accounts case study

8/3/2019 Accounts Case Study

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CAPITAL STRUCTURE

POLICY



INTRODUCTION

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y The objective of a firm should be directed towards the

maximization of the firm·s value.

y The capital structure or financial leverage decision should beexamined from the point of its impact on the value of the firm.



Capital Structure Theories:

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y Net operating income (NOI) approach.

y Traditional approach and Net income (NI) approach.

y MM hypothesis with and without corporate tax.

y Miller·s hypothesis with corporate and personal taxes.

y Trade-off theory: costs and benefits of leverage.



Net Income (NI) Approach

y According to NI approachboth the cost of debt and thecost of equity are independentof the capital structure; theyremain constant regardless of

how much debt the firm uses.As a result, the overall cost of capital declines and the firmvalue increases with debt. Thisapproach has no basis inreality; the optimum capital

structure would be 100 percent debt financing under NIapproach.

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The effect of leverage on the cost of

capital under NI approach



MM·s Proposition I: Key Assumptions

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y Perfect capital markets

y Homogeneous risk classes

y Risk

y No taxes

y Full payout



MM·s Proposition II

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y Financial leverage causes two opposing effects: it increases the

shareholders· return but it also increases their financial risk.

Shareholders will increase the required rate of return (i.e., the cost of

equity) on their investment to compensate for the financial risk. The

higher the financial risk, the higher the shareholders· required rate of

return or the cost of equity.

y The cost of equity for a levered firm should be higher than the

opportunity cost of capital, ka; that is, the levered firm·s ke > ka. It

should be equal to constant ka, plus a financial risk premium.



Net Operating Income (NOI) Approach

y According to NOI approach the value of the firm andthe weighted average cost of capital are independent of the firm·s capital structure. In the absence of taxes, an

individual holding all the debt and equity securities willreceive the same cash flows regardless of the capitalstructure and therefore, value of the company is thesame.

y MM·s approach is a net operating income approach.

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RELEVANCE OF CAPITAL STRUCTURE:

THE MM HYPOTHESIS UNDER CORPORATE TAXES

y MM show that the value of the firm will increase with debt

due to the deductibility of interest charges for tax

computation, and the value of the levered firm will be higher

than of the unlevered firm.



Example: Debt Advantage: Interest Tax Shields

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y Suppose two firms L and U are identical in all respects except that firm L is levered

and firm U is unlevered. Firm U is an all-equity financed firm while firm L employs

equity and Rs 5,000 debt at 10 per cent rate of interest. Both firms have an

expected earning before interest and taxes (or net operating income) of Rs 2,500,

pay corporate tax at 50 per cent and distribute 100 per cent earnings as dividends toshareholders.



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y You may notice that the total income after corporate tax is Rs 1,250 for the

unlevered firm U and Rs 1,500 for the levered firm L. Thus, the levered firm L·s

investors are ahead of the unlevered firm U·s investors by Rs 250. You may also note

that the tax liability of the levered firm L is Rs 250 less than the tax liability of the

unlevered firm U. For firm L the tax savings has occurred on account of payment of interest to debt holders. Hence, this amount is the interest tax shield or tax

advantage of debt of firm L: 0.5 × (0.10 × 5,000) = 0.5 × 500 = Rs 250.Thus,



Miller·s Model

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y To establish an optimum capital structure both corporate and personal taxes paidon operating income should be minimised. The personal tax rate is difficult todetermine because of the differing tax status of investors, and that capital gains areonly taxed when shares are sold.

y Merton miller proposed that the original MM proposition I holds in a world with both corporate and personal taxes because he assumes the personal tax rate onequity income is zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax rate. At thispoint, there will be no net tax advantage to companies from issuing additional

debt.

y It is now widely accepted that the effect of personal taxes is to lower the estimateof the interest tax shield.



