Financial Management

Assignment on Factors Determining Optimal Capital Structure

ITM Business School, Kharghar

Submitted To: Submitted By:

Prof. Bharat Shah Arindam Mitra

KHR2009PGDMF002

Batch – A

Factors Determining Optimal Capital Structure

Introduction

The capital structure of a company has to be planned initially when it is promoted. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve the target capital structure. The financial manager has also to deal with an existing capital structure. The company needs funds to finance its activities continuously. Every time when the funds have to be procured, the financial manager weighs pros and cons of various sources of finance and selects the most advantageous sources keeping in view the target capital structure. Thus the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances.

Generally the following factors should be considered whenever a capital structure decision has to be taken-

1. Assets

The forms of assets held by a company are important determinants of its capital structure. Tangible fixed assets serve as collateral to debt. In the event of financial distress, the lenders can access these assets and liquidate them to realize funds lent by them. Companies with higher tangible fixed assets will have less expected costs of financial distress and hence, higher debt ratios. On the other hand, companies, whose primary assets are intangible assets will not have much to offer by way of collateral and will have higher costs of financial distress.

2. Growth opportunities

The nature of growth opportunities has an important influence on a firm’s financial leverage. Firms with high market to book value ratios have high growth opportunities. A substantial part of the value for these companies comes from organizational or intangible assets. These firms have a lot of investment opportunities. There is also higher threat of bankruptcy and high costs of financial distress associated with high growth firms once they start facing financial problems. These firms employ lower debt ratios to avoid the problem of under-investment and costs of financial distress. High growth firms would prefer to take debts with lower maturities to keep interest rates down and to retain the financial flexibility since their performance can change unexpectedly any time. They would also prefer unsecured debt to have operating

flexibility. Mature firms with low market to book value ratio and limited growth opportunities face the risk of managers spending free cash flow either in unprofitable maturing business or diversifying into risky businesses. Both these decisions are undesirable. This behavior of managers can be controlled by high leverage that makes them more careful in utilizing surplus cash.

3. Trading on equity

The use of fixed cost sources of finance, such as debt and preference share capital to finance the assets of the company is known as financial leverage or trading on equity. The word “equity” denotes the ownership of the company. If the assets financed with the use of debt yield a return greater than the cost of debt, the earnings per share increase without an increase in the owner’s investment. The earnings per share also increase when the preference share capital is used to acquire assets. But the leverage impact is more pronounced in case of debt because (a) the cost of debt is usually lower than the cost of preference share capital and (b) the interest paid on debt tax deductible. Because of its effect on earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of earnings before interest and taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholder’s equity.

The EBIT-EPS analysis is one important tool in the hands of the financial manager to get an insight into the firm’s capital structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financial plans. If the probability of earning a rate of return on the firm’s assets less than the cost of debt is insignificant, a large amount of debt can be used by the firm in its capital structure to increase the earnings per share. This may have a favorable effect on the market value per share. On the other hand, if the probability of earning the rate of return on the firm’s assets less than the cost of debt is very high, the firm should refrain from employing debt capital. It may thus be concluded that the greater the level of EBIT and lower the profitability of downward fluctuation, the more beneficial it is to employ debt in capital structure.

4. Debt and Non-debt Tax shields

Debt reduces tax liability due to interest deductibility and increases the firm’s after-tax free cash flows. In the absence of personal taxes, the interest tax shields increase the value of the firm. Generally, investors pay taxes on interest income but not on equity income. Hence, personal taxes reduce the tax advantage of debt over equity. The tax advantage of debt implies that firms will employ more debt to reduce tax liabilities and increase value. Firms also have non-debt tax shields available to them. However, there is a link between the non-debt tax shields and the debt tax shields since companies with

higher depreciation would tend to have higher fixed assets, which serve as collateral against debt.

5. Financial flexibility

It is prudent to maintain financial flexibility that enables the firm to adjust to any change in the future events or forecasting error. Financial flexibility means a company’s ability to adapt its capital structure to the needs of the changing conditions. The company should be able to raise funds, without undue delay and cost, whenever needed, to finance the profitable investments. It should also be in a position to redeem its debt whenever warranted by the future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure as warranted by the company’s operating strategy and needs. It should also be able to substitute one form of financing for another to economize the use of funds. Flexibility depends on loan covenants, option to early retirement of loans and the financial slack, viz., excess resources at the command of the firm.

