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STUDY MATERIAL
SYLLABUS: Capital structure - Factors influencing capital structure - optimal capital structure
- Dividend and Dividend policy: Meaning, classification - sources available for dividends -
Dividend policy general, determinants of dividend policy.
MEANING OF CAPITAL STRUCTURE
Capital structure is the permanent financing of the company represented primarily by long-
term debt and shareholder’s funds but excluding all short-term credit. The term capital structure differs
from financial structure.
Financial structure refers to the way the firm’s assets are financed. In other words, it includes
both, long-term as well as short-term sourced of funds. Thus a company’s capital structure is only a
part of its financial structure.
PATERNS OF CAPITAL STRUCTURE
In case of new company, the capital structure may be of any of the following four patterns.
(1) Capital structure with equity shares only.
(2) Capital structure with both equity and preference shares.
(3) Capital structure with equity shares and debentures.
(4) Capital structure with equity shares, preference shares and debentures
FACTORS AFFECTING CAP[ITAL STRUCTURE
Capital Structure depends on a number of factors such as,
The nature of the business,
Regularity of earnings,
Conditions of the money market,
Attitude of the investor,
Debt-equity mix:
There is a basic difference between debt and equity. Debt is a liability on which interest has to
be paid irrespective of the company’s profits. While equity consists of shareholders or owners funds
on which payments of dividend depends upon the company’s profits. A high proportion of the debt
content in the capital structure increases the risk and many lead to financial insolvency of the company
in adverse times.
However, raising funds through debt is cheaper as compared to raising funds through shares.
This is because interest on debt is allowed as an expense for tax purpose. Dividend is considered to be
an appropriation of profits and so payment of dividend does not result in any tax benefit to the
company. This means if a company, which is in 50% tax bracket, pays interest at 12% on its
debentures, the effective cost to it comes only to 6%, while if the amount is raised by issue of 12%
preference shares, the cost of raising the amount would be 12%.
Thus, raising of funds by borrowing is cheaper resulting in higher availability of profits for
shareholders. This increases the earnings per equity share of the company, which is the basic
objective of a financial manager.
OPTIMUM CAPITAL STRUCTURE
A firm should try to maintain an optimum capital structure with a view to maintain financial
stability. This optimum capital structure is obtained when the market value per equity share is the
maximum.
It may, therefore, be defined as that relationship of debt and equity securities which maximizes
the value of a company’s share in the stock exchange. In case a company borrows and this borrowing
helps in increasing the value of the company’s shares in the stock exchanges, it can be said that the
borrowing has helped the company in moving towards its optimum capital structure.
In case, the borrowing results in fall in market value of the company equity shares, it can be
said that the borrowing has moved the company away from its optimum capital structure.
The objective of the term should therefore be to select a financing or debt equity mix, which
will lead to maximum value of the firm.
According to EZRA SOLOMAN : “Optimum leverage can be defined as that mix of debt and
equity, which will maximize the market value of a company i.e., the aggregate value of the claims, and
ownership interests represented on the credit interests represented on the credit side of the balance
sheet. Further the advantages of having an optimum, financial structure if such an optimum does exist,
is two-fold; it minimizes the company’s cost of capital which in turn increases it ability to find new
wealth-creating investment opportunities. Also by increasing the firm’s opportunity to engage in
future wealth-creating investment it increases the economy rate of investment and growth”.
CONSIDERATIONS
The following considerations will be greatly helpful for a finance manager in achieving his goal of
optimum capital structure.
(1) He should take advantage of favourable financial leverage. In other words if the ROI is higher
than the fixed cost of funds, he may prefer raising funds having a fixed cost to increase the return of
equity shareholders.
(2) He should take advantage of the leverage offered by the corporate taxes. A high corporate income
tax also provides some a form of leverage with respect to capital structure management. The higher
cost of equity financing can be avoided by use of debt, which in effect provides a form of income tax
leverage to the equity shareholders.
