What is meant by Capital Structure of Business | ApnaCourse

by | Jun 1, 2016 | Financial Management

 Manu Conversation Between  Vinu
 1  Manu and Vinu about
Capital structure of Business
 2
Manu Hi Vinu! Wats up?
Vinu Ya! I have and upgraded also!!!
Manu Vinu!!! I think this is the greatest joke of the year.
Vinu Come on Manu!
Accept small humour from my side also. Don’t be too rigid all the time.
Manu Ok! Ok! Accepted.
So, how things are moving at your end?
Vinu Fine Manu! Now I have a new challenge.
Manu What is that?
Vinu I have to advice capital structure for a subsidiary to be floated by our company.
Manu Is it? It is the beautiful part in financial structuring!
Vinu How do you say that?
Manu Yes! It is the beautiful part because it decides the future direction of any business entity.
Vinu Like?
Manu Like success/failure, Profit/Loss, Growth/ Sustainability, etc.
Vinu But how come capital structure decides all the above? I was under the impression  only  profit  making  capability  decides  Success/  failure/profit/loss, etc.
Manu Ok! Then I’ll put it like this. Capital Structure also decides factors like success/failure/profit/loss/growth/sustainability.
Vinu It makes Some sense! Can you elaborate with some numbers?
Manu Sure! As usual let us assume we want to start a new business.
Vinu Ok! I’ll invest Rs.100crs!
Manu No! This Time we shall start from assets!
Vinu Ok.
Manu You have to acquire assets worth Rs.100crs
Vinu That’s what ; said, I’ll invest Rs.100Crs.
Manu Let me complete!
Vinu Ok! Ok! Please proceed!
Manu You want to acquire assets worth Rs.100crs. But you don’t have resources for Rs.100 Crs. Meaning, you cannot bring all money
Vinu So?
Manu So, you have to make alternate arrangements for structuring capital now!
Vinu Ya!!! Here comes, capital structuring! So, you are trying to say, I have limited resources, but I have to take up project costing Rs.100crs.
Manu Yes! Let us say, now you can afford for only Rs.25crs.
Vinu It means, I have to arrange Rs.75 Crs. funds from outside?
Manu Yes! Can you tabulate this funding structure?
Vinu Yes!

Own funds 25.00 Assets 100.00
Outside funds 75.00
100.00 100.00
Manu Good! This table is nothing but your Projected Balance sheet where in you are showing source of funds and use of funds.
Vinu True!
Manu So now your business capital is structured as 25% of own funds and 75% of outsiders funds
Vinu Correct! Debt is 75 and Equity is 25.
Manu This gives debt-equity ratio of 75/25. i.e. 3:1
Vinu Correct Manu! But what is the significance of this capital structure?
Manu It has lots of significance. Your business is now funded 75% by Outsiders funds and only 25% by your own funds.
Vinu True!
Manu This has lots of plus and minus. Before going into that, let me ask you certain fundamental questions.
Vinu Please Manu!
Manu Why do you want to invest in business?
Vinu To earn return?
Manu How much?
Vinu Some 7% – 10%
Manu Then why are you investing in business. You can invest safely in Bank Fixed Deposits. It will give you that return without any risk
Vinu True!
Manu If you are investing in Business, you should be expecting more, right?
Vinu Yes! That’s correct.
Manu Now tell me, how much you should be expecting?
Vinu Somewhere between 20% – 25%?
Manu Ok!  That’s a reasonable expectation on the amount invested commensurate with risk taken!
Vinu Pardon me!
Manu What?
Vinu On the amount invested? I was mentioning return expected from sales!
Manu Come on Vinu! You are getting me wrong! I asked you, ‘’Return expected for amount invested in Business”. I didn’t ask you return on Sales. Both are different!
Vinu Ok! Ok! I got it!
Return on sales is  (Profit / Sales) x 100
Return on Investments is(Profit / Total Investments or Capital Employed) x 100
Ya! Both are different!
Former is expressed as % against sales and latter is expressed as % against capital employed or Investment. Is that right?
Manu Good! Return on Investment is the reward for any investor.
Vinu But what role capital structure has to play here?
Manu Yes! It has.  Let’s say you expect 25% return.
Vinu Ok!
Manu Now tell me, how will you get this 25%
Vinu Out of sales!
Manu How you will achieve sales?
Vinu By making use of assets and all facilities.
Manu So, you will be pushing all the assets to work for your objective to earn 25%, right?
Vinu Yes! My 100crs assets will be working for earning 25%
Manu Fine! You said your 100crs assets will be working for 25%
Vinu Yes! Because that is our objective and expectation.
Manu But, your major stake holder is not expecting that!
Vinu Who is that?
Manu Look at your Balance Sheet!

Own Funds 25cr
Outside funds 75cr Assets 100cr
100cr 100cr

75% of Your assets are funded by outsiders. Let’s say they are Bankers and they are expecting only 15%

Vinu It is not my fault. Let them expect 15% But I will expect all my assets to generate 25%
Manu Now you sound like a true business man.
Here comes the play. You expected your assets to generate return of 25%, right?
Vinu Ya! Correct.
Manu So, 25% on total assets is 100 x 25% = 25crs.
Vinu Ya! This is my profit generated using my assets.
Manu Is this profit available for you in totality?
Vinu How it can be? It is generated on total assets which is also funded by outsiders. I should give them their share of return right?
Manu Absolutely! I am amazed with your authority! So, What is the return payable to outsiders?
Vinu It is interest on the loan borrowed!
Manu Very much correct! So, this return of 25% on total assets is before interest or after interest?
Vinu Obviously, it is before interest.
Manu So, it can also be called as ????
Vinu Now I am getting it. It is EBIT. (Earnings Before Interest and Tax)
Manu Good! Can you calculate the interest amount?
Vinu Yes!

