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Optimization of Capital Structure: An Important Financial Decision

Ruchi Gandhi

| Updated: May 19, 2020 | Category: CFO Service, Finance & Accounting

Capital structure

What do Capital structure decisions deal with?

Capital structure refers to the combination of capital funds obtained by an enterprise from different sources of finance. It is comprised of equity shareholders’ funds, preference share capital, and long-term external debts. Capital structure decisions entail decisions regarding the source and quantum of capital required in a business keeping in mind factors such as control (existing shareholders to hold majority stake), level of financial risk (not beyond the tolerable limit), and cost of capital (to be minimum). Capital structure decisions need to be designed by finance managers with utter care and caution.

In brief, capital structure decisions deal with the following:

  • Deciding the different forms of financing (which sources to be tapped)
  • Their actual fund requirements (amounts to be procured or funded)
  • Their relative proportions (mix) in total capitalization, i.e., the relative weight of debt and equity

The prime objective while deciding about the optimal capital structure of a firm is to maximize the value of the company.

Choice of the source of funds

The business firm, while raising funds for financing its investment proposals, has to make a choice from amongst different sources in different proportions. These can be the following:

  • Exclusive use of debt
  • Exclusive use of equity share capital
  • Exclusive use of preference share capital
  • Use of a combination of debt and equity in different proportions of capital structure mix
  • Use of a combination of debt, equity and preference share capital in different proportions
  • Use of a combination of debt and preference share capital in different proportions

The financing pattern that a firm should choose, while designing its capital structure, is majorly affected by the factors such as nature of the industry, the timing of the fresh issue, competition in the industry, the flexibility of management to sources of financing, degree of financial risk, dilution in existing management control and ownership, growth and stability of sales, etc.

Optimizing capital structure decisions

The objective of financial management is to maximize wealth and, therefore, one should choose a capital structure that maximizes wealth for the company’s stakeholders as a whole. The main objective of financial management is to devise an appropriate capital structure that can provide the highest earnings per share (EPS) over the company’s expected range of earnings before interest and taxes (EBIT). For the analysis of capital structure decisions of an entity, the following techniques may be used:

1. EBIT-EPS-MPS Analysis:

The EBIT-EPS-MPS analysis holds significant importance and, if executed properly, can prove to be an effective tool in the hands of a financial manager to get an insight into the planning and designing of the capital structure of the firm.

Designing an appropriate capital structure is concerned with choosing a capital structure that can provide the highest wealth, i.e., the highest MPS. This, in turn, is dependent upon EPS.

For a particular level of EBIT, the EPS will be different under different financing mix depending upon the extent of debt financing. The effect of financial leverage on the EPS arises due to the existence of fixed financial charges represented by the interest on the debt and fixed dividend on preference share capital. Further, the effect of financial leverage on the EPS is directly dependent upon the relationship between the rate of return on assets and the rate of fixed financial charge.

If the rate of return on assets is greater than the rate of fixed financial charge/ cost of financing, then the increasing use of debt and preference share capital is likely to result in a favourable increase in the EPS. On the flip side, if the rate of return on assets is lower than the rate of fixed financial charge/ cost of financing, then the increasing use of debt and preference share capital is likely to result in an unfavourable decline in the EPS.

The analysis of the different types of capital structure and the impact of financial leverage on the expected EPS and, eventually, MPS provides a useful guide to the selection of a particular level of debt financing.

Let us apprehend this with the help of an example:

Suppose a business entity has an all-equity capital structure consisting of 200,000 equity shares of Rs. 10 each. It wants to raise Rs. 500,000 to finance its future investments and contemplates three alternative forms of financing. These are (i) to issue 50,000 ordinary equity shares at Rs. 10 each, (ii) to borrow Rs. 500,000 at 8 percent rate of interest, and (iii) to issue 5,000 preference shares of Rs. 100 each at an 8 percent rate of dividend. Here, if the firm’s earnings before interest and taxes (EBIT) after additional investment are Rs. 625,000 and the tax rate is 50 percent, then the impact on the earnings per share (EPS) under the three financing alternatives shall be as follows:

EBIT-EPS-MPS Analysis

The earnings per share (EPS) is maximized when the firm resorts to debt financing. The market price per share is equal to earning per share multiplied by price earning (PE) ratio. If the PE ratio is the same for all three plans, then the plan, which has the highest EPS, will also have the highest MPS, and the finance manager will select that. However, this is true only when the rate of return on assets is greater than the rate of fixed financial charge/ cost of financing. Here, the increasing use of debt and preference share capital is likely to result in a favourable increase in the EPS. Conversely, if the rate of return on assets is lower than the rate of fixed financial charge/ cost of financing, then the increasing use of debt and preference share capital is likely to have an adverse impact on the EPS. Suppose if, in the above example, the firm had an EBIT of Rs. 150,000, then the EPS would have been 0.30, 0.275, and 0.175 for equity financing, debt financing, and preference financing, respectively. Thus, when the rate of return on the total assets is less than the cost of debt, the earnings per share will fall with the degree of leverage (DOL).

