Capital Structure

Financial risk is the possibility that a firm will fail to meet its fixed financial obligations — such as interest payments on debt and repayment of the principal — and thereby face insolvency or a fall in the earnings available to shareholders. It arises from the use of debt (fixed-charge bearing capital) in the capital structure.

Two features of optimal capital structure:

1. Maximum value of the firm — It is that mix of debt and equity at which the overall cost of capital is minimum and the value of the firm (or wealth of shareholders) is maximum.
2. Minimum weighted average cost of capital (WACC) — At the optimal point, the overall cost of capital is the lowest, since the benefit of cheaper debt is not yet offset by the rising cost of equity due to increased financial risk.

Any two of the following:

1. Cost of debt / interest rate — cheaper debt encourages more borrowing in the capital structure.
2. Tax rate — higher tax rate makes debt cheaper (interest is tax-deductible), favouring debt.
3. Business risk — a firm with high business risk uses less debt to avoid financial risk.
4. Control — issuing equity may dilute control, so owners may prefer debt.
5. Flexibility / financial leverage — the firm's ability to raise funds and its desired degree of leverage.
6. Growth and stability of sales — stable earnings support a higher debt proportion.

Financial structure is the composition of a firm's total capital, i.e. the mix of all long-term and short-term sources of funds such as equity shares, preference shares, debentures, bonds, and short-term liabilities. It represents the entire liabilities side of the balance sheet.

Using the approximation formula for cost of debentures:

$k_d = \frac{I(1-t) + \dfrac{F - NP}{n}}{\dfrac{F + NP}{2}}$

where $F$ = redemption (face) value = Rs 100, $I = 10\% \times 100 =$ Rs 10, $t = 25\%$, $n = 8$ years. Flotation cost = $4\% \times 100 =$ Rs 4. After-tax interest: $10(1-0.25) =$ Rs 7.5.

(a) Issued at 10% premium

Issue price = Rs 110, so net proceeds $NP = 110 - 4 =$ Rs 106.

$k_d = \frac{7.5 + \dfrac{100-106}{8}}{\dfrac{100+106}{2}} = \frac{7.5 - 0.75}{103} = \frac{6.75}{103} = 6.55\%$

(b) Issued at 10% discount

Issue price = Rs 90, so $NP = 90 - 4 =$ Rs 86.

$k_d = \frac{7.5 + \dfrac{100-86}{8}}{\dfrac{100+86}{2}} = \frac{7.5 + 1.75}{93} = \frac{9.25}{93} = 9.95\%$

The cost is higher when debentures are issued at a discount, because the firm receives less cash but still pays the same interest and repays Rs 100.