(3) He should avoid a perceived high risk capital structure. This is because if the equity shareholders
perceive an excessive amount of debt in the capital structure of the company, the price of the equity
shares will drop. The finance manager should not therefore issue debentures or bonds whether risky
or not, if the investors perceive an excessive risk and therefore it is likely to depress the market prices
of equity shares.
CAPITAL STRUCTURE THEORIES
B = Market value of debt.
Market value of Equity can be ascertained as follow
S=NI / ke
Where: S = Market value of equity
NI = Earnings available for equity shareholders;
Ke = Equity capitalization Rate.
II. NET OPERATING INCOME (NOI) APPROACH. (Suggested by Durand)
This is just opposite of the Net income approach. According to this approach the market
value of firm is not at all affected by the capital structure changes .The market value of the firm is
ascertained by the capitalizing the net operating income at the overall cost of capital (k), which is
considered to be constant .The market value of equity is ascertained by deducting the market value of
the debt from the market value of the firm.
ASSUMPTIONS:
(i) Over cost of capital (k) remains constant for all degrees of debt equity mix or leverage.
(ii) The market capitalizes the value of the firm as a whole and therefore, the split between debt and
equity is not relevant.
(iii) The use of debt having low cost increases the risk of equity shareholders, this, results in increase
in equity capitalization rate. Thus, the advantage of debt is set off exactly by increase in the equity
capitalization rate.
(iv) There are no corporate taxes.
VALUE OF THE FIRM:
According to the NOI approach, the value of a firm can be determined by the following equation:
V = EBIT/k
Where V = value of the firm,
K = overall cost of capital, EBIT = earnings before interest and tax.
Value of equity: The value of equity (s) is a residual value, which is determined by deducing the total
value of debt (b) from the total value of the firm (v) thus, the value of equity (s) can be determined by
the following equation.
S = V - B
Where:
S = value of equity
V = value of firm B = value of debt
OPTIMUM CAPITAL STRUCTURE:
According to net operating income (NOI) approach, the total value of the firm remains
constant irrespective of the debt-equity mix or the degree of leverage. The market price of equity
shares will, therefore, also not change on account of change in debt-equity mix. Hence, there is
nothing like optimum capital structure. Any capital structure will be optimum according to this
approach.
In those cases where corporate taxes are presumed, theoretically there will be optimum capital
structure when there is 100% debt content. This is because with every increase in debt content declines
and the value of the firm goes up. However due to legal and other provisions, there has to be a
minimum equity. This means that optimum capital structure will be at a level where there can be
maximum possible debt content in the capital structure.
III. MODIGILIANI-MILLER APPROACH
The Modigiliani-Miller approach is similar to the net operating income (NOI) approach. In
other words, according to this approach, the value of a firm is independent of its capital structure.
However, there is a basic difference between the two. The NOI approach is purely conceptual.
It does not provide operational justification for irrelevance of the capital structure in the valuation of
the firm. While MM approach supports the NOI approach provides justification for the independence
of the total valuation and cost of capital of the firm from its capital structure. In other words, MM
approach maintains that the overall cost of capital does not change in the debt equity mix or capital
structure of the firm.
BASIC PROPOSITIONS:
The following are the three basic propositions of the MM approach.
- The overall cost of capital (k) and the value of the firm (V) are independent of the capital structure. In other words k and V are constant for all levels of debt-equity mix. The total
market value of the firm is given by capitalizing the expected net operating income (NOI) by
the rate appropriate for that risk class.
- The cost of equity is equal to capitalization rate of a pure equity stream plus a premium for the
financial risk. The financial risk increases with more debt content in the capital structure. As a result, ke increases in a manner to off set exactly the use of a less expensive source of funds
represented by debt.
- The cut-off rate for investment purposes is completely independent of the way in which an
investment is financed.
ASSUMPTIONS :
(i)Capital markets are perfect. This means
(a) Investors are free to buy and sell securities. (b) The investors can borrow without restriction on the same terms on which the firm can
borrow;
(C) The investors are well informed;
(d) The investors behave rationally; and
(e) There are no transaction costs.
