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The determinants of a Capital Structure

Capital Structure can be defined as a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. A company has 2 primary sources of funds

Equity

Debt

Capital structure decision addresses the question “Can the value of firm be enhanced by changing the mix of debt and equity?” Capital Structure decision refers to the proportion of equity and debt and finding out whether there is a capital structure that can be said to be optimum for the shareholders of the firm. Capital structure assumes

Replacement of one form of capital with another

Firm value is consistent with shareholders wealth

Capital structure would be optimum when cost of capital is minimized

Elements of Capital Structure:

Long-term debts: By standard accounting definition, long-term debt includes obligations that are not due to be repaid within the next 12 months. Such debt consists mostly of bonds or similar obligations, including a great variety of notes, capital lease obligations, and mortgage issues. (Definition from: www.investopedia.com)

Preferred stock: This represents an equity (ownership) interest in the corporation, but one with claims ahead of the common stock, and normally with no rights to share in the increased worth of a company if it grows. (Definition from: www.investopedia.com)

Common stockholders' equity: This represents the underlying ownership. On the corporation's books, it is made up of: (1) the nominal par or stated value assigned to the shares of outstanding stock; (2) the capital surplus or the amount above par value paid the company whenever it issues stock; and (3) the earned surplus (also called retained earnings), which consists of the portion of earnings a company retains after paying out dividends and similar distributions. Put another way, common stock equity is the net worth after all the liabilities (including long-term debt), as well as any preferred stock, are deducted from the total assets shown on the balance sheet. For investment analysis purposes, security analysts may use the company's market capitalization—the current market price times the number of common shares outstanding—as a measure of common stock equity. They consider this market-based figure a more realistic valuation. (Definition from: www.investopedia.com)

Debt is always a cheaper source of fund and its availability depends on the institutional context of the economy of the particular company. The interest is fixed and the creditor had no control or stake in the operations of the company. On the other hand equity is an expensive source of fund and the equity shareholder has a controlling stake in the operations of the company. But the equity shareholders have only residual claim and are long term investors for the company. Company has to pay the equity share holders when all other liabilities are over while creditors have first claim on the profits of the company (even if the company faces loss it has to pay to the creditors)

Factors Influencing a Company's Capital-Structure Decision

A company's capital-structure is influenced by the following factors:

Business risk

Company's tax exposure

Liquidity and norms

Financial flexibility

Management style

Management Control

Growth rate

Market Conditions

Quality of asset and securities

Business Risk

As the business risk increases, the optimal debt ratio decreases. For example, if we compare a retile apparel company with a utility company we can find that the stability in earnings is higher in the case of the utility company. The business risks for a utility company are less with its stable revenue stream. However, the potential of the retail apparel company is more when it comes to variability in earnings. The business risks for a retail apparel company are comparatively higher, given that the sales are dependent primarily on fashion industry’s changing trends. To summarize, the optimal debt ratio would be lower for a retail apparel company would be lower in order to convince the investors of the company’s ability to attain its objectives and targets in both good times and the bad.

Tax Exposure of the company

As the debt payments attracts tax benefits, funding a project through debt is more attractive if the tax liability of the company is high and some of the income can be protected through reduced tax burden.

Liquidity and norms

While defining the capital structure a very important consideration is the environment in financial markets, particularly relating to institutional finance. The amount/proportion of debt depends on its availability. Availability of loan cannot be taken for granted if the amount if the amount of loan does not conform to the norms of debt-equity ratio, debt service etc. For the most part such norms set the limit on the amount of borrowing.

Financial Flexibility

As the saying goes, when the going gets tough, the tough get the going, which is indeed true for a company that plans to raise money during difficult times. A company finds it easier to raise funds during the good times, when the company’s income statements are strong, which shows continuous growth in sales and income. The companies should make wise decisions while raising capital during the good times, as lower debt levels give the company more financial flexibility.

E.g. Aviation industry - In the aviation industry there is a strong cash flow and steady sales, during the good times and during the bad times, the industry would need to look at different sources of funds to raise capital, including debt. When debts increase as compared to equity, in other words with a high debt-equity ratio, an airline’s ability to raise capital from the debt market reduces and investors would also doubt the capability of the airline to payback the additional debt over the existing amount.

