capital structure fahim

8/8/2019 Capital Structure Fahim

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BZU SUB CAMPUS SAHIWAL

CAPITAL STRUCTURE THEORY

In finance, capital structure refers to the way a corporation finances its assets throughsome combination of equity, debt, or hybrid securities. A firm's capital structure is then

the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion inequity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed.The firm's ratio of debt to total financing, 80% in this example is referred to as the firm'sleverage. In reality, capital structure may be highly complex and include dozens ofsources. Gearing Ratio is the proportion of the capital employed of the firm which comefrom outside of the business finance, e.g. by taking a short term loan etc.

The Modigliani-Miller theorem, proposed by FrancoModigliani and MertonMiller,forms the basis for modern thinking on capital structure, though it is generally viewed asa purely theoretical result since it assumes away many important factors in the capitalstructure decision. The theorem states that, in a perfect market, how a firm is financed is

irrelevant to its value. This result provides the base with which to examine real worldreasons why capital structure is relevant, that is, a company's value is affected by thecapital structure it employs. Some other reasons include bankruptcy costs, agency costs,taxes, and information asymmetry. This analysis can then be extended to look at whetherthere is in fact an optimal capital structure: the one which maximizes the value of thefirm.

Capital structureinaperfect market

Assume a perfect capital market (no transaction or bankruptcy costs; perfect

information); firms and individuals can borrow at the same interest rate; no taxes; and

investment decisions aren't affected by financing decisions. Modigliani and Miller made

two findings under these conditions. Their first 'proposition' was that the value of a

company is independent of its capital structure. That is, you cannot change the size of a

cake by cutting it into different sized pieces. Their second 'proposition' stated that the cost

of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus

an added premium for financial risk.

The definition of capital structure illustrate three terms

EquityDebt

Hybrid securities

EQUITY:

In accounting and finance, equity is the residual claim or interest of the most junior class

of investors in assets, after all liabilities are paid. If valuations placed on assets do not


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exceed liabilities, negative equity exists. In an accounting context, Shareholders' equity

(or stockholders' equity, shareholders' funds, shareholders' capital or similar terms)

represents the remaining interest in assets of a company, spread among individual

shareholders of common or preferred stock.

Debt:

Debt is that which is owed; usually referencing assets owed, but the term can also covermoral obligations and other interactions not requiring money. In the case of assets, debt isa means of using future purchasing power in the present before a summation has beenearned. Some companies and corporations use debt as a part of their overall corporatefinance strategy.

A debt is created when a creditor agrees to lend a sum of assets to a debtor. In modernsociety, debt is usually granted with expected repayment; in most cases, plus interest.

Hybrid securities

Hybrid securities are a broad group of securities that combine the elements of the twobroader groups of securities, debt and equity.

Hybrid securities pay a predictable (fixed or floating) rate of return or dividend until acertain date, at which point the holder has a number of options including converting thesecurities into the underlying share.

Therefore, unlike a share of stock (equity) the holder has a 'known' cash flow, and, unlikea fixed interest security (debt) there is an option to convert to the underlying equity. Morecommon examples include convertible and converting preference shares.

A hybrid security is structured differently and while the price of some securities behavemore like fixed interest securities, others behave more like the underlying shares intowhich they convert.

Example

yA convertible bond is a bond (

i.e.

a loan to the issuer) that can be converted intocommon shares of the issuer. A convertible bond can be valued as a combinationof a straight bond and an option to purchase the company's stock.[1]

y An income security is a hybrid between a stock and a bond. The bond portion paysinterest, and the stock portion pays dividends. Income securities are popular inCanada.


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y A PIK loan may carry a detachable warrant (the right to purchase a certain numberof shares of stock or bonds at a given price for a certain period of time) the loanis the debt, while the warrant is the equity

y The important hybrid instruments are:o Preference shareso Convertible/exchangeable debentures/bondso Debt with attached warrants

Types ofEquity Investment Instruments

There are three major types of equity investments in stock investing. Before developingan equity investment strategy, it is valuable to know the traits of each one.

