Business Studies Part I
Business Studies Part II

Capital Structure

One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds. On the basis of ownership, the sources of business finance can be broadly classified into two categories viz., ‘owners funds’ and ‘borrowed funds’. Owner’s funds consist of equity share capital, preference share capital and reserves and surpluses or retained earnings. Borrowed funds can be in the form of loans, debentures, public deposits etc. These may be borrowed from banks, other financial institutions, debentureholders and public. Capital structure refers to the mix between owners and borrowed funds. These shall be referred as equity and debt in the subsequent text. It can be calculated as debt-equity ratio i.e., Debt Equity  or as the proportion of debt out of total capital i.e., Debt Debt + Equity. Debt and equity differ significantly in their cost and riskiness for the firm. Cost of debt is lower than cost of equity for a firm because lender’s risk is lower than equity shareholder’s risk, since lenders earn on assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profits. Increased use of debt, therefore, is likely to lower the overall cost of capital of the firm provided that cost of equity remains unaffected. Impact of a change in the debt-equity ratio upon the earning per share is dealt with in greater details later in this chapter. Debt is cheaper but is more risky for a business because payment of interest and the return of principal is obligatory for the business. Any default in meeting these commitments may force the business to go into liquidation. There is no such compulsion in case of equity, which is therefore, considered riskless for the business. Higher use of debt increases the fixed financial charges of a business. As a result, increased use of debt increases the financial risk of a business. Financial risk is the chance that a firm would fail to meet its payment obligations. Capital structure of a business thus, affects both the profitability and the financial risk. A capital structure will be said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share. In other words, all decisions relating to capital structure should emphasis on increasing the shareholders wealth. The proportion of debt in the overall capital is also called financial Example I Company X Ltd. Total Funds used Rs. 30 Lakh Interest rate 10% p.a. Tax rate 30% EBIT Rs. 4 Lakh Debt Situation I Nil Situation II Rs. 10 Lakh Situation III Rs. 20 Lakh EBIT-EPS Analysis Situation I Situation II Situation III EBIT 4,00,000 4,00,000 4,00,000 Interest NIL 1,00,000 2,00,000 EBT 4,00,000 3,00,000 2,00,000 (Earnings before taxes) Tax 1,20,000 90,000 60,000 EAT 2,80,000 2,10,000 1,40,000 (Earnings after taxes) No. of shares of Rs.10 3,00,000 2,00,000 1,00,000 EPS 0.93 1.05 1.40 (Earnings per share) leverage. Financial leverage is computed as D E or D D+E when D is the Debt and E is the Equity. As the financial leverage increases, the cost of funds declines because of increased use of cheaper debt but the financial risk increases. The impact of financial leverage on the profitability of a business can be seen through EBITEPS (Earning before Interest and Taxes-Earning per Share) analysis as in the following example. Three situations are considered. There is no debt in situation-I i.e. (unlevered business). Debt of Rs. 10 lakh and 20 lakh are assumed in situations-II and III, respectively. All debt is at 10% p.a. The company earns Rs. 0.93 per share if it is unlevered. With debt of Rs. 10 lakh its EPS is Rs. 1.05. With a still higher debt of Rs. 20 lakh, its, EPS rises to Rs. 1.40. Why is the EPS rising with higher debt? It is because the cost of debt is lower than the return that company is earning on funds employed. The company is earning a return on investment (RoI) of 13.33% EBIT Total Investment 100⎟, 4Lakh 30Lakh 100 . This is higher than the 10% interest it is paying on debt funds. With higher use of debt, this difference between RoI and cost of debt increases the EPS. This is a situation of favourable financial leverage. In such cases, companies often employ more of cheaper debt to enhance the EPS. Such practice is called Trading on Equity. Trading on Equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest. Now consider the following case of Company Y. All details are the same except that the company is earning a profit before interest and taxes of Rs. 2 lakh. Example II Company Y Ltd. Situation I Situation II Situation III EBIT 2,00,000 2,00,000 2,00,000 Interest NIL 1,00,000 2,00,000 EBT 2,00,000 1,00,000 NIL Tax 60,000 30,000 NIL EAT 1,40,000 70,000 NIL No. of shares of Rs.10 3,00,000 2,00,000 1,00,000 EPS 0.47 0.35 NIL BUSINESS FINANCE 253 In this example, the EPS of the company is falling with increased use of debt. It is because the Company’s rate of return on investment (RoI) is less than the cost of debt. The RoI for company Y is 2Lakh 30Lakh 100 i.e., 6.67% whereas the interest rate on debt is 10%. In such cases, use of debt reduces the EPS. This is a situation of unfavorable financial leverage. Trading on Equity is clearly unadvisable in such a situation. Even in case of Company X, reckless use of Trading on Equity is not recommended. An increase in debt may enhance the EPS but as pointed out earlier, it also raises the financial risk. Ideally, a company must choose that risk-return combination which maximises shareholders wealth. The debt-equity mix that achieves it, is the optimum capital structure.

