Capital Structure: Definition, Features, Determinants

Capital Structure Definition

• Refers to the mix of long-term debt, specific short-term debt, common equity, and preferred equity a company uses to fund operations and growth.
• Represents how a firm finances its operations and growth through different sources of funds.
• A well-planned structure balances debt and equity to minimize capital costs, maximize shareholder value, and manage risks from high debt levels.

Features of a Sound Capital Structure

• Profitability: It should be optimized to be most advantageous within given constraints, maximizing leverage at the lowest cost.
• Solvency: Excessive debt can threaten a company's solvency, so debt should be employed judiciously to maintain financial stability.
• Flexibility: It should be adaptable to changing conditions, allowing the company to adjust with minimal cost and delay and secure funds as needed.

Determinants of Capital Structure

• Leverage or Trading on Equity
• Cost of Capital
• Cash Flow
• Control
• Flexibility
• Size of the Company
• Marketability
• Floatation Costs

Leverage or Trading on Equity

• Involves using borrowed funds to increase the potential return on equity.
• Utilizing debt can amplify returns but also increases financial risk.
• Proper leverage can enhance shareholder value, however excessive debt can lead to financial instability.

Cost of Capital

• The cost of capital is the return expected by those who provide funds to the company.
• A balanced structure minimizes the overall cost by blending debt, which has a lower cost due to tax deductibility, and equity, which is usually more expensive.

Cash Flow

• The ability to generate consistent and sufficient cash flow is crucial in determining its structure.
• Strong cash flow supports higher levels of debt because the company can meet its interest obligations without stress.
• Companies with volatile or weak cash flows might rely more on equity to avoid the risk of insolvency.

Control

• Issuing new equity can dilute the ownership and control of existing shareholders.
• Companies might prefer debt to maintain control.
• The impact on control is a significant consideration when deciding between financing options.

Flexibility

• A flexible structure allows a company to adapt to changing market conditions and take advantage of new opportunities with minimal cost and delay.
• It should enable the company to raise funds quickly if necessary and restructure its financing efficiently.

Size of the Company

• Larger companies typically have better access to capital markets.
• Larger companies can secure debt more easily and at lower costs than smaller companies.
• The size of the company influences its ability to raise capital through both debt and equity.

Marketability

• The ease with which securities can be bought and sold in the market affects capital structure decisions. Companies prefer to issue securities that are marketable and attractive to investors.
• The liquidity of these securities can influence the choice between debt and equity.

Floatation Costs

• These are the costs associated with issuing new securities, including underwriting fees, legal fees, and registration fees.
• High floatation costs can deter companies from issuing new equity, making debt a more attractive option.
• Minimizing these costs is an important consideration in capital structure planning.

Objectives of Capital Structure

• Reduce cost of capital
• Minimize risk
• Maximize returns
• Control over organization

Key Factors

• Capital structure is the mix of debt and equity a company uses to finance its operations and growth.
• It's a key factor in determining a company's financial health and risk profile.
• Debt: Money borrowed from lenders like banks or bondholders that must be repaid with interest.
• Equity: Represents ownership in the company, including funds raised by issuing stock to investors and the company's retained earnings.
• Capital structure balance: The ideal balance between debt and equity minimizes the cost of financing while maximizing the company's value.
• Capital structure importance: It is a critical aspect of financial decision-making because it affects a company's cost of capital, profitability, and ability to withstand financial challenges.
• Capital structure types: A hybrid structure is a balanced mix of equity and debt that allows a company to take advantage of the benefits of each type of financing.

Cost of Debt and Equity

• In capital structure, kd and ke refer to the cost of debt and cost of equity, respectively.
• Cost of debt (kd): The minimum yield that debt holders require to provide debt capital to a borrower - Usually lower than the cost of equity because interest payments are tax-deductible.
• Cost of equity (ke): The minimum rate of return that common equity investors require - Usually higher than the cost of debt because dividends paid to shareholders are not tax-deductible.
• The cost of debt and cost of equity are used to calculate a company's weighted average cost of capital (WACC). The WACC equation is: WACC (Ko) = Kd×(1-T)×D% + Ke×E%
• Kd: Cost of debt before taxes
• T: Tax rate
• D%: Percentage of debt on total value
• Ke: Cost of equity
• E%: Percentage of equity on total value.
• The values for debt and equity can be calculated using either market value or book value.

