Capital structure is also called as capital mix. This post discusses about setting up optimum capital structure (not financial structure).
There is always some confusion regarding the terms capital structure and financial structure. Capital management refers to the total combined investments of a business comprising bonds, long-term loans and the total of the shareholders’ funds. Capitalization strictly speaking has no meaning when the balance sheet of a company contains share capital as the only item. Therefore the word capital structure will be appropriate to be used when the capitalization contains debt also.
So, what is capital structure and what is financial structure? How are they managed? How to set up an optimum capital structure (capital mix)?
Financial structure refers to the liabilities side of a balance sheet which contains the item of resources purchased by the company. On the other hand, capital structure refers to the permanent financing of a company, composed of long-term debt preference share capital and shareholders’ funds.
Therefore in a broader sense, capital structure includes the long-term debt such as bonds, preference shares capital and the net worth. It refers to permanent financing. For a long-time, the word, capitalization was in vogue, to refer to the capital structure but this has been superseded, by the term capital structure.
The term capital structure comprises the book-values of all classes of share capital other long-term funds. For the use of these funds, the investors are paid a limited amount of return. On the other hand, when a company raises funds on the issue of equity shares only there is no trading on equity because there is no limit as regards the return on the equity shares. This concept is applicable to all cases of businesses which pay a fixed rate on the funds used by them whether they are long term or short term sources.
Trading On Equity
In the case of companies which employ high percentage of debt and preference shares, they are said to be trading on equity on a higher degree than companies which employ only a smaller percentage of debt.
A company is said to trade on equity, because the creditors and preference shareholders are willing to advance funds to the business on the strength of the funds supplied by the equity shareholders who are called “residual owners” and on the earning capacity of the business. A company which obtains funds from creditors and preference shareholders trades on the equity to higher degree than a company that obtains less funds from these sources.
The reason for trading on equity is to employ the “senior” funds at a rate of return higher than their cost to increase the return on the investment of the residual owners. If the earnings are high, the equity shareholders profit, and when the earnings are low, they lose because the company has to pay interest which is more than the income from investments. Their investment serves as a protection to both income and the principal of the bond holder. The equity shareholders receive nothing until the creditors are paid in full in case of liquidation.
When funds are obtained from sources such as bonds or preference shares which are paid a fixed rate of return, any profits generated by the funds in excess of bond interest and preference dividends are available to equity shareholders. If the profits earned are not sufficient to meet the bond interest and the preference dividends, the deficiency has to be made good by the equity shareholders. If additional equity shares issued are large and if a significant portion of the same falls in the hands of a specific group, the ability of the old shareholders to retain complete or partial control of the company will be seriously affected.
The degree of risk can be judged by the prospective investor in the capital structure of a company. The main reason for the employment of debt is that up to a certain point debt is a less expensive source of funds than that of equity shares. As long as the interest cost of debt is lower the equity shareholders are benefited.
Evaluating and Setting Up Optimum Capital Structure (Capital Mix)
A company should periodically evaluate the sources of capital mix that is being used. The optimum capital mix depends upon factors such as terms of agreement with the creditors and owners. Although a company would have exercised great caution at the time of raising funds in the past, yet in due course, one of the sources of capital mix may become obsolete. This may be due to external and internal changes. Therefore, it is necessary to adopt new mix.
Examples of external changes are change in the bank interest rates, rise and fall in the market prices and changes in the income-tax structure. Examples of internal changes are increase in the size of the company, and conversion of a private company into a public company.
The result is, what was optimum source of capital is not now an optimum on!
It is therefore necessary to evaluate the sources of capital with the object of taking necessary remedial measures. This is done by changing the composition of the source of capital. The tests can be applied successfully for evaluating the source of capital mix.
We have already seen that trading on equity is done when a company pays a limited return on the sources of funds it uses. It should be seen whether the trading on equity is beneficial to the residual owners and whether the rate of return earned on the residual owners’ equity is higher than that if there is no trading on equity. Further the money market rates, may have declined since the company obtained funds by bonds and preference shares.
