OPTIMAL CAPITAL STRUCTURE INTRODUCTION This report tries to visualize “OPTIMAL CAPITAL STRUCTURE” and represent the facts that include features of capital structure, determinants of capital structure, and patterns of capital structure, types and theories of capital structure, theory of optimal capital structure, risk associated with capital structure, external assessment of capital structure and some assumption related to capital structure. BROAD OBJECTIVE •To determine features of capital structure •To know about determinants of capital structure To evaluate pattern and form of capital structure •To identify the types and theories of capital structure •To analyze the theories of optimal capital structure •To determine the risk associated with capital structure •To have an overview about external assessment of capital structure •To know the assumptions related to capital structure SOURCES OF INFORMATION •Books on financial management •Articles published on capital structure •Search out different websites for data collection related to capital structure decisions.
Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables.
Poor capital decision can result in a high cost of capital thereby lowering the NPVs of projects and making more of them unacceptable. In practical sense, a firm can probably more readily increase its value by improving quality and reducing costs than fine tuning its capital structure. Effective capital structure can lower the cost of capital, resulting in higher NPVs and more acceptable projects, and thereby increasing the value of the firm.
A firm’s major decision is its financing decisions which are analysied in the theory of corporate capital structure and based on the model developed by Dodd (1986), capital structure is determined mainly by three agency costs variables- agency equity, agency debt and bankruptcy risk and other potential variables such as growth rate, profitability and operating leverage. The firm’s capital structure should result from balancing the costs of certain relationships between firm related groups. Somtime agent does nat act in line with the set objectives of the principal. •Shareholders are the owner of the firm.
If shareholders value increases they will be benefited and vice-versa. shareholders value maximization depends on managers activities. But as a rational being, managers try to maximizes their own interest. As a result agency and equity cost arises which tend to discourage the use of equity. •Debt holders have no voice on management issue. Managers are accountable only to the firm. So, they are trying to maximize the wealth of shareholders not debt holders. There is an agency-debt cost which discourages the issuance of debt. •There is a possibility of bankruptcy if the firm taking more debt capital.
Because the greater the firms debt capital, higher the possibility of default on interest and capital repayment. •Three other potential determinants of capital structure are also included in the model developed by Dodd. Firms growing at higher rates should have higher debt ratios than firms with lower growth rates. The relationship between debt ratios and growth rate is expected to be positive. Firms with higher profitability ratio may be expected to have more equity than firms with lower ratios. Management of companies with high operating leverage may use lower levels of financial leverage i. . debt. CAPITAL STRUCTURES Capital structure is the manner in which a firm’s assets are financed; that is, the right-hand side of the balance sheet. Capital structure is normally expressed as the percentage of each type of capital used by the firm-debt, preferred stock, and common equity. Combination of capital is called capital structure. The firm may use only equity. Or only debt, or a combination of equity and debt, or a combination of equity, debt, preference shares or may use other similar combinations. FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE
Capital structure is that level of debt- equity proportion where the market value per share is maximum and the cost of capital is minimum. Appropriate capital structure should have the following features •Profitability/ return •Solvency/risk •Flexibility •Conservation/capacity •Control DETERMINANTS OF CAPITAL STRUCTURE Formation of capital structure depends on many factors which are normally called the determinants of capital structure. The determinants based on which capital structure were formed are listed below •Seasonal variations •Tax benefits of debt •Flexibility •Control •Industry leverage ratios Agency costs •Industry life cycle •Degree of competition •Company characteristics •Requirements of investors •Timing of public issue •Legal requirements PATTERNS / FORMS OF CAPITAL STRUCTURE Following are the forms of capital structure: •Complete equity share capital; •Different proportions of equity and preference share capital; •Different proportions of equity and debenture(debt) capital and •Different proportions of equity, preference and debenture(debt) capital. CAPITAL STRUCTURE THEORY Capital structure theory provides some insights into the value of debt verses equity financing.
Modern capital structure theory began in 1958, when Modigliani and Miller proved, under a very restrictive set of assumptions, that a firm’s value is unaffected by its capital structure. There are 4 theories: •NI approach (Net income approach) •NOI Approach (net operating income approach) •MM approach (Modigliani-Millar approach) •Traditional approach THEORY OF OPTIMAL CAPITAL STRUCTURE This theory states that we can have an optimum capital structure – as we raise the debt, we can raise the value of the firm to some extent. Thus level of debt can be increased up to some level. That level is the ideal capital structure.
Ultimate objective of finance manager is to raise the value of the firm and raise the wealth- which is possible by an ideal capital structure. TYPES OF CAPITAL There are two types of capital which are: •Debt capital: current liabilities •Assets: equity capital –stockholder’s equity, preferred stock, Common stock DESIGN COST OF CAPITAL Capital of a firm can be designed by considering the following facts •It should minimize cost of capital •It should reduce risks •It should give reduced flexibility •It should provide required control to the owners •It should enable the company to have adequate finance.
RISKS ASSOCIATED WITH CAPITAL STRUCTURE DECISIONS Meaning of risk is variability in income. Business risk is the situation, when the EBIT may vary due to change in capital structure. It is influenced by the ratio of fixed cost in total cost. if the ratio of fixed cost is higher, business risk is higher. Financial risk is the variability in EPS due to change in capital structure. It is caused due to leverage. If leverage is more, variability will be more and thus financial risk will be more. USES OF FINANCIAL LEVERAGE IN CAPITAL STRUCTURE The degree to which an investor or business is utilizing borrowed money.
Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the shareholders’ return on their investment and often there are tax advantages associated with borrowing. also called leverage. The uses of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure, is described as financial leverage or gearing or trading on equity.
Operating leverage is the extent to which fixed costs are used in a firm’s operations. If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage. Operating leverage is a measure of one element of business risk, but does not include the second major element, sales variability. Financial leverage is the extent to which fixed-income securities(debt and preferred stock) are used in a firm’s capital structure. If a high percentage of a firm’s capital structure is in the form of debt and preferred stock, the firm is said to have a high degree of financial leverage.
The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners’ equity. The rate of return on the owners’ equity is leveraged above or below the rate of return on total assets. Financial leverage can be measured by: •Debt ratio, •Debt-equity ratio and •Interest coverage. ASSUMPTIONS OF CAPITAL STRUCTURE THEORIES Assumptions related to capital structure are as follows: •There are only two sources of funds i. e. : debt and equity. The total assets of the company are given and do no change. •The total financing remains constant. The firm can change the degree of leverage either by selling the shares and retiring debt or by issuing debt and redeeming equity. •Operating profits (EBIT) are not expected to grow. •All the investors are assumed to have the same expectation about the future profits. •Business risk is constant over time and assumed to be independent of its capital structure and financial risk. •Corporate tax does not exist. •The company has infinite life. •Dividend payout ratio= 100%
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