Download 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 (debtequity 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 point
EBIT).
2. Debt- Capacity of the firm:
(i) Interest Coverage Ratio:
The ability of the firm to borrow more is determined by the following
ratios:(a)
(b)
EBIT
= -----------Interest
A high ratio indicates better ability to burrow. Another ratio is:
Interest Coverage Ratio
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
factor determining the type of securities shall be issued.
(V) Maintaining maneuverability for commercial strategy:
Maneuverability refers to the firm ability to either increasing or decreasing
its sources of funds in response to changes in the need of funds on while 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 firms capital 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 when not 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 arising from flexibility.
7. Timing of Issues:
Public offer should be made at a time when a stated economy as well
as the capital market is ideal to provide funds. High debenture yields indicate a relater
security of debenture 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 have more 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
i.
Debenture nominee of the board of directors
ii.
Appointment of Debenture trustee.
iii.
Maintaining a maximum current ratio.
iv.
Fixing the maximum dividend payable.
v.
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
Particulars
Option I
Option II
Option III
Option IV
5000Eq.S+
5000+1000=6000
2000 PS @8%
300000 @
Eq. shares &
dividend
10%
Rs.200000 deb.
5000+3000=8000 5000+1000Eq.S+
Eq. Shares only
debenture
@ 10%
EBIT
150000
150000
150000
150000
- Interest
-
-
30000
20000
EBT
150000
150000
120000
130000
-Tax @ 30%
75000
75000
60000
65000
EAT
75000
75000
60000
65000
-Pref. div
-
16000
-
-
Profit available
75000
59000
60000
65000
8000
6000
5000
6000
9.375
9.83
12
10.83
for E. S Holders
(1)
No of E. Shares
(2)
EPS (1)/(2)
Option 3 will be selected because it has higher EPS
Q.2) AB ltd gives you the following figures
EBIT
Less: 12 % Debenture Int
Less: Income tax @ 50%
EAT
300000
60000
240000
120000
120000
No. of Equity shares = 40000
120000
EPS = ------------ = Rs 3 per share
40000
Market price per share = Rs.30
Market Price Per share
Price Earning Ratio (PE) =
-----------------------EPS
30
= ------ = 10
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 raise the 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
= ----------------------150000
= 20%
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
rticulars
Debt
Equity
EBIT
340000
340000
Less: Deb. Interest:
Existing 500000 * 12%
New
200000 * 14%
(60000)
60000
(28000)
EBT
252000
280000
Less : Tax at 50%
126000
140000
EAT
126000
140000
Less: Pref. Dividend
-
-
Amount available to Eq. shareholders
126000
140000
No. of Equity shares
40000
40000+6667
=46667
EPS
3.15
3
Market Price per share= PE ratio * EPS
8*3.15 = 25.20
10 * 3 = 30
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
Less: - 8% Debenture Int
2300000
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
8 % Debentures ( 80000 * 100/8)
Loan ( 220000 * 100/11)
E share( 500000 * 10)
2000000
1000000
2000000
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
Add:- New Fund raised
Less: Redemption of Reserves
10000000
3000000
13000000
1000000
12000000
New EBIT = 12000000 * 25% = Rs. 3000000
Particulars
Option I
Option II
12% loan
Rs. 2000000 shares
Rs. 3000000 loan
Rs.1000000
loan
EBIT
3000000
3000000
12%
Less:- Interest 11% loan
220000
220000
360000
120000
EBT
2420000
2660000
Less:- Tax @ 50%
1210000
1330000
PAT
1210000
1330000
EPS
2.42
2.22
12% loan
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
Less:- Total Cost
EBIT
Less: Interest
EBT
Less: Tax
EAT
300000
269000
31000
1000
30000
10500
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
Particulars
Option I
Option II
Debt
Equity
EBIT
46000
46000
Less:- Interest Existing
1000
1000
New Int (50000 * 7%)
3500
-
EBT
41500
45000
Less:- Tax (10500* 100/30000)= 35%
14525
15750
EAT
26975
29250
No of Shares
5000
7000
EPS
5.395
4.18
Market Price= EPS * PE ratio
32.37
29
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
are1. 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)
No. of Equity shares
=
( EBIT – Interest ) ( 1- Tax)
No of Equity shares
EBIT ( 1- 0.5)
30000
=
( EBIT – 150000 ) ( 1- 0.5)
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
Particulars
Option (a)
Option (b)
Option ( c )
EBIT
20000
20000
20000
Less: Interest
-
8000
-
EBT
20000
12000
20000
Less:- Tax @ 50%
10000
6000
10000
EAT
10000
6000
10000
Less: Pref Dividend
-
-
10000
10000
6000
Nil
200000/10
100000/20
100000/20
= 10000
=5000
=5000
1
1.20
Nil
No. of Equity shares
EPS
Option (b) should be recommended because it has high EPS.
Indifference Point between (a) and (b)
EBIT (1- Tax)
No. of Equity shares
=
EBIT ( 1- 0.5)
=
10000
5 EBIT = 10 EBIT – 80000
( EBIT – Interest ) ( 1- Tax)
No of Equity shares
( EBIT – 8000 ) ( 1- 0.5)
5000
10 EBIT – 5 EBIT = 80000
5 EBIT = 80000
EBIT = Rs 16000
Indifference Point between (a) and (c)
EBIT [ 1- Tax]
No. of Equity shares
EBIT [ 1- 0.5]
10000
EBIT [0.5]
10000
=
( EBIT – Nil ) ( 1- 0.5) – 10000
5000
=
=
( EBIT – Interest ) ( 1- Tax) – Preference dividend
No of Equity shares
EBIT ( 0.5) – 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)
No. of Equity shares
( EBIT – 8000 ) ( 1- 0.5)
5000
EBIT – 8000 (0.5)
5000
2.5 EBIT – 20000
=
( EBIT – Nil ) ( 1- 0.5) – 10000
5000
=
EBIT ( 0.5) – 10000
5000
=
=
( EBIT – Interest ) ( 1- Tax) – Preference dividend
No. of Equity shares
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
Particulars
Option I
Option II
EBIT
6000000
6000000
Less: Interest
400000
-
EBT
5600000
6000000
Less: Tax @ 50%
2800000
3000000
EAT
2800000
3000000
No. of Equity shares
1040000
1120000
EPS
Rs. 2.69
Rs. 2.68
Option I should be accepted because it has a high EPS.
Indifference point two option
( EBIT – Interest ) ( 1- Tax)
No of Equity shares
= EBIT [ 1- Tax]
No. of Equity shares
( EBIT – 400000 ) ( 1- 0.5)
1040000
= EBIT [ 1- 0.5]
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)
No of Equity shares
= EBIT [ 1- Tax]
No. of Equity shares
( EBIT – 400000 ) ( 1- 0.5)
1040000
= EBIT [ 1- 0.5]
1120000
56 EBIT – 50400000 = 52 EBIT
56 EBIT – 52 EBIT = 50400000
4 EBIT = 50400000
EBIT = Rs. 12600000