IDBI federal Life Insurance Co. Ltd. 2014

THE STUDY ON CAPITAL STRUCTURE AT IDBI FEDERAL LIFE INSURANCE CO. LTD.(A summer training project report submitted in partial fulfillment of the requirement of Post-Graduation Diploma in Management)

(Session 2013-2015)

Under the guidance of: Submitted By:

Ms. Piyushi Verma P.NITHIN REDDY (MANAGER DISTRIBUTION) PGDM 2ND YEARIDBI FEDERAL LIFE INSURANCE Roll No.-:22024Co. LTD.

Siva Sivani Institute of Management

(kompally, Secundrabad, 500014 )

INTERNSHIP CERTIFICATE

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ACKNOWLEDGEMENTI express my sincere gratitude to my company guide Ms. Piyushi verma,

Manager Distribution, IDBI FEDERAL LIFE INSURANCE COMPANY

Ltd., for entrusting me and providing me valuable inputs for my project “STUDY

ON CAPITAL STRUCTURE AT IDBI FEDERAL LIFE INSURANCE Co

Ltd” also my company coordinator, Mr. Chandu Sudheer Kumar for

encouragement, support and valuable guidance throughout the project duration. In

spite of being fraught with unending engagements in office, he kept me motivating

to try best at all times the project field work was entirely unknown to me. I would

like to express my gratitude to him, for constantly elucidating upon my repetitive

queries and without whom the whole field work would not have been possible.

I would also like to thank my faculty guide, Mrs. L. Krishna Veni for providing

me with her constant support and guidance all through the IIP.

A special thanks to all the IDBI FEDERAL HYDERABAD branch employees who

made the IIP a memorable learning experience.

I would like to thank SSIM and IDBI FEDERAL LIFE INSURANCE

COMPANY LTD. for providing me an opportunity to gain hands-on experience by

working in a corporate environment. Lastly, I would like to thank my parents,

friends and well-wishers who encouraged me to do this research work and all the

dealers and retailers who contributed directly or indirectly in completing this

project to whom I am obligated to even though anonymously.

P.NITHIN REDDY

22024

SIVA SIVANI INSTITUTE OF MANAGEMENT, Hyderabad

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PREFACE

Life insurance business is booming in India. The business of life insurance is

related to the protection of the economic value of human life and this project is just

offered to draw the attention of individuals, who are interested in life insurance

business running by insurance regulatory Development Authority (IRDA).

Insurance industry has Ombudsmen in 12 cities. Each Ombudsman is

empowered to redress customer grievances in respect of insurance contracts on

personal lines where the insured amount is less than Rs. 20 lakh, in accordance

with the Ombudsman Scheme. Addresses can be obtained from the offices of LIC

and other insurers.

This project is like just an extract of my rigorous work in Life Insurance

Companies, and I hope the beneficiaries’ decision regarding recruitment of advice;

or, all information and data. This responsibility really in hence my effective

communication and convincing power and such quality will help me in near future

for having decision making.

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DECLARATION

This is to certify that the projects titled: “STUDY ON CAPITAL STRUCTURE

OF IDBI FEDERAL LIFE INSURANCE Co Ltd” is a bonafide work completed

by P.NITHIN REDDY, Enrolment Number 22024, in partial Fulfilment of the

requirements of the PGDM Program and submitted to SIVA SIVANI INSTITUTE

OF MANAGEMENT.

I declare that this project is a result of my own efforts and has not been copied

from any Source. References from which information has been taken have been

given in the references section.

This work has not been submitted earlier at any other university or institute for the

award of the degree.

P.NITHIN REDDY

22024

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TABLE OF CONTENTS

Contents1. EXECUTIVE SUMMERY..................................................................................................................1

2. INTRODUCTION...................................................................................................................................3

2.1 BACKGROUND OF THE TOPIC....................................................................................................3

2.2 NEED OF THE STUDY...................................................................................................................5

2.3 OBJECTIVES OF THE PROJECT...................................................................................................5

2.4 SCOPE OF THE STUDY..................................................................................................................5

2.5 LIMITATIONS TO THE PROJECT.................................................................................................5

3. COMPANY ANALYSIS.....................................................................................................................6

3.1 INDIAN INSURANCE INDUSTRY AT PRESENT:.......................................................................7

3.2 VISION, MISSION AND VALUES.................................................................................................8

3.3 COMPETITORS OF IDBI FEDERAL LIFE INSURANCE CO. LTD.................................................9

3.4 ORGANIZATION STRUCTURE...................................................................................................10

