Paul I. Louangrath
Appendix 1: ASEAN Corporate Governance Scorecard Items – Part D. The Disclosure and Transparency
1. OVERVIEW OF CAPITAL STRUCTURE & CORPORATE FINANCE Meaning of relevant technical terms
Financial Structure: It is the relative proportion of various sources of funds used in a business.
Capital Structure: Capital structure is a part of financial structure and is the mix of different categories of financial capital that a corporation, partnership, or other economic entity raises as long-term capital and utilizes to conduct its operations. It is the way a corporation finances its assets through some combination of equity, debt or hybrid securities.
In other words, a firm's capital structure is the composition or structure of its liabilities. It is the permanent financing of a firm represented by long-term debt, preferred stock (preference share capital) and net worth (shareholders’ funds) and excludes short-term borrowings.
Various Definitions of Capital Structure:
The quantitative composition or make up of a firm's capitalization, including all long term capital resources, like loans, reserves, shares and bonds (Gerestenberg).
Balancing the array of fund sources in a proper manner, i.e. in relative magnitude or in proportions (Keown et al)
Essentially concerned with how a firm decides to divide its cash flows into two broad components, a fixed component earmarked to meet the obligations toward debt capital and a residual component belonging to equity shareholders (P.Chandra)
Patterns of Capital Structure: A complex capital structure pattern of an established firm may be of following forms: 1. Equity Shares and Debentures, 2. Equity Shares and Preference Shares, and 3. Equity Shares, Preference Shares and Debentures. However, irrespective of the pattern of the capital structure, a firm must try to maximize the earnings per share for the equity shareholders and also the value of the firm.
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Value of a Firm: The sum of market values of outstanding debts and equity of a firm.
Leverage/Gearing: It represents the proportion of a firm's capital that is obtained through debt (either bank loans or bonds).
Perfect Capital Market: It is a capital market characterized by no transaction or bankruptcy costs, perfect information, same interest rate for firms and individuals, no corporate income taxes, and investment returns not affected by financial uncertainties. As can be expected, it is an imaginary, non-existent or theoretical market.
Real World Capital Market: A real world capital market has all the imperfections and is devoid of all the characteristics of a perfect market. The assumptions made for a perfect market have to be relaxed and modified in the form of various theories and hypotheses to address the imperfections of the real market.
Corporate Finance: It is the area of finance dealing with the sources of funding and the capital structure of corporations and the actions that managers take to increase the value of the firm to the shareholders, as well as the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.
Capital structure decisions
Capital structure decision is a decision about the proportion among the different kinds of securities raised by an enterprise as long-term finance and involves: A.) Type of securities to be issued: equity shares, preference shares and long term borrowings (Debentures) and B.) Relative ratio of securities determined by the process of capital gearing. On this basis, companies are divided into two: 1. Highly Geared Companies, with a small proportion of equity capitalization, and 2. Low Geared Companies, with equity capital dominating total capitalization. Such decisions can affect the value of a firm either by changing the expected earnings or the cost of capital or both. An optimum capital structure would be obtained at that combination of debt and equity that maximizes the total value of the firm (value of shares plus value of debt) or minimizes the weighted average cost of capital. Getting the capital structure designed in the most optimal way can mean the difference between success and failure of a business entity. Such decisions relating to financing the assets of a firm are very crucial in every business and the finance manager is often caught in the dilemma of what the optimum proportion of debt and equity should be. As a general rule there should be a proper mix of debt and equity capital in financing the firm’s assets. Capital structure is usually designed to serve the interest of the equity shareholders.
Properly Designed Capital structure & its Importance
To remain debt-free may be the goal of life in the lower echelons of finance, but in the higher echelons that idea is almost anathema. Many of the most successful companies in the world base their capital structure on one simple consideration, the cost of capital. The proportion of debt in the capital structure depends on the security of revenue generation of the business. Great managers attempt at consistently lowering the weighted average cost of capital of their business by increasing productivity, seeking out higher return products, and other means. To truly understand the idea of capital structure, it is important to understand that the capital structure represents one of the three components in determining the rate of
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return a company will earn on the money its owners have invested in it. The main objectives of capital structure decision are:
A.) Value Maximization: Market value of the firm is maximized.
B.) Cost Minimization: A proper mix of fund sources minimizes the overall cost of capital.
C.) Increase in Share Price: Increase in 'earnings per share' (E.P.S.) and in shareholders' dividend.
D.) Investment Opportunity: Company's ability to find new wealth creating opportunities &
increase in debtor's confidence.