If so, the company can payoff these sources of funds by the proceeds raised at lower interest or dividend rates. The company can issue equity shares and payoff the preference shares. The management should therefore be on the right vigil for taking the opportunity of replacing one source of credit with another which is lower.
A company should earn sufficient profits and generate sufficient cash to support its capital mix. The problem of the company’s ability to pay the loans and interest is when due depends upon comparison of future inflows with the outflows.
There are two approaches one can utilize to taking necessary remedial measures for optimal capital mix which I will discuss on the next sections. Read on…
Using Intermediate (Traditional) Approach
The traditional approach also known as ‘intermediate approach’ is a compromise between the two approaches discussed above. This approach assumes that there is an optimum capital structure by increasing the value of the company or the cost of capital by a judicious use of debt and equity capital.
According to this approach, there is optimum capital structure when the cost of capital of the company is at its lowest and the value of the company is at its highest. Since the cost of debt is cheaper than the equity capital; the weighted cost of debt and equity will be less than the cost of equity capital as compared to that existing before debt financing. Solomon a supporter of the traditional approach is of the view that increase in the leverage will have effect in the company’s total market value.
There are three stages in the effect on the market value as leverage is increased:
- In the first stage the following can be noticed. The above factors are responsible for the increase in the market value of the company and decrease in the weighted average cost of capital.
- The second stage, increase of debt after a certain degree of leverage has been reached will produce only a slight increase in the market value. As a result, the weighted cost of capital remains constant.
- In the third stage, the addition of debt to the capital structure of a company, after a critical point will result in the decrease in the market value as well as an increase in the weighted cost of capital.
In other words, both cost of debt and cost of equity will increase at an abnormal rate! The overall effect of the three stages discussed above implies that the cost of capital declines with leverage. It begins to rise after a certain point. Solomon is of the view that there is a ‘precise point’ at which the market value will decline and weighted cost of capital will increase.
Margin of protection falls below the safety position fixed lip by the company-it means that the solvency position of the company is in danger. In addition, to considering the question of earning sufficient profits to pay bond interest and preference dividend, the company should also pay attention to pay current liabilities, when they become due. It has already been pointed out that the current ratio should be 2:1.
It is common knowledge that companies having higher current ratio are at times financial difficulties while those with lower rates are quite solvent. If the company finds that the solvency position requires any improvement, it should take remedial measures immediately such as paying off the bonds by issue of equity shares retaining a higher proportion of its profits in the business.
As regards the restrictions, the management may find in due course, that they are not conducive to the progress as anticipated at the time of original issue. In such a case, the company should make efforts to revise the terms or failing which, the company should make suitable arrangements to payoff these funds. If the company had raised the original loan by mortgages of specific assets and if it now finds that additional funds are required from other sources for which additional assets could not be hypothecated, the only course open to the company is to recast the entire capital mix.
Where a company has already reached the optimum number of shares outstanding, and if the price of the equity shares has gone up, the company will increase the number of shares by stock-split, a technique that reduces the price of each share, to a level that will induce the public to purchase shares to be issued.
The important reason for a company to use debt in addition to share capital in its capital structure is to increase its earnings. The use of debt has the effect of increasing the return on equity capital. But the financial risk of the company increases thereby. This has the effect of bringing the company to insolvency and also creating variations in the return to the equity, shareholders. Even though the management of every more.
To issue securities with less than maximum value is to deprive the already existing security holders of a part of what could be got. When a company is likely to require new financing, it should set up the capital structure conservative enough to permit subsequent issues. The cost of equity can be considered as an opportunity cost.