Cost of Equity vs. Cost of Debt

• The cost of equity is typically higher than the cost of debt.
• Equity is riskier than debt because shareholders are more at risk than lenders, because lenders are legally entitled to be paid back regardless of a company's profits, while shareholders are not.
• Equity shares are harder to sell, don't offer a fixed dividend rate, and are generally less valuable than debentures.
• Tax benefits exist because interest paid on debt is tax-deductible, reducing the pre-tax income of a company which is known as the "interest tax shield."

Theories of Capital Structure

• Explore the various ways in which a firm can finance its operations and growth through different combinations of debt and equity.
• Provide insights into how firms can optimize their capital structure to minimize the cost of capital and maximize shareholder value.
• Net Income Theory
• Net Operating Income Theory
• Traditional Approach
• Modigliani-Miller Theory
• Pecking Order Theory

Net Income Theory (David Durand)

• The capital structure of a firm is relevant and that a firm can enhance its value and minimize its overall cost of capital by incorporating debt into its capital structure.
• The greater the proportion of debt capital employed, the lower the overall cost of capital and the higher the value of the firm.

Net Income Theory (Assumptions)

• Lower Cost of Debt: The cost of debt is assumed to be less than the cost of equity.
• Constant Risk Perception: The risk perception of investors is not influenced by the use of debt, meaning that the equity capitalization rate (ke) and the debt capitalization rate (kd) remain unchanged with leverage.
• Absence of Corporate Taxes: The theory assumes there are no corporate taxes affecting the cost of debt or equity.
• Under these assumptions, since debt is cheaper than equity and their costs remain constant regardless of leverage, using more debt capital reduces the overall cost of capital increases the firm's value by taking advantage of the lower cost of debt financing. V=S+D, V = Value of the firm, D = Market Value of Debt, S = Market Value of equity = NI / Ke, NI = Earning available to equity shareholders, Ke = Equity capitalization rate, Ko = Overall Cost of Capital = EBIT / V.

Net Operating Income Theory (NOI) (David Durand)

• The capital structure of a firm is irrelevant to its value and cost of capital.
• The way a firm finances itself through debt and equity does not influence its overall cost of capital or its value.
• V = EBIT / Ko
• Ko is the overall cost of capital and depends on the business risk of the firm.
• Is not affected by financing mix.

NOI Assumptions

• Firm Value Capitalization: The market capitalizes the value of the firm as a whole, making the debt-equity split unimportant.
• Constant Business Risk: The business risk remains constant regardless of the debt-equity mix.
• No Corporate Taxes: The approach assumes there are no corporate taxes.
• Constant Debt Capitalization Rate: The debt capitalization rate (Kd) remains constant.
• Using less costly debt capital initially appears advantageous.
• Increases the risk to equity shareholders.
• This heightened risk causes the equity capitalization rate (Ke) to rise.
• The low-cost advantage of debt is precisely offset by the increase in the equity capitalization rate.
• The overall capitalization rate (Ko) remains constant.
• The value of the firm does not change, regardless of its capital structure.

Traditional Theory (Ezra Solomon)

• Known as the intermediate approach.
• A compromise between the Net Income Approach and the Net Operating Income Approach.
• The cost of capital can be minimized, and the value of the firm can be maximized, through a judicious mix of debt and equity.
• The cost of capital decreases with an increase in debt up to a reasonable level but rises beyond that point.

