Capital Structure & Financing Decisions: Mix, Costs, Trade-offs & Real Cases

TAKEAWAYS:

• Capital structure is the mix of debt and equity a firm uses to finance its operations, balancing risk (debt) and control (equity) to minimize the weighted average cost of capital (WACC).
• Optimal capital structure occurs where the firm’s value is maximized (or WACC is minimized) by trading off tax shields from debt against bankruptcy costs—visualized via the Modigliani-Miller (MM) propositions and trade-off theory.
• Financing decisions (debt vs. equity) affect dividend policy, tax liabilities, and financial distress risk—e.g., Ncell’s 2023 bond issuance (₹10B) lowered its WACC by 1.5% but increased interest coverage ratio constraints.
• CAPM (Capital Asset Pricing Model) links a project’s cost of equity to its systematic risk (β), while WACC combines debt and equity costs to evaluate capital budgeting proposals (e.g., Gandaki Hydropower’s ₹50B dam expansion).
• Trade-offs in real world: Daraz uses short-term debt for inventory financing (low-cost, high-risk), while banks like NMB issue perpetual bonds (no maturity, stable funding).
• Exam focus: Define terms precisely, calculate WACC, analyze trade-offs, and justify financing choices using numerical examples (e.g., Sunrise Battery Company’s leverage impact on EPS).

1. What is Capital Structure?

Capital structure refers to the proportion of debt and equity used by a firm to finance its assets and operations. It answers:

• How much should we borrow (debt) vs. issue shares (equity)?
• What mix minimizes our cost of capital while managing risk?

Key Components of Capital Structure

classDiagram
    class CapitalStructure {
        +Debt: Liabilities (Bonds, Loans, Trade Payables)
        +Equity: Shareholders' Funds (Common Stock, Retained Earnings, Preferred Stock)
        +Hybrid: Convertible Debt, Preferred Shares
        +WACC: Weighted Average Cost of Capital (Debt Cost × Debt Weight + Equity Cost × Equity Weight)
        +Optimal Mix: Minimizes WACC → Maximizes Firm Value
    }
    CapitalStructure --> Debt : "Risk: High (Bankruptcy), Benefit: Tax Shield"
    CapitalStructure --> Equity : "Risk: Low (No Obligation), Beneft: Control"
    CapitalStructure --> Hybrid : "Flexibility: Convertible to Equity"

Why Does Capital Structure Matter?

• Cost Efficiency: Debt is cheaper than equity (interest tax-deductible), but too much debt increases bankruptcy risk.
• Value Creation: Optimal capital structure maximizes shareholder wealth by balancing these trade-offs.
• Market Signaling: How a firm finances itself (e.g., issuing equity vs. debt) signals confidence to investors.

2. Theories of Capital Structure

Three dominant theories explain how firms choose their capital structure:

WORKED EXAMPLE: Kathmandu Manufacturing Company (KMC) KMC is a textile firm with:

• Current Capital Structure: 40% debt (₹40M), 60% equity (₹60M).
• Tax Rate: 25%.
• Debt Cost (rd): 10% (interest rate).
• Equity Cost (re): 15% (from CAPM: re = rf + β(rm – rf) = 8% + 1.2(7%) = 15%).

Question: How does KMC’s WACC change if it increases debt to 60% (₹60M debt, ₹40M equity)?

Step 1: Calculate Current WACC

$$\text{WACC}=(E/V\times re)+(D/V\times rd\times (1-T))$$ Where:

• $E=₹60M$, $D=₹40M$, $V=E+D=₹100M$,
• $T=25\%$ (tax rate).

$${\text{WACC}}_{\text{current}}=(0.6\times 15\%)+(0.4\times 10\%\times 0.75)=9\%+3\%=12\%$$

Step 2: Calculate New WACC (60% Debt)

• New $D=₹60M$, $E=₹40M$, $V=₹100M$.
• Equity cost increases due to higher risk (β rises to 1.5): $r{e}_{\text{new}}=8\%+1.5(7\%)=18.5\%$.

$${\text{WACC}}_{\text{new}}=(0.4\times 18.5\%)+(0.6\times 10\%\times 0.75)=7.4\%+4.5\%=11.9\%$$

Conclusion: WACC decreases slightly (12% → 11.9%), but financial risk rises. KMC must weigh:

• Tax benefit: ₹6M/year saved (₹60M × 10% × 25%).
• Bankruptcy risk: Higher debt increases probability of default.