6. Loan covenants

Restrictive covenants are commonly included in the long-term loan agreements and debentures. These restrictions curtail the company’s freedom in dealing with the financial matters and put it in an inflexible position. Covenants in loan agreement may include restrictions to distribute cash dividends, to incur capital expenditure, to raise additional external finances or to maintain working capital at a particular level. The types of covenants restricting the firm’s investment, financing and dividend policies vary depending on the source of debt. While private debt contains both affirmative and negative covenants, public debt has a lot of negative covenants and commercial paper does not entail much restrictions. Growth firms prefer to take private rather than public debt since it is much easier to negotiate terms in time of crisis with few private lenders than several debenture-holders. A highly levered firm is subject to many constraints under debt covenants that restrict its choice of decisions, policies and programmes. Violation of covenants can have serious adverse consequences. The firm’s ability to respond quickly to changing conditions also reduces.

7. Sustainability and Feasibility

The financing policy of a firm should be sustainable and feasible in the long run. Most firms want to maintain the sustainability of their financing policy over a long period of time. The sustainable growth model helps to analyze the sustainability and the feasibility of the long-term financial plans in achieving growth. This model is based on the assumption that the firm uses the internal financing and debt, consistent with the

target debt-equity ratio and payout ratio and does not issue shares during the planning horizon.

Sustainable growth = ROE x (1 - payout)

The sustainable growth model indicates the growth rate that the firm should target. Any other growth rate will not be consistent with the financial policies set by the management. If the firm intends to achieve a different growth rate than that implied by the sustainable growth model, it will have to change its financial policy, either the debt-equity ratio, or the payout ratio or both. In fact, the model also indicates the trade-offs between the financing and operating policies. The firm should also examine the impact of alternative financial policy on the value of the firm.

8. Degree of Control

In a company, it is the directors who are so called elected representatives of equity shareholders. These members have got maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Preference shareholders have reasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain their voting rights in their hands, the capital structure consists of debenture holders and loans rather than equity shares.

9. Choice of Investors

The company’s policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors.

10. Capital Market Condition

In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the company’s capital structure generally consists of debentures and loans, while in period of boons and inflation, the company’s capital should consist of share capital generally equity shares with high premium. The internal conditions of a company may also dictate the marketability of securities. For example, a highly leveraged company may find it difficult to raise additional debt. Similarly, when restrictive covenants in existing debt debt-agreements preclude payment of dividends on equity shares, convertible debt may be the only source to raise additional funds. A small company may find difficulty in issuing any security in the market merely because of its small size. The heavy indebtedness, low payout, small size,

low profitability, high degree of competition etc. cause low rating of the company which would make it difficult for the company to raise external finance at favorable terms.

11. Period of Financing

When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures.

12. Issue Costs

Issue or flotation costs are incurred when the funds are externally raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage companies to use debt than issue equity shares. Retained earnings do not involve floatation costs. The source of debt also influences the issue costs with fixed costs being much higher for issue of commercial paper and public debt (debenture) than the private debt. Debt instruments must be used when large amounts of funds are needed. Issue costs as a percentage of funds raised will decline with larger amounts of funds. A large issue of securities can however curtail a company’s financial flexibility. The company should employ only that much of funds, which it can employ profitably.

13. Stability of Sales

An established business which has a growing market and high sales turnover, the company is in position to meet fixed commitments. Interest on debentures has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are high and company is in better position to meet such fixed commitments like interest on debentures and dividends on preference shares. If company is having unstable sales, then the company is not in position to meet fixed obligations. So, equity capital proves to be safe in such cases.

14. Legal Requirements

The Government has also issued certain guidelines for the issue of shares and debentures. The legal restrictions are very significant as these lay down a framework within which capital structure decision has to be made. For example, the controller of capital issues, now SEBI grants his consent for capital issue when (a) debt equity ratio does not exceed 2:1 (for capital intensive projects a higher debt equity ratio may be allowed), (b) the ratio of preference capital to equity does not exceed 1:3 and (c) promoters hold at least 25% of the capital.

15. Consultation with Investment Bankers and Lenders

Another useful approach in deciding the proportion of various securities in a firm’ structure is to seek the opinion of investment analysts, institutional investors,

investment bankers and lenders. These analysts having been in the business for a considerable period acquire expertise and have access to information regarding securities of a large number of companies and know how the market evaluates them. They are therefore in a better position to assess a particular financial plan. Similarly the opinions of perspective lenders and investors are likely to be very useful to the firm; it is they who will ultimately provide funds to the firm. Therefore, the type of securities which they will prefer to buy is very significant information for the financial manager and helps him in taking a decision regarding the form of the securities to be issued.

16. Size of the company

Small size business firm’s capital structure generally consists of loans from banks and retained profits. While on the other hand, big companies having goodwill, stability and an established profit can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions. The bigger the size, the wider is total capitalization.