Financial Framework: Capital Structure, Cost of Capital & Profit Distributional Structure

Financial framework: capital structure, cost of capital, and profit distribution play a crucial role in effective financial management. These elements help businesses make informed decisions to optimize resources, ensure stability, and drive long-term growth. Understanding them is essential for sustainable financial success.

Capital Structure

Previous Year Questions

Year	Question	Marks
2023	Who propounded the theory of ‘Irrelevance of Capital Structure’ ? Write one keyassumption of the theory.	2M
2018	What is the Operating Cycle Concept of Working Capital ?	5M
2016	Differentiate between Net Income Theory and Net Operating Income Theory of CapitalStructure.	5M
2016	What do you understand by Net Working Capital ?	2M
2016	What is the ‘Capital Structure’ of a company ?	5M

• Capital Structure refers to the specific mix of debt(loan, bonds) and equity(equity share capital, retained earnings) that a company uses to finance its overall operations and growth.
• Owner’s capital- Equity share capital, preference share capital,  reserves, and surpluses or retained earnings
• Borrowed Capital- Loans, debentures, public deposits, etc. 

Evaluation of capital structure

• Debt-to-Equity Ratio (D/E Ratio)

Explanation: This ratio compares the company’s total debt to its total equity. A higher ratio indicates that the company is more leveraged, meaning it relies more on debt to finance its operations. This can increase financial risk but also potentially enhance returns on equity

• Leverage Ratio

Explanation: This ratio gives a broader view of a company’s leverage by considering both debt and equity in the context of total financing. It helps assess how much of the company’s capital is coming from debt.

Features of Capital Structure:

Debt

• Principal and interest are assured to bondholders. Bondholders face lesser risk as compared to equity holders that is why debt instruments cost less for an organization.
• Debt is cheaper but riskier for an organization due to the obligation to pay principal and interest. 
• That is why sometimes high financing through debt funding may drag an organization into a debt trap. 

Equity

•  In equity finance there is no surety of regular payment of dividends. It makes equity financing costlier for shareholders. 
• Equity financing is less risky for an organization as it is not mandatory to pay regular dividends.

Impact of Capital Structure

• Cost of Capital:
  • Debt vs. Equity– Debt is cheaper due to tax benefits, potentially lowering the overall cost of capital, but excessive debt can increase financial risk and raise the cost of equity.
• Financial Risk:
  • Leverage– More debt increases financial risk due to obligatory payments, raising the risk of financial distress or bankruptcy.
• Return on Equity (ROE):
  • Leverage Effect– Debt can enhance ROE when returns exceed the cost of debt but also amplify losses if returns fall short.
• Company Valuation:
  • Optimal Structure: A balanced capital structure maximizes company value by minimizing the cost of capital.
• Cash Flow Management:
  • Debt Obligations– High debt requires consistent cash outflows, limiting flexibility, while equity provides more financial freedom.
• Control and Ownership:
  • Debt- Allows retention of control but may impose restrictive covenants.
  • Equity– Dilutes ownership but avoids increasing financial risk.
• Stock Price Impact:
  • Investor Perception- A balanced capital structure can enhance investor confidence and stabilize stock prices.
• Tax Implications:
  • Tax Shield- Debt offers tax benefits through deductible interest, reducing overall tax liability.
• Financial Flexibility:
  • Equity- Offers more flexibility during downturns, while high debt limits future borrowing capacity.
• Growth Opportunities:
  • Debt- Can finance expansion but may limit future borrowing.
  • Equity- Supports growth without immediate repayment obligations.
• Credit Rating:
  • Debt Influence– Excessive debt can lead to credit downgrades, increasing borrowing costs.

Factors Affecting the Capital Structure

• Cash Flow Position– If high cash outflow then it is not easy to maintain further debt financing. It needs to maintain sufficient cash reserves to meet unexpected obligations.
• Interest Coverage Ratio (ICR)- This is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense during a given period. If it is higher (more than one at least) then no risk of failure of interest payment.
• Debt Service Coverage Ratio (DSCR) – Assesses the company’s ability to repay loans by comparing cash profits with total debt(principal + interest+Preferential share dividend) commitments. A higher DSCR indicates a stronger capacity to meet debt obligations.
• Return on Investment (RoI) – Indicates how efficiently a company generates profits from its assets. Higher RoI allows for greater use of debt to enhance earnings per share (EPS).
• Cost of Debt – Lower cost of debt increases the company’s ability to take on more debt.
• Tax Rate – Higher tax rates make debt more attractive due to the tax deductibility of interest and high tax on dividends. 
• Cost of Equity – As debt increases, equity risk rises, potentially raising the cost of equity and lowering share prices.
• Floatation Costs – Costs involved in raising capital, such as issuing shares or debentures, affect the choice between debt and equity.
• Other Factors – Stock market conditions, peer capital structures, and regulatory frameworks also play a role in determining capital structure.

Capital Structure Theories

Net Income (NI) Theory – By David Durand

• Proposed by David Durand, the Net Income Theory suggests that a firm can increase its value and decrease its cost of capital by using more debt financing.
• Since debt is cheaper than equity (due to tax benefits), increasing the debt-to-equity ratio lowers the overall cost of capital (Weighted Average Cost of Capital – WACC) and increases firm value.

Key Assumptions

• No corporate taxes
• Debt is always cheaper than equity
• Cost of debt remains constant
• Cost of equity does not increase with leverage

Implications

• Firms should maximize debt in their capital structure to maximize firm value.
• More debt = Lower cost of capital = Higher firm value

Criticism

• In reality, high debt increases financial risk, which raises the cost of equity, making this theory unrealistic.

