Capital Structure Decision

Capital Structure Decision

It is a decision regarding debt equity mix. There is a Optimum mix of debt and equity which minimizes the cost of capital and in the total value of the firm.

Factors affecting the capital Structure

1. The Profitability Model

(i) EBIT-EPS Analysis

EBIT-EPS analysis shows the impact of various financing option (debt-equity mix on the EPS various level of EBIT) A company which has debt in the capital structure is said to be trading on equity if the return on investment is greater than the after tax cost of debt. The benefit of trading on equity is available even if the return on investment is greater than the after tax cost of debt. The benefit of trading on equity is available even if preference share are issued. But the benefit is greater, if debt is used since debt is cheaper than equity and because of the tax benefit on interest payment. If however the return on investment is lower than the cost of debt then the use of debt will reduce the EPS. It therefore stands to reason there is particular level of EBIT at which the EPS will remain the same whatever be the method of financing used ( indifference pointEBIT).

2. Debt- Capacity of the firm:

(i) Interest Coverage Ratio:

The ability of the firm to borrow more is determined by the following ratios:-

EBIT

(a) Interest Coverage Ratio = ------

Interest

A high ratio indicates better ability to burrow. Another ratio is:

(b) Debt Servicing Ratio

It indicates the amount of EBIT to cover the interest and annual transfer of sinking fund for the redemption of debt.

EBIT

Debt Servicing Ratio = ------

Interest + (Sinking Fund appropriation /1-tax)

3. Liquidity Aspect

The company’s EBIT may be adequate to meet the commitments arising out of the debt issue. But the firm may not have sufficient cash since its income may be blocked in inventory or receivables. In the absence of cash the firm which is other wise profitable sound would have problem in paying the debts interest and the return of principal leading to financial distress. Hence the ability to generate sufficient cash profit would determine the level of debt to be issued.

4. Control Aspects

If the main object of the management is to maintain control the company shall raise the additional capital requirements through debts or preference shares. So that they do not dilute the control.

5. Leverage Industry of Other Firm in The industry

Compare debt-equity ratios of company’s in the same industry having a smaller business risk. This will tell us if the firms ratio is more or less then the industry in which case it should know the reason why is it difficult and be safety that there are good reason for such difficulty.

6. Nature of Industry

(i) Sales:-

Firms whose sale fluctuates widely should employ less debt. The opening leverage will be high. Eg. Durable Consumer goods, Firms dealing in non durable consumer goods i.e. items with inelastic demand will rely more on debt.

(ii) Competition:-

Firms operating is more high competitive market share depend more on equity. Public Utilities which are relatively free competition can use more debt.

(iii) Life Cycle stage:-

In the infancy stage of the life cycle the firm should rely more on equity as the firm goes and reach the maturity debt can be relied upon.

(iv)Capital Market considerations:

The type of securities that the investors prepare to buy is an important factordetermining the type of securities shall be issued.

(V) Maintainingmaneuverability for commercial strategy:

Maneuverabilityrefers to the firm ability to either increasing or decreasing its sources of funds in response to changes in the need of funds onwhile designing the capital structure it should not loose site of the future impact of its present financial plan. For example if the firm has exhausted its firmscapital it may be force to issue equity shares for future financing on unfavorable term due to heavy debt. Hence the firm should all ways return some unused debt capacity for future needs. Flexibility also implies the firm’s ability to refund money whennot required for which purpose it may have to incorporate a provision to refund the amount before the due date with adequate notice in the loan agreement. This facility can be obatain only at a higher cost far the funds barrowed. He has to assure himself that he is not buying flexibility at a higher cost than is warranted by the gains arisingfrom flexibility.

7. Timing of Issues:

Public offer should bemade at a time when a stated economy as well as the capital market is ideal to provide funds. High debenture yields indicatea relater security ofdebenture funds and a P.E ratio is an indicate of scarcity Equity funds. The financial manager expends interest rate to fall in future borrowings may be postponed and vice-versa.

8. Characteristics of the Company

Small firms will havemore depends on owners funds. Large firms have a choice of different sources of funds. Firms enjoying the high credit standing can raise different source of funds.