Management Style

Management styles can differ from company to company. Some companies adopt a conservative approach and are often less inclined to raise capital from the debt market in order to reduce the risks. On the other hand, companies adopting an aggressive approach tend to grow quickly at a lower cost and raise debts to increase the shareholders earnings.

Management Control

The company has to also take care of some strategic considerations for prevention of the hostile takeover bids and tactical considerations of the management of the enterprise on routine matters. Since Equity shareholders have controlling stake in the company, management has to decide how much control it can give to the shareholders and define their responsibilities and limitations. This will be based on the amount of control (stake)/equity they own in the business. E.g. in India, Control of the firm cannot be challenged if the promotes hold a minimum of 51% and similarly a special resolution can be blocked by a 26% vote against.

Growth Rate

Firms in their growth stage of financial cycle normally have a tendency to borrow and raise money through debts so that they have access to funds quickly and at a low rate. But the main problem is that in this phase the revenues of the firm are unstable and unproven because such firms are normally new ventures with a new business proposal or the company is involved in too many expenses to grow quickly. On the other hand the stable firms have less need to raise debts because they have a stable and proven revenue model.

Market Conditions

Market conditions also influence the firm’s capital structure decisions. Let’s take an example in which a company wants to establish a new plant and it want funds for the purpose. Suppose market conditions are not favorable and company is not able to raise equity capital from the market then in this case the interest rate for raising debts will increase and company has to pay higher for raising debts. In this case company has 2 options either to delay the project and wait till the market conditions are better or raise capital at higher rate of interest.

Quality of Assets and Securities

The nature and quality of the asset base also impact the capital structure. If the assets are tangible and form a good security, mobilizing debts is rather easy, perhaps more economical when compared with a firm that derives its value from intangibles. Therefore, firms functioning in conventional areas such as steel, cement, etc. with large investments in plants and machinery have rather easy access to loans and can have capital structures oriented towards debt. Investments in real estate and plant and machinery are regarded as better collaterals for loans. In contrast industries such as software development, Information Technology etc. who derive their worth on the basis of human capital, have capital structures heavily oriented towards equity, as getting debt is rather difficult because of lack of confidence in the securities of assets.

Financial Leverage

While deciding Capital Structure of the company

Motive of Management – Arrange for capital at the lowest feasible cost

Motive of Investor – Maximum return on investment.

How can a company achieve both targets? The answer to the question is “LEVERGE” – i.e. a company takes proportionately higher debts than equity capital. But increase in debt component of the capital structure will also increase the risk component in the business.

The company has some fixed financial commitments like interests on borrowed funds, dividends to preferential shareholders, rentals on leased assets and finally residual earnings are used to service equity shareholders. The pie that is available to the shareholders is measured in terms of Earnings per share (EPS). [EPS = EBT or EAT/ no. of shares]. Another method is to measure ROE i.e. return on equity [ROE = EBT or EAT/ value of equity].

Financial leverage refers to use of debt financing and the resultant of sensitivity of the earnings available to shareholders (EPS) by the substitution of their capital with charge finance. If the company has no fixed financial charges (interest on debts), then any change in EBIT will be transferred to the shareholders but all the business risk is borne by the shareholders.

However if some of the equity capital is substituted by fixed charge capital (debt), changes in EBIT changes in EBIT will be larger as compared to all equity financing option.

Example

100% equity

Assume 100 share holders contributing $ 10 each (total capital = $1000) in a firm having an expected income of $ 100, providing an expected income of $ 1 to each of the share holder. If the income of the firm is doubled to $ 200, then proportionately income of each shareholder will be doubled to $ 2.If the income of the firm is halved to $ 50, then proportionately income of each shareholder will be halved to $ 0.50.