3. Factors Affecting Capital Structure

Firms don’t choose capital structure arbitrarily. Key factors include:

A. Industry Norms

Different industries have standard debt-to-equity ratios due to risk and cash flow stability:

• Capital-Intensive (High Debt): Utilities (70% debt), Telecom (60% debt). Example: NTC’s 2023 Balance Sheet shows 65% debt (₹80B) to fund fiber expansion.
• Low-Capital (Low Debt): Tech, Retail (30-40% debt). Example: Daraz’s 2023 Financing relies on 35% debt (₹3B) for inventory, rest equity.

B. Firm-Specific Factors

C. Market Conditions

• Low Interest Rates: Cheaper debt → Firms borrow more (e.g., Nepal Rastra Bank’s 2023 repo rate cut to 6% → More corporate bonds).
• Equity Market Sentiment: If markets are volatile, firms avoid equity issuance (e.g., NEPSE’s 2023 crash → Few IPOs).

4. Cost of Capital: WACC and CAPM

A. Weighted Average Cost of Capital (WACC)

WACC is the average cost a firm pays to finance its assets, blending debt and equity costs.

$$\text{WACC}=\left(\frac{E}{V}\times re\right)+\left(\frac{D}{V}\times rd\times (1-T)\right)$$ Where:

• $E=\text{Market Value of Equity}$,
• $D=\text{Market Value of Debt}$,
• $V=E+D$,
• $re=\text{Cost of Equity}$ (from CAPM),
• $rd=\text{Cost of Debt}$ (after-tax),
• $T=\text{Tax Rate}$.

B. CAPM: Cost of Equity

CAPM calculates the required return on equity based on risk: $$re=rf+\beta \times (rm-rf)$$ Where:

• $rf=\text{Risk-free rate}$ (e.g., 7% for Nepali govt. bonds),
• $\beta =\text{Firm’s systematic risk}$ (e.g., Ncell β = 1.2, Daraz β = 1.5),
• $rm=\text{Market return}$ (e.g., NEPSE index return = 10%).

Example: For Sunrise Battery Company (SBC):

• $rf=7\%$, $rm=10\%$, $\beta =1.3$,
• $re=7\%+1.3\times (10\%-7\%)=10.9\%$.

WORKED EXAMPLE: Sunrise Battery Company (SBC) SBC’s balance sheet (simplified):

Given:

• Market value of equity ($E$) = ₹800,000 (P/E = 10, EPS = ₹80).
• Market value of debt ($D$) = ₹600,000 (current debt ₹500K + new bonds).
• $rd=9\%$, $T=25\%$, $rf=7\%$, $rm=10\%$, $\beta =1.2$.

Calculate WACC:

1. Cost of Equity ($re$): $$re=7\%+1.2\times (10\%-7\%)=10.2\%$$
2. Weights: $E/V=800,000/1,400,000=57.1\%$, $D/V=600,000/1,400,000=42.9\%$.
3. WACC: $$\text{WACC}=(0.571\times 10.2\%)+(0.429\times 9\%\times 0.75)=5.83\%+2.88\%=8.71\%$$

Interpretation: SBC’s WACC is 8.71%. Any project with a return >8.71% should be accepted (e.g., a new battery line with 12% IRR).

5. Financing Decisions: Debt vs. Equity Trade-offs

A. Advantages and Disadvantages of Debt Financing

Real-World Example:

• Ncell’s 2023 Bond Issuance: Raised ₹10B at 9% (after-tax cost = 6.75%). Tax shield = ₹6.75B/year. But interest coverage ratio dropped to 1.8x (risky).

B. Advantages and Disadvantages of Equity Financing

Real-World Example:

• Daraz’s Equity Issuance (2022): Raised ₹5B via preferred shares (8% dividend). Avoids debt but dilutes Alibaba’s stake.