If an investor commits money to a business, he is foregoing to invest elsewhere. The cost is therefore the amount of income foregone. We have seen that debt is cheaper source of funds than equity. But it will be expensive for a company to use further debt than the addition of equity capital. Too much of leverage will result in the secure position of the equity shareholders and in the variation of the reform on equity shares. This will therefore also increase the cost of equity capital. And, it will therefore be correct to assume that there is some capital structure which will increase the value of the company. But, it will be difficult to define that particular capital structure. The objective should be one that will maximize the value of equity share.
It will not be possible to determine precisely, what that particular structure is for a company if we consider cost alone. You have to take into account other relative factors as well:
1. Conservation Factor – A company is considered to be conservatively financed if it is in a position to meet its fixed charge out of cash flows generated by the company to meet these charges. There should be the least danger of it not being able to meet its fixed charges when they become due. Even though increasing the proportion of debt in the capital structure will result in the cost of capital yet if the debt is carried too much the company cannot be considered to be conservatively financed. Another aspect connected with conservation is that if a company is already high leveraged it will find it difficult to raise funds both by debt and equity capital.
2. Flexibility Of The Capital Structure Factor – This signifies the company’s ability to change its capital structure without any difficulty. The company should be able to change from one source of funds to another. Flexibility in the amount of fixed interest charges created by the capital structure is a point to be considered. A company’s capital structure is considered to be flexible if its fixed charges are flexible.
3. Restrictive Covenants Factor – Covenants incorporated in the loan agreements may be reasonable from the view point of the creditors but this may be undesirable as regards capital structure of a company. These restrictions may be hindrance to the management in the matter of controlling the business. These restrictions should not be unreasonable. Assume that a company has borrowed $ 600,000 on 6 per cent 10 year term loan from a financial institution with a covenant that the company should not borrow any more money except on current liabilities so long as this term loan is outstanding. After some time the company, in order to expand its business requires additional funds to the extent of $100,000. This amount cannot be raised by way of long term loan under the terms of the existing loan. The original lender may permit the company to borrow elsewhere provided the new loan is subordinate to the original loan, or it may refuse to permit the company to raise the loan elsewhere. It may insist upon the company to take a loan from the institution for the unpaid amount of the original loan and the additional amount now required at an increased rate of interest for the entire amount. This course will naturally make the cost of the new loan high. The company has to pay during the subsequent period higher interest of say 2 per cent not only on the additional funds needed but also on the unpaid balance of the original loan. The same kind of control will be exercised by the financial institution for the new loan advanced. This kind of restriction is inflexible with regard to changing the sources of funds of the company.
4. Marketability of the Securities Factor (as the capital markets are changing very often) – At a particular time the market will be favorable for sale of securities and at another time it may not be so favorable. The company should sell the securities at the right time and the right type which will have bearing on the cost of capital. Capital structure of a business company is a characteristic feature depending upon each type of the company. The relation between market price and earnings is complicated by the difference in the market value of a specified amount of earnings resulting from difference in capital structure. Where there exists a capital structure with a judicious combination of bonds and shares, there will be higher market value than one consisting of a single issue of equity shares. This difference is due to two important factors:
- The use of bonds creates an interest charge which reduces the burden of income tax and thereby results in the outcome of total income available for the security holders
- The wise use of the bond debt creates a greater market value as compared to the equity shares, which will be less on account of risk of prior securities.
Assume a company has only equity share capital and earns $ 100,000. The net income after tax of 50 per cent would be $ 50,000. If this income is capitalized at 10 per cent it will give share value of 50,000 x 100/10 = $ 500,000. However, if the company issues 5 per cent bonds for $ 20,00,000, the interest on these would amount to $ 100,000 which would duce the income with income tax and if this is capitalized by a higher percentage because of the greater risk or the shares preceded by bonds, the capitalization.
Different Approaches: As regards the theory of capital structure there are different kinds of concepts propounded by different authors The main contributors of the theories are Durand, Modigliani, Miller and Solomon. Durand advocates two approaches as regards the valuation of the earnings of a company. They are (1) the Net-Income (NI) approach, and (2) the Net Operating Income (NOI) approach. As regards the measurement of the degree of leverage of a company, above approaches are considered to be the extremes.
