CAPITAL STRUCTURE & LEVERAGES
UNIT-I: CAPITAL STRUCTURE DECISIONS
THEORETICAL QUESTIONS
Q. 1. Distinguish between: Financial Structure & Capital Structure. [June 2009 (5 Marks)], [Dec. 2011 (5 Marks)] [Dec. 2013 (5 Marks)], [June 2016 (5 Marks)] [June 2019 (4 Marks)]
Ans.
Following are the main points of difference between nancial structure and capital structure: Points Financial Structure Capital Structure
Meaning Financial structure consists of all assets, all liabilities and the capital. The manner in which an organization’s assets are nanced is referred to as its nancial structure.
Capital structure is the sum total of all long-term sources of capital and thus is a part of the nancial structure. It includes debentures, long term debt, preference share capital, equity share capital and retained earnings. In the simplest of terms, capital structure of a company is that part of nancial structure that re ects long-term sources of capital.
Creation of assets
Financial structure involves creation of both long-term and short-term assets.
Capital structure relates to long-term capital deployment for creation of longterm assets.
Size Financial structure is boarder concept. Capital structure is narrow concept.
Q. 2. “The choice of an appropriate debt policy involves a trade-off between tax benefits and the cost of financial distress.” Comment. [Dec. 2006 (5 Marks)]
15.2
Ans. Capital structure is signi cant for a rm because the long term pro tability and solvency of the rm 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 nancial distress and bankruptcy. Thus, management has to strike a proper balance between owned funds and debt funds.
Q. 3. Write a short note on: Vertical Capital Structure. [Dec. 2008 (5 Marks)] Or
‘Vertical capital structure’ and ‘pyramid shaped capital structure’ exhibit opposite dimensions in analyzing its utility. Discuss. [Dec. 2014 (4 Marks)]
Ans. Capital structure can be of various kinds as described below:
(1) Horizontal Capital Structure: In a Horizontal capital structure, the rm has zero debt components. The structure is quite stable. Expansion of the rm takes in a lateral manner, i.e. through equity or retained earning only. The absence of debt results in the lack of nancial leverage. Probability of disturbance of the structure is remote.
(2) Vertical Capital Structure: In a 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 nancial risk of the rm and renders the structure unstable. The rm, because of the relatively lesser component of equity capital, is vulnerable to hostile takeovers.
(3) Pyramid Shaped Capital Structure: A pyramid shaped capital structure has a large proportion consisting of equity capital and retained earnings which have been ploughed back into the rm over a considerably large period of time. The cost of share capital and the retained earnings of the rm are usually lower than the cost of debt. This structure is indicative of risk averse conservative rms.
(4) 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 capital structure in the recent past have been made through debt only. Chances are that the retained earnings of the rm are shrinking due to accumulating losses. Such a capital structure is highly vulnerable to collapse.
Q. 4. Discuss the concept of “optimum capital structure”. [Dec. 2009 (5 Marks)], [June 2012 (5 Marks)] [June 2015 (5 Marks)], [Dec. 2015 (5 Marks)]
Ans. Optimum capital structure deals with the issue of right mix of debt and equity in the long-term capital structure of a rm. According to this, if a company takes on debt, the value of the rm increases up to a certain point. Beyond that value of the rm will start to decrease.
If the company is unable to pay the debt within the speci ed 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.
Q. 5. While deciding upon the capital structure, the firm has to consider the different life cycle stages. Comment. [June 2010 (5 Marks)]
Ans. The rm has to consider the following life cycle stages while deciding upon the capital structure:
(a) Pioneering Stage: It is the starting stage when there is rapid increase in demand for the product/services of company. At this stage only ef cient 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.
(
b) 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 nancial leverage.
(
c) Stabilization/Stagnation Stage: In this stage, management looks out for expansion and diversi cation into new projects. Takeovers, mergers, acquisition and strategic alliances are main activities. In this stage, capital structure depends on these activities.
