ch 20 designing capital structure

8/19/2019 Ch 20 Designing Capital Structure

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Designing Capital

Structure

Presenter:

Prof. Isha Dave

N.R. Institute of Business Management

GLS Institute of Computer echnolog!"MB#


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# host of factors$ %oth &uantitative an' &ualitative$ inclu'ing

su%(ective (u'gment of )nancial managers$ have a %earing on

the 'etermination of an optional capital structure of a )rm.

he! are not onl! highl! comple* %ut also con+icting in nature

an'$ therefore$ cannot )t entirel! into a theoretical frame,or-.

Moreover$ the ,eights assigne' to various factors also var!

,i'el!$ accor'ing to con'itions in the econom!$ the in'ustr!

an' the compan! itself.

herefore$ a corporate shoul' attempt to evolve an

appropriate capital structure ,here cost of capital is minimum$

given the facts of a particular case.


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he -e! factors relevant to 'esigning an appropriate capital

structure are:

/ Pro)ta%ilit!

0/ Li&ui'it!

1/ Control

2/ Leverage ratios in in'ustr!3/ Nature of in'ustr!

4/ Consultation ,ith investment %an-s5len'ers

6/ Commercial strateg!

7/ iming

8/ Compan! characteristics

9/ a* planning


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/ arnings Before Interest an' a* ;BI/ < arnings per Share

;PS/ #nal!sis

=%(ective of )nancial management is to ma*imi>e the

sharehol'ers ,ealth$ a corporate shoul' carr! out pro)ta%ilit!

anal!sis in terms of 'etermining the amount of BI

;in'i?erence point/ at ,hich its PS 5 MPS is i'entical un'er t,o

propose' )nancial plans.

In general$ the higher the level of BI than the in'i?erence

point an' the lo,er the pro%a%ilit! of its 'o,n,ar' +uctuation$

the greater is the amount of 'e%t that can %e emplo!e' %! a

corporate.


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0/ Interest Coverage Ratio

Interest Coverage ratio ;BI5I/ can also %e use' to (u'ge the

a'e&uac! of BI to meet the )rm@s o%ligations to pa! )nancial

charges$ interest on loan.

# higher ratio implies that the )rm can go for larger

proportion of 'e%t in its capital structure.

he ratio measures the si>e of the interest pa!ments relative

to the BI.

he reciprocal of this Income gearing ratio ;I5BI/ measures

the proportion of BI 'evote' to interest pa!ments.

. Pro)ta%ilit

! #spect


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Cash Alo, #nal!sis

Li&ui'it! position of a )rm is anal!>e' %! cash +o, anal!sis.

=ne measure relates the ratio of )*e' )nancial charges to net

cash in+o,s. # )rm can a?or' higher 'e%t if the ratio is high.

#nother measure to 'etermine the a'e&uac! of cash +o,s to

meet the )*e' o%ligations is Cash %u'get.

# cash %u'get shoul' %e prepare' for a range of possi%le cash

in+o,s ,ith a pro%a%ilit! attache' to each of them.

he )rm can 'etermine the level of 'e%t it can emplo! an'

still remain ,ithin an insolvenc! limit tolera%le to the


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Len'ers have no 'irect voice in the management of a compan!.

he! ma!$ place certain restrictions in the loan agreement on the

management@s activities.

So long as there is no 'efault in the pa!ment of interest or the

repa!ment of the principal$ there is little that the! can 'o legall!

against the compan!.

he! have ver! little sa! in the polic!"'ecisions of the compan!

or in the selection of the %oar' of 'irectors.

Preference sharehol'ers 'o not have the right to vote for the

appointment of the %oar' of 'irectors.

1. Control


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o,ever$ if the compan! 'oes not pa! 'ivi'en's on

preference shares for a certain num%er of !ears ;0"!ear perio'

in In'ia/$ the! are given the right to atten' the meetings an'

participate in the voting.

In most of the cases$ the!$ li-e the cre'itors$ 'o not have an!

sa! in the selection of the management. he po,er to choose

the management in most cases rests ,ith the e&uit!"hol'ers.

#ccor'ingl!$ if the main o%(ect of the management is to

maintain control$ the! ,ill li-e to have a greater ,eightage for

'e%t an' preference shares in a''itional capital re&uirements$

1. Control


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Compare ,ith the 'e%t"e&uit! ratios of companies %elonging to the

same in'ustr!$ having a similar %usiness ris-.

In'ustr! stan'ar's provi'e a useful %enchmar-.

his 'oes not necessaril! impl! that the )rm@s capital structure

planning is inappropriate. It ma! ,ell %e possi%le that other )rms ma!

not %e using appropriate 'e%t"e&uit! ratios.

he! ma! %e more conservative or more aggressive ris-"ta-ers than

'esire'.

o,ever$ comparison is helpful as it acts as a re' signal to the

management that there ma! %e something ,rong ,ith the 'e%t"

e&uit! mi* of the compan!.

2. Leverage Ratios of =ther

Airms In he In'ustr!


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he nature of in'ustr! is one of the most important elements in

'etermining the 'egree of )nancial leverage a )rm can carr!

safel! ,ithout an! ris- of %an-ruptc!.

If an in'ustr!@s sales are su%(ect to ,i'e +uctuations$ over a

%usiness c!cle$ the )rm shoul' have a lo, 'egree of )nancial

leverage.