(ii) The firms can be classified into homogeneous risk classes all firms within the same class will have
the same degree of business risk.
(iii) All investors have the same expectation of a firms net operating income (EBIT) with which to
evaluate the value of any firm.
(iv) The dividend payout ratio is 100%. In other words, there are no retained earnings.
therefore the effective cost if debt is less than the contractual rate of interest. A levered firm should
have, therefore, a greater market value as compared to an unlevered firm. The value of the levered
firm would exceed that of the unlevered firm by an amount equal to the levered firm’s debt multiplied
by the tax rate. This can be put in the form of the following form aula:
VL = Vu + Bi
Where
VL = value of levered firm;
Vu = value of an unlevered firm; B = amount o9f debt; and
T = tax rate
The market value of an unlevered firm will be equal to the market value of its shares.
Vu = S Where
Vu = market value of an unlevered firm
S = market value of equity;
S = Profits available for equity shareholders
Equity capitalization rate
In other words, the value of Vu can be determined by the following equation.
Vu = (1-t) EBT
Ke
Where;
EBT = earnings before tax T = tax rate.
Ke = equity capitalization rate.
Since in case of unlevered firm there is no debt content, earning before tax (EBT) means earning
before interest and tax (EBIT).
IV. TRADITIONAL APPROACH
The net income approach and net operating income approach represent two extremes. According to
NI approach the debt content in the capital structure affects both the overall cost capital and total
valuation of the firm while NOI approach suggests that capital structure is totally irrelevant so far as
total valuation of the firm is concerned.
- The traditional approach is similar to NI approach to the extent that it accepts that the capital structure or leverage of the firm affects the cost of capital and its valuation. However, it does
not subscribe to the NI approach that the value of the will necessarily increase with all degree
of leverages.
- It subscribes to NOI approach that beyond a certain degree of leverage, the overall cost of capital increases resulting in decrease in the total value of the firm. However, it differs from
NOI approach in the sense that the overall cost of capital will not remain constant for all
degree of leverage.
The essence of the traditional approach lies in the fact that a firm through judicious use of debt-equity
mix can increase its total value and thereby reduce its overall cost of capital. This is because debt is
relatively a cheaper source of funds as compared to raising money through shares because of tax
advantage. However, beyond a point raising of funds through debt may become a financial risk and
would result in a higher equity capitalization rate. Thus, up to a point, the content of debt in the
capital structure will favorably affect the value of the firm. At this level of debt equity mix, the capital
structure will be optimum and the overall cost of capital will be the least.
OPTIMUM CAPITAL STRUCTURE
The optimum capital structure may be defined as “ Capital Structure or combination of debt
and equity that leads to the maximum value of the firm. Optimal capital structure maximizes the value
of the firm and hence the wealth of its owners and minimizes the company’s cost of capital.
The following considerations should be kept in mind while maximizing the value of the firm in
achieving the goal of optimum capital structure.
(i) It is the return on investment is higher than the fixed cost of funds, the company should prefer to raise funds having affixed cost, such as debentures, loans and preference share
capital. It will increase earnings per share and market value of the firm. Thus company
should make maximum possible use for leverage.
(ii) When debt is used as a source of finance, the firm saves a considerable amount in payment
of tax as interest is allowed as a deductible expense in computation of tax. Hence the effective cost of debt is reduced called tax leverage. A company should take advantage of
tax leverage.
(iii) The firm should avoid undue financial risk attached with the use of increased debt
financing. If the shareholders perceive high risk in using further debt-capital, it will reduce
the market price of shares. (iv) The capital structure should be flexible
FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE.
1.PROFITABILITY:
The capital structure of the company should be most profitable, the most profitable capital
structure is one that tend sot minimize cost of financing and maximize earning per equity share.
2.SOLVENCY:
The pattern of capital structure should be so devised as to ensure that the firm does not run the
risk of becoming insolvent. Excess use of debt threatens the solvency of the company. The debt
content should not therefore be such that it increases risk beyond manageable limits.