9. Tax Planning

Under Income tax Act, interest on burrowed fund is allowed as deduction for computing taxable profit. Whereas dividend on shares cannot be deducted.

With effect from 1.7.91, company has paid 10% of tax on dividend declared and distributed.

Cost of raising fund for burrowing is deductible in the year of burrowing. Cost of issue of equity shares is allowed as deductible over 5 years.

10. Legal Framework:

Long Term are available on securities. Debentures can be issued and redeemable after 18 months from the date of issue. Credit rating shall be issued secured debentures only. No such approval is necessary for raising loans for financial institution.

11.Agency Costs:

Since Equity share holders control the firms’ management and decision making. Their interest will dominate the interest if debenture holders take some protective action form of condition with loan agreement such as

1. Debenture nominee of the board of directors
2. Appointment of Debenture trustee.
3. Maintaining a maximum current ratio.
4. Fixing the maximum dividend payable.
5. Regular follower and reporting.

Conclusion

There is no standard Debt equity mix which is suitable for all firms some of the factors discussed above are conflicting in nature. The determination of most desirable Debt-Equity Mix is corrected by risk, control, flexibility and maintains these factors should be given taking into account and also consider the nature of industry and the position of the company.

Q1) A Ltd has an equity capital consisting of 5000 Equity shares of Rs 100 each. It plans to raise Rs. 300000 for the financial expansion programme and identify four options for raising funds.

1. Issued Equity shares of Rs 100 each
2. Issue 1000 Equity shares of Rs.100 each and 2000 8% Preference shares of Rs 100 each
3. Burrow of Rs 300000 at 10% interest p.a
4. Issue 1000 Equity shares of Rs.100 each and Rs. 200000, 10% debentures

This company has EBIT of Rs 150000 of its expansion. Tax rate is 50%. Suggest the source in which funds should be raised.

Sol.

Statement showing EPS

Option 3 will be selected because it has higher EPS

Q.2) AB ltd gives you the following figures

EBIT 300000

Less: 12 % Debenture Int 60000

240000

Less: Income tax @ 50% 120000

EAT 120000

No. of Equity shares = 40000

120000

EPS = ------= Rs 3 per share

40000

Market price per share = Rs.30

Market Price Per share 30

Price Earning Ratio (PE) = ------= ------= 10

EPS 3

The company has undistributed reserves of Rs.600000 It requires Rs.200000 for expansion. This amount will earn the same rate of return on funds employed as it is earned now.

You are informed that the Debt-Equity ratio = (Debt/ Debt + Equity) higher than 35% will reduce the PE ratio to 8 and raisethe interest rate on additional funds burrowed to 14%.

The company would prefer to raise the entire funds required through equity or through debt. Which would you recommend?

Sol.

Total Funds employed at Present

Equity Capital (40000 * 10) 400000

Add: Reserves 600000

Debentures (600000* 100/12) 500000

Total Funds Employed 1500000

EBIT

Return on Funds employed = ------X 100

Funds Employed

300000 X 100

= ------= 20%

150000

Total Funds after expansion will be

= 1500000 ( existing ) + 200000 ( new) = Rs 1700000

New EBIT after expansion = 1700000 * 20 % = Rs. 340000

Working Note

New Debt Equity Ratio =

Debt 500000 + 200000

------= ------

Debt + Equity 700000 + 1000000

700000

= ------X 100 = 41%

1700000

Debt Equity ratio is more than 35 %

Therefore PE ratio in the first option is 8

Statement Showing EBIT

Note

It is assumed a new Equity shares will be issued at the current market price Rs 30 each. Therefore no of new shares issued will be 200000/30 = 6667 shares

Normally we decide the financing option by finding out which option gives the highest EPS. But if the PE ratio is given we calculate the market price of the shares and determine which option gives the highest market price. That option will be selected. In the above case the company should financial expansion with equity issue.

Q.3) From the following details relating to K ltd.

