Question

Describe some of the empirical regularities related to capital structure policy.

Answer 1

MM HYPOTHESIS WITH CORPORATE TAX [THEORY OF RELEVANCE]
Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the un-levered cash flow plus an amount equal to the tax deduction on interest. Capitalising the first component of cash flow at the all-equity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the un-levered firm plus the interest tax shield which is tax rate times the debt. It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

MM APPROACH WITHOUT TAX: PROPOSITION II The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firm‟s debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases.

MM APPROACH WITHOUT TAX: PROPOSITION I [THEORY OF IRRELEVANCE] MM‟s Proposition I, states that the firm‟s value is independent of its capital structure .The Total value of firm must be constant irrespective of the Degree of leverage(debt equity Ratio). With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm. This will continue till the market prices of identical firms become identical. This is called arbitrage.

TRADITIONAL THEORY This theory was propounded by Ezra Solomon. It’s a Midway Between Two Extreme (NI & NOI Approach) According to this theory, a firm can reduce the overall cost of capital or increase the total value of the firm by increasing the debt proportion in its capital structure to a certain limit. Because debt is a cheap source of raising funds as compared to equity capital.

NET OPERATING INCOME (NOI) APPROACH This theory was propounded by “David Durand” and is also known as “Irrelevant Theory”. According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firm‟s capital structure. Overall cost of capital is independent of degree of leverage. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.

NET INCOME (NI) APPROACH This theory was propounded by “David Durand” and is also known as “Fixed „Ke‟ Theory”. According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach

Growth and stability of sales Stability of sales ensures that the firm will not face any difficulty in meeting its fixed commitments of interest payment & repayment of debt. Usually, greater the rate of growth in sales, greater can be the use of debt in the financing of firm. On the other hand, if the sales of a firm are highly fluctuating or declining, it should not employ, as far as possible, debt financing in its capital structure. Cost of Capital It refers to the minimum return expected by its suppliers. The return expected by the suppliers of capital depends upon the risk they have to undertake. While formulating a capital structure, an effort must be made to minimize the overall cost of capital.

Cash flow ability to service debt A firm which shall be able to generate larger & stable cash inflows can employ more debt in its capital structure as compared to the one which has unstable & lesser ability to generate cash inflows. Whenever a firm wants to raise additional funds, it should estimate, project its future cash inflows to ensure the coverage of fixed charges. Fixed charges Coverage Ratio & Interest Coverage Ratio may be calculated for this purpose. Nature & Size of a Firm Public utility concerns may employ more of debt because of stability & regularity of their earnings. On the other hand, a concern which cannot provide stable earnings due to the nature of its business will have to rely mainly on equity capital. Small companies have to depend mainly upon owned capital as it is very difficult for them to raise long-term loans on reasonable terms.

Control Whenever additional funds are required by a firm, the management of the firm wants to raise the funds without any loss of control over the firm. In case the funds are raised through the issue of equity shares, the control of the existing shareholders is diluted. Hence, they might raise the additional funds by way of fixed interest bearing debt & preference share capital. Preference shareholders & debentures holders do not have the voting right. Hence, from the point of view of control, debt financing is recommended. Flexibility Capital structure should be as capable of being adjusted according to the needs of the changing conditions. It should be in such a manner that it can substitute one form of financing by another. Redeemable preference shares & convertible debentures may be prefered on account of flexibility.

Requirements of Investors It is necessary to meet the requirements of both institutional as well as private investors when debt financing is used. Investors are generally classified under three kinds,i:e. Bold investors, Cautious investors & Less cautious investors. Capital market conditions Capital market conditions do not remain the same for ever. Sometimes there may be depression while at other times there may be boom in the market. The choice of the securities is also influenced by the market conditions. If the share market is depressed & there are pessimistic business conditions, the company should not issue equity shares as investors would prefer safety. But in case there is boom period, it would be advisable to issue equity shares.

Assets structure The liquidity & the composition of assets should also be kept in mind while selecting the capital structure. If fixed assets constitute a major portion of the total assets of the company, it may be possible for the company to raise more of long term debts. Purpose of financing If funds are required for a productive purpose, debt financing is suitable & the company should issue debentures as interest can be paid out of the profits generated from the investment. However, if the funds are required for unproductive purpose or general development on permanent basis, we should prefer equity capital.

Period of Finance The period for which the finances are required is also an important factor to be kept in mind while selecting an appropriate capital mix. If the finances are required for a limited period of, seven years, debentures should be preferred to shares. Redeemable preference shares may also be used for a limited period finance, if found suitable otherwise. However, in case funds are needed on permanent basis, equity share capital is more appropriate. Costs of floatations Although not very significant, yet costs of floatation of various kinds of securities should also be considered while raising funds. The cost of floating a debt is generally less than the cost of floating an equity & hence it may persuade the management to raise debt financing. The costs of floating as a percentage of total funds decrease with the increase in size of the issue.

Personal consideration The personal considerations & abilities of the management will have the final say on the capital structure of a firm. Managements which are experienced & are very enterprising do not hesitate to use more of debt in their financing as compared to the less experienced & conservative management. Corporate Tax Rate High rate of corporate taxes on profits compel the companies to prefer debt financing, because interest is allowed to be deducted while computing taxable profits. On the other hand, dividend on shares is not an allowable expense for that purpose.

Legal Requirements The government has also issued certain guidelines for the issue of shares & debentures. The legal restrictions are very significant as these lay down a framework within which capital structure decision has to be made.