E.) Growth of the Country: Increase in company's wealth creation leads to country's growth.
Sources of Capital:
Broadly speaking, there are two forms of capital: equity capital and debt capital, each with its own benefits and drawbacks. A substantial part of wise corporate management is in attempting to find the perfect capital structure mix in terms of risk / reward payoff for shareholders.
1. Equity Capital: Corporations can sell shares of the company to investors to raise capital.
Investors buy shares expecting to make their investment to be a profitable purchase. It consists of two types: A) contributed capital, the money originally invested in the business in exchange for shares of stock or ownership, and B) retained earnings, the profits from past years kept by the company to strengthen the balance sheet, fund growth, acquisitions, or expansion. Shareholder value and market value of stock is increased when corporations invest equity capital and other funds into projects that earn a positive rate of return in the future. It may also be increased when corporations payout excess cash from retained earnings that are not needed for business in the form of dividends. Equity capital is considered by many to be the most expensive type of capital a company can utilize, because its "cost" is the return the firm must earn to attract investment.
2. Debt Capital or Credit: It refers to borrowed money that is at work in the business. It comes in several forms, like bank loans, notes payable and bonds issued to the public. The safest type is generally considered long-term bonds, because the company has years, if not decades, to come up with the principal, while paying interest only in the meantime. Other types include short-term commercial paper utilized by giant companies from the capital markets to meet day-to-day working capital requirements such as payroll and utility bills. Its cost in the capital structure depends on the health of the company's balance sheet. A highly rated firm is able to borrow at extremely low rates, compared to a speculative company with tons of debt, which may have to pay high rates of interest in exchange for debt capital.
3. Hybrid Securities: They are a broad group of securities that combine the elements of the two broader groups of securities, debt and equity. They pay a predictable (fixed or floating) rate of return or dividend until a certain date, when the holder has a number of options like converting the securities into the underlying share. A hybrid security is structured differently and while the price of some securities behave more like fixed interest securities, others behave more like the underlying shares into which they convert. Unlike equity, the holder has a 'known' cash flow and unlike debt, there is an option to convert to the underlying equity.
Common examples are: 1. Preference Shares (or preference stocks) : convertible and converting, 2. Convertible/Exchangeable Debentures or Bonds, 3. Debt with Attached Warrants and 4. Basket D Security.
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4. Other Forms of Capital: Vendor financing is an example. A company can sell goods before they have to pay the bill to the vendor. The cost of such other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.
Determinants of Capital Structure:
1. Trading on Equity: If the rate of dividend on preference capital and the rate of interest on borrowed capital are lower than the general rate of company’s earnings, a company should go for a judicious blend of preference shares, equity shares and debentures. It also becomes more important when expectations of shareholders are high.
2. Degree of Control: If the company's management policy favours retaining voting rights, a capital structure with debenture holders and loans rather than equity shares, is preferred.
3. Flexibility of Finance Plan: Issue of debentures and other loans, rather than equity shares, renders the capital structure flexible.
4. Choice of Investors: Bold and adventurous investors generally go for equity shares and loans and cautious investors prefer debentures. A company's capital structure should give enough choice to all kind of investors to invest.
5. Capital Market Condition: The market price of a company's shares has got an important influence on capital structure. During the depression period, the capital structure generally consists of debentures and loans, while in period of boom and inflation, the capital consists of share capital, generally equity shares.
6. Period of Financing: To raise finance for a short period, a company goes for loans from banks and other institutions, while for long periods, it goes for issue of shares and debentures.
7. Cost of Financing: At the time of profit earning debentures prove to be a cheaper source of finance compared to equity shares, as equity shareholders demand an extra share in profits.
8. Stability of Sales: A mature company with high sales and profits and better positioned to meet its fixed commitments, like interest on debentures and dividends on preference shares, from its internal revenues doesn't need external sources of funds. For a growing company with unstable revenues and not in a position to meet fixed obligations, equity capital source is a safer bet than going for a high debt load.
9. Size of a Company: The bigger the size of a company, the wider is its total capitalization.
Small firms generally depend on loans from banks and retained profits, whereas big companies with goodwill, stability and an established profit, can easily go for issuance of shares and debentures as well as loans and borrowings from financial institutions.
10. Management Style: A conservative management is less inclined to use debt to increase profits, whereas an aggressive one may use significant amounts of debt to ramp up the growth of the company's earnings per share.
