Once the funds requirements of the enterprise are determined, the finance manager has to decide the make-up of capitalisation in such a way as to minimise cost of funds and maximise return without exposing the firm to risk. Minimisation of the cost of financing enables the firm to increase its surplus and wealth. A company is said to be highly geared if the large amount of capital is composed of debts. Thus, higher the amount of debt vis-a-vis equity means capital gearing ratio is high because equity component is low. When interest rates are high the firm should prefer low debt proportion in its capital structure and vice versa. Because a high interest rate means greater cash outflow in the form of high interest payments.
- It refers to the additional profit which equity shares make at the expense of other forms of securities.
- At the time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration at Carnegie Mellon University.
- The long-term debt to capitalization ratio (one of several capitalization ratios) compares long-term debt to the capital structure of a company, which is represented by long-term debt and total shareholder equity.
- Thus by issuing preference shares and debentures in large proportion, the rate of dividend on equity shares can be considerably increased.
Thus, the question of capital gearing arises as to on which fund a fixed rate of interest or dividend is paid. If the existing capital structure of the company consists mainly of the equity shares, the return on equity shares can be increased by using borrowed capital. This is so because the interest paid on debentures is a deductible expenditure for income tax assessment and the after-tax cost of debenture becomes very low. Cost of capital means cost of raising the capital from different sources of funds. A business enterprise should generate enough revenue to meet its cost of capital and finance its future growth.
Capital Structure – Trading on Equity
Use of several types of securities with varied terms and conditions may create confusion among investors. It may also result in an increase in the administrative cost of the company. The determination of capital structure is necessary both at the time of establishment https://1investing.in/ of the business enterprise and at any time, the firm changes its capital structure. The finance manager should always ensure that optimum capital structure is attained and kept flexible enough to take care of solvency threats and other bankruptcy costs.
Understanding the Traditional Theory of Capital Structure
A sum of Rs.52,000 will be available for paying dividends to the equity shareholders. As the amount of equity capital is now only Rs.3,00,000, the dividend will be at the rate of 17.33%. On borrowed capital as also on preference capital, the company pays only a fixed rate of interest or dividend. If this fixed rate is lower than the general rate of company’s earnings, the equity shareholders will enjoy an advantage in the form of additional profit; and this amounts to trading on the equity. Capital gearing refers to the relationship between owned funds and borrowed funds or fixed interest or dividend carrying funds. Capital gearing indicates proportion of equity share capital (with reserves and surplus) which is higher than the other kinds of securities in the total capitalisation.
When the capital structure is composed of Equity Capital only or with Retained earnings, the same is known as Simple Capital Structure. Great strain is thrown on the banking world which is busily engaged in saving fixed assets from being altogether destroyed by forced liquidation on a panic-stricken market. Commodity prices and those for securities must be brought into harmony with producing and consuming power. A check must be imposed upon unrestricted expansion which has been engendered by the preceding period of improvement. The point of indifference is very useful in choosing the most suitable pattern of capitalisation for the firm. This occurs because when D/E increases, rD which is lower than rE, has a higher weight in the calculation of rA.
Gears have to be used in an automobile for maintaining the desired speed. Initially, the automobile starts with a low gear and as it gets momentum low gear has to be changed to high gear. In the same way in the beginning an enterprise will have to be started with a low gear i.e. with a larger amount (or proportion) of equity share capital. (a) The traditional theory suggests that investors value levered firms more than unlevered firms. This implies that they willingly pay a premium for the shares of levered firms. Initial increase in the cost of equity with leverage is not much and is offset by the lower cost of debt.
What Is the Modigliani-Miller Theorem (M&M)?
Fixed investment requires equity financing but medium term capital needs can be fulfilled by debentures and preference shares. If the debt- proportion in the capital structure is high, it increases the risk and it may lead to financial insolvency of the company in adverse times. However, raising of funds through debt is cheaper as compared to raising funds through equity. This may require to have efficient leverage of debt and equity to meet the obligation towards investors. The fund manager has to use different long term sources of funds judiciously such that the overall cost of capital is maintained at optimum level.
