Capital Structure & Long-Term Financing: Debt, Equity, Leverage & Costs

TAKEAWAYS:

• Capital structure is the mix of debt, equity, and hybrid financing that minimizes cost of capital and maximizes firm value.
• Debt financing (bonds, loans) reduces taxes but increases financial risk; equity financing (common/stock) dilutes ownership but carries no repayment obligation.
• The Modigliani-Miller (MM) theorem shows how leverage affects firm value under perfect markets (no taxes, bankruptcy costs).
• Warrants, convertibles, and rights issues are hybrid tools to raise equity at lower costs or incentivize investors.
• Cost of capital (WACC) integrates debt and equity costs to guide financing decisions.
• Optimal capital structure balances risk, cost, and control—no single "best" ratio exists.

1. Introduction to Capital Structure

Capital structure refers to the proportion of debt vs. equity a firm uses to finance its operations and growth. The goal is to choose a mix that:

• Minimizes the weighted average cost of capital (WACC).
• Maximizes shareholder value.
• Avoids excessive financial risk (e.g., bankruptcy).

Why does it matter? Firms with high debt (e.g., Ncell’s telecom infrastructure loans) pay lower taxes but face higher interest obligations. Firms like Daraz rely on equity to avoid debt burdens during rapid expansion.

2. Sources of Long-Term Financing

Long-term financing is divided into three primary categories:

A. Debt Financing

• Bonds: Fixed-income securities with coupon payments and maturity dates.
• Loans: Direct borrowing from banks or financial institutions (e.g., NTC’s infrastructure loans).
• Leasing: Off-balance-sheet financing (Unit 6 covers this in depth).

How it works: Debt provides tax shields (interest is deductible) but increases financial leverage risk.

B. Equity Financing

• Common Stock: Ownership shares with voting rights (e.g., NEPSE-listed companies).
• Preferred Stock: Hybrid equity-debt with fixed dividends (no voting rights).
• Rights Issues: Existing shareholders get first dibs to buy new shares (e.g., Himal Cement’s Rs 50M rights offer).

How it works: Equity has no repayment obligation but dilutes ownership and requires dividend payments.

C. Hybrid Financing

• Convertible Bonds: Bonds that can be converted into equity (e.g., Pathao’s early-stage funding).
• Warrants: Options to buy shares at a fixed price (attached to bonds or debt).
• Debentures: Unsecured debt with equity-like features.

3. Financial Leverage and Its Effects

Definition: Financial leverage is the use of debt to amplify returns (good or bad). It is measured by:

• Debt-to-Equity Ratio (D/E) = Total Debt / Total Equity
• Times-Interest-Earned Ratio (TIE) = EBIT / Interest Expense

Impact of Leverage:

Example: A firm with Rs 1M equity and Rs 2M debt (D/E = 2) earns Rs 500K EBIT. If it repays debt, ROE drops to 25%, but if it defaults, shareholders lose everything.

4. Theories of Capital Structure

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

Assumes:

• Perfect capital markets.
• No taxes or bankruptcy costs.
• Proposition I: Firm value (V₀) = Unlevered value (Vᵤ) + Tax benefit of debt (T*D). $$V_L=V_U+T_D$$
• Proposition II: Cost of equity (rₑ) increases with leverage: $$r_e=r_0+(r_0-r_d)(D/E)$$

B. MM Theory with Taxes

Introduces tax shield benefit of debt: $$V_L=V_U+T_D$$ Where T = corporate tax rate, D = debt value.

C. Trade-Off Theory

Balances:

• Tax benefits of debt (↓ WACC).
• Bankruptcy costs (↑ financial distress risk).

D. Pecking Order Theory

Firms prefer:

1. Internal financing (retained earnings).
2. Debt (cheaper than equity).
3. Equity (last resort, signals bad news).

5. Cost of Capital and WACC

Weighted Average Cost of Capital (WACC) combines debt and equity costs: $$WACC=(E/V\times r_e)+(D/V\times r_d\times (1-T))$$ Where:

• E/V = Equity weight, D/V = Debt weight.
• rₑ = Cost of equity, r_d = Cost of debt.
• T = Tax rate.

Example Calculation: A firm has:

• Rs 500K equity (cost = 12%).
• Rs 500K debt (cost = 8%, tax rate = 30%).
• WACC = (0.5 × 12%) + (0.5 × 8% × 0.7) = 9.6%.