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Important Factors Affecting the Choice of Capital Structure
Under the capital structure decision the proportion of long-term sources of capital is determined. Most favourable proportion, wherein earnings per share (E.P.S.) happens to be the maximum, determines the optimum capital structure. Some of the chief factors affecting the choice of the capital structure are the following:
(1) Cash Flow Position: While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good, because a lot of cash is needed in order to make payment of interest and refund of principal.
(2) Interest Coverage Ratio (I.C.R.): With the help of this ratio an effort is made to find out how many times the earnings before interests and taxes (E.B.I.T.) is available to the payment of interest. The capacity of a company to use debt capital will be in direct proportion to this ratio. It is possible that, in spite of a better ICR, the cash flow position of the company may be weak. Therefore, this ratio is not an appropriate measure of the capacity of a company to pay interest. It is equally important to take into consideration the cash flow position.
(3) Debt Service Coverage Ratio (D.S.C.R.): This ratio removes the weakness of ICR, as it shows the cash flow position of the company, the cash payments to be made, like preference dividend, interest & debt capital repayment, and the amount of cash available. A better ratio means the better capacity of the company for debt payment and utilization of more debt in the capital structure.
(4) Return on Investment (R.O.I.): The greater the ROI, greater is the company's capacity to utilize more debt capital.
(5) Cost of Debt: The capacity of a company to take debt depends on the cost of debt.
If the rate of interest on the debt capital is less, more debt capital can be utilized and vice versa.
(6) Tax Rate: The rate of tax affects the cost of debt. If it is high, the cost of debt decreases, as the deduction of interest on the debt capital from the profits by considering it a part of expenses effects a saving in taxes.
(7) Equity Capital: The cost of equity capital, which means the expectations of the equity shareholders from the company, affects the use of debt capital. The greater use of debt capital increases the cost of equity capital and the risk of the equity shareholders. This limits the use of the debt capital and if debt capital is used beyond this limit, the cost of equity capital increases rapidly adversely affecting the market value of the shares, which is not a good situation.
(8) Floatation Costs: These are the expenses incurred while issuing securities, like equity shares, preference shares and debentures and include commission of underwriters, brokerage and stationery expenses. The lesser cost of issuing debt capital than the share capital attracts companies towards debt capital.
(9) Risk Consideration: There are two types of risks in business: A.) Operating/Business Risk, which is the risk of inability to discharge permanent operating costs, like rent of the building, payment of salary and insurance installment, and B.) Financial
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Risk, which is the risk of inability to pay fixed financial payments, like payment of interest, preference dividend and return of the debt capital as promised by the company. The total risk depends on both types of risk. If the operating risk is less, the financial risk can be faced and more debt capital can be utilized. On the contrary, if the operating risk is high, the financial risk from the greater use of debt capital is better avoided.
(10) Flexibility: Capital structure should be fairly flexible, i.e. amount of capital in the business could be increased or decreased easily as per needs. If at any given time a company has more capital than necessary, then both the debt capital or preference share capital can be repaid. But repayment of equity share capital is not possible during the company's lifetime. Thus, for flexibility, issue of debt capital and preference share capital is better.
(11) Control: At the time of preparing capital structure the control of the existing shareholders over the affairs of the company should not be adversely affected by raising funds from issue of equity shares. When funds are raised through debt capital, there is no such effect on control, because the debenture holders have no say over the affairs of the company.
(12) Regulatory Framework: Capital structure is also influenced by government regulations. For instance, banking companies can raise funds by issuing share capital alone, not any other kind of security. Similarly, it is compulsory for other companies to maintain a given debt-equity ratio while raising funds. Different ideal debt-equity ratios such as 2:1; 4:1;
6:1 have been determined for different industries. The public issue of shares and debentures has to be made under the Securities Exchange Board of India (SEBI) guidelines.
(13) Stock Market Conditions: Stock market conditions, like upward or downward trends in capital market, can influence the selection of sources of finance. When the market is dull, investors are mostly afraid of investing in the share capital due to high risk. When conditions in the capital market are cheerful, they treat investment in the share capital as the best choice to reap profits. Companies should, therefore, make selection of capital sources as per the conditions in the capital market.
(14) Capital Structure of Other Companies: Capital structure is influenced by the industry to which a company is related, as all companies in a given industry have a similar pattern of capital structure. Hence there are different D/E ratios prevalent in different industries. Hence, at the time of raising funds a company must take into consideration D/E ratio prevalent in the related industry.
2. THEORIES OF CAPITAL STRUCTURE