Question

Case 2 – Capital Structure

1. PT Kreasi Nusantara plans to re-structure its capital due to the demand of some shareholders who would with draw their shares from company’s equities. To maintain a level of total assets, the company should either increase long-term debts or issue common shares to other shareholders (could be through private placement or initial public offering). Using 2 theories of capital structure, explain how does PT Kreasi Nusantara re-structure its capital! (20%)
2. Discuss why the dividends payment process is much simpler for private companies than for public companies! Use an example of your current company you work with! (15%)

Answer 1

A. Capital Structure refers to a blend of all sources of finances which involves Equity Capital, Reserves and Surplus, Debentures, Loan etc. It is solely the responsibility of the company to decide how it wants to finance its workings.

However, debt is usually considered as a cheaper source of finance because of the lower interest rate as compared to the cost of equity and also interest payable on debt attracts tax shield. So, it is always a challenge for a company to decide the appropriate proportion for equity and debt so as to maximise the shareholder’s wealth and at the same time keeping the cost of capital to a minimum.

There are four types of capital structure theories:

1. Net Income Theory: It works on the principle that if debt proportion is increased, it can reduce the overall cost of capital for the company which in turn would increase the value of the firm. It assumes that the cost of equity is higher than the cost of debt due to the risk involved and there are no corporate taxes.

2. Net Operating Income Theory: This theory is complete opposite of the Net Income Theory. It says that the change in capital structure create no effect on the value of the firm and the overall cost of capital remains same.

It says if the debt value is increased, the risk for equity shareholders also increases which will, in turn, increases the cost of equity. And at the same time, the cost of debt will remain constant because the risk of the debt lenders will remain unaffected.

3. Traditional Theory- This theory is an agreement between the above two stated theories. It says that the value of the firm can be increased by increasing debt proportion in the capital structure because debt is the cheaper source of finance. Therefore, to have an optimum capital structure, a company needs to have a proper debt-equity mix in its capital structure. But after a certain point of time, due to the increased debt component, the cost of equity will increase. And the lower cost of debt will get set-off by the higher cost of equity. There will come a point after some time where increased cost of equity cannot be set-off by the cost of debt.

Thus, overall cost of capital will decrease up to a certain point but beyond a certain stage it will start increasing.

4. Modigliani and Miller Theory- Assuming no taxes, Modigliani and Miller Theory is similar to Net Income Operating Theory. However, if taxes are to be considered, it is identical with the Net Income Theory.

Considering the above theories, PT Kreasi Nusantara should increase the debt component in its capital structure up to a certain level which will decrease the cost of equity and ultimately increase the value of the firm. Beyond a certain stage, any increase in the debt component will not affect the overall cost of the capital and the value of the firm will remain constant.

B.

· As a general practice of payment of dividend by a company, it has to deposited in a separate bank account opened especially for this purpose within 5 days of its declaration and it can be paid to the shareholders within 30 days of declaration.

· It shall be paid in cash or cheque or warrant or in any electronic mode. It cannot be utilized for any other purpose.

· If for any reason the balance remains unpaid for 30 days since its declaration, then such unpaid amount shall be transferred to the Unpaid Dividend account within 7 days after the completion of such 30 days.

· The amount unclaimed or unpaid in the Unpaid Dividend Account for a period of 7 years from its transfer shall be transferred to the Investor Education and Protection Fund within 30 days of expiry of 7 years.

However, since a public company is subject to more regulations and compliances, the dividend declaration process is a bit more complex in public companies as compared to the private companies.

Dividend is declared in an Annual General Meeting proposed by the Board of Directors and declared by the members. However, the members have no power to increase the rate of dividend recommended by the Board. The private company is free from all the compliances and regulations and the dividend payment process is way too simple.

A public company is bound by a lot of regulations and compliances under Companies Act and also there are a lot of members as compared to the private company which makes it a cumbersome process to declare dividend.

In a listed company, the compliances are even more as it required previous intimation to the Stock Exchanges regarding the meeting in which the dividend is to be recommended. Also, the intimation regarding the dispatch of the dividend warrant is also sent to the Stock Exchanges. The company also needs to disclose the dividend payment in its Corporate Governance Report.

Therefore, as concluded, due to the presence of excessive regulations and compliances, the public company follows a tedious process of payment of dividend as compared to the private company.