Capital structure

TOPIC

FINANCIAL MANAGEMENT

SWAPNIL KOCHREKAR : 30SUSHANT PATIL : 51TUSHAR HOLEY : 17GANESH KHADE : 27BHASKAR YADAV : 70ROHAN VICHARE : 68 JAYESH DHUMAL : 14

GROUP MENBERS :-

IntroductionDEFINATION:

Capital Structure:

“Capital structure of company refers to the make-up of its capitalization and it includes all long term capital resources viz , shares loans reserves and bonds.”

_gerstenberg.

“Capitalizations includes capital stock and debt”.

_dewing.

“Capitalisation is the total accounting value of the capital stock, surpluses in whatever from it may appear and Long term debt.”

_Lillian dories.

Capital structure consist of:

1.Owned funds:

Owned funds includes share capital ,free reserve and surplus.

2.Borrow funds :

borrowed funds are represented by debentures, bonds and long term loans provided by banks and term lending institutions.

Capital Structure represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, earned revenue, capital surpluses, etc. Theterm capital structure is used to represent the proportionate relationship between debt and equity.

The Board of Directors or the financial manager of a company should always endeavor to develop a capital structure that would lie beneficial to the equity shareholders in particular and to the other groups such as employees, customers, creditors, society in general. While developing an appropriate capital structure for its company the financial manager should aim at maximizing the long-term market price per share. This can be done only when all these factors which are relevant to the company's capital structure decisions are properly analyzed and balanced.

What is capital structure?

What is “Financial structure”?

Balance Sheet

Current assets Current liabilities

Fixed assets Debentures & preference shares

Financial structure

Ordinary shares

Balance Sheet

Current assets Current liabilities

Fixed assets Debentures & preference shares

Capital structure

Ordinary shares

What is “Capital Structure”?

Features of an Optimal Capital Structure

An optimal capital structure should have the following features:

Profitability - The company should make maximum use of leverage at a minimum cost.

Flexibility - The capital structure should be flexible to be able to meet the changing conditions. The company should be able to raise funds whenever the need arises and also retire debts whenever it becomes too costly to continue with that particular source.

CONT……….

Control - The capital structure should involve minimum dilution of control of the company.

Solvency - The use of excessive debt threatens the solvency of the company. In a high interest rate environment, Indian companies are beginning to realize the advantage of low debt. Companies are now launching public issues with the sole purpose of reducing debt. The recent equity issue of more than Rs.30 crore by Ballarpur Industries was purely aimed at repaying term loans and retiring debentures.

Essentials of an optimum capital structure

1.Economy :

the capital structure must ensure the maximum use of leverage at minimum cost.

2.Efficiency :

the capital structure must ensure intensive utilization of available resources.

3.Simplicity:

the capital structure must be made easy to understand by avoiding doubts and complexities.

4.Safety: the capital structure should ensure safety in the business

by maintaining adequate cash flow (liquidity) in the business.

5.control: while designing the capital structure it should be kept in

mind that the controlling position of present shareholders remains undisturbed.

CONT…………

Determinants of capital structure

1.Nature of business: those business exposed to more risk and unstable income

should prefer equity shares whereas firms engaged in producing commodities and public utilities .

2.Stability of earning : if the volume ,stability and predictability of earning are there

then the firm will be service the fixed obligation of debts and dividend on preference share with less risk.

3.Amount of initial capital required: in the initial stages of business since the risk involved is

high an ideal capital structure in such a case would be equity only.

CONT…..

4.Growth rate :

in the initial stages the of growth is high gradually

decreasing as the markets saturation point is reached.

5.Nature of investors:

investors have generally different preferences and are of different economic status.

6 Financial leverage or trading on equity:

the firm has to determine an appropriate debt-equity mix , where the capital structure would be optimum.

7.Return on investment :

if the firm earns a high rate of return it can finance the expansion from internal sources .

8.Trends in capital market :

the conditions prevailing in the capital market determine the types of securities to be issued and also the rate interest on debenture and rate of dividend on preference share.

9.Government regulation:

govt. may influence the issue of securities on capital issues and taxation policies.

10.Lenders attitude:

if the attitude of lending institution is favorable then the company can get debt finance easily and that too at lower rate of interest.

