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

TAKEAWAYS:

• Capital structure is the mix of debt and equity that minimizes a firm’s weighted average cost of capital (WACC) while balancing risk and return.
• Optimal capital structure occurs where value is maximized (or WACC is minimized) by trading off tax shields from debt against costs of financial distress.
• Modigliani-Miller (MM) propositions provide a theoretical framework: without taxes, capital structure is irrelevant; with taxes, debt is cheaper due to interest tax shields.
• Real-world constraints (e.g., bank lending limits, investor risk tolerance, regulatory rules) force firms to deviate from theoretical "optimal" structures.
• Financing decisions (debt vs. equity) affect dividend policy, agency costs, and shareholder wealth—not just immediate cost savings.
• CAPM and WACC are used to discount cash flows in capital budgeting, linking financing choices to investment appraisal.

1. What is Capital Structure?

Capital structure refers to the proportion of debt and equity used to finance a company’s assets and operations. It answers:

• How much of the firm’s capital comes from shareholders (equity) vs. creditors (debt)?
• What is the risk-return trade-off of each source?

Visual: The Capital Structure Pie Chart

pie
    title Capital Structure of a Typical Nepali Firm (e.g., Ncell)
    "Debt (60%)" : 60
    "Equity (40%)" : 40
    "Preferred Stock (0%)" : 0

Why does it matter?

• Debt is cheaper (interest is tax-deductible), but increases financial risk.
• Equity is expensive (dividends are not tax-deductible), but reduces risk.
• The optimal mix balances these trade-offs to maximize shareholder value.

2. Theories of Capital Structure

A. Modigliani-Miller (MM) Propositions (No Taxes)

MM’s 1958 theory states:

"In a perfect capital market (no taxes, no transaction costs, no bankruptcy), a firm’s capital structure is irrelevant to its value."

Key Implications:

• Value of the firm (V) = Value of unlevered firm (V_L) (no debt).
• Cost of equity (r_e) rises with more debt (due to higher risk).
• Weighted Average Cost of Capital (WACC) remains constant regardless of debt levels.

Visual: MM Proposition (No Taxes)

B. MM Proposition with Corporate Taxes (1963)

When taxes exist, debt becomes cheaper because:

• Interest payments are tax-deductible (unlike dividends).
• Value of levered firm (V_L) = V_U + t_c * D, where:
  • t_c = corporate tax rate
  • D = debt value

Example (Nepal’s Tax Rate: 25%) If a firm has:

• Unlevered value (V_U) = Rs. 100 crore
• Debt (D) = Rs. 40 crore
• Tax shield = 25% of Rs. 40 crore = Rs. 10 crore → Levered value (V_L) = Rs. 100 crore + Rs. 10 crore = Rs. 110 crore

Visual: Tax Shield Effect

C. Trade-off Theory (Real-World Adjustments)

In reality, firms do not use 100% debt because:

1. Costs of financial distress (bankruptcy, lost sales, employee turnover).
2. Agency costs (conflicts between shareholders and creditors).
3. Asymmetric information (investors may perceive high debt as risky).

Optimal Capital Structure = Debt level where tax benefits > costs of distress

3. Factors Affecting Capital Structure

4. Costs of Capital and WACC

A. Components of WACC

The Weighted Average Cost of Capital (WACC) is calculated as: $$WACC=\left(\frac{E}{V}\times r_e\right)+\left(\frac{D}{V}\times r_d\times (1-t_c)\right)$$ Where:

• E = Market value of equity
• D = Market value of debt
• V = E + D (Total firm value)
• r_e = Cost of equity (from CAPM)
• r_d = Cost of debt (interest rate)
• t_c = Corporate tax rate

B. Worked Example: Kathmandu Retail Shop

Given:

• Equity (E) = Rs. 50,00,000 (10,000 shares @ Rs. 500 each)
• Debt (D) = Rs. 30,00,000 (bank loan at 10% interest)
• Tax rate (t_c) = 25%
• Cost of equity (r_e) = 15% (from CAPM)
• Cost of debt (r_d) = 10%

Step 1: Calculate WACC $$WACC=\left(\frac{50}{80}\times 15\%\right)+\left(\frac{30}{80}\times 10\%\times (1-0.25)\right)$$ $$WACC=(0.625\times 15\%)+(0.375\times 7.5\%)=9.375\%+2.8125\%=\ast \ast 12.19$$

Step 2: Impact of Increasing Debt to Rs. 40,00,000

• New D/V = 40/90, E/V = 50/90
• r_e rises to 16% (due to higher risk) $$WACC=\left(\frac{50}{90}\times 16\%\right)+\left(\frac{40}{90}\times 10\%\times 0.75\right)=8.89\%+3.33\%=\ast \ast 12.22$$ → WACC increases slightly because the cost of equity rises more than the tax benefit of debt.

Visual: WACC vs. Debt-Equity Ratio

5. Financing Decisions in Practice

A. Debt Financing

Sources in Nepal:

Advantages: ✅ Tax-deductible interest reduces taxable income. ✅ Cheaper than equity (lower cost of capital). ✅ No dilution of ownership.