Equity Capital Structure(Rs.in Cr)

Year Authorised Issued Subscribed Called UpLess : Calls

in ArrearsForfeited Paid Up

2011 349.25 338.63 338.63 338.63 0.00 0.38 339.01

2010 349.25 338.63 338.63 338.63 0.00 0.38 339.01

2009 349.25 338.63 338.63 338.63 0.00 0.38 339.01

2008 349.25 338.63 338.63 338.63 0.00 0.38 339.01

2007 349.25 339.33 339.33 339.33 0.38 0.00 338.95

2006 349.25 339.33 339.33 339.33 0.39 0.00 338.94

2005 349.25 339.33 339.33 339.33 0.40 0.00 338.93

2004 349.25 339.33 339.33 339.33 0.43 0.00 338.90

2003 349.25 339.33 339.33 339.33 0.50 0.00 338.83



CAPITAL STRUCTURE PLANNING AND POLICY

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y Theoretically, the financial manager should plan an optimum

capital structure for the company. The optimum capital structure

is one that maximizes the market value of the firm.

y The capital structure should be planned generally, keeping inview the interests of the equity shareholders and the financial

requirements of a company.

y While developing an appropriate capital structure for its

company, the financial manager should inter alia aim atmaximizing the long-term market price per share.



Elements of Capital Structure

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1. Capital mix

2. Maturity and priority

3. Terms and conditions

4. Currency

5. Financial innovations

6. Financial market segments



Framework for Capital Structure:

The FRICT Analysis

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y Flexibility

y Risk

y Income

y Control

y Timing



APPROACHES TO ESTABLISH TARGET

CAPITAL STRUCTURE

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1. EBIT³EPS approach for analyzing the impact of debt on

EPS.

2. Valuation approach for determining the impact of debt

on the shareholders· value.3. Cash flow approach for analyzing the firm·s ability to

service debt.



EBIT-EPS Analysis

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y The EBIT-EPS analysis is a first step in deciding about a firm·s capital

structure.

y It suffers from certain limitations and does not provide unambiguous guide

in determining the level of debt in practice.

y The major shortcomings of the EPS as a financing-decision criterion

are:

y It is based on arbitrary accounting assumptions and does not reflect the

economic profits.

yIt does not consider the time value of money.

y It ignores the variability about the expected value of EPS, and hence, ignores

risk.



Valuation Approach

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y The firm should employ debt to the point where the marginal benefits

and costs are equal.

y This will be the point of maximum value of the firm and minimum

weighted average cost of capital.y The difficulty with the valuation framework is that managers find it

difficult to put into practice.

y The most desirable capital structure is the one that creates the

maximum value.



Cash Flow Analysis

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y Cash adequacy and solvency

y In determining a firm·s target capital structure, a key issue is the

firm·s ability to service its debt. The focus of this analysis is also

on the risk of cash insolvency³the probability of running out of

the cash³given a particular amount of debt in the capitalstructure. This analysis is based on a thorough cash flow analysis

and not on rules of thumb based on various coverage ratios.

y Components of cash flow analysis

y Operating cash flows

y Non-operating cash flows

y Financial cash flows



Cash Flow Analysis Versus EBIT²EPS

Analysis

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y The cash flow analysis has the following advantages over EBIT² EPS analysis:1. It focuses on the liquidity and solvency of the firm over a long-period of

time, even encompassing adverse circumstances. Thus, it evaluates the

firm·s ability to meet fixed obligations.2. It goes beyond the analysis of profit and loss statement and also considers

changes in the balance sheet items.

3. It identifies discretionary cash flows. The firm can thus prepare an actionplan to face adverse situations.

4. It provides a list of potential financial flows which can be utilized underemergency.

5. It is a long-term dynamic analysis and does not remain confined to a singleperiod analysis.



Practical Considerations in Determining

Capital Structure

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1. Assets

2. Growth Opportunities

3. Debt and Non-debt Tax Shields

4. Financial Flexibility and Operating Strategy

5. Loan Covenants

6. Financial Slack

7. Sustainability and Feasibility

8. Control

9. Marketability and Timing10. Issue Costs

11. Capacity of Raising Funds

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