6. Rights Issues and Warrants

mindmap
  Capital Structure
    Rights Issues
      Himal Cement (2023)
        • Subscription Price: Rs 175
        • Discount: Rs 75
        • Rights-on Value: Rs 175
      Daraz (2022)
        • Equity Financing: $1B
        • No Debt Burden
    Warrants
      Pathao (2021)
        • Bond + Warrant
        • Exercise Price: Rs 150
        • 5-Year Term

A. Rights Issues

• Existing shareholders get preemptive rights to buy new shares at a discount.
• Example: Himal Cement’s Rs 50M rights offer (Rs 100 par, Rs 250 market price).
  • Subscription price = Rs 175 (Rs 250 - Rs 75 discount).
  • Rights-on value = Rs 250 - (Rs 75 × 1) = Rs 175.

B. Warrants

• Call options attached to bonds/debt, allowing buyers to purchase shares at a fixed price.
• Example: A bond with a 5-year warrant (exercise price = Rs 150) may trade at a premium if the stock rises above Rs 150.

7. Real-World Applications

In the Real World

1. Ncell’s Debt vs. Equity Mix

   • Ncell relies on bank loans (debt) for network expansion but issues bonds (hybrid) to diversify funding.
   • Why? Debt is cheaper, but equity reduces leverage risk during economic downturns.

2. Daraz’s Equity Financing

   • Daraz raised $1B+ in equity (e.g., from Alibaba) to avoid debt during COVID-19.
   • Why? Equity avoids interest payments and signals investor confidence.

3. NEPSE Listed Companies (e.g., NMB Bank)

   • Banks use debt (loans) for liquidity but issue preferred stock for stable funding.
   • Why? Debt is tax-deductible, but preferred stock provides steady income without dilution.

8. Worked Example: Himal Cement’s Rights Offer

Scenario: Himal Cement wants to raise Rs 50M via a rights issue.

• Par value = Rs 100.
• Market price = Rs 250.
• Subscription price = Rs 175 (Rs 75 discount).
• Existing shares outstanding = 200,000.

Steps:

1. Calculate rights-on value: $$\text{Rights-on value}=\text{Market price}-(\text{Discount}\times \text{Number of rights})$$ $$=250-(75\times 1)=175$$

2. Determine subscription ratio:

   • 1 right per existing share.
   • Total rights needed = 50M / 175 = 285,714 shares.
   • New shares issued = 285,714 (existing shareholders buy 200,000; rest sold to public).

3. Post-issue share price:

   • Total shares = 200,000 + 285,714 = 485,714.
   • Total value = 50M + (200,000 × 250) = Rs 550M.
   • New market price ≈ Rs 1,132 (theoretical ex-rights price).

9. Advantages and Disadvantages of Long-Term Bonds

10. Exam Tip

• Focus on WACC calculations (most exam questions).
• Understand MM theory (with/without taxes) and trade-off theory.
• Practice rights issues (subscription price, ex-rights price).
• Compare debt vs. equity (tax benefits vs. risk).
• Memorize formulas:
  • WACC = (E/V × rₑ) + (D/V × r_d × (1 - T)).
  • Debt-to-Equity Ratio = Total Debt / Total Equity.
• Real-world link: Always tie theory to Nepali firms (e.g., Ncell, NMB, Daraz).

Key Visuals

1. Capital Structure Mix (Debt vs. Equity)

pie
    title Capital Structure of a Typical Firm
    "Debt (40%)" : 40
    "Equity (60%)" : 60

2. WACC Calculation Flowchart

flowchart TD
    A["Start"] --> B{"Is it Debt or Equity?"}
    B -->|"Debt"| C["Cost of Debt (r_d × (1 - T))"]
    B -->|"Equity"| D["Cost of Equity (r_e)"]
    C --> E["Weighted by D/V"]
    D --> F["Weighted by E/V"]
    E --> G["Sum to get WACC"]
    F --> G

3. Rights Issue Subscription Table

Final Note

Capital structure is not one-size-fits-all. Firms like Ncell (high debt) and Daraz (high equity) choose mixes based on industry, risk tolerance, and growth stage. Always calculate WACC and compare financing options before deciding.