Disadvantages: ❌ Fixed obligations (interest must be paid regardless of profits). ❌ Increased financial risk (bankruptcy if cash flows drop). ❌ Covenants (banks may restrict dividends or new debt).

B. Equity Financing

Sources in Nepal:

Advantages: ✅ No repayment obligation (dividends are optional). ✅ No increase in financial risk. ✅ Improves credit rating (lower debt-to-equity ratio).

Disadvantages: ❌ Expensive (dividends are not tax-deductible). ❌ Dilutes ownership (new shareholders gain control). ❌ Market perception (issuing new shares may signal poor performance).

6. Real-World Applications in Nepal

A. eSewa (Digital Payments)

• Capital Structure: ~80% equity (venture capital), 20% debt (bank loans).
• Why?
  • High growth stage → prefers equity for flexibility.
  • Regulatory risks (Rastra Bank scrutiny) limit debt.
  • Tech startups typically avoid high leverage.

B. Ncell (Telecom)

• Capital Structure: ~60% debt, 40% equity (including foreign investment).
• Why?
  • Stable cash flows (low business risk) → can handle debt.
  • Tax benefits from interest deductions.
  • Infrastructure-heavy (needs long-term debt for towers).

C. Pathao (Ride-Hailing)

• Capital Structure: ~90% equity (investors like Ant Group), 10% debt.
• Why?
  • High operating risk (driver payouts, fuel costs) → avoids debt.
  • Scaling rapidly → needs investor capital, not bank loans.

D. Gandaki Hydropower (GTC)

• Capital Structure: ~30% debt, 70% equity (government + private).
• Why?
  • High project risk (construction delays, political risks) → limited debt.
  • Long payback period → equity investors provide patient capital.

7. Capital Structure and Financial Distress

A. Costs of Financial Distress

When a firm takes too much debt, it risks:

1. Bankruptcy costs (legal fees, lost contracts).
2. Agency costs (shareholders may take risky projects to avoid debt repayment).
3. Loss of customers/suppliers (e.g., Kathmandu Sugar Mills defaulting on loans).

Example: Nepal’s Banking Crisis (2001-2002)

• Many banks took excessive loans to finance risky projects.
• Non-performing loans (NPLs) rose to 30%.
• Government had to bail out banks, costing Rs. 50+ billion.

B. Optimal Capital Structure in Practice

Most Nepali firms follow a rule of thumb:

• Manufacturing: 50-60% debt
• Services (e.g., banks, telecom): 60-70% debt
• Startups/Tech: <20% debt

Visual: Optimal Capital Structure Curve

8. Capital Asset Pricing Model (CAPM) and Cost of Equity

CAPM helps estimate the cost of equity (r_e): $$r_e=r_f+\beta (r_m-r_f)$$ Where:

• r_f = Risk-free rate (e.g., Nepal Treasury Bill rate ~7%).
• β (beta) = Market risk (e.g., Ncell β = 1.2, Pathao β = 1.8).
• (r_m - r_f) = Market risk premium (~8% globally, ~10% in Nepal).

Example: Calculating Cost of Equity for a Nepali Firm

9. Financing Decisions and Dividend Policy

Financing choices affect dividend policy:

• High debt → Less flexibility to pay dividends (must service debt first).
• High equity → More flexibility but higher pressure to pay dividends (shareholders expect returns).

Example: NMB Bank vs. CG Group

10. Exam Tip: How to Score Full Marks

A. Common Exam Questions & How to Answer

B. Model Answer Structure (10 Marks)

Question: "Describe the features of an optimal capital structure for a business corporation, using a Nepali example."

Answer: An optimal capital structure is the mix of debt and equity that maximizes shareholder wealth by minimizing the firm’s WACC while balancing tax benefits and costs of financial distress.

Key Features:

1. Minimizes WACC

   • Example: Ncell’s WACC is ~12% due to its 60% debt, 40% equity structure.
   • Calculation: $WACC=(0.4\times 15\%)+(0.6\times 10\%\times 0.75)=12\%$.

2. Balances Tax Benefits and Distress Costs

   • Debt provides tax shields (interest deductions), but too much debt increases bankruptcy risk.
   • Example: Gandaki Hydropower uses only 30% debt due to high project risk.

3. Aligns with Industry Norms

   • Telecom (Ncell, NTC): 60-70% debt (stable cash flows).
   • Startups (Pathao, eSewa): <20% debt (high risk).

4. Considers Regulatory Constraints

   • Banks (NMB, Global IME): Debt-to-equity ratio capped by NRB at 80%.
   • Public firms (NEPSE-listed): Must disclose capital structure in annual reports.

5. Flexibility for Growth

   • High-growth firms (Khalti, F1Soft): Prefer equity to avoid debt covenants.
   • Mature firms (Unilever Nepal): Use debt for tax benefits.

Conclusion: The optimal capital structure is not a fixed ratio but a dynamic decision based on tax laws, industry risk, and growth needs. For example, Ncell’s 60% debt is optimal because its stable cash flows justify higher leverage, whereas Pathao’s low debt reflects its high operating risk.

Final Summary Table