EBIT 2300000

Less: - 8% Debenture Int 80000

2220000

Less:- 11% Loan Int 220000

EBT 2000000

Less:- Tax at 50% 1000000

EAT 1000000

No of Equity shares ( Rs 10 each) = 500000 shares

Market Price per shares = Rs 20

PE ratio = 10

The company has undistributed Reserves of Rs 2000000 . It requires Rs, 3000000 to redeem the debentures and modernize its plant which has the following financial option-

1. Borrow 12% loan from banks
2. Issue 100000 Equity shares of Rs. 20 each and balance from a 12% bank loans

The Company expects to improve its rate of return by 2% as a result of modernization However the PE ratio is likely to reduce if entire amount is burrowed. Advice the company.

Sol:

Computation of Existing Capital employed

Reserves 2000000

8 % Debentures ( 80000 * 100/8) 1000000

Loan ( 220000 * 100/11) 2000000

E share( 500000 * 10) 5000000

10000000

Existing Return on Capital employed =

EBIT 2300000

------X 100 = ------X 100 = 23 %

Cap. Employed 10000000

Existing Return on Capital = 23%

Add:- Increased by 2%

Return after modernization 25% on

New capital employed

Existing Capital employed 10000000

Add:- New Fund raised 3000000

13000000

Less: Redemption of Reserves 1000000

12000000

New EBIT = 12000000 * 25% = Rs. 3000000

Market Price = 6 * 2.42 = 19.36

In case of Equity and Debt issue the P/E remains the same Market price is also assumed to be the same i.e. Rs 20

As Market price is higher in the second option debt and equity issue is preferred.

Q.4) X ltd has to make a choice between debt issue and equity issue for its expansion programme. Its current position as follows-

The capital structure consist of 5% Debentures Rs. 20000: E. Share Capital (Rs.10) Rs 50,000 and Reserves Rs. 30000. Its income statement is as follows

Sales 300000

Less:- Total Cost 269000

EBIT 31000

Less: Interest 1000

EBT 30000

Less: Tax 10500

EAT 19500

The Expansion Programme is expected to cost Rs. 50000. This si financed through debt the rate of Interest will be 7% and the PE ratio will be 6. If the expansion is financed through Equity the new shares are sold Rs.25 each and the PE ratio will be 7.

The expansion will increase the sales by 50% with the return of 10% on the new sales before interest and Taxes. Advice the company.

Solution.

New Sales from expansion 300000 * 50% = 150000

EBIT on New sales (150000 * 10%) 15000

(+) Existing EBIT 31000

New EBIT 46000

Option I is better because it has highest market price.

Indifference Point EBIT

It is the level of EBIT at which EPS is same for two option in financing, since the EPS is same , the firm will be indifferentiate between the two option.-

1. EPS under Equity only

EBIT [ 1- Tax]

No of Equity shares

2. EPS with debt and Equity

( EBIT – Interest ) ( 1- Tax)

No. of Equity shares

3. EPS with debt, Equity and Preference shares

( EBIT – Interest ) ( 1- Tax) – Preference dividend

No. of Equity shares

Q.1) The New project under consideration requires Rs. 3000000. The financing option are-

1. Issue of Equity shares of Rs. 100 each
2. Issue Equity shares of Rs. 2000000 and 15% debentures for Rs. 1000000

Tax rate is 50%.Calculate the indifference point EBIT

Solution

a)EPS under option I (EPS under equity only)

EBIT [ 1- Tax]

No of Equity shares

b)EPS under Option II ( EPS with debt and equity)

( EBIT – Interest ) ( 1- Tax)

No. of Equity shares

EBIT (1- Tax) = ( EBIT – Interest ) ( 1- Tax)

No. of Equity shares No of Equity shares

EBIT ( 1- 0.5) = ( EBIT – 150000 ) ( 1- 0.5)

30000 20000

2 EBIT = 3 EBIT – 450000

3 EBIT – 2 EBIT = 450000

EBIT = 450000

Q.2) X ltd requires Rs. 200000 for expansion. It has the following financial option.

a)100% equity shares of Rs 10 each at Rs 10 Premium

b)50% equity issue of Rs. 10 each at Rs 10 Premium and 50% , 8% debentures

c)50% equity issue of rs. 20 each and 50%, 10% preference shares

The company expects return of 10% on its investment after expansion. Which financing option would you recommend and also calculate indifference point of EBIT between various plans.