Understanding the different types of equity investment instruments available will help aninvestor realize all possible options for stock investing. The equity market is a risk-filled,volatile arena. It has yielded huge earnings for both lucky and wise equity investors, andhas helped to sustain businesses. It has also crushed people's financial dreams. Whetherbuying preferred stock, common stock, or warrants, there are benefits and costs involvedwith each.

Buying Preferred Stock

Buying preferred stock has many financial benefits. It is not quite as risky as buying

common stock, and entitles the holder to regular dividend payments. These dividends arean integral part of the investment, independent of the market. Their inherent nature issomewhat similar to a bond; they could even be considered a hybrid investmentinstrument of corporate bonds and common stock shares. Preferred shares are a morestable investment like a bond, promising regular revenue, and they come with a greaterclaim to assets than common shares in the case of bankruptcy. Owners of this type ofequity investment do not have a say in company decisions.

When buying preferred stock, there are different types to choose from. Convertiblepreferred stock can be turned into common stock at a predetermined price. Participating

preferred shares will receive higher dividend rates when and if common stock dividendsare of a greater value. Adjustable-rate shares have a floating dividend rate, depending oninterest rates.


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Investingin Common Stock

Common stock is the essence of the equity market. Shareholders own a part of thecompany, and from the point of purchase on, have the same vital goal of a particular firmto make money. The more money the company makes, the more the shareholder profits,

if the shares are sold before losing their value. Dividends are distributed when earningsare strong, although they are not guaranteed.

This form of equity investment does give the investor some say in the structure anddecisions of the business, although this power is minimal for most shareholders. Commonstock may be offered in classes for instance, in which case some owners are entitled to astronger vote, higher dividend payments, and greater rights to assets, than others.

Investing in common stock is also one of the riskiest ventures, and potentially thegreatest. Money can be quickly earned, and quickly lost. Some stocks may be relatively

predictable, with a steady rise in value, while others may be highly unpredictable, withboth the possibility of bankruptcy and a value spike just around the bend.

Warrants onthe EquityMarket

Warrants are a unique instrument on the equity market. They offer the right to purchasecommon stock at a specific price during a pre-determined time period. If the stock is notpurchased, then the warrant becomes worthless. This type of investment offers apotentially good return in the future, and increases the capital of the issuing firm.Warrants are often offered to current shareholders, or in combination with stock andbonds.

Choosingthe Right Equity Investment Instrument

Equity investors have a range of options to choose from. Preferred stock is more stable,common stock has more potential, and warrants provide an investment in the future. Asthere is risk involved with all three types, it is important to evaluate every financialopportunity. What are the potential returns and the likeliness of those returns? What arethe potential losses, and can those losses be buffered by anything else? Ultimately, equityinvestments can be useful for those capable of handling risk, and especially for those whoare aware of the capabilities of a business. They are also an essential component of a

diversified investment portfolio, although for many, equities may work best as a smallsegment of a solid investment plan.


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Capital market instruments are responsible for generating funds for companies,

corporations, and sometimes national governments.

These are used by the investors to make a profit out of their respective markets. There area number of capital market instruments used for market trade, including

y Stocksy Bondsy Debenturesy Treasury-billsy Foreign Exchangey Fixeddeposits, andothers

Capital market is also known as securities market because long term funds are raised

through trade on debt and equity securities. These activities may be conducted by both

companies and governments. This market is divided into primary capital market.

The instruments traded can be classified into the following segments based on thecharacteristics of the identity of the issuer of these securities:

Market

Segment

Issuer Instruments

GovernmentSecurities

Central Government Zero Coupon Bonds, Coupon Bearing Bonds,Treasury Bills, STRIPS

State Governments Coupon Bearing Bonds.

Public SectorBonds

Government Agencies/ Statutory Bodies

Govt. Guaranteed Bonds, Debentures

Public Sector Units PSU Bonds, Debentures, Commercial Paper

Private SectorBonds

Corporate Debentures, Bonds, Commercial Paper,Floating Rate Bonds, Zero Coupon Bonds,Inter-CorporateDeposits

Banks Certificates ofDeposits, Debentures, Bonds

Financial Institutions Certificates ofDeposits, Bonds

The G-secs are referred to as SLR securities in the Indian markets as they are eligible

securities for the maintenance of the SLR ratio by the Banks. The other non-Govt

securities are called Non-SLR securities.ss

capital structure fahim

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