ownership and Creditorship securities are the two most
common sources. Most large industrial enterprises use both forms of
securities as well as long-term loans from financial institutions. Any
company's capital structure planning is critical to any company as it has a
significant impact on its profitability. A bad decision in this regard could be
quite costly to the firm.

While deciding on a capital structure, it is important to keep the goals in

mind, such as; profitability, solvency, and flexibility. The amount of debt and
other fixed-income securities on one hand, and variable-income securities,
such as equity shares on the other, is determined after a comparison of the
characteristics of each type of security and careful consideration of internal
and external factors affecting the firm's operations.
In the real world, concessions must be made somewhere between the
aspirations of enterprises seeking funding and the expectations of those who
offer them. The fundamental distinctions between debt and equity remain
unchanged as a result of these concessions. In most cases, the choice of
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financing is not between equity and debt, but rather between the best possible Capital Structure

mixture of the two.

Suitability, risk, income, control, and timing all play a role in determining the
debt-equity mix. The weights attributed to these elements will differ from
firm to firm, based on the industry and the firm's current status. Perhaps there
will never be an accurate mathematical solution to the decision on capital
structure design. Human judgement is crucial in analysing conflicting factors
before deciding on an acceptable capital structure.

10.6 KEY WORDS

Capital structure: The mix of various types of long-term sources of
financing, such as; debentures, bonds, loans from financial institutions,
preference shares, and equity shares including retained earnings is referred to
as capital structure (also known as financial structure).
Cost of Capital is the (weighted) average cost of various sources of finance
used by a company.
Financial Leverage (or Trading on Equity) is a type of financial planning
that allows a corporation to boost its return on equity by employing loans
with a lower fixed cost that is lower than the overall return on investment.
Because of the financial burden, changes in EBIT (Earnings Before Interest
and Taxes) have a greater impact on EPS (Earnings Per Share).

10.7 SELF ASSESSMENT QUESTIONS/

EXERCISES
1) What are the features of an appropriate capital structure?
2) Discuss the determinants of capital structure?
3) Do you think that different factors affecting capital structure decision
will be viewed differently by different companies? Support your answer
with suitable examples.
4) Make a comparative assessment of different types of securities from the
point of view of capital structuring.
5) Under what conditions different types of securities would be considered
more suitable?
6) Write notes on the following:
a) Trading on equity b) Cost of capital c) Flexibility in capital
structure d) Closely held company.
7) A company wishes to determine the optimal capital structure from the
following information. Determine the optimum capital structure from the
viewpoint of minimising the cost of capital.

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Financing
Decisions Financing Debt Equity After Tax Cost
Plan Amount Amount Cost of debt equity
(Rs.) (Rs.) Ki% Ke%
A 8,00,000 2,00,000 14 20
B 6,00,000 4,00,000 13 18
C 5,00,000 5,00,000 12 16
D 2,00,000 8,00,000 11 18

10.8 FURTHER READINGS

1. Chandra, Prasanna. 2019, Financial Management, Theory and Practice,
Mc Graw-Hill, New Delhi
2. Pandey. I.M., 2021, Financial Management, Pearson Education India,
New Delhi
3. Sheridan Titman, Arthur J. Keown, and John D. Martin, 2019, Financial
Management: Principles and Applications, Pearson Education India,
New Delhi.
4. M.Y. Khan. M. Y and Jain. P.K., 2018, Financial Management,
McGraw Hill Education, New Delhi
5. Eugene F. Brigham, Joel F. Huston, 2018, Fundamental of Financial
Management, Cengage Learning India, New Delhi.
6. Richard Brealey, Stewart Myres & Franklin Allen, 2019, Principles of
Corporate Finance, Mc Graw Hill, New Delhi.

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