3.FLEXIBILITY:
The capital structure should be such that it can be easily maneuvered to meet the requirements
of changing conditions. Moreover, it should also be possible for the company to provide funds
whenever need to finance its profitable activities.
4.CONSERVATISM:
The capital structure should be conservative in the sense that the debt content in the total
capital structure does not exceed the limit which the company can bear. In other words, it should be
such as is commensurate with the company ability to generate future cash flows.
considered to be less risky by the investors and therefore they can issue different types of securities
and collect their funds from difficult sources. They are in a better bargaining position and can get
funds form the sources of their choice.
7.RETAINING CONTROL:
The capital structure of a company is also affected by the extent to which the promoter’s
management of the company desires to maintain control over the affairs of the company. The
preference shareholders and debenture holders have not much say in the management of the company.
It is the equity shareholders who select the team of managerial personnel. It is necessary for the
promoters to own majority of the equity share capital in order to exercise effective control over the
affairs of the company. The promoters or the existing management are not interested in losing their
grip over the affairs of the company and at the same time, they need extra funds.
8.PURPOSE OF FINANCING:
The purpose of financing also to some extent affects the capital structure of the company. In
case funds are required for some directly productive purposes, for example, purchase of new
machinery, the company can afford to raise the funds by issue of debenture. This is because the
company will have the capacity to pay interest on debentures out of the profits so earned.
9.REQUIREMENT OF INVESTORS:
Different types of securities are to be issued for different classes of investors. Equity shares
are best suited for bold or venturesome investors. Debentures are suited for investors who are very
cautious while preference shares are suitable for investors who are not very cautious. In order to
collect funds form different categories of investors, it will be appropriate for the companies to issue
different categories of securities.
10.PERIOD OF FINANCE:
The period for which finance is required also affects the determination of capital structure of
companies. In case, funds are required, say for 3 to 10years, it will be appropriate to raise them by
issue of debentures rather than by issue of shares. This is because in case issue of shares raises the
funds, their repayment after 8 to 10 years will be subject to legal complications.
11. CAPITAL MARKET CONDITONS:
Capital market conditions do not remain the same forever. Some times there may be depression
while at other times there may be boom in the market. The choice of the securities is also influenced
by the market conditions. If the share market is depressed the company should not issue equity shares
and investors would prefer the company should not issue equity shares. It is advisable to issue equity
shares in the boom period.
12. ASSET STRUCTURE:
The liquidity and the composition of assets should also be kept in mind while selecting the
capital structure. If fixed assets constitute a major portion of the total assets of the company. It may be
possible for the company to raise more of long-term debts.
13.COSTS OF FLOATATIONS:
The Cost of floating a debt is generally less than the cost of floating equity and hence it may persuade
the management to raise debt financing. The costs of floating as a percentage of total funds decrease
with the increase n size of the issue.
14.GOVERNMENT POLICY:
Government policy is also an important factor in planning the company capital structure. For
example a change in the lending policy of financial institutions may mean a complete change in the
financial pattern. Similarly, by virtue of the capital issues control act, 1947 and the rules made there
under, the controller of capital issues cal also considerably affects the capital issue policies of various
companies.
15.LEGAL REQUIREMENTS:
The promoters of the company have also to keep in view the legal requirements while
deciding about the capital structure of the company. This is particularly true in case of bank9ing
companies, which are not allowed to issue any other type of security for raising funds except equity
share capital on account of the banking regulation act.
16. CORPORATE TAX RATE:
High rate of corporate taxes on profits compel the companies to prefer debt financing,
because interest is allowed to be deducted while computing taxable profits. On the other hand,
dividend on shares is into an allowable expense for that purpose.
MEANING OF DIVIDEND
The term dividend refers to that part of the profits of a company, which is distributed amongst
its shareholders.
(ii) Investors behave rationally. Information is freely available to them and there are no transaction and
floatation costs.
