Capital Structure

Capital Structure

One of the most important decisions in financial management is deciding how to raise funds — specifically, what proportion should come from owners' funds and what proportion from borrowed funds. This mix is called the capital structure of a company.

Owners' Funds vs Borrowed Funds

On the basis of ownership, sources of business finance fall into two broad categories:

• Owners' funds include equity share capital, preference share capital, and reserves and surpluses (retained earnings).
• Borrowed funds include loans, debentures, public deposits, and funds from banks and other financial institutions.

Capital structure refers to the mix between owners' funds (called equity) and borrowed funds (called debt). It can be measured as the debt-equity ratio — Debt divided by Equity — or as the proportion of debt in total capital — Debt divided by the sum of Debt and Equity.

Why Debt and Equity Are Different

Debt and equity differ significantly in their cost and riskiness for the firm.

Debt is cheaper than equity for two reasons:

• The lender's risk is lower than the equity shareholder's risk because the lender earns an assured return and gets repayment of capital. So lenders require a lower rate of return.
• Interest paid on debt is a tax-deductible expense, whereas dividends are paid out of after-tax profit.

Because of these advantages, increased use of debt is likely to lower the overall cost of capital of the firm — provided the cost of equity remains unaffected.

But debt is more risky for the business. Payment of interest and repayment of principal are obligatory. Any default can force the business into liquidation. Equity has no such compulsion and is therefore considered riskless for the business.

Higher use of debt increases the fixed financial charges of a business, which increases financial risk — the chance that a firm will fail to meet its payment obligations.

Optimal Capital Structure

A capital structure is said to be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share. In other words, all capital structure decisions should focus on increasing shareholders' wealth.

Financial Leverage and Trading on Equity

The proportion of debt in the overall capital is also called financial leverage. It is computed as D ÷ E, or D ÷ (D + E), where D is the Debt and E is the Equity.

As financial leverage increases, the cost of funds declines because of increased use of cheaper debt, but financial risk increases.

The impact of financial leverage on profitability can be seen through EBIT-EPS analysis (Earnings Before Interest and Taxes — Earnings Per Share).

Example I: Favourable Financial Leverage

Consider Company X Ltd with total funds of Rs 30 lakh, interest rate 10% per annum, tax rate 30%, and EBIT of Rs 4 lakh.

Why is EPS rising with higher debt? Because the company's Return on Investment (RoI) is 13.33% (Rs 4 lakh ÷ Rs 30 lakh × 100), which is higher than the 10% interest it pays on debt. This difference between RoI and cost of debt increases EPS. This is a situation of favourable financial leverage.

When companies employ more cheaper debt to enhance EPS, this practice is called Trading on Equity — the increase in profit earned by equity shareholders due to the presence of fixed financial charges like interest.

Example II: Unfavourable Financial Leverage

Now consider Company Y Ltd with all details the same except EBIT of only Rs 2 lakh.

Here, EPS falls with increased use of debt because the company's RoI is only 6.67% (Rs 2 lakh ÷ Rs 30 lakh × 100), which is lower than the 10% interest rate. This is unfavourable financial leverage. Trading on equity is clearly unadvisable in such a situation.

Even in favourable conditions, reckless use of trading on equity is not recommended. An increase in debt may enhance EPS but also raises financial risk. A company must choose the risk-return combination that maximises shareholders' wealth.

Factors Affecting the Choice of Capital Structure

Deciding the relative proportion of various types of funds depends on several factors:

1. Cash Flow Position

The size of projected cash flows must be considered before borrowing. Cash flows must not only cover fixed cash payment obligations but also provide a sufficient buffer. A company has cash payment obligations for normal business operations, investment in fixed assets, and meeting debt service commitments (interest payment and repayment of principal).

2. Interest Coverage Ratio (ICR)

This ratio shows how many times earnings before interest and taxes (EBIT) cover the interest obligation — ICR is calculated as EBIT divided by Interest.

The higher the ratio, the lower the risk of the company failing to meet its interest payment obligations. However, this ratio is not an adequate measure by itself — a firm may have high EBIT but low cash balance. Repayment obligations are also relevant.

3. Debt Service Coverage Ratio (DSCR)

DSCR takes care of the deficiencies in ICR. Cash profits generated by operations are compared with total cash required for servicing debt and preference share capital — DSCR is calculated as (Profit after tax + Depreciation + Interest + Non-cash expenses) divided by (Preference dividend + Interest + Repayment obligation).

A higher DSCR indicates better ability to meet cash commitments and consequently, greater potential to increase the debt component in capital structure.

4. Return on Investment (RoI)

If RoI is higher, the company can use trading on equity to increase EPS — its ability to use debt is greater. As seen in Example I, a firm earning 13.33% RoI can profitably use more debt. In Example II, with only 6.67% RoI, higher debt reduces EPS. RoI is an important determinant of a company's ability to use trading on equity.

5. Cost of Debt

A firm's ability to borrow at a lower rate increases its capacity to employ higher debt.

6. Tax Rate

Since interest is a deductible expense, cost of debt is affected by the tax rate. In the examples, firms borrow at 10% but with a 30% tax rate, the after-tax cost of debt is only 7%. A higher tax rate makes debt relatively cheaper and increases its attraction compared to equity.

7. Cost of Equity

Stock owners expect a rate of return commensurate with the risk they assume. When a company increases debt, the financial risk faced by equity holders increases, so their desired rate of return may increase. A company cannot use debt beyond a point — beyond that point, cost of equity may go up sharply and share price may decrease despite increased EPS. For maximisation of shareholders' wealth, debt can be used only up to a certain level.

8. Floatation Costs

Raising resources involves costs. Public issue of shares and debentures requires considerable expenditure, while getting a loan from a financial institution may cost less. These considerations affect the choice between debt and equity.

9. Risk Consideration

Use of debt increases financial risk — the risk of being unable to meet fixed financial charges (interest, preference dividend, repayment obligations). Every business also has operating risk (business risk), which depends on fixed operating costs. Higher fixed operating costs result in higher business risk. Total risk depends on both business risk and financial risk. If a firm's business risk is lower, its capacity to use debt is higher, and vice versa.

10. Flexibility …