Factors affecting the Choice of Capital Structure Deciding about the capital structure of a firm involves determining the relative proportion of various types of funds. This depends on various factors. For example, debt requires regular servicing. Interest payment and repayment of principal are obligatory on a business. In addition a company planning to raise debt must have sufficient cash to meet the increased outflows because of higher debt. Similarly, important factors which determine the choice of capital structure are as follows:

  1. Cash Flow Position: Size of projected cash flows must be considered before issuing debt. Cash flows must not only cover fixed cash payment obligations but there must be sufficient buffer also. It must be kept in mind that a company has cash payment obligations for (i) normal business operations; (ii) for investment in fixed assets; and (iii) for meeting the debt service commitments i.e., payment of interest and repayment of principal.
  2. Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. This may be calculated as follows: ICR = EBIT Interest The higher the ratio, lower is the risk of company failing to meet its interest payment obligations. However, this ratio is not an adequate measure. A firm may have a high EBIT but low cash balance. Apart from interest, repayment obligations are also relevant.
  3. Debt Service Coverage Ratio (DSCR): Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest Coverage Ratio (ICR). It is calculated as follows: A higher DSCR indicates better ability to meet cash commitments and consequently, the company’s potential to increase debt component in its capital structure.
  4. Return on Investment (RoI): If the RoI of the company is higher, Who funds Indian industry, why it matters? Using data on listed Indian firms from the mid-1980s to the 1990s, several issues relating to Indian industry were investigated. One aspect then was the extremely limited extent to which promoters and entrepreneurs actually owned shares in the various companies they had control of Proportions of the total capital of the firm Percentage Share Where did the borrowing come from Borrowing from Commercial Bank 26.69 Borrowings from Financial Institutions 19.89 Debentures 7.78 Fixed deposits 3.86 Other borrowings 8.78 Who owned the shares? Shares held by the public at large 10.88 Foreign shareholding 3.54 Government shareholding 5.49 Institutional shareholding 8.44 Directors’ shareholding 2.81 Top 50 shareholders shareholding 1.85 Total Debt and Equity Capital of a Company 100 Nevertheless, in spite of the relative lack of ownership, the majority of listed entities, mostly private sector companies, were managed by these founders, their successive family members and other promoters as if they were fiefdoms. By and large, Indian companies were essentially financed by debt. This was unlike in the West. If the total debt plus nominal equity capital in the average. Indian company was 100, then 67 per cent of that amount came in the form of debt capital while equity capital contributed only 33 per cent. If the share of government ownership in corporate equity and the share of financial institutions’ equity was added, then over 60 per cent (26.69 + 19.89 + 5.49 + 8.44) of firms’ finances were funded by the state in one form or another. Foreign shareholders, in spite of a lot a clamour about their role in India’s corporate economy, hardly owned more than 4 per cent (3.54) of the shares in India’s listed companies. While the public at large provided about 11 per cent of the finances of an average Indian listed company, the share of the Top 50 shareholders was less than 2 (1.85) per cent. It is within this particular shareholding category that promoters, entrepreneurs and the other large shareholders’ equity stakes fall under for the purposes of classification. The public at large provides five times as much money for the company as the entrepreneurs. Yet, a group of individuals, whose financial contributions towards a company are exceedingly small in magnitude, effectively control the company.  choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater. We have already observed in Example I that a firm can use more debt to increase its EPS. However, in Example II, use of higher debt is reducing the EPS. It is because the firm is earning an RoI of only 6.67% which lower than its cost of debt. In example I the RoI is 13.33%, and trading on equity is profitable. It shows that, RoI is an important determinant of the company’s ability to use Trading on equity and thus the capital structure.