(iii) There are either no taxes or there are no differences in the tax rates applicable to capital gains and
dividends.
(iv) The firm has a fixed investment policy.
(v) Risk or uncertainty does not exist.
According to MM hypothesis, the market value of a share in the beginning of the period is
equal to the present value of dividends paid at the end of the period plus the market price of the share
at the end of the period.
This can be put in the form of the following equation:
Po = ( 1 )
Ke
D P
Where Po = Prevailing market price of a share.
Ke = Cost of equity capital.
D1 = Dividend to be received at the end of the period one.
P1 = Market Price of a share at the end of the period one.
From the above equation, the following equation can be derived for determining the value of P1.
P1 = Po (1 + Ke) – D
Criticism of MM hypothesis:
(i)Tax: MM hypothesis assumes that taxes do not exist, is far from reality.
(ii)Floatation costs: A firm has always to pay floatation cost in term of underwriting fee and broker’s
commission whenever it wants to raise funds from outside.
(iii)Transaction costs: The shareholder has to pay brokerage fee, etc, when he wants to sell the shares.
(iv)Discount rate: The assumption under MM hypothesis that a single discount rate can be used for
discounting cash inflows at different time periods is not correct. Uncertainty increases with the length
of the time period.
II. WALTER’S APPROACH
This comes under the relevance concept of dividend.
Relevance concept :
A firm’s dividend policy has a very strong effect on the firm’s position in the stock market.
Higher dividends increase the value of stock while low dividends decrease their value. This is because
dividends communicate information to the investors about the firm’s profitability.
According to Prof.James E. Walter’s approach, the dividend policy always affects the value of
the enterprise. The finance manager can, therefore use it to maximize the wealth of the equity
shareholders. Walter has also given a mathematical model to prove this point.
Prof. Walter’s model is based on the relationship between the firm’s
(i) Return on investment or internal rate of return (i.e.)
(ii) Cost of Capital or required rate of return. (i.e., k)
According to Prof.Walter, if r > k, i.e., the firm can earn a higher return than what the
shareholders can earn on their investments, the firm should retain the earnings. Such firms are known
as growth firms, and in their case the optimum dividend policy would be to plough back the entire
earnings. In their case the dividend payment ratio (D/P ratio) would, therefore, be zero. This would
maximize the market value of their shares.
In case of firm, which does not have profitable investment opportunities (i.e., r, k), the
optimum dividend policy would be to distribute the entire earnings as dividend. The shareholders will
stand to gain because they can use the dividends so received by them in channels, which can give them
higher return. Thus, 100% payout ratio in their case would result in maximizing the value of he equity
shares.
In case of firms, where r = k, it does not matter whether the firm retains or distributes earnings.
In their case the value of the firm’s shares would not fluctuate with change in the dividend rates. There
is, therefore, no optimum dividend policy for such firms.
ASSUMPTIONS:
(i) The firm does the entire financing through retained earnings. It does not use external
source of funds such as debt or new equity capital.
(ii) The firm’s business risk does not change with additional investment. It implies the firm’s
internal rate of return (i.e., r) and cost of capital (i.e., k) remains constant. (iii) In the beginning earning per share (i.e. E) and dividend (i.e., D) per share remain constant.
It my be noted that the values of ‘E’ and ‘D’ may be changed in the model for determining
the results, but any given values of ‘E’ and ‘D’ are assumed to remain constant in
determining a given value.
(iv) The firm has a very long life.
MATHEMATICAL FORMULA:
Prof. Walter has suggested the following formula for determining the market value of a share:
P =
Ke
(E-D)
D+r
Ke
Where P = Market price of an equity share
D = Dividend per share R = Internal rate of return
E = Earning per share
Ke = Cost of equity capital
CRITICISM:
(i) Walter’s assumption that financial requirements of a firm are met only by retained earnings
and not by external financing, is seldom true in real situations.
(ii) The assumption that the firm’s internal rate of return (i.e.,r) will remain constant does not
hold good.