Total Outside funds 75 Cr
Rate of Interest 15%
Interest on Outside funds 11.25 Cr
Manu How much you have invested?
Vinu I have invested – Rs.25crs.
Manu What was your Expectation?
Vinu I was expecting 25% on Rs.25crs
25crs x 25% = 6.25cr
Manu Now see the Wonder!
You expected your business to earn 25%. If it earns 25%, return will be25cr of which 11.25 cr will be used for paying outside fund (Banker) as interest.
Vinu So, it will have balance of Rs.13.75cr.

EBIT 25.00
Less: Interest (75 x 15%) (11.25)
PBT 13.75

Am I Correct?

Manu Yes! But don’t forget the tax on your profits.
Vinu Ok! I’ll assume average tax of 30% on profit.
Manu In that case, your tax will be Rs.4.125 cr.

PBT 13.75
Less: Tax @ 30% (4.125)
Vinu And my Profit after tax will be

PBT 13.750
Less: Tax@30% (4.125)
PAT 9.625

Is it correct?

Manu Yes! Here comes the role of capital structuring!
You expected a return of 25% on your Rs.25crs. Investment which was only Rs.6.25 Crs.
You pushed your business to earn 25%. But your other Stake holders expected only 15%. So after paying them their interest and also after paying taxes, you have balance profit of Rs.9.625. Who is entitled to this profit?
Vinu Obviously, me!
Manu Can you tabulate your expectation and actuals?
Vinu Ya ! I’ll do that.

Particulars Expected Actual
Profit 6.25 Cr 9.625 Cr
Capital Employed 25 Crs 25 Crs
Return (%) 25% 38.50%

Wow! I have earned 38.50% against my expectation of 25% How did this happened?

 

Manu It happened because of your capital structure. You funded major portion of Assets with low cost funds. But pushed all the assets to earn returns as if funds are high cost. So your assets earned, 25% on all the assets where 75% of the assets deserved only 15%
Vinu Now I am getting it. Debt funded assets also earned 25% whereas cost of debt funds are only 15% So they gave me a bonus of 10% (25% – 15%)
Manu That’s true. Debt funded assets worked more for you and gave you handsome returns. Apart from saving you from major tax out flow as well.
Vinu What’s that? I couldn’t get it!
Manu I said debt funds are cheap at 15%. It is not mere 15%. It is even far below because of tax effect.
Vinu How that works?
Manu Imagine that entire Rs.25 crs was earned by you without debt funds. In that case, you won’t be paying interest right?
Vinu Yes!
Manu Please tabulate your profit (with and without debt) and Tax.
Vinu Ok!

Particulars With Debt (Rs. In Cr.) Without Debt (Rs. In Cr.)
EBIT 25.00 25.00
Less: Interest 11.25
PBT 13.75 25.00
Less: Tax @ 30% (4.125) (7.50)
Manu Now look at your Tax

Tax (without debt) 7.500
Tax (with debt) (4.125)
Vinu Ya! If I have debt, my tax is only Rs.4.125cr. whereas without debt, my tax is Rs.7.50 cr.
I would pay additional tax of Rs.3.375 cr, If I don’t have debt.
Manu Rather, put it in this way!
Debt fund will save your tax by Rs.3.375cr.
Vinu Correct!
Manu What was your interest cost?
Vinu Rs.11.25 cr.
Manu What is your savings in Income Tax?
Vinu Rs.3.375 cr.
Manu So, what is your effective interest cost?
Vinu I got it: My effective Interest Cost

Interest 11.25
Less: Tax Benefit (3.375)
Effective Interest 7.875
Manu Can you Express that in percentage?
Vinu Ya!

(7.875 / 75) x 100  =10.50%

Wow ! It is very cheap fund @ 10.50%

Manu Yes! Debt funds were earning 25% through assets but have taken only 10.50% for them and have given the balance to you.
Vinu Cho Chweet!!!
Manu Even though you were expecting only 25%, debt funds made you to receive more. It all happened because of your capital structure!
Vinu Ya! Understood the importance of capital structure! So do you mean to say we should have more debt fund?
Manu No!  I  never  said  that!  Your  capital  structure  should  depend  on circumstances!
Vinu Meaning?
Manu Everything depends on your ability to earn EBIT.
If you are in a position to earn good EBIT, then you can have debt funds.
Because, EBIT is not decided by your capital structure by your business efficacy, efficiency and environment.
Vinu I could understand!
EBIT is decided by my business whereas PBT & PAT is decided by Interest cost.
Manu True! If you have low EBIT or negative EBIT, debt will kill you.
Vinu Understood! EBIT less Int. gives PBT

EBIT XXX
Less: Interest (xxx)
PBT XXX

So, if my EBIT is low, I should try to reduce Interest cost otherwise, PBT will be low or will become negative and no returns will be available to me.

Manu You got that straight! If you have more EBIT, you can have more debt funds and vice versa to ensure returns for owners.
Vinu Ya! After all, at the end of the day, returns available for the owners is the crux in any business.  Thanks Manu! Now  I could appreciate the importance of capital structure!
Manu I am glad Vinu! Have a good day!
N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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