Capital structure of Business

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!

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!

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!

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 be 25cr 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.

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.

Vinu          

And my Profit after tax will be

 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.

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!        

Manu       

Now look at your Tax

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

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

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!