Capital Structure Decision

June 2nd, 2010 Dallas TX, USA An organization employs different types of funding to run a business smoothly. Capital Structure is a composition of different types of financing employed by a firm to acquire resources necessary for its operations and growth. Capital Structure primarily comprises of long-term debt, preferred stock, and net worth. It can be quantified by taking how much of each type of financing a company holds as a percentage of all its financing. Capital Structure is different from financial structure as this includes short-term debt, accounts payable, and other liabilities. Most of the companies raises fund by equity or debt. Debt comes in the form of bond or long-term notes payable, whereas equity is classified as common stock, preferred stock, or retained earnings. Both the financing has advantages and disadvantages over each other. The founders hold the ownership rights and control of the company if they raise capital by debt. The company has to pay the principal and interest to the concerned debt holders. This privilege will be lost in equity, as the shareholders become an integral part of the company. Debt financing is easier and less expensive for small firms. Payment of interest on regular becomes burden for a company and reduces their earnings. There is no obligation in equity financing to repay the money. Shareholders take a chance on good ideas for better growth opportunities of the firm. There are two main theories of capital structure:Trade Off Theory This theory proposes to increase debt levels to balance interest to shield against the cost of financial distress. The company should keep on borrowing until the marginal tax advantage of additional debt is offset by the increase in present value of the expected costs of financial distress. Pecking Order Companies with higher earnings should take less debt, as they require less of funding requirements due to funding met by the internal resources. A high profit making company can generate internal cash to fund their new projects. A balance between risk and return met by capital structure is known as the most favorable capital structure. A sound capital structure aims at minimizing the risk and maximizing the profit margins. It maximizes the price of the stock and minimizes the cost of capital at the same time. n Financial Management book, you would read the topic theories of capital structure. Here, I have made these theories simplified. I hope, you can study these theories here and use these theories as reference. We all know that capital structure is combination of sources of funds in which we can include two main sources' proportion. One is share capital and other is Debt. All four theories are just explaining the effect of changing the proportion of these sources on the overall cost of capital

and total value of firm. If I have to write theories of capital structure in very few lines, I will only say that it propounds or presents the effect on overall cost of capital and market or total value of firm, if I change my capital structure from 50: 50 to any other proportion. First 50 represent the share capital and second 50 represent the Debt. Now, I am ready to explain these four theories of capital structure in simple and clean words.

1st Theory of Capital Structure Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital. For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share. High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value. 2nd Theory of Capital Structure Name of Theory = Net Operating income Theory of Capital Structure Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure Name of Theory = Traditional Theory of Capital Structure This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand: Ist Stage In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 2nd Stage In second stage, after increasing debt in equity debt mix, company gets the position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. 3rd Stage Company can gets loss in its market value because increasing the amount of debt in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital. 4th Theory of Capital Structure Name of theory = Modigliani and Miller MM theory or approach is fully opposite of traditional approach. This approach says that there is not any relationship between capital structure and cost of capital. There will not effect of increasing debt on cost of capital. Value of firm and cost of capital is fully affected from investor's expectations. Investors' expectations may be further affected by large numbers of other factors which have been ignored by traditional theorem of capital structure.
Advantages of Leasing: Leasing offers fixed rate financing; you pay at the same rate each month. Leasing is inflation friendly. As the costs go up over five years, you still pay the same rate as when you began the lease, therefore making your dollar stretch farther. There is less upfront cash outlay; you do not need to make large cash payments for the purchase of needed equipment.

 Leasing better utilizes equipment; you lease and pay for equipment only for the time you need it (until the end of the lease). There is typically an option to buy equipment at end of the term of the lease. You can keep upgrading; as new equipment becomes available you can upgrade to the latest models each time your lease ends. It is easier to obtain lease financing than loans from commercial lenders (in most cases). It offers potential tax benefits depending on how the lease is structured.

Disadvantages of Leasing: Disadvantages of Leasing: - Leasing is a preferred means of financing for many businesses. However, it is not for every business. The type of industry and type of equipment required also need to be considered. Tax implications also need to be compared between leasing and purchasing equipment outright.

You have an obligation to continue making payments. Typically, leases may not be terminated before the original term is completed. The renter is responsible for paying off the lease. This can create a major financial problem for the owner of a business experiencing a downturn.

You have no equity until you decide to purchase the equipment at the end of the lease term, at which point the equipment may have depreciated significantly.

Although you are not the owner, you are still responsible for maintaining the equipment as specified by the terms of the lease.