(iii) The assumption that ‘k’ will also remain constant does not hold good.
FACTORS AFFECTING DIVIDEND POLICY
The factors affecting the dividend policy are both external as well as internal.
EXTERNAL FACTORS
1. General state of economy :
(ii) Dividends : The shareholders also expect a regular return on their investment from the firm.
In most cases, the shareholder’s desire to get dividends takes priority over the desire to earn
capital gains because of the following reasons:
Reduction of uncertainty: Capital gains or a future distribution of earnings involves more uncertainty than a distribution of current earnings.
Indication of strength: The declaration and payment of cash dividend carries
information content that the firm is reasonably strong and healthy.
Need for current income : Many shareholders require income from the investment to
pay for their current living expenses. Such shareholders are generally reluctant to sell their shares to earn capital gain.
2. FINANCIAL NEEDS OF THE COMPANY:
The financial needs of the company may be in direct conflict with the desire of the shareholders to
receive large dividends. However, a prudent management has to give weightage to the financial needs
of the company rather than the desire of the shareholders. In order to maximize the shareholder’s
wealth, it is advisable to retain the earnings in the business only when the company has better
profitable investment opportunities as compared to the shareholders. However, the directors must
retain some earnings, whether or not profitable investment opportunity exists, to maintain the
company as a sound and solvent enterprise.
3. NATURE OF EARNINGS :
A firm having stable income can afford to have a higher dividend pay out ratio as
compared to a firm, which does not have such stability in its earnings.
4. DESIRE TO CONTROL :
Dividend policy is also influenced by the desire of shareholders or the management to
retain control over the company.
5. LIQUIDITY POSITION:
The payment of dividends results in cash outflow from the firm. A firm may have
adequate earnings but it may not have sufficient cash to pay dividends. It is, therefore, important for
the management to take into account the cash position and overall liquidity position of the firm before
and after the payment of dividends while taking the dividend decision. A firm may not, therefore in a
position to pay dividends in cash or at a higher rate because of insufficient cash resources. Such a
problem is generally faced by growing firms which need constant funds for financing their expansion
activities.
SUGGESTED QUESTIONS
OBJECTIVE TYPE:
- ----------------refers to make-up of a firm’s capitalization.
- The arbitrage process is the behavioral foundation for the ----------------.
- Optimum leverage can be defined as that mix of debt and equity, which will -----------------the
market value of the firm.
- MM approach is similar to ---------------- approach.
- ---------------- refers to that EBIT level at which EPS remains the same.
- The policy concerning quantum of profits to be distributed as dividend is termed as --------------.
- According to MM hypothesis, the price of a company’s share is determined by its investment policy
and not by pattern of its ------------------------------.
- In case of firms having ‘r’ > ‘k’, the optimum dividend policy requires---------------payout ratio.
- A firm having ‘r’ < ‘k’ can be termed as a ------------------.
- The most appropriate dividend policy is payment of --------------------.
Short answer type:
- Explain the term “ Point of indifference”.
- Differentiate ‘Capitalisation’ and ‘Capital Structure’.
3.What is Optimum Capital Structure?
- Write a note on “Arbitrage Process”.
- Define the terms “Dividend” and “Dividend policy”.
- Write short notes on the classification of dividends.
Essay type:
- What do you understand by capital structure of a corporation? Discuss the qualities, which a sound
capital structure should possess?
- Critically examine the Net Income and Net Operating Income approaches to capital structure.
- What do you understand by a Balanced Capital Structure? Why should a company aim at a balanced
capital structure?
4.Explain the factors that determine the capital structure of a firm.
- Explain “Arbitrage Process” under MM approach.
- Explain EBIT-EPS approach for determining capital structure of a company.
- What are the determinants of the dividend policy of a corporate enterprise?
- Explain Walter’s approach of dividend policy in detail.
- What is the MM approach of irrelevance concept of dividends? Under what assumptions do the
conclusions hold good?
- Explain the shortcomings of the dividend Theories.
