Analyzing a Company’s Capital Structure
In Figure-6, X-axis shows the percentage of debt in financing mix, while Y-axis shows the cost of capital. We can see that the increase in debt capital is followed by decline in total cost of capital as Ko is moving downward. Further increase in debt capital in the capital structure will bring the total cost of capital to its minimum point. High corporate tax, high tax on dividend and capital gain directly influence the capital structure decisions. High tax discourages the issues of equity shares and encourages issuing more debentures.
- An increase in leverage level induces a higher default probability to a company.
- A sound capital structure of any business enterprise maximises shareholders’ wealth through minimisation of the overall cost of capital.
- The periods of trade activity, or general business prosperity, are reasonably well heralded in advance by the conditions of the money market and the stock market.
- The capital structure should be as elastic as possible so as to provide for expansion and raising of future capital.
Miller and Modigliani published a number of follow-up papers discussing some of these issues. So, as an investor, you should be happy to see high ratings on the debt of companies in which you may invest. We know that a firm obtains its requirement from various sources and invest the same also in various forms of assets. In order to explain the theories of capital structure we are to use the following systems in addition to the above assumptions. From the point of view of the investor, the time and amount of investment will very largely depend upon the nature of the security, as also on his own way of thinking.
Meaning and Definition of Capital Structure
Capital structure describes the mix of a firm’s long-term capital, which is a combination of debt and equity. Capital structure is a type of funding that supports a company’s growth and related assets. Sometimes it’s referred to as capitalization structure assumptions of capital structure or simply capitalization. A firm’s judicious use of debt and equity is a key indicator of a strong balance sheet. A healthy capital structure that reflects a low level of debt and a large amount of equity is a positive sign of investment quality.
Although the extra debt still increases the chance of a company’s default, investors are less prone to negatively reacting to the company taking additional leverage, as it creates the tax shields that boost its value. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC). When analysts https://1investing.in/ refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight into how risky a company’s borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. On the other hand, the capitalization ratio that compares the long-term debt component to the debt and equity in a company’s capital structure can present a clearer picture of financial health.
Bonds can always be issued more cheaply than shares, for the buyer of bonds looks more for safety than the size of the income. The company can deduct the interest paid on bonds or debentures as a business expense in arriving at its income tax, thus further reducing the cost of capital. Yet, debentures should never be issued if there is any doubt about the regular payment of interest. Funds needed for short periods are usually borrowed from banks as short period loans or received as public deposits for a year or two. Such loans can be paid back as soon as the company has raised its own funds. Gearing means the ratio of different types of securities to the total capitalisation.
Capital Structure Theory: What It Is in Financial Management
There is also another advantage and that is the saving of income tax, because interest paid on debentures is an admissible expenditure. Thus, the double advantage generally tempts the promoters or directors to resort to trading on equity. The company pays only a fixed rate of interest on borrowed capital (i.e. on debentures) and a fixed rate of dividend on preference capital (preference shares). But the rate of dividend on equity capital (i.e. equity shares) varies from year to year depending upon the amount of profit available to them. If debt component increases in the capital structure of a company, the financial risk (i.e., payment of fixed interest charges and repayment of principal amount of debt in time) will also increase.
Financial Structure and Capital Structure:
Bank loans, retained earnings and working capital might also be part of the company’s capital structure. If funds are raised by the issue of equity shares, it requires dividends only if there is sufficient profits, whereas, in the latter case, it requires a fixed rate of interest irrespective of the profit or loss. Thus, the question of capital gearing arises relating to which fund a fixed rate of interest or dividend is paid. As regards capital structure, the significant point to be noted is the proportion of owned capital and borrowed capital by way of different securities to the total capitalisation for raising finance.
Astute use of leverage can increase the financial resources available to a company for growth and expansion. The debt ratio relates to how much of a company’s assets are paid for with debt. The problem with this measurement is that it is too broad in scope and gives equal weight to operational liabilities and debt liabilities. When analyzing a company’s balance sheet, seasoned investors would be wise to use this comprehensive total debt figure. The selection of capital structure is also affected by the capacity of the business to generate cash inflows.
Current and operational liabilities, especially the latter, represent ongoing obligations. Also, unlike with long-term debt, there are no fixed payments of principal or interest attached to operational liabilities. By using three broad types of measurements—working capital, asset performance, and capital structure—you may evaluate the strength of a company’s balance sheet, and thus, its investment quality. If the level of EBIT is low from HPS point of view, equity is preferable to debt.
Long-term debt can cost less than shareholder equity because it can be tax-deductible. The financial structure of a firm comprises the various ways and means of raising funds.’ In other words, financial structure includes all long-term and short-term liabilities. But if short-term (i.e. current liabilities) liabilities are excluded the same is known as net worth or capital structure.
A sound capital structure protects a business enterprise from such financial risk through a judicious mix of debt and equity in the capital structure. It is important to note that higher the gear the more speculative would be the equity shares. In this way, by issuing debentures and preference shares, the rate of dividend to equity shareholders is considerably increased.
It advocates that the optimal capital structure of the firm at which the overall cost of capital (Ko) will be minimum and thereby the value of the firm increases. Similarly, SEBI guidelines on investors’ protection maintaining debt-equity ratio and current ratio as per norms, promoters’ contribution etc. have direct bearing on capital structure. The legal and statutory requirements of the government also influence the capital structure.
The change in the degree of leverage employed by a firm cannot change these underlying factors. The desire to retain the voting control of the company in the hands of a particular limited group may also influence the pattern of capital structure. In a closely held company, efforts are made to use debentures and non-voting shares to avoid the sharing of control with others. A company has to consider its cash flow position before deciding on the type of financing because in the case of debentures or long term debt it will have to pay out interest along with installments at fixed time intervals.
So ultimately, profits earned are distributed to a large number of equity shareholders and as a result of which earnings per share decline. The total capitalisation of both the companies is the same but its composition varies. The capital structure of X company is low geared as it has 80 percent of the total capital in the form of equity share capital and 20 percent in the form of fixed cost capital. For example, in times of depression investors will look more to safety than to income, and will be willing to invest in debentures and not in equity shares. The management, looking for more funds, must therefore watch the mood of the market and adjust its financial plan to it for successful capital-gearing. It is the equity shareholders who exercise control as they enjoy the voting powers, and the debenture holders and holders of preference shares have no voting rights.