Next, let’s discuss both Net Income and Net Operating Income approach with case examples. Read on..
Using Net Income Approach
According to this approach, a company can increase its value or reduce the overall cost of capital by increasing the proportion of debt in its capital structure. In this approach, the essential assumptions are:
1. As the use of debt does not alter the risk element, the equity capitalization rate and debt capitalization rate will remain unchanged.
2. The debt capitalization rate is less than the equity capitalization rate.
3. Income-tax considerations are ignored.
This approach can be explained by the following examples:
Assume that the company’s capital structure consists of : 6% bonds for $ 10,000.
Assume that the company expects a net income of $ 4,000.Equity capitalization rate may be assumed at 10%.
The total value of the company is calculated as follows:
Net Income = $4,000
Less bond interest = $ 600
Earnings available to equity shareholders = $3,400
Rate of equity capitalization is 10%
Market value of the equity shares will be:
3,400 x 100/10 = $340,000/10 = $34,000
Market value of the bonds = $14,000 (=10,000 + 4,000)
Total value of the business = $44,000 (=34,000 + 10,000)
In the above example, the earnings available to equity shareholders has been capitalized at a constant rate of 10 per cent. As a result, the implied overall capitalization percentage rate is:
= (Earning / Value of the Company) x 100
= (4,000 x 100) / 44,000
= 9% approx.
Assume that the bond debt is increase by the company from $ 1,000 to $25,000. Assume that the interest rate of bonds remains the same. The value of the company will be calculated as follows:
Earnings = $4,000
Bond interest = ($1,500)
Available to equity shareholders = $2,500
If equity share is capitalized at 10 per cent, market value of the equity shares will be:
(2500 x 100)/10 = $25,000
Market value of the bonds = $25,000
Value of the company = $50,000
As a result the implied overall capitalization percentage will be:
($4000 x 100) / $50,000 = 8%
The above example shows the effect of the various degrees of financial leverage on the value of the company and the cost of capital, under the net income approach. It will be noticed that the value of the company increases as the debt ratio increases and the average cost of capital declines.
The optimum capital structure would be at the point where the value of the company is maximum and the overall cost of capital is the minimum. Therefore under this approach a company will have the maximum value and the lowest cost of capital when it has much debt. This approach signifies that a company can reduce the cost of capital and increase its total value by the use of debt. As the degree of leverage is increased from the point of view of the investors there is not much of risk.
Using Net Operating Income Approach
According to this approach, change in the capital structure of a company does not effect the market value of the company. The overall capitalization rate of the company is constant for all degrees of leverage. Net operating income is capitalized at an overall or weighted average cost of capital. The total value of the company is found out by dividing the net operating income by the overall cost of capital. The market value of the equity shares can be arrived at by deducting the value of debt from the total market value of the company.
This is explained in the following table:
Assume that the net operating income of a company is $200,000
The average cost of capital is 10%
It has bond debt of $ 1,000,000 @ 6%
Under this approach, the total value of the company will be arrived at as follows :
Net Operating income = $200,000
Market value of the company
[=$200,000 x (100/0)] = $2,000,000
Market value of bonds = ($1,000,000)
Market value of equity shares = $1,000,000
The cost of equity share will be:
= (200,000 – 60,000) / (2,000,000 – 1,000,000)
= $140,000 / 1,000,000
Assume that the company increases the debt from $ 1,000,000 to $ 15,00,000 the value of the company will be unchanged at $ 2,000,000. The value of the equity share will increase to $ 500,000 and the equity capitalization rate will be:
= (200,000 – 90,000) x 100 / 500,000
= (110,000 x 100) / 500,000
It will be noticed that equity capitalization rate rises with the degree of leverage, the total value of the company remains unchanged by the capital structure. This approach implies that the cost of capital will be the same irrespective of capital structure. Therefore according to this approach all capital structures are optimum; since the market price per share does not change with the leverage.