Traditional Theory

• Stage I: The cost of equity (Ke) and the cost of debt (Kd) remain constant, with the cost of debt being lower than the cost of equity; employing debt capital up to a reasonable level will cause the overall cost of capital to decline due to the lower cost of debt.
• Stage II: After reaching a reasonable level of leverage, any further increase in debt will not affect the value of the firm or the cost of capital; The increased risk to equity shareholders causes equity capitalization rate (Ke) to rise, offsetting the low-cost advantage of debt, the overall cost of capital remains constant.
• Stage III: The firm continues to increase debt capital beyond the reasonable level, it will heighten the risk to both equity shareholders and debt holders, increases both the cost of equity and the cost of debt to rise, leading to an overall increase in the cost of capital.
• Keypoint is that the cost of capital declines and the value of the firm increases with the rise in debt capital up to a certain reasonable level; if debt capital is increased beyond this level, the overall cost of capital (Ko) starts to rise, leading to a decline in the value of the firm.

Modigliani - Miller (MM) Hypothesis - Without Taxes

• The Net Operating Income approach aligns with this.
• Franco Modigliani and Merton Miller argued that, in the absence of taxes, the cost of capital and the value of a firm are unaffected by changes in its capital structure.
• Capital structure decisions are irrelevant, and the value of the firm is independent of the debt-equity mix.

Basic Propositions: MM Hypothesis

• Proposition I: The overall cost of capital (Ko) and the value of the firm are independent of the capital structure, the total market value of the firm is determined by capitalizing the expected net operating income at a rate appropriate for the risk class of the firm.
• Proposition II: Financial risk increases with a higher debt content in the structure; the cost of equity increases in a manner that exactly offsets the low-cost advantage of debt; the overall cost of capital remains unchanged.
• Perfect Capital Market: Investors are free to buy and sell securities without restrictions - Investors can borrow funds on the same terms as firms - Investors behave rationally and make decisions based on available information - There are no transaction costs.
• Homogeneous Risk Classes: Firms in risk classes have the same level of financial risk.
• Uniform Expectations: Investors have the same expectations regarding a firm's net operating income (EBIT).
• Dividend Payout Ratio: 100%, meaning all earnings are distributed as dividends with no retained earnings.
• No Corporate Taxes: Was later modified. V = S + D = NOI / Ko
• V= the market value of the firm, S = the market value of equity, D = the market value of debt, NOI = the expected net operating income (EBIT), Ko = the capitalisation rate appropriate to the risk class of the firm.
• If firms have different market values, arbitrage will occur. Arbitrage involves switching investments from one firm to another. Investors will sell securities in the higher-valued firm and buy securities in the lower-valued firm, taking advantage of the price disparity.
• The market price of securities in the higher-valued firm will decrease, while the market price of securities in the lower-valued firm will increase.
• M-M argue that because of this process, it is impossible for identical firms to have different market values.
• Leverage has neither an inherent advantage nor disadvantage.
• MM demonstrate that the value of a firm is not affected by its debt-equity mix asserts that capital structure is irrelevant to the firm's market value under ideal market conditions

Cost Of Equity

• Is equal to the constant average cost of capital (Ko) plus a premium for financial risk.
• This premium is determined by the debt-equity ratio multiplied by the spread between the average cost of.
• Capital and the cost of debt (Kd). Ke = Ko + (Ko - Kd) D/S, D/S = debt - equity ratio; Ke = cost of equity

Modigliani - Miller (MM) Hypothesis - With Corporate Taxes

• Recognise the importance of the existence of corporate taxes.
• The value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges.
• The optimum capital structure can be achieved by maximising debt component in the capital structure. Value of Levered Firm (Vl) = Vu + Dt; Value of Unlevered Firm (Vu) = (EBIT / Ko) (1-t); EBIT = Earnings before interest and taxes, Ko = Overall cost of capital, D = Value of debt capital, t = Tax rate

Pecking Order Theory

• Companies prefer to use internal funds (retained earnings) first for new projects, as there are no issuance costs.
• When internal funds are insufficient, firms opt for debt over equity due to the lower risk, lower cost, and the advantage of not diluting ownership.
• Issuing new equity is considered a last resort because it can be more expensive and may send negative signals to the market, potentially leading to a decline in stock price.
• The rationale behind this preference order is rooted in asymmetric information, where managers have more knowledge about the firm's prospects than external investors.
• Making external financing costlier.
• Internal financing avoids transaction costs, and debt financing allows existing owners to retain control.
• Highly profitable firms highly likely to have lower debt levels due to sufficient internal funds, influencing their structure.