Significance of Financial Leverage: Financial leverage helps in deciding the appropriate Capital Structure. One of the objectives of planning an appropriate Capital Structure is to maximize the return on equity shareholders funds or maximize the earning per share. Financial leverage is double-edged sword. On one hand, it increases the earning per share and on the other hand it

increases the financial risks. High financial leverage means high fixed financial cost and high financial risk i.e., as the debt content in Capital Structure increases, the financial leverage increases and at the same time the financial risk also increases i.e., risk of insolvency increases. The finance manager is required to trade-off between risk and return for determining the appropriate amount of debt.

(213)---CERTAINTY EQUIVALENT METHOD FOR RISK ANALYSIS

Certainty Equivalent Method for Risk Analysis

Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. For example, if an investor, according to his best estimate expects a cash flow of 60000$ next year, he will apply an intuitive correction factor and may work with 40000$ to be on safe side. There is a certainty-equivalent cash flow. In formal way, the certainty equivalent approach may be expressed as: Net present value = (the risk adjusted factor X the forecasts of net cash flow) / (1 + Risk free rate) The certainty equivalent coefficient, the risk adjustment factor assumes a value between zero and one, and varies inversely with risk. A lower risk adjustment rate will be used if lower risk is anticipated. The decision maker subjectively or objectively establishes the coefficients. These coefficients reflect the decision makers confidence in obtaining a particular cash flow in period. For example, a cash flow of 20000$ may be estimated in the next year, but if the investor feels that only 80% of it is a certain amount,

then the certainty-equivalent coefficient will be 0.8. That is, he consider only 16000$ as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients. The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is: Risk adjustment factor = certain net cash flow / Risky net cash flow For example, if one expected a risky cash flow of 80000$ in period and certain cash flow of 60000$ equally desirable, then risk adjustment factor will be 0.75 = 60000/80000. If the internal rate of return method is used, we will calculate that rate of discount, which equates the present value of certainty equivalent cash outflows. The rate so found will be compared with the minimum required risk free rate. Project will be accepted if the internal rate is higher than the minimum rate; otherwise it will be unacceptable. Evaluation of certainty equivalent The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give

forecasts according to best estimate. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments.

Sunday, July 25, 2010

(214)---RISK ADJUSTED DISCOUNT RATE

Risk Adjusted Discount Rate

For a long time, economic theorists have assumed that, to allow for risk, the businessman required a premium over and above an alternative, which was risk-free. Accordingly, the more uncertain the returns in the future, the grater the risk and grater the premium required. Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for money is to be recognized by discounting estimated future cash flows, at some risk free rate, to their present value, then, to allow for the riskiness, of those future cash flows a risk premium rate may be added to risk-free discount rate. Such a composite discount rate, called the risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and risk-premium rate reflecting the investors attitude towards risk. The riskadjusted discount rate method can be formally expressed as follows:

Risk-adjusted discount rate = Risk free rate + Risk premium Under capital asset pricing model, the risk premium is the difference between the market rate of return and the risk free rate multiplied by the beta of the project. The risk adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk of investment projects. A higher rate will be used for riskier projects and a lower rate for less risky projects. The net present value will decrease with increasing risk adjusted rate, indicating that the riskier a project is perceived, the less likely it will be accepted. If the risk free rate is assumed to be 10%, some rate would be added to it, say 5%, as compensation for the risk of the investment, and the composite 15% rate would be used to discount the cash flows. Advantages of risk adjusted discount rate

It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude towards uncertainty.

Disadvantages This approach, however, suffers from the following limitations:

There is no easy way deriving a risk adjusted discount rate. Capital asset pricing model provides a basis of

calculating the risk adjusted discount rate. Its use has yet to pick up in practice. It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years. It is based on the assumption that investor are riskaverse. Through it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay premium to take risks. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.

The consequences of using more debt: (1) The earnings per ordinary share will increase if the investment financed by the debt issue is able to generate a return greater than the cost of the debt but will decrease if the return generated is less than the cost of the debt. (2) The use of debt increase the financial risk which is faced by ordinary shareholders with the result that their required rate of return is likely to increase the greater the companys debt equity ratio. The returns & risks expected by a companys ordinary shareholders are likely to change, therefore as the company change its capital structure. The use of more debt is not necessarily in the interest of shareholders.

Significance of operating leverage: Operating leverage explains why the value premium is weak and non-monotonic across industries, but strong and monotonic within industries. Intra-industry differences in book-to-market are driven by differences in operating leverage, giving rise to expected return differences. Industry

differences in book-to-market are driven by differences in the capital intensity of production unrelated to returns.