6. Optimal Capital Structure

Optimal capital structure is the mix of debt and equity that:

1. Minimizes WACC (→ Maximizes firm value).
2. Balances tax benefits vs. bankruptcy costs.

Graphical Representation: Trade-off Theory

graph LR
    A["Debt Level"] --> B["Tax Benefit ↑"]
    A --> C["Bankruptcy Cost ↑"]
    B --> D["Firm Value ↑"]
    C --> D["Firm Value ↓"]
    D --> E["Optimal Debt: Max Value"]

Key Insight: As debt increases:

• Tax benefits rise (lower WACC).
• Bankruptcy costs rise (higher WACC).
• Optimal point = Where marginal benefit = marginal cost.

Example: Kathmandu Retail Shop

• Current: 30% debt (₹3M), 70% equity (₹7M).
• Proposed: Increase debt to 50% (₹5M).
• Impact:
  • Tax Shield: ₹5M × 10% × 25% = ₹125K/year.
  • Bankruptcy Risk: Interest coverage ratio drops from 5x to 3x.
  • WACC: Decreases from 14% to 13.5%.

Decision: If the shop’s ROA > 13.5%, increasing debt is optimal.

7. Real-World Applications in Nepal

A. eSewa’s Financing Mix

• Debt: ₹2B short-term loans for liquidity.
• Equity: 60% owned by Ncell (parent company).
• Why? High growth phase → Relies on parent’s equity to avoid debt servicing.

B. NTC’s Capital Structure

• 70% Debt: Funds infrastructure-heavy projects (fiber networks).
• 30% Equity: Government ownership.
• Trade-off: High debt for tax shields, but NTC’s interest coverage is 1.5x (close to distress).

C. Pathao’s Ride-Hailing Financing

• Debt: ₹1B term loans for driver incentives.
• Equity: Backed by Japanese investors (SoftBank).
• Why? High β (1.8) → Equity financing signals growth potential.

8. Exam Tip: How to Score Full Marks

1. Define Terms Precisely:

   • "Capital structure is the proportion of debt and equity used to finance a firm’s operations, aiming to minimize WACC and maximize shareholder value."

2. Use Formulas Correctly:

   • Always show WACC and CAPM calculations step-by-step.
   • Label weights ($E/V$, $D/V$) clearly.

3. Compare Theories:

   • "While MM Proposition II suggests debt increases firm value via tax shields, trade-off theory argues that bankruptcy costs limit leverage."

4. Numerical Examples:

   • Must include:
     • Given data (balance sheet, rates, β).
     • Step-by-step WACC/CAPM calculations.
     • Interpretation (e.g., "Since the project’s IRR (12%) > WACC (8.71%), it should be accepted.").

5. Real-World Links:

   • "Like Ncell’s 2023 bond issuance, which lowered WACC by 1.5% but required maintaining an interest coverage ratio >1.8x."

6. Diagrams/Tables:

   • Draw:
     • T-accounts for debt/equity changes.
     • Trade-off theory graph.
     • WACC breakdown tables.

Past Exam Question Analysis: Question: "Describe features of optimal capital structure of a business corporation." Model Answer: Optimal capital structure has these features:

1. Minimizes WACC: Achieved by balancing tax benefits of debt and bankruptcy costs.
2. Maximizes Firm Value: Occurs at the debt level where marginal benefit = marginal cost.
3. Industry Benchmarks: Aligns with peers (e.g., telecom firms use 60-70% debt).
4. Flexibility: Allows for growth opportunities without over-leveraging.
5. Investor Confidence: Signals stable cash flows to attract low-cost capital.

Example: Gandaki Hydropower’s 65% debt is optimal because:

• High tangible assets (dam, turbines) → Easy to collateralize.
• Stable cash flows (long-term PPAs) → Low bankruptcy risk.
• Tax shield from ₹32.5B debt (25% tax rate) adds ₹8.1B to NPV.

Final Checklist for Exams:

• Define capital structure and optimal mix.
• Explain trade-off theory vs. pecking order theory.
• Calculate WACC and CAPM for a given firm.
• Compare debt vs. equity pros/cons with Nepali examples.
• Draw a trade-off theory graph or T-account.
• Link to real firms (Ncell, Daraz, NTC).