CONT………

Sources of capital

Ordinary shares (common stock)

Preference shares (preferred stock)

Loan capital◦ Bank loans◦ Corporate bonds

Ordinary shares (common stock)

Risk finance

Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders

A high rate of return is required

Provide voting rights – the power to hire and fire directors

No tax benefit, unlike borrowing

Preference shares (preferred stock)

Lower risk than ordinary shares – and a lower dividend

Fixed dividend - payment before ordinary shareholders and in a liquidation situation

No voting rights - unless dividend payments are in arrears

Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments

Participating - an extra dividend is possible

Redeemable - company may buy back at a fixed future date

Loan capital

Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed)

Bank loans or corporate bondsInterest on debt is allowed against tax

Seniority of debt

Seniority indicates preference in position over other lenders.

Some debt is subordinated. In the event of default, holders of

subordinated debt must give preference to other specified creditors who are paid first.

INTERPRETATION:

COMPOSITION OF CAPITAL STRUCTURE

Loan Fund = 48%Reserves = 51%Share Capital = 1%

1 20

0.2

0.4

0.6

0.8

1

1.2

0

0.51

0

0.48

0

0.0100000000000001

CURRENT YEAR (2007-2008)

The above graph clearly depicts that the proportion of debt in the financing mix of Hindalco is much more as compared to share capital. The debt content is 48% whereas the proportion of share capital and reserves and surplus is 1% and 51% respectively.

Capital Structure of Hindalco for Four Years (2004-05 to 2007-08)

Particulars 2007-08 2006-07 2005-06 2004-05Share Capital

1226 1043 986 928

Reserves 171737 123105 95017 75644Loan Funds

83286 73592 49034 38000

Years 2007-08 2006-07 2005-06 2004-05

0

20000

40000

60000

80000

100000

120000

140000

160000

180000

Share Cap-ital

Reserves

Loan Fund

Illustration 1

Goodshape Company has currently an ordinary share capital of Rs. 25 lakhs, consisting of 25,000 shares of Rs. 100 each. The management is planning to raise another Rs. 20 lakhs to finance a major programme of expansion through one of four possible financing plans. The options are:

(i) Entirely through ordinary shares.(ii) Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through long-term

borrowings at 8 per cent interest per annurn.(iii) Rs. 5 lakhs through ordinary shares and Rs. 15 lakhs through long-term

borrowings at 9 per cent interest per annum.(iv) Rs. 10 lakhs through ordinary shares and Rs. 10 lakhs through preference

shares with 5 per cent dividend.

The company's expected Earnings Before Interest and Tax (EBIT) will be Rs. 8 lakhs. Assuming a corporate tax rate of 50 per cent, determine the Earnings Per Share (EPS) in each alternative, and comment on the implications of financial leverage. 22

Solution :-

23

Comments

The above analysis shows that Proposal 3 gives the highest earning per share. It is on account of the following reasons:

– Rate of interest on loan is fixed and independent of the profit or loss and is treated as an expense by the Income Tax authorities. Thus, the company's profit is taxed after deduction of this interest charge.

– Dividend per share is more. It will, therefore, attract shareholders for further investment.

– The borrowers are not the owners, hence there will be least interference from them in the management of the company:

Ratio to be used for capital structure analysis

•Earnings per share.•Dividend per share.•P/E ratio.•Dividend pay-out ratio.•Debt-equity ratio.•Interest coverage ratio.•Return on investment.

2007-08 2006-07 2005-06 2004-05 2003-04

Net earnings (Rs. mn.) 28,609 25,643 16,556 13,294 8,389

Cash earnings (Rs. mn.) 34,487 32,024 21,767 17,927 11,563

EPS (Rs.) 24.51 25.52 16.79 134.48 8.53

CEPS (Rs.) 29.55 31.87 22.07 18.18 11.76

Dividend per share (Rs.) 1.85@ 1.70 2.20 2.00 1.65

Dividend pay out (%) 9.3@ 7.9 14.9 16.0 20.5

Book value per share (Rs.) 142.09 118.97 97.40 82.54 74.16

Price to earning 6.7 5.1 10.9 9.0 13.4

Price to cash earning 5.6 4.1 8.3 6.7 9.7

Price to book value 1.2 1.1 1.9 1.6 1.7

Per share data (As on 31st March)

Particulars 2007-08 2006-07 2005-06 2004-05

Earnings per share

24.51 25.52 16.79 13.48

Earning per shareEPS shows the profitability of the firm on a per share basis, it does not reflect how much is paid as dividend and how much is retained in the business.

