Capital Structure& Capital Is At Ion

Capital Structure & Capitalisation What Does Capital Structure Mean? A mix of a company's long-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Definition The permanent long-term financing of a company, including long-term debt, common stock and preferred stock, and retained earnings. It differs from financial structure, which includes short-term debt and accounts payable. Investopedia explains Capital Structure A company's proportion of debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a long term loan etc. The Modigliani-Miller (MM) theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. Let us look at an example. Company A & B are identical in all respects except the capital structure. Both have capital employed of Rs 100 lacs and earn Rs 15 lacs (i.e. 15% on capital employed). Company A has all equity and equity holders earn the same 15% return. Company B has Rs 50 lacs of equity and Rs 50 lacs of 10% debentures. After paying Rs 5 lacs interest to debentures and the world of no taxes, equity holders of Company B make Rs 10 lacs on their investment of Rs 50 lacs ( i.e. 20% return through ‘Trading on Equity’). According to MM, an individual can achieve the same gearing what a company can do. E.g. An individual who has Rs 1000 can buy 100 shares @ Rs 10 in B and earn Rs 200 as explained above. Alternatively, he can borrow Rs 1000 @ 10% (MM assumption that the borrowing rate for an individual is the same as Company’s borrowing rate!) and buy 200 shares of Company A for Rs 2000. He will earn

return @ 15% of Rs 300 from which he will pay interest of Rs 100, retaining Rs 200. The same return had he invested in Company B without any borrowing. According to MM, the arbitrage (like the one explained in this para) in the perfect market will ensure that cost of capital for both companies is the same. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other reasons include bankruptcy costs, agency costs, taxes, information asymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm. Other theories of capital structure are Net Income Approach (debt is cheaper and risk profile is not changed by use of debt) and Traditional Approach which advocates optimum capital structure. Capital structure in a perfect market Assume a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all. Capital structure in the real world If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model. Trade-off theory Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefit of debts) and that there is a cost of financing with debt (the bankruptcy costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry. Pecking order theory

Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence: internal debt is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers (1984) when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance. Agency Costs There are three types of agency costs which can help explain the relevance of capital structure. •

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Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. Underinvestment problem: If debt is risky (eg in a growth company), the gain from the project will accrue to debt holders rather than shareholders. Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

Arbitrage Similar questions are also the concern of a variety of speculator known as a capitalstructure arbitrageur. A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and convertible bonds. The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. The value of the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. If the spread, the difference between the convertible and the non-convertible bonds grows excessively, then the capital-structure arbitrageur will bet that it will converge. Capital Gearing It is the relationship between equity funds (including retained earnings) and long term debt. Preference shares are normally clubbed with debt for this purpose as it affects return

on equity. Americans call it leverage or financial leverage. The resultant effect is Trading on Equity as illustrated below : Capital employed Rs 250 lacs financed by 10% debentures to the extent of Rs 1.25 crore, 8% Preference shares of Rs 50 lacs and balance by equity. Expected Return @ 18%

Rs 45 lacs. (EBIT)

Less: Debenture Interest

Rs12.5 lacs

Earning Before Tax (EBT)

Rs 32.5 lacs

Less: Income-tax @ 30%

Rs 9.75 lacs Rs 22.75 lacs

Less: Preference Dividend

Rs 4

lacs

Balance available for Equity

Rs 18.75 lacs or 25% on equity capital of Rs 75 lacs.

Thus, 18% pre-tax (12.6% post tax) overall return fetches 25% on equity by ‘Trading on Equity’. Calculate similarly if expected return is 8% to see how this double edged sword works. Capitalisation Capital plays an important role in any business. Capitalisation refers to the long term indebtedness and includes both the ownership capital and the borrowed capital. Capital and Capitalisation are two different terms. The term 'capitalisation' is used only in relation to companies and not in respect of partnership firms or sole proprietorships. It is distinguished from capital which represents total investment or resources of a company. It thus represents total wealth of the company. It should be distinguished from share capital which refers only to the paid up value of the shares issued by the company and definitely excludes bonds, debentures, loans and other form of borrowings. Capitalisation means the total par value of all the securities, i.e. shares and debentures issued by a company and reserves, surplus and value of all other long term obligations. The term thus includes the value of ordinary and preference shares, the value of all surplus – earned and capital, the value of bonds and securities still not redeemed and the value of long term loans. Capitalisation is thus the sum total of all long term funds available to the firm along with the free reserves. According to E.T. Lincoln capitalisation is "a word ordinarily used to refer to the sum of outstanding stocks and funded obligations which may represent fictitious values". According to Gerstenbug, capitalisation is that which "comprises of a company's ownership capital which includes capital stock and surplus in whatever form it may appear and borrowed capital which consists of bonds or similar evidences of long-term debt". Cost & Earnings Theory of Capitalisation OVER CAPITALISATION A company is said to be over capitalised when its earnings are not sufficient to yield a fair return on the amount of shares or debentures. IN other words, when a company is not in a position to pay dividends and interests on its shares and debentures at fair rates, it is