Such )rms ,ill alrea'! have a high operating leverage.

=n the other han'$ in'ustries 'ealing ,ith non"'ura%le consumer

goo's ;foo'/ or ,ith ine*pensive items ;paper clips$ match %o*es/

or ,ith items in ha%itual use ;cigarettes/ or all those pro'ucts

3. Nature of In'ustr!


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Such in'ustries can a?or' to have higher 'e%t proportions in

capital structure as in lean !ears the! 'o not run the ris- of %eing

una%le to meet their commitments.

It ma! %e inferre' that those in'ustries ,hich have -een

competition among themselves shoul' have a relativel! greater

proportion of e&uit! than 'e%t.

Aor e*ample$ in the garment in'ustr! much of the competition is

%ase' on st!le. he st!les %eing unpre'icta%le an' transitor! thepro)ts also +uctuate accor'ingl!.

#t the other e*treme$ there are pu%lic utilit! un'erta-ings

involve' in the pro'uction of electricit!$ gas$ ,ater$ transportation

services or telephone services$ ,hich are relativel! free fromintra"in'ustr com etition.

3. Nature of In'ustr!


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#nother useful approach is to see- the opinion of investment

anal!sts$ institutional investors$ investment %an-ers an'

len'ers. hese anal!sts$ having %een in %usiness for a consi'era%le

perio' of time$ ac&uire e*pertise an' have access to

information regar'ing securities of a large num%er of

companies an' -no, ho, the mar-et evaluates them.

he! are$ therefore$ in a %etter position to assess a particular

)nancial plan.

4. Consultation ith

Investment Ban-ers Len'ers


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Ale*i%ilit! refers to a )rm@s a%ilit! to a'(ust its sources of fun's

in either 'irection–increase or 'ecrease–in response to changes

in the nee' for fun's. hat is$ the )nance manager must -eep himself in a situation

,here he can change positions.

herefore$ ,hile 'esigning the capital structure$ he shoul' not

lose sight of the future impact on the present )nancial plan.

6. Maintaining Ale*i%ilit! Aor

Commercial Strateg!


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20-

14

Are&uentl! ver! su%stantial savings ma! %e o%taine' %!

proper timing of securit! issues.

hus$ the timing of the pu%lic o?erings is also an important

consi'eration in capital structure 'ecisions of a )rm.

Pu%lic o?ering shoul' %e ma'e at a time ,hen the state of

the econom! as ,ell as the capital mar-et is i'eal to provi'e

the fun's.

he monetar! an' )scal policies that are pursue' %! the

government are also important in this regar'. The

government follows a cheap money policy to boost theeconom durin a recession and a dear mone olic durin

7. iming =f Issue


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igh 'e%entures !iel's are associate' ,ith relative scarcit!

of 'e%t mone! an' lo, P5 ratios on shares are an in'ication

of the relative scarcit! of e&uit! fun's.

Are&uentl!$ therefore$ the compan! has to 'eci'e ,hether

to )nance initiall! ,ith an e&uit! issue an' later ,ith a 'e%t

issue$ or vice-versa.

7. iming =f Issue


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he characteristics of a compan! in terms of si>e an' cre'it

stan'ing$ among others$ also pla! a vital role in 'etermining the

share of 'e%t an' e&uit! in its capital structure.

Airms en(o!ing a high cre'it stan'ing among investors5len'ers

in the capital mar-et are in a %etter position to get fun's from

the sources of their choice.

If the cre'it stan'ing is poor$ the )rm@s choice of o%taining

fun's is rather limite'.

8. Characteristics =f he Compan


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he choice of an appropriate 'e%t polic! involves a tra'e"o?

%et,een ta* %ene)ts an' the cost of )nancial 'istress.

Moreover$ the management shoul' consi'er the implicit cost ofthe ta* su%si'! in using 'e%t.

9. a* Planning


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20-

18

C#PI#L SRECER PR#CICS IN

INDI#In'ian corporate emplo! su%stantial amount of 'e%t in their

capital structure in terms of the 'e%t"e&uit! ratio as ,ell as total'e%t to total assets ratio.

Nonetheless$ the foreign controlle' companies in In'ia use less

'e%t than the 'omestic companies. he 'epen'ence of the In'ian

corporate sector on 'e%t as a source of )nance has over the

!ears 'ecline' particularl! since the mi'"nineties.

he corporate enterprises in In'ia seem to prefer long"term

%orro,ings over short"term %orro,ings. =ver the !ears$ the!

seem to have su%stitute' short"term 'e%t for lon "term 'e%t. he


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#s a result of 'e%t"'ominate' capital structure$ the In'ian

corporates are e*pose' to a ver! high 'egree of total ris- as

re+ecte' in high 'egree of operating leverage an' )nancial

leverage an'$ conse&uentl!$ are su%(ect to a high cost of

)nancial 'istress ,hich inclu'es a %roa' spectrum of

pro%lems ranging from relativel! minor li&ui'it! shortages to

e*treme cases of %an-ruptc!. he foreign controlle'

companies$ ho,ever$ are e*pose' to lo,er overall ris- as ,ell

as )nancial ris-.

he 'e%t service capacit! of the a si>ea%le segment of the

corporate %orro,er as measure' %! ;i/ interest coverage ratio

C#PI#L SRECER PR#CICS ININDI#


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ch 20 designing capital structure

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