EPS= Profit after tax / No. of sharesSignificanceThe EPS helps in determining the market price of the equity shares of the company. A comparison of earning per share of the company with another will also help in deciding whether the equity share capital is being effectively used or not. Helps in estimating the company’s capacity to pay dividend to its equity shareholder.

EPS of Hindalco

InterpretationThe EPS of Hindalco shows an upward trend since FY-04. There is a considerable increase in EPS till FY-07 but there is a decrease in FY-08 i.e. 24.51.

Particulars 2007-08 2006-07 2005-06 2004-05Dividend per share (computed)

1.85 1.70 2.20 2.00

Dividend Per ShareIt indicates the amount of profit distributed to shareholders per share. It is calculated as: DPS = PAT / No. of Equity shares DPS of Hindalco

InterpretationOver the years the DPS of Hindalco has been increasing from Rs.2.00 per share to Rs.2.20 per share till FY 2006.But it decreased in FY 2007 to 1.70 again showing increase in FY 2008 to Rs.1.85. This dividend payment is quite low showing that retaining most of its earnings for future investments in projects.

Particulars 2007-08 2006-07 2005-06 2004-05

Price to Earning

6.7 5.1 10.9 9.04

Price to EarningThis ratio indicates the number of times the earning per share is covered by its market price. P/E ratio = MP per share / EPSSignificanceP/E ratio helps the investor in deciding whether to buy or not to buy the share of the company at a particular market price. Price to Earning of Hindalco

InterpretationP/E ratio of Hindalco considerably increased in FY 2004, but it has decreased to great extent in FY 2007 again showing an increased in FY 2008 i.e. 6.7 Thus, the EPS is covered by its market price by 6.7 times.

Particulars 2007-08 2006-07 2005-06 2004-05DPS(Rs) 1.85 1.70 2.20 2.00EPS(Rs) 24.51 25.52 16.79 13.48Pay-out ratio

0.07 0.07 0.13 0.15

Dividend Payout Ratio The ratio indicates what proportion of EPS has been used for paying dividend. Payout ratio = DPS/ EPSSignificanceThe payout ratios are indicators of the amount of earning that have been ploughed back in the business. Lower payout, the higher the amount earnings ploughed back in the business and vice-versa. Pay-out ratio of Hindalco

InterpretationThe ratio has decreased to a large extent in 2007 as compared to previous financial years maintaining the same in 2008 i.e. 0.07. It indicates that company is ploughing back a large amount of its earnings for future expansion of business.

Particulars 2007-08 2006-07 2005-06 2004-05

Debt Equity Ratio

0.48 0.59 0.51 0.50

Debt – Equity RatioThe relationship between borrowed funds and owners capital is a popular measure of the financial solvency of a firm. That is shown by debt equity ratio. It is a ratio of the outsiders fund to the owner’s fund.

Debt-Equity ratio = Total Debt / Net Worth

InterpretationThe debt equity ratio has shown a considerable increase till FY 2007 i.e. 0.59 but again resulted in a decrease i.e. 0.48 in the FY 2008.Thus, it is apparent that there is a scope for the company to raise further loan capital.

Particulars 2007-08 2006-07 2005-06 2004-05Interest Coverage Ratio

13.88 18.09 12.65 14.98

Interest- Coverage RatioThe interest coverage ratio shows the number of times the interest charged is covered by funds that are ordinarily available for the payment. Since taxes are computed after interest, interest-coverage is calculated in relation to before tax earning. Depreciation is a non-cash item. Therefore, funds equals to depreciation are also available to pay interest charges. We can thus calculate interest coverage ratio as earning before depreciation, interest and taxes divide by interest. ICR = EBIDTA / Interest

InterpretationThe interest coverage ratio is considered to be ideal if it is 5 to 6 times of interest charge is covered by funds that are ordinarily available for the payment. Interest coverage ratio of Hindalco is showing a downward trend in 2007-08 as compared to other years showing a negative effect.

Particulars 2007-08 2006-07 2005-06 2004-05EBIT 33062 38323 23279 20833Capital Employed

270881 208999 157370 125869

ROCE 0.12 0.18 0.14 0.16

Return on Capital Employed It is calculated by dividing EBIT by capital employed. ROCE = EBIT / Capital Employed

InterpretationThe ROCE has increased in the FY 2007 i.e.18% but decreased in the FY 2008.Now it stands at 12%