Net Operating Income (NOI) Theory – By David Durand

• David Durand’s NOI Theory contradicts NI Theory and suggests that capital structure is irrelevant in determining a firm’s value.
• The cost of capital remains constant regardless of the debt-equity mix.

Key Assumptions

• The market assesses risk based on business income, not capital structure
• Debt is cheaper but increases financial risk, leading to higher cost of equity
• Overall WACC remains unchanged

Implications

• The firm cannot change its value by altering its capital structure.
• Capital structure does not matter; managers should focus on business operations rather than financing mix.

Criticism

• Ignores tax advantages of debt
• Assumes that debt risk is always perfectly offset by rising equity cost

Traditional Approach (Intermediate Theory)

• The Traditional Approach (or Intermediate Approach) combines elements of NI and NOI theories.
• Suggests that an optimal capital structure exists, where a balance between debt and equity minimizes WACC and maximizes firm value.

Phases of Capital Structure

1. Leveraging Effect (Favorable Stage)
   • Moderate debt lowers WACC, as debt is cheaper than equity.
2. Neutral Stage (Optimum Capital Structure)
   • A point where the advantage of debt is offset by the rising cost of equity.
3. Overleveraging Effect (Unfavorable Stage)
   • Too much debt increases financial risk, raising WACC and decreasing firm value.
4. Implications
   • Firms should use a moderate level of debt to maximize value without excessive financial risk.
5. Criticism
   • Lacks precise guidelines for determining the optimal capital structure.

Modigliani and Miller (M&M) Theorem

Proposition 1: Capital Structure Irrelevance (Without Taxes)

• In a perfect market, capital structure does not affect firm value.
• Whether a firm uses all debt, all equity, or a mix of both, the value remains the same.
• Assumptions: No taxes, no bankruptcy costs, perfect information, and no transaction costs.

Proposition 2: Cost of Equity Increases with Leverage

• As a firm increases debt, its equity becomes riskier, raising the cost of equity.
• The benefit of cheaper debt is offset by higher equity costs, keeping WACC constant.
• M&M Theorem with Taxes (Revised Model)
• When corporate taxes are introduced, debt financing reduces taxable income, increasing firm value.
• Firms should maximize debt to take full advantage of the tax shield on interest payments.

Implications

• Without taxes: Capital structure is irrelevant.
• With taxes: Firms should use more debt to increase value.

Criticism

• Real-world factors like bankruptcy costs and imperfect markets make excessive debt risky.

Pecking Order Theory – By Myers and Majluf

• Firms prefer internal financing (retained earnings) over debt and equity.
• If external financing is needed, firms prefer debt over equity because issuing new shares may signal that the company is overvalued.

Order of Financing Preference

1. Internal Funds (Retained Earnings)
2. Debt Financing (Loans, Bonds, etc.)
3. Equity Financing (Issuing New Shares)

Implications

• Profitable firms use less debt since they have retained earnings.
• High-growth firms rely more on debt because they exhaust internal funds quickly.

Criticism

• Ignores the potential benefits of equity financing.

Cost of Capital

• The cost of capital is the rate of return required by investors or creditors to provide capital to a business. It is the cost of obtaining funds, whether through equity or debt and includes the returns expected by shareholders and the interest expenses on debt. 
• Cost of debt is merely the interest rate paid by the company on its debt

Cost of Equity is the percentage return demanded by a company’s shareholders.

• Weightage Average Cost of Capital :The Firm’s overall cost of capital is based on the weighted average of the above-given costs.

Importance of cost of capital calculation

Capital Budgeting Decisions

• Companies use the cost of capital as a discount rate to evaluate investment projects.
• It helps in determining whether a project will generate returns higher than the cost of financing (debt and equity).

Optimal Capital Structure

• Cost of capital helps in determining the best mix of debt and equity for financing.
• A well-balanced capital structure minimizes the Weighted Average Cost of Capital (WACC) and maximizes the firm’s value.

Financial Performance Evaluation

• It acts as a benchmark to measure the performance of a company.
• If the company’s return on investment (ROI) is greater than its cost of capital, it indicates profitability.

Investment and Expansion Decisions

• Helps in deciding whether to invest in new projects, expansions, or acquisitions.
• Companies compare the expected return of a new investment with the cost of capital before making decisions.

Dividend Policy Decisions

• Helps companies decide how much profit to retain and how much to distribute as dividends.
• If a company has a high cost of capital, it may choose to retain earnings instead of paying dividends to finance future projects.

Distribution of Profit

Profit distribution is the process of allocating a company’s profits to various stakeholders, including shareholders, employees, and management.

• Single partner
  • According to profit-loss account
• Partnership
  • Preparation of profit-loss appropriation account
  • Modifications
    • Interest on Capital
    • Interest on Drawings
    • Commission to partners
    • Salary to partners
  • Distribution of profit according to shareholding.
• Company
  • Management decides dividend distribution according to dividend policy. 
  • Preferential shareholders get regular dividends. 

• Types of Dividends:
  • Cash Dividends: dividend amount is transferred to the shareholder’s account
  • Stock Dividends: Additional shares are issued to existing shareholders of the company.
  • Special Dividends: The company rewards its shareholders with a special reward, usually a one-time or unusually high dividend.

Financial Framework/ Financial Framework/ Financial Framework/ Financial Framework Financial Framework Financial Framework Financial Framework