Q. 6. Distinguish between: Horizontal Capital Structure & Vertical Capital Structure. [June 2011 (5 Marks)]
Ans. Following are the main points of difference between horizontal capital structure & vertical capital structure:
Points
Horizontal Capital Structure
Meaning In a Horizontal capital structure, the rm has zero debt components in the structure mix.
Expansion/ addition Expansion of the rm takes in a lateral manner, i.e. through equity or retained earning only.
Risk The absence of debt it results in the lack of nancial leverage and hence low nancial risk.
Vertical Capital Structure
In a 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.
The high nancial leverage in the capital structure increases the nancial risk of the rm and renders the structure unstable.
EPS Low EPS. High EPS.
15.4
Q. 7. Financial gearing is a double-edged sword. Comment. [Dec. 2011 (5 Marks)] Or
Financial gearing is a fair weather friend. Comment. [Dec. 2013 (5 Marks)]
Ans. Using borrowed funds or xed cost funds in the capital structure of a company is called nancial gearing. High nancial 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 nancial 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 pro ts 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 nancial gearing, the greater will be the risk. Those who take risk should appreciate that in dif cult times their reward will be below average but in good times they will receive above average rewards. The lower the levels of nancial gearing, the more conservative are the nancial policies of the company and the less will be deviations over time to earnings per share. Hence, nancial gearing is a double–edged sword.
Q. 8. A firm’s stock price is not related to its mix of debt and equity financing. Comment. [June 2011 (5 Marks)], [June 2015 (5 Marks)]
Ans. Theory of modern nancial management – by Franco Modigliani and Merton Miller concluded that the value of a rm depends solely on its future earnings stream, and hence its value is unaffected by its debt/equity mix. They concluded that a rm’s value stems from its assets, regardless of how those assets are nanced.
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 nancing resulted in a higher value for the rm than equity nancing, then investors who owned shares in a leveraged (debt- nanced) rm could increase their income by selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all equity- nanced) rm. The simultaneous selling of shares in the leveraged rm and buying of shares in the unleveraged rm would drive the prices of the stocks to the point where the values of the two rms would be identical. Thus, according to MM Hypothesis, a rm’s stock price is not related to its mix of debt and equity nancing.
Q. 9. Distinguish between: Net Income Approach and Net Operating Income Approach. [Dec. 2011 (5 Marks)], [Dec. 2014 (4 Marks)], [June 2015 (5 Marks)]
Ans.
Following are the main points of difference between net income approach and net operating income approach:
Points Net Income Approach Net Operating Income Approach
Meaning According to this approach, capital structure decision is relevant to the value of the rm.
Increase or decrease in nancial leverage
An increase in nancial leverage will lead to decline in the weighted average cost of capital, while the value of the rm 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.
According to this approach, capital structure decisions of the rm are irrelevant. As a result, the division between debt and equity is irrelevant.
Any change in the leverage will not lead to any change in the total value of the rm and the market price of shares, as the overall cost of capital is independent of the degree of leverage. An increase in the use of debt which is apparently cheaper is offset by an increase in the equity capitalization rate. This happens because equity investors seek higher compensation as they are opposed to greater risk due to the existence of xed return securities in the capital structure.
Change in capital
According to this approach, the rm can increase its total value by decreasing its overall cost of capital through increasing the degree of leverage.
Conclusion The significant conclusion of this approach is that it pleads for the rm to employ as much debt as possible to maximize its value.
According to this approach, changes in capital do not lead to change in overall cost of capital.
According to this approach, capital structure decisions of the rm are irrelevant. Hence employment more debt does increase the overall value of the rm.