(All risk and profit is borne by the shareholders)

50% equity and 50% debt @ 5%

Now 50 shareholders contribute $10 each (total equity capital = $ 500) and remaining capital is raised through debt @ 5% i.e. fixed financial charges of $ 25.When earning of the firm is $ 100 then $ 25 is paid as fixed financial charges and remaining $ 75 is distributed among shareholder, each receiving an income of $ 1.5. When earning of the firm is doubled to $ 200, $ 25 is paid as fixed financial charges and remaining $ 175 is allocated among the share holders, each receiving an income of $ 3.5. When earning of the firm is halved to $ 50, $ 25 is paid as fixed financial charges and remaining $ 25 is allocated among shareholders, each receiving an income of $ 0.50. Thus returns to the shareholders are increased by adjusting the proportion of debt to equity in the capital structure.

The presence of a fixed financial charge in the financing of the firm leverages the EPS for a given change in EBIT. This is called as Financial Leverage.

Degree of Financial Leverage – is the percentage change in the Earning per share (EPS) with 1% change in EBIT level.

DFL = [% change in EPS / % change in EBIT]; minimum value of DFL = 1

When DFL = 1 it implies that all funding is done through equity.

At breakeven point DFL is undefined, because EBIT is 0 at breakeven (no profit no loss)

The larger the value of DFL, the greater is the change in earnings for the shareholders and hence greater is the financial risk. DFL is the measure of financial risk. DFL in the range of 1 to 3 is good.

EBIT- EPS analysis is a powerful tool that helps in evaluation of the different financing patterns and in establishing an optimal target capital structure.

Example

$ mn

Financing Plans

All Equity

A

B

C

D

Debt Ratio

0%

10%

30%

50%

70%

Capital

1000

1000

1000

1000

1000

Equity

1000

900

700

500

300

Debt

0

100

300

500

700

Interest rate

10%

10%

10%

10%

10%

Return on Assets

15%

15%

15%

15%

15%

$ mn

Financing Plans

All Equity

A

B

C

D

EBIT

150

150

150

150

150

Interest

0

10

30

50

70

EBT

150

140

120

100

80

Tax (40%)

60

56

48

40

32

PAT

90

84

72

60

48

No. of Shares

100

90

70

50

30

EPS

0.9

0.93

1.03

1.20

1.60

ROE

9%

9.3%

10.3%

12%

16%

The table shows the variation of EPS and ROE according the variation in the capital structure. As the debt component part increases in the capital structure the Return on Equity increases for the shareholder.

The general effect of leverage on share holder earning can be summarized as

Substitution of equity with debt enhances earnings for the equity shareholder, as cheaper debt replaces more expensive equity.

Although EPS for the shareholder increases, variability of EPS too increases. In effect, this means that shareholders are exposed to greater risk as more and more debt substitutes for equity.

Country specific determinants of Capital Structure

A company’s capital structure is not only influenced by firm-specific factors but also by country specific factors. Country-specific factors can affect company’s leverage in two ways

These factors can influence leverage directly e.g. a more developed bond market facilitating issue and trading of public bonds may lead to the use of higher leverage in a country, while a developed stock market has the opposite effect.

Country-specific factors can also influence corporate leverage indirectly through their impact on the effect of firm-specific factors e.g. although the developed bond market of a country stimulates the use of debt, the role of asset tangibility as collateral in borrowing will be rather limited for firms in the same country. In other words, country characteristics may explain why in one country a firm’s tangibility affects leverage, but not in another country.

Leverage is affected by country-specific factors such as

GDP growth

Capital market development

Degree of development in the banking sector, and equity and bond markets

Cross-country legal institutional differences

Shareholder/creditor right protection

Industry Norms for Capital Structure

Industry norms for capital structure include:

Interest Coverage Ratio

Interest Coverage Ratio = EBIT/Interest

For an Auto Comp industry Interest Coverage ratio of 3.00 is acceptable. Anything more than 3.00 is good. The interest cover provides an impression about the safety of the interest portion of debt only. It is an important figure because we consider continuing debt.

Cash Coverage Ratio

Cash Coverage ratio = [EBIT +depreciation + non-cost expense] / [Interest + Loan Installment/ (1-T)]; where T = tax%

The Cash Cover Ratio assesses the chances of recovery of principal amount. Cash Coverage ratio less than ‘1’ is not permissible.

Debt Equity Ratio

Capital Structure focuses on liquidity, solvency and safety. The company and the financial institutions must follow the debt equity norms prevailing in the industry to which the company belongs.

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