  5. Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to employ higher debt. Thus, more debt can be used if debt can be raised at a lower rate.
  6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. The firms in our examples are borrowing @ 10%. Since the tax rate is 30%, the after tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.
  7. Cost of Equity: Stock owners expect a rate of return from the equity which is commensurate with the risk they are assuming. When a company increases debt, the financial risk faced by the equity holders, increases. Consequently, their desired rate of return may increase. It is for this reason that a company can not use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease inspite of increased EPS. Consequently, for maximisation of shareholders’ wealth, debt can be used only upto a level.
  8. Floatation Costs: Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.
  9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Apart from the financial risk, every business has some operating risk (also called business risk). Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.
  10. Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of unforeseen circumstances.
  11. Control: Debt normally does not cause a dilution of control. A public issue of equity may reduce the managements holding in the company and make it vulnerable to takeover. This factor also influences the choice between debt and equity especially in companies in which the current holding of management is on a lower side.
  12. Regulatory Framework: Every company operates within a regulatory framework provided by the law e.g., public issue of shares and debentures have to be made under SEBI guidelines. Raising funds from banks and other financial institutions require fulfillment of other norms. The relative ease with which these norms can, be met or the procedures completed may also have a bearing upon the choice of the source of finance.
  13. Stock Market Conditions: If the stock markets are bullish, equity shares are more easily sold even at a higher price. Use of equity is often preferred by companies in such a situation. However, during a bearish phase, a company, may find raising of equity capital more difficult and it may opt for debt. Thus, stock market conditions often affect the choice between the two.
  14. Capital Structure of other Companies: A useful guideline in the capital structure planning is the debtequity ratios of other companies in the same industry. There are usually some industry norms which may help. Care however must be taken that the company does not follow the industry norms blindly. For example, if the business risk of a firm is higher, it can not afford the same financial risk. It should go in for low debt. Thus, the management must know what the industry norms are, whether they are following them or deviating from them and adequate justification must be there in both cases.

The four factors which affect the choice of capital structure of a company are described below:

  • Risk: Financial risk refers to a situation when a company is unable to meet its fixed financial charges. Financial risk of the company increases with the higher use of debt. This is because issue of debt involves fixed commitment in terms of payment of interest and repayment of capital.
  • Flexibility: Too much dependence on debt reduces the firm’s ability to raise debt during unexpected situations. Therefore, it should maintain flexibility by not using debt to its full potential.
  • Interest Coverage ratio (ICR): The interest coverage ratio refers to the number of times earnings before interest and taxes of a company covers the interest obligation. This may be calculated as follows:
    ICR = EBIT/Interest. If the ratio is higher, lower is the risk of company failing to meet its interest payment obligations hence debt may be issued or vice versa. But besides interest payment related repayment obligations should also be considered.
  • Cash flow position: The issue of debt involves a fixed commitment in the form of payment of interest and repayment of capital. Therefore if the cash flow position of the company is weak it cannot meet the fixed obligations involved in issue of debt it is likely to issue equity or vice versa.