Question

Imagine that you are a venture capitalist, seeking to invest in a new company. In preparation for meetings with prospective clients, you are developing a presentation on the valuation fundamentals of a company.

In your initial discussion, include an explanation of why capital structure is so important to a company, and analyze the reasons why firms from different industries have different capital structures and valuations. Also, discuss how an investor can use leverage ratios and industry benchmarks to evaluate the financial health of a company and determine the optimal capital structure.

Answer 1

To begin with, various decisions are to be taken to invest in a company.

Financing decisions play an important role in those decisions. Capital structure, one among them, play a substantially typical role in providing the various alternatives to the investors to weigh their judgements.

Capital structure is the combination of capitals from different sources of finance. The capital consists of common stock, preference stock and debts. The quantum of capital is based on the need of the company and the stage where it requires it. Suppose, in initial stage it may require capital for the purpose of making investment in assets etc. So it requires huge capital at the start. After that, a few quantum of capital matters.

It is widely known that one of the main objective of the company is to maximise the wealth of shareholders. So capital structure decisions should be taken carefully keeping this objective in view. If such a decision is not taken rightly, ultimately company may end up bearing a high cost of capital and thereby dissatisfying shareholders' regards.

In the way of sourcing of finance, one cannot, prima facie, conclude that only common stock or only debt will be a huge benefit to the organisation. The mix of capital shall be determined based on the various factors considering debt interest rate, shareholders' expected rate, inflation in the economy, general borrowing rates, quantum and timing of cash flows etc.

Also, different firms have different capital structures and also may largely vary with that of average industry standards. Because we cannot compare an FMCG firm with that of construction company. We cannot compare software export services firm with a Cash and Carry operational firm.

The nature of business plays a major role in the capital structure of the company. For example, if one sees the balance sheet of the construction company, it will find to be the Debt/Equity ratio to be minimum of 5:1 to 20:1. Their assets might also have a bigger portion of it. It is a two sided view. Cash and Carry operational firm's requirement of debt is far low. Their debtors turnover ratio is very low and almost, at times, nil.

So we cannot conclude the firm's value only based on the debt/equity ratios. Other factors have the same importance.

Coming to the leverages,

Leverage, in general, can be termed as risk. But, in particular, it includes return also while calculating risk.

Leverage refers to the ability of the firm in employing the long term funds of fixed cost to enhance the return to the shareholders. It is the relationship between two interrelated variables.

Broadly classified into three types, leverage decisions are useful in making capital structure decisions and one can assess the risk of the firm based on these three types of ratios.

1. Operating leverage : Refers to the business risk. It is the risk associated with firm's business operations. It is the uncertainty of the future operating income. It is calculated by the formula = (% change in EBIT / % change in Sales)

2. Financial leverage : Refers to the risk placed on the shareholders' value due to the reason of employment of debt in the firm. Firm which have high debt in its balance sheet will face high financial leverage. It is calculated by the formula = (% change in EBIT / % change in EBT)

3. Combined leverage : Refers to the mix of above two leverages. It is the use of both operating and financial costs, which magnify the effect of Sales volume change on the earnings per share of the shareholder. It is calculated by the formula = (Operating leverage / Financial leverage)

These risks are associated invariably with various industries.

High operating leverage refers to the high business risk where the firm has to concentrate on cutting down its fixed costs. High financial leverage refers to the high financial risk / high debt risk where one has to reduce the interest burden to enhance the return to the shareholders.