Q. 10. Write a short note on: Net Income Approach. [June 2014 (5 Marks)]
Ans. According to this approach, capital structure decision is relevant to the value of the rm. An increase in nancial leverage will lead to decline in the weighted average cost of capital, while the value of the rm 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 rm on the basis of Net Income Approach can be ascertained as follows:
V = S + D
Where,
V = Value of the rm
S = Market value of equity
D = Market value of debt
Market value of equity (S) = Net Income
K e
Net income = Earnings available for equity shareholders
K e = Equity capitalization rate
Under, NI approach, the value of the rm will be maximum at a point where weighted average cost of capital is minimum. Thus, the theory suggests total or maximum possible
15.6 PART II : FINANCIAL MANAGEMENT
debt nancing for minimizing the cost of capital. The overall cost of capital under this approach is:
Overall cost of capital = EBIT Value of rm
Thus, according to this approach, the rm can increase its total value by decreasing its overall cost of capital through increasing the degree of leverage. The signi cant conclusion of this approach is that it pleads for the rm 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 rm
Net operating income/EBIT 5,00,000 (–) Interest on debentures (20,00,000 × 10%) (2,00,000)
Earnings available for equity holders i.e. (NI) 3,00,000
Equity capitalization rate (Ke) 16%
(3,00,000/16%)
Overall cost of capital = EBIT = 5,00,000 = 12.90% Value of rm 38,75,000
Q. 11. The nature of the industry plays an important role in capital structure decisions. Comment. [Dec. 2015 (5 Marks)]
Ans. Capital structure is in uenced 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 pro tability, and hence the pattern of their capital structure 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.
Q. 12. Explain ‘pecking order hypothesis’ relevant to capital structure planning. [Dec. 2015 (4 Marks)]
Ans. In corporate nance, pecking order theory postulates that the cost of nancing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of nancing, rst preferring internal nancing, and then debt, lastly raising equity as a “last resort”. Hence, internal nancing is used rst; 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 nancing sources and prefer internal nancing when available, and debt is preferred over equity if external nancing is required. Thus, the form of debt a rm chooses can act as a signal of its need for external nance.
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 rm 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.
Q. 13. “Modigliani–Miller theory amplifies that value of the levered firm is same as value of the unlevered firm.” Under which circumstances this proposition can be proved. [June 2016 (5 Marks)]
Ans. The propositions made by Modigliani and Miller are:
(i) Proposition I: The total market value of a rm and its cost of capital are independent of its capital structure. The total market value of the rm is given by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its risk class.
(ii) Proposition II: The cost of equity (Ke) is equal to capitalization rate of pure equity stream plus a premium for nancial risk. The nancial risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to offset exactly the use of less expensive source of funds.
(iii) Proposition III: The cut-off rate for investment decision making for a rm in a given risk class is not affected by the manner in which the investment is nanced. It emphasizes the point that investment and nancing decisions are independent because the average cost of capital is not affected by the nancing 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 rm is not affected by its capital structure i.e. the total value of the rm remains the same irrespective of its nancing 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 rms and the value of unlevered rms 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 capital structure decisions, because such decisions would have no impact on stock prices. However, like most theories, MM’s results would hold true
15.8
PART II : FINANCIAL MANAGEMENT
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 nancing can affect the value of a rm.
Q. 14. Differentiate between: Pyramid Shaped Capital Structure and Inverted Pyramid Shaped Capital Structure. [June 2017 (4 Marks)]
Ans. 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 rm over a considerably long period of time. The cost of equity and the retained earnings of the rm is usually lower than the cost of debt. This structure is indicative of risk averse conservative rms.
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 capital structure in the recent past have been made through debt only. Chances are that the retained earnings of the rm are shrinking due to accumulating losses. Such a capital structure is highly vulnerable to collapse.
Q. 15. The capital structure is significant for the overall ranking of the firm in the industry group. Discuss. [Dec. 2021 (4 Marks)]
Ans.
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. The capital structure also is significant for the overall ranking of the firm in the industry group. The significance of the capital structure is discussed below:
1. It re ects the rm’s strategy: The capital structure re ects the overall strategy of the rm. The strategy includes the pace of growth of the rm. In case the rm 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 rm would nd that nancial leverage is an important tool in funding the acquisitions.
2. It is an indicator of the risk pro le of the rm: One can get a reasonably accurate broad idea about the risk pro le of the rm from its capital structure. If the debt component in the capital structure is predominant, the xed interest cost of the rm increases thereby increasing its risk. If the rm 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.
3. 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 rm having healthy growth in operating pro ts would nd it worthwhile to incorporate debt in the capital structure in a greater measure.
