Capital Structure & Leverages – Understanding Debt | Equity | Financial Decisions

Following are the main points of difference between financial structure and capital structure:

Capital structure is significant for a firm because the long term profitability and solvency of the firm is sustained by an optimal capital structure consisting of an appropriate mix of debt and equity.

While deciding about capital structure, the debt proportion needs to be appropriate. High proportion of debt in capital structure leads to high interest burden on the company, it reduces the taxable income and thus reduces taxable income but at the same time due high debt funds equity funds will be less and hence also increases the EPS of the company.

Though high debt funds in capital structure increases EPS but one cannot ignore the risk involved on it. High debt funds also increases the operating or business risk of the company and may lead to financial distress and bankruptcy. Thus, management has to strike a proper balance between owned funds and debt funds.

Capital structure can be of various kinds as described below:

• Horizontal Capital Structure – The firm has zero debt components. The structure is quite stable. Expansion of the firm takes in a lateral manner, i.e. through equity or retained earning only. The absence of debt results in the lack of financial leverage. Probability of disturbance of the structure is remote.
• Vertical Capital Structure – The base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built. The incremental addition in the capital structure is almost entirely in the form of debt. Quantum of retained earnings is low and the dividend pay-out ratio is quite high. In such a structure, the cost of equity capital is usually higher than the cost of debt. The high component of debt in the capital structure increases the financial risk of the firm and renders the structure unstable. The firm, because of the relatively lesser component of equity capital, is vulnerable to hostile takeovers.
• Pyramid Shaped Capital Structure – It has a large proportion consisting of equity capital and retained earnings which have been ploughed back into the firm over a considerably large period of time. The cost of share capital and the retained earnings of the firm are usually lower than the cost of debt. This structure is indicative of risk averse conservative firms.
• Inverted Pyramid Shaped Capital Structure – It has a small component of equity capital, reasonable level of retained earnings but an ever increasing component of debt. All the increases in the capital structure in the recent past have been made through debt only. Chances are that the retained earnings of the firm are shrinking due to accumulating losses. It is highly vulnerable to collapse.

Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a firm. According to this, if a company takes on debt, the value of the firm increases up to a certain point. Beyond that value of the firm will start to decrease.

If the company is unable to pay the debt within the specified period then it will affect the goodwill of the company in the market.

Therefore, company should select its appropriate capital structure with due consideration of all factors.

The firm has to consider the following life cycle stages:

• Pioneering Stage – It is the starting stage when there is rapid increase in demand for the product/services of company. At this stage only efficient companies survive. Due to risk perception about the company the cost of borrowing is high. To survive in this stage, capital structure is more oriented towards equity and avail more soft loans.
• Expansion Stage – In this stage strong companies having survived the competition struggle successfully expand their market share and volumes. For this requirement of funds is high. Therefore, the company in this stage resorts to financial leverage.
• Stabilization/Stagnation Stage – In this stage, management looks out for expansion and diversification into new projects. Takeovers, mergers, acquisition and strategic alliances are main activities. In this stage, capital structure depends on these activities.

Following are the main points of difference between horizontal & vertical capital structure:

Using borrowed funds or fixed cost funds in the capital structure of a company is called financial gearing. High financial gearing will increase the EPS of the company if earnings before interest and taxes are rising, as compared to the EPS of the company with low or no financial gearing. It may be understood that leverage and gearing are used interchangeably.

So at times when the economy is doing well, the shareholders of a highly geared company will do better than the shareholders of a low geared company. However, if the company is not doing well, when its profits before interest and taxes are falling, EPS of highly geared company will fall faster than those of the low geared company.

Higher the level of financial gearing, the greater will be the risk. Those who take risk should appreciate that in difficult times their reward will be below average but in good times they will receive above average rewards. The lower the levels of financial gearing, the more conservative are the financial policies of the company and the less will be deviations over time to earnings per share. Hence, financial gearing is a double–edged sword.

Theory of modern financial management – by Franco Modigliani and Merton Miller concluded that the value of a firm depends solely on its future earnings stream, and hence its value is unaffected by its debt/equity mix. They concluded that a firm’s value stems from its assets, regardless of how those assets are financed.

The theory was based on restrictive set of assumptions, including perfect capital market (which implies zero taxes). They used an arbitrage proof to demonstrate that capital structure is irrelevant. If debt financing resulted in a higher value for the firm than equity financing, then investors who owned shares in a leveraged (debt-financed) firm could increase their income by selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all equity-financed) firm. The simultaneous selling of shares in the leveraged firm and buying of shares in the unleveraged firm would drive the prices of the stocks to the point where the values of the two firms would be identical.

Thus, according to MM Hypothesis, a firm’s stock price is not related to its mix of debt and equity financing.

Following are the main points of difference between net income approach and net operating income approach:

According to this approach, capital structure decision is relevant to the value of the firm. An increase in financial leverage will lead to decline in the weighted average cost of capital, while the value of the firm as well as market price of ordinary share will increase. Conversely a decrease in the leverage will cause an increase in the overall cost of capital and a consequent decline in the value as well as market price of equity shares.