Sol.

EBIT after expansion = 200000* 10% = 20000

Statement showing EPS

Option (b) should be recommended because it has high EPS.

Indifference Point between (a) and (b)

EBIT (1- Tax) = ( EBIT – Interest ) ( 1- Tax)

No. of Equity shares No of Equity shares

EBIT ( 1- 0.5) = ( EBIT – 8000 ) ( 1- 0.5)

10000 5000

5 EBIT = 10 EBIT – 80000

10 EBIT – 5 EBIT = 80000

5 EBIT = 80000

EBIT = Rs 16000

Indifference Point between (a) and (c)

EBIT [ 1- Tax] = ( EBIT – Interest ) ( 1- Tax) – Preference dividend

No. of Equity shares No of Equity shares

EBIT [ 1- 0.5] = ( EBIT – Nil ) ( 1- 0.5) – 10000

10000 5000

EBIT [0.5] = EBIT ( 0.5) – 10000

10000 5000

2.5 EBIT = 5 EBIT -100000

5 EBIT – 2.5 EBIT = 100000

2.5 EBIT = 100000

EBIT = Rs. 40000

Indifference Point between (b) and (c)

( EBIT – Interest ) ( 1- Tax) = ( EBIT – Interest ) ( 1- Tax) – Preference dividend

No. of Equity shares No. of Equity shares

( EBIT – 8000 ) ( 1- 0.5) = ( EBIT – Nil ) ( 1- 0.5) – 10000

5000 5000

EBIT – 8000 (0.5) = EBIT ( 0.5) – 10000

5000 5000

2.5 EBIT – 20000 = 2.5 EBIT – 50000

2.5 EBIT – 2.5 EBIT = 50000-20000

EBIT = 30000/0 = Nil

Therefore there is no indifference point between them.

Q.3) A company approaches the financial institution for a sum of Rs 60000 for expansion 10% loan provided the company as debt- Equity ratio of 1:3

1. The present capital structures consist of 1000000 Equity shares of Rs 10 each only which option should the company adopts.
2. At what level of EBIT, the firm will be indifferent between the two financing option.
3. Calculate the level of EBIT at which the uncommitted EPS would be the same if sinking fund obligation in respect of Debenture issue of Rs. 250000 p. annum

Assume tax rate 50%

Note: The new share will be issued at a premium of Rs 40 each.

Sol:

The total fund offer expansion will be –

Existing E. share 100000 * 10 = Rs 100 lakhs

Add: funds for expansion = 60 lakhs

160

Debt

Existing Debt equity ratio = ------= 1:3

Equity

= 1+3 = 4

Existing & New amount = 160/4 = 400000

Debt = 4000000*1 = 400000

Equity = 4000000 * 3 = 12000000

Option I

The company will burrow from the financial institution only Rs 4000000 at 10% interest and the remaining Rs 2000000/50 through equity shares. i.e 40000

Option II

Rs 600000 for equity shares only that is 600000/50 = 120000 shares

Which option company adopts if the post expansion EBIT is Rs 6000000

Statement showing EPS

Option I should be accepted because it has a high EPS.

Indifference point two option

( EBIT – Interest ) ( 1- Tax) = EBIT [ 1- Tax]

No of Equity shares No. of Equity shares

( EBIT – 400000 ) ( 1- 0.5) = EBIT [ 1- 0.5]

1040000 1120000

112 EBIT – 44800000 = 104 EBIT

112 EBIT – 104 EBIT = 44800000

8 EBIT = 44800000

EBIT = Rs 5600000

3. Sinking Fund Obligation and Option IV

( EBIT – Interest) ( 1- Tax) = EBIT [ 1- Tax]

No of Equity shares No. of Equity shares

( EBIT – 400000 ) ( 1- 0.5) = EBIT [ 1- 0.5]

1040000 1120000

56 EBIT – 50400000 = 52 EBIT

56 EBIT – 52 EBIT = 50400000

4 EBIT = 50400000

EBIT = Rs. 12600000