4. 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.
PROBLEMS & SOLUTIONS
Problem No. 1] Distance Sensor Ltd. is an all equity nanced company with a market value of ` 35,00,000 and cost of equity, Ke = 20%. The company wants to buy-back equity shares worth ` 8,00,000 by issuing and raising 10% perpetual debt of the same amount. Rate of tax may be taken at 35%.
Applying the MM Model (with taxes), how would the capital restructuring affect –
(a) Market value of Distance Sensor Ltd.
(b) Cost of equity (Ke)
(c) Weighted Average Cost of Capital (WACC) of the company.
[Dec. 2009 (10 Marks)], [Dec. 2014 (4 Marks)]
Ans.
Computation of EBIT of the unlevered company:
of equity (PAT/Capitalization rate) × 100 (given)
Perform reverse calculation to nd out EBIT.
7,00,000 6,48,000
According to MM, the value of levered rm would exceed that of the unlevered rm by an amount equal to the levered rms debt multiplied by the tax rate.
Value of unlevered rm + (Value of debt × Tax rate) = Total Value
Value of the company with ` 8,00,000 in debt:
35,00,000 + (8,00,000 × 35%) = 37,80,000
Total value – Value of debt = Value of equity
37,80,000 – 8,00,000 = 29,80,000
K e = D = 6,48,000 = 0.2175 i.e. 21.75% P0 29,80,000
15.10
Cost of debt:
Kd = I (1 – t) = 10 (1 – 0.35) = 6.5%
Calculation of overall cost of capital (market value basis):
Problem No. 2] Maxwell Ltd. is operating in electronic equipments development and its sales and EBIT for the current year were ` 70,00,000 and ` 18,00,000 respectively. During the year, interest expense was ` 16,000 and preference dividend was ` 20,000. These xed charges are expected to continue for the next year. The company is thinking to diversify its operations which will require ` 7,00,000 and is expected to increase EBIT by ` 4,00,000 to ` 22,00,000.
The company has the following three nancing alternatives under its consideration:
Alternative-1: Issue 10,000 equity shares at ` 70 per share. The company has currently 80,000 shares of common stock outstanding.
Alternative-2: Issue ` 7,00,000, 15 years 15% debentures. Sinking fund payments on these debentures will commence after 15 years.
Alternative-3: Issue ` 7,00,000, 14% preference shares.
You are required to calculate –
(i) The EPS at the expected earnings before interest and taxes level of ` 22,00,000 for each nancing alternative.
(ii) The equivalency level of earnings before interest and taxes between the debt and common stock alternatives.
(iii) The equivalency level of earnings before interest and taxes between the preference shares and common stock alternatives.
Assume 30% income-tax rate. [June 2012 (12 Marks)], [Dec. 2014 (8 Marks)]
Ans.
Capital structure for new nance:
Statement showing pro t available for equity shareholder and EPS: Particulars
(-) Interest
(-) Preference dividend
Calculation of indifferent point between Alternative 1 & 2:
(EBIT – I) (1 – t) – Dp = (EBIT – I) (1 – t) – Dp N1 N2
Let the EBIT be ‘x’. (x – 16,000) (1 – 0.3) – 20,000 = (x – 1,21,000) (1 – 0.3) – 20,000
0.7x – 31,200 = 0.7x – 1,04,700 9 8
5.6x – 2,49,600 = 6.3x – 9,42,300
– 0.7x = – 6,92,700 x = EBIT = 9,89,571
Calculation of indifferent point between Alternative 1 & 3:
(EBIT – I) (1 – t) – Dp = (EBIT – I) (1 – t) – Dp N1 N2
Let the EBIT be ‘x’.
(x – 16,000) (1 – 0.3) – 20,000 = (x – 16,000) (1 – 0.3) – 1,18,000 90,000 80,000
0.7x – 31,200 = 0.7x – 1,29,200 9 8
5.6x – 2,49,600 = 6.3x – 11,62,800
– 0.7x = – 9,13,200 x = EBIT = 13,04,571