said to be over capitalised. It means that an over-capitalised company is unable to pay a fair return on its investment. According to Hoagland, "whenever the aggregate of the par values of stocks or bonds outstanding exceeded the true value of the fixed assets the corporation is said to be over-capitalised". According to Gerstenberg, "a corporation is over-capitalised when its earnings are not large enough to yield a fair return on the amount of stocks and not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of assets". Over-capitalisation is not synonymous with excess capital. Excess of capital may be one of the reasons for over-capitalisation. A company is over capitalised only because of its capital and funds not being effectively and profitably deployed with the result that there is a fall in the earning capacity of the company and in the rate of dividend to be paid to its shareholders as well as a fall in the market value of its shares. Causes of Over-capitalisation Floating of excess capital Purchasing property at an inflated price Inflationary conditions High cost of promotion Borrowings at a higher than normal rate Purchase of assets in the boom period Incorrect capitalisation rate applied Insufficient provision for depreciation High rates of taxation Liberal dividend policy Wrong estimation of future earnings Low production Remedial measures to correct Over-capitalisation Reduction of funded debts Reduction of interest on debentures and loans Reduction of preference shares Reduction of face value of the shares Reduction in the number of equity shares Ploughing back of profits Effects of Over-capitalisation Loss of goodwill Difficulty in obtaining capital Window dressing of accounts Decline in efficiency Liquidation Loss of Market Low rate of dividend Fall in the Market value of shares Loss on re-organization Small value of collateral Speculative gambling Reduction in quality Cuts in wages Competition Misapplication of society's resources Gambling in shares Setback to industry

Watered Capital 'Water' is said to be present in the capital when a part of the capital is not represented by assets. It is considered to be as worthless as water. Sometimes the services of the promoters are valued at an unduly high price. Similarly, the concern may pay too high a price for an asset acquired from a going concern. The capital becomes watered to the extent of the excess price paid for an asset. Thus, if a company pays 1,25,000 on account of goodwill, which if valued correctly is worth Rs. 50,000 only, the capital is watered to the extent of Rs. 75,000. 'Watered capital' must be distinguished from 'over capitalisation'. 'Water enters the capital usually in the initial period-at the time of promotion. Over capitalisation can, however, be found out only after the company has worked for sometime. Although watered capital can be a cause of over capitalisation, yet it is not exactly the same thing. If the earnings are up to the general expectation, a concern will not be over capitalized even though a part of its capital is watered. UNDER CAPITALISATION Under capitalisation is just reverse of over capitalisation. The state of under-capitalisation is where the value of assets are much more than it appears in the books of the company. In well established companies, there is a large appreciation in assets, but such appreciation is now shown in the books. As against over capitalisation, under capitalisation is associated with an effective utilisation of investments, an exceptionally high rate of dividend and enhanced prices of shares. In other words, the capital of the company is less in proportion to its total requirements under the state of undercapitalisation. In the words of Gerstenberg, "A corporation may be under capitalised when the rate of profits it is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry or when it has too little capital with which to conduct its business". Under capitalisation is a condition where the real value of the company is more than its book value. The assets bring profits but it would appear to be much larger than warranted by book figures of the capital. In such cases, the dividend will naturally be high and the market value of shares will be much higher. Under capitalisation and inadequacy of capital are regarded as inter-changeable terms but there is a difference between these two terms. Under-capitalisation does not mean inadequacy of capital. Profits are high in such companies and a part of the profits are ploughed back in the business directly or indirectly. The value of assets is shown at lower price than their real value. It means that there are secret reserves in under-capitalised companies. Causes of Under Capitalisation Under estimation of capital requirements Under estimation of future earnings Promotion during deflation Narrow dividend policy Desire of control Excessive depreciation provided Maintenance of high efficiency Secret reserves Difficulty in procurement of capital Remedies of under capitalisation Splitting up of shares Increasing the number of shares

Increase in the par value of shares Issue of Bonus shares Fresh issue of shares Effects of under capitalization Limited marketability of shares Cut-throat competition Industrial unrest Dissatisfaction of customers Government control Inadequacy of capital. Secret reserves and window dressing of accounts High taxes Manipulation of share values Financial Break Even & Indifference Analysis That level of EBIT when after meeting interest cost, tax and preference dividend, EPS on equity is zero. On the other hand, at indifference point under two alternate finance plans, EPS is the same.