The value of the firm on the basis of Net Income Approach can be ascertained as follows:

V = S + D

Where,

V = Value of the firm

S = Market value of equity

D = Market value of debt

Net income = Earnings available for equity shareholders

K_e = Equity capitalization rate

Under, NI approach, the value of the firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible debt financing for minimizing the cost of capital. The overall cost of capital under this approach is:

Thus, according to this approach, the firm can increase its total value by decreasing its overall cost of capital through increasing the degree of leverage. The significant conclusion of this approach is that it pleads for the firm to employ as much debt as possible to maximize its value.

Example: R Ltd.’s EBIT is ` 5,00,000. The company has 10%, ` 20,00,000 debentures. The equity capitalization rate i.e. K_e is 16%.

Statement showing value of firm

Capital structure is influenced by the industry to which a company is related.

All companies related to a given industry produce almost similar products, their costs of production are similar, they depend on identical technology, they have similar profitability, and hence the pattern is almost similar. Because of this fact, there are different debt-equity ratios prevalent in different industries.

Hence, at the time of raising funds a company must take into consideration debt-equity ratio prevalent in the related industry.

In corporate finance, pecking order theory postulates that the cost of financing increases with asymmetric information.

Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a “last resort”. Hence, internal financing 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 and Majluf (1984) where they argue that equity is a less preferred means to raise capital because when managers 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.

The propositions made by Modigliani and Miller are:

• Proposition I – The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its risk class.
• Proposition II – The cost of equity (K_e) is equal to capitalization rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, K_e increases in a manner to offset exactly the use of less expensive source of funds.
• Proposition III – The cut-off rate for investment decision making for a firm in a given risk class is not affected by the manner in which the investment is financed. It emphasizes the point that investment and financing decisions are independent because the average cost of capital is not affected by the financing decision.

Assumptions – MM approach is based on the following assumptions.

1. Capital markets are perfect.
2. All information is freely available and there is no transaction cost.
3. All investors are rational.
4. Investors have homogenous expectations. They hold identical subjective probability distributions about future operating earnings.
5. No existence of corporate taxes. (MM removed this assumption later on).
6. Firms can be grouped into “Equivalent risk classes” on the basis of their business risk.

According MM, the total value of a firm is not affected by its capital structure i.e. the total value of the firm remains the same irrespective of its financing mix. The support for this hypothesis lies in the presence of arbitrage in the capital markets. They argue that through personal arbitrage, investors, would quickly eliminate any inequalities between the value of levered firms and the value of unlevered firms in the same risk class. They contend that arbitragers will substitute personal leverage for corporate leverage. The basic argument is that individuals (arbitragers) through the use of personal leverage can alter corporate leverage. This argument is not tenable in the practical world, because it is extremely doubtful that personal investors would substitute personal leverage for corporate leverage, since they do not have the same risk characteristics. M&M assumed the availability of free and up to date information. This is also not normally valid.

Criticism of MM Hypothesis – If the MM theory was correct, managers would not need to concern themselves with decisions, because such decisions would have no impact on stock prices. However, like most theories, MM’s results would hold true only under a particular set of assumptions. Still, by showing the conditions under which capital structure is irrelevant, MM provided important insights into when and how debt financing can affect the value of a firm.

Pyramid shaped Capital structure – A pyramid shaped capital structure has a large proportion of equity capital and retained earnings which have been ploughed back into the firm over a considerably long period of time. The cost of equity and the retained earnings of the firm is usually lower than the cost of debt. This structure is indicative of risk averse conservative firms.

Inverted Pyramid shaped Capital Structure – Such a capital structure has a small component of equity capital, reasonable level of retained earnings but an ever increasing component of debt. All the increases in the recent past have been made through debt only. Chances are that the retained earnings of the firm are shrinking due to accumulating losses. Such a capital structure is highly vulnerable to collapse.

Capital structure is significant for a firm because the long term profitability and solvency of the firm is sustained by an optimal capital structure consisting of an appropriate mix of debt and equity. This is also significant for the overall ranking of the firm in the industry group. The significance is discussed below:

• It reflects the firm’s strategy – The capital structure reflects the overall strategy of the firm. The strategy includes the pace of growth of the firm. In case the firm wants to grow at a faster pace, it would be required to incorporate debt in its capital structure to a greater extent. Further, in case of growth through acquisitions or the inorganic mode of growth as it is called, the firm would find that financial leverage is an important tool in funding the acquisitions.
• It is an indicator of the risk profile of the firm – One can get a reasonably accurate broad idea about the risk profile of the firm from its capital structure. If the debt component in the capital structure is predominant, the fixed interest cost of the firm increases thereby increasing its risk. If the firm has no long term debt in its capital structure, it means that either it is risk averse or it has cost of equity capital or cost of retained earnings less than the cost of debt.
• It acts as a tax management tool – The capital structure acts as a tax management tool also. Since the interest on borrowings is tax deductible, a firm having healthy growth in operating profits would find it worthwhile to incorporate debt in the greater measure.
• It helps to brighten the image of the firm – A firm can build on the retained earnings component of the capital structure by issuing equity capital at a premium to a spread out base of small investors. Such an act has two benefits. On the one hand, it helps the firm to improve its image in the eyes of the investors. At the same time, it reduces chances of hostile take-over of the firm.