2. Financial Break-even Point Analysis:

A financial break-even point is referred to as the minimum level of EBIT, which is needed to satisfy all the fixed financial charges, i.e., interest on debt and preference dividends. Thus, it signifies the level of EBIT for which the company’s EPS equals zero.

If the EBIT level is less than the financial break-even point, then the EPS will be negative, and the firm would not be in a situation to meet its fixed financial charges. On the other hand, if the expected level of EBIT is more than the financial break-even point, then more fixed costs financing instruments can be taken in the capital structure. Otherwise, equity would be preferred. This EBIT-EPS financial break-even analysis is useful for determining the appropriate amount of debt a company might carry in its capital structure.

3. Indifference Point Analysis:

Indifference Point Analysis

Another method to compare different financing options is through indifference point analysis. Financial analysts use this method to consider the impact of various financing alternatives on earnings per share. This point is a helpful guide in formulating the capital structure. This is known as EPS equivalency point or indifference point since this shows that, between the two given alternatives of financing (i.e., regardless of the level of financial debt in the financial plans), EPS would be the same at the given level of EBIT.

What is over-capitalization?

A business firm is over-capitalized when it has more capital than what it needs. In other words, assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest expenses. Over capitalization arises when the present capital of the company is not effectively utilized on account of fall in the firm’s earning capacity while the company has raised funds more than its requirements. A decline in payment of dividends and interest, thereby leading to a decline in the value of the company’s shares, is a major sign of over-capitalization.

Some of its causes, consequences, and remedies are as mentioned below:

Causes of over-capitalization:

  • Raising more money through issue of shares/debentures than what can be employed profitably
  • Borrowing at a higher rate than the company’s earning rate
  • Excessive payment for the acquisition or purchase of fictitious assets
  • Improper provision for asset depreciation and replacement of assets

Consequences:

  • Reduction in the rate of dividend payments and interest payments
  • Reduction in the market price of shares
  • Window dressing
  • Opting for re-organization and sometimes resulting in liquidation

Remedies for over-capitalization:

  • Go for thorough re-organization
  • Buyback of shares
  • Reduction in claims of debenture-holders and creditors
  • Value of shares may also be reduced to generate sufficient funds to carry out asset replacement

What is under capitalization?

Under-capitalization is just the reverse of over-capitalization. It signifies a situation when the actual capitalization in a company is a lot lower than its proper capitalization as warranted by its earning capacity. It usually occurs in case of businesses that have insufficient capital but large secret reserves in the form of considerable appreciation in the values of the fixed assets not brought into the books.

Some of its causes, consequences, and remedies are as mentioned below:

Causes of under-capitalization:

  • Future capital requirements are under­estimated by the promoters
  • Building up of excess reserves
  • Appreciation of assets attributable to the conservative dividend policy adopted by the management
  • Employment of new techniques of production and rationalization of production activities leading to high standards of efficiency

Consequences:

  • The dividend rate will be higher in comparison to similarly situated companies
  • A rise in the market price of shares
  • A high rate of dividend encourages the workers’ union to demand high wages
  • Manipulation of share values

Remedies for under-capitalization:

  • Splitting up the shares of the company
  • Issue of Bonus Shares
  • By revising upward the par value of shares in exchange of the existing shares held by shareholders
  • Issue of more shares and debentures if under-capitalization is due to shortage of capital

Summary note

Neither over-capitalization nor under-capitalization is good for a company. However, the situation of over-capitalization is somewhat more concerning to the company, stakeholders, and society than under-capitalization. Comparatively, under-capitalization can be handled easily and is rather a problem of adjusting capital structure. Nevertheless, the company should strive to have proper capitalization and avoid both situations. The availability of funds should be neither too much nor too low, and the capital structure of the company should be fair.

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Ruchi Gandhi

A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.

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