There is a strain put upon banking resources, loans have increased rapidly and overrun deposits. 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. And they proceed in a logical way, by first involving the more basic lines of manufacturing, and subsequently spreading to industries dealing with complex products and Consumers’ goods. It may be noted that the trade cycle is the result of the reactions of three markets – the money market, the stock market and the market for industrial, mining and agricultural products. Normally, funds which are required for a comparatively short period are raised through borrowings, because then the loan can be repaid as soon as the company comes into possession of its own funds.
As in any other sphere, so in financial planning too, one must comply with the legal provisions regarding the issue of different securities. Not all businesses may be subject to these legal provisions but for some these do apply. In India, banking companies are not allowed by the Banking Companies Act to issue any type of securities except the equity shares. If there is a prolonged slump or depression, the company may find it very difficult to make these fixed payments. To obtain the benefit of ‘trading on equity’ the business must have an established and non-speculative field of operations with stable earnings. The benefit of trading can be obtained better by companies which have an established business with stable earnings.
The sales of the company are growing and to support this, the company wants to raise additional funds by borrowing Rs. 15 lakh from banks. Calculate the change in interest coverage rate after the additional borrowing. (i) Rate of interest is fixed and it must be paid whether the company makes profit or loss. The capital structure should not be rigid but dynamic enough to be adapted to the changing needs of the company. It should permit the company to raise further finance for expansion, modernisation, etc. easily and economically.
Equity shares appeal most to those who can, and would like to, take risks for higher incomes. The nominal value of the shares should also be adjusted so as to secure subscription from the middle-class sections of the society. The principal invested in it must be sure, it must yield a fairly good return and provide stable income. In addition, it must command a ready market and value as collateral, should be of an acceptable denomination and duration, and should enjoy potential appreciation. Therefore, the amount to be borrowed must not be more than a figure on which the interest will add up to Rs.20,000. If the rate of interest is 10% the amount of the borrowed funds should not exceed Rs.2,00,000, for if they exceed this figure the interest will exceed Rs.20,000.
The first stage begins with the introduction of debt in the firm’s capitalisation. As a consequence of the use of low cost debt, the firm’s net income tends to rise. Cost of equity capital (Ke) rises with the additional dose of debt but the rate of increase will be less than the rise in net earnings rate. In the first phase, the overall cost of capital declines with financial leverage because the rise in cost of equity does not entirely offset the benefit incurred by using the cheaper fixed cost debt. The response of capitalisation costs to financial leverage can be divided into three phases.
The traditional approach stands between the net income approach and the net operating income approach. Therefore, the traditional approach is also called the intermediate approach. The second viewpoint states that the optimal capital structure will not have any bearing on the value of the firm and the market value of the firm remains the same for any combination of capital ratio.
The determination of the degree of liquidity of a firm is no simple task. In the long run, liquidity may depend on the profitability of a firm; but whether it survives to achieve long-run profitability depends to some extent on its capital structure. This term includes only long-term debt and total stockholders’ investment. The financial structure of a firm comprises of the various ways and means of raising funds. In other words, financial structure includes all long-term and short-term liabilities.
The overall cost of capital begins to rise because the rise in cost of equity is more the benefits of cheaper debt. Thus, a finance manager in his endeavour to maximise his owners’ welfare would, in the first instance, select the best pattern of capitalisation with greater amount of skill and prudence. Any error in this respect may jeopardize financial stability of the firm and land it in grave financial crisis. The business risk is independent of capital structure and financial risks. On the other hand modern experts of finance believe that no such optimum capital structure exists.
When capital structure is composed of more than one source or identical nature, the same is known as Complex Capital Structure. Developed in the 1950s, the theory has had a significant impact on corporate finance. The ratings provided by reputable credit agencies also help shed light on the capital structure of a firm. Not only is too much debt a cause for concern, too little debt can be as well.
The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula, however, has implications assumptions of capital structure for the difference with the WACC. The use of fixed interest bearing securities along with owner’s equity as sources of finance is known as trading on equity.
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