3.5 PRODUCTS OF IDBI FEDERAL..................................................................................................10

3.6 SWOT ANALYSIS OF IDBI FEDERAL LIFE..............................................................................14

3.7 COMPETITOR ANALYSIS:..........................................................................................................15

4. ECONOMIC INDUSTRY ANALYSIS................................................................................................19

4.1. INTRODUCTION TO INSURANCE INDUSTRY:......................................................................19

4.2TYPES OF INSURANCE:...............................................................................................................19

4.3 INSURANCE SECTOR IN INDIA:................................................................................................20

4.4 INDIAN INSURANCE INDUSTRY AT PRESENT:.....................................................................21

4.5 REGULATORY ISSUES:...............................................................................................................21

4.6 CRITICAL SUCCESS FACTORS:.................................................................................................22

4.7 DOMESTIC ECONOMIC CONDITIONS:.....................................................................................24

4.8 GLOBAL ECONOMIC ENVIRONMENT:....................................................................................25

4.9 DEMAND DRIVERS:.....................................................................................................................25

5 LITERATURE REVIEW.......................................................................................................................27

5.1 LITERATURE................................................................................................................................27

5.2 THEORIES OF CAPITAL STRUCTURE......................................................................................31

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5.2.1 INTRODUCTION:...................................................................................................................31

5.3 DIFFERENT THEORIES OF CAPITAL STRUCTURE................................................................39

5.3.1 NET INCOME APPROACH....................................................................................................39

5.3.2 NET OPERATING INCOME (NOI) APPROACH:.................................................................42

5.3.3 TRADITIONAL APPROACH:................................................................................................44

5.3.4 MODIGLIANI – MILLER (MM) HYPOTHESIS....................................................................45

5.4 ARBITRAGE PROCESS................................................................................................................46

5.5 CRITICISM OF MM HYPOTHESIS..............................................................................................48

5.6 M-M HYPOTHESIS CORPORATE TAXES.................................................................................49

5.7 AGENCY COSTS...........................................................................................................................49

5.8 PECKING ORDER THEORY........................................................................................................50

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1. EXECUTIVE SUMMERYThe Indian insurance industry has undergone transformational changes since

2000 when the industry was liberalized. With a one-player market to 24 in 13 years, the industry has witnessed phases of rapid growth along with extent of growth moderation and intensifying competition.

There have also been a number of product and operational innovations necessitated by consumer need and increased competition among the players. Changes in the regulatory environment also had a path-breaking impact on the development of the industry. While the insurance industry still struggles to move out of the shadows cast by the challenges posed by economic uncertainties of the last few years, the strong fundamentals of the industry augur well for a roadmap to be drawn for sustainable long-term growth.

The decade 2001-10 was characterized by a period of high growth (compound annual growth rate of 31 percent in new business premium) and a flat growth (CAGR of around two percent in new business premium between 2010-12)

There was exponential growth in the first decade of insurance industry liberalization. Backed by innovative products and aggressive expansion of distribution, the life insurance industry grew at jet speed.

Regulatory changes were introduced during the past two years and life insurance companies adopted many new customer-centric practices in this period. Product-related changes, first in ULIPs (Unit Linked Insurance Plans) in September 2011 and now in traditional products, will have the biggest impact on the industry

This project is done on CAPTIAL STRUCTURE on IDBI Federal Life Insurance Company Limited with comparison to leading private companies in India. The project is all about study of comparative analysis of IDBI FEDERAL LIFE INSURANCE Co. Ltd with different private companies and LIC. The objective of the project was to check the awareness level of Insurance, position of

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company in term of size, Growth, Productivity, Grievance handling in market place and attitude of the people towards insurance in the current market.

The project relates to the study of the financial analysis and the current performance of the company and how effective the assets of the company are managed. Financial analysis is done using ratio analysis and the trend projection graph provides the fluctuations that have occurred. The study shows how effective the company is able to make use of its funds and revenues generated. Future growth of the firm is also estimated in the analysis.

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2. INTRODUCTION

2.1 BACKGROUND OF THE TOPICThe term capital structure refers to the percentage of capital (money) at work

in a business by type. There are two forms of capital: equity capital and debt capital. Debt includes loans and other types of credit that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus earn a return on their investment as well as exercising some degree of control over how the business is run. Each has its own benefits and drawbacks.

A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

It is the composition of long-term liabilities, specific short-term liabilities like bank notes, common equity, and preferred equity which make up the funds with which a business firm finances its operations and its growth. The capital structure of a business firm is essentially the right side of its balance sheet. Companies and small business owners trying to determine how much of their startup money should come from a bank loan without endangering the business.

There is a saying that “If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance.” There are few theories backing this statement (trade-off theory and pecking order theory).

Merits of Equity Finance

(1)Permanent source of capital. (2)No payment of interest.

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(3) Improved ability to face business recession. (4)Freedom from financial worries of borrowing. (5)Earnings remain with the firm. (6)Liquidation of assets. (In case a business is liquidated the assets of the

business remain with the owners.)(7)Repayment of funds.(8)Financial base. (The funds supplied by owners provide a financial base to

the capital structure of a business.)(9)Ability to borrow. (If a business is financed well with equity capital, its

ability to obtain borrowed capital in improved).

Demerits of Equity Financing

(1) Idle cash balances. (2)Over capitalization. (3)Weak control(4)No advantage of borrowed capital. (5) Investor expectations

Merits of Debt Finance

(1)Tax shield(2)Positive influence on R&D activities(3)More control

(4)Easy to administer (5) Increases the EPS(6)Lower interest rate

Demerits of Debt Finance

(1)High risk(2) Insolvency(3)Bankruptcy(4)Regular payment of interest(5)Reduction in cash flows(6)Failure to make payments

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(7) Impacts your credit rating (the more you borrow, the higher the risk to the lender, and the higher interest rate you’ll pay.)

(8) It works against the company if earning from investments does not exceed the interest payments

2.2 NEED OF THE STUDY To know whether there is a balance between debt and equity To know the equation of capital structure in IDBI Federal Life Insurance Co

Ltd To know the variations in debt and equity when compared to previous years To know the capital structures impact on operating cash flows and cost of

capital To know various factors affecting the capital structure such as taxes,

industry standards etc. To understand the financial risk business risk and tradeoff between them

2.3 OBJECTIVES OF THE PROJECT

To understand the capital structure of IDBI Federal Life Insurance Co Ltd To find debt ratio, debt-equity ratio and interest coverage ratio of the

company EBIT-EPS Analysis to find the right capital mix To know the stability of IDBI Federal Life Insurance Co Ltd capital

structure when compared to its competitors SBI LIFE, LIC, ICICI securities To understand the value of the firm with variations in capital structure

2.4 SCOPE OF THE STUDY A study of the capital structure involves an examination of long term as well as short term sources that a company taps in order to meet its requirements of finance.

2.5 LIMITATIONS TO THE PROJECT Time duration IDBI Federal Life Insurance Co Ltd is no listed Industry dynamics People perceptions towards insurance

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3. COMPANY ANALYSIS

IDBI Federal Life Insurance Co Ltd is a joint-venture of IDBI Bank, India’s premier development and commercial bank, Federal Bank, one of India’s leading private sector banks and Ageas, a multinational insurance giant based out of Purpose. In this venture, IDBI Bank owns 48% equity while Federal Bank and Ageas own 26% equity each. . Having started in March 2008, in just five months of inception, IDBI Federal became one of the fastest growing new insurance companies to garner Rs 100 Cr in premiums. Through a continuous process of innovation in product and service delivery IDBI Federal aims to deliver world-class wealth management, protection and retirement solutions that provide value and convenience to the Indian customer. The company offers its services through a vast nationwide network of 2137 partner bank branches of IDBI Bank and Federal Bank in addition to a sizeable network of advisors and partners. As on 28th February 2013, the company has issued over 8.65 lakh policies with a sum assured of over Rs. 26,591Cr.

IDBI Federal today is recognized as a customer-centric brand, with an array of awards to their credit. They have been awarded the PMAA Awards (2009) for best Dealer/Sales force Activity, EFFIE Award (2011) for effective advertising, and conferred with the status of ‘Master Brand 2012-13’ by the CMO Council USA and CMO Asia.

Federal Bank Ltd is engaged in the banking business. The Bank operates in four segments: treasury operations, wholesale banking, retail banking and other banking operations.

Ageas is an international insurance group with a heritage spanning more than 180 years. Ranked among the top 20 insurance companies in Europe, Ageas has chosen

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to concentrate its business activities in Europe and Asia, which together make up the largest share of the global insurance market.

3.1 INDIAN INSURANCE INDUSTRY AT PRESENT:

Life Insurance Corporation (LIC) had the monopoly over the market till the late 90’s when the insurance sector in India was opened for private players. Before that there were only two state insurer, one was LIC (Life Insurance Corporation of India) and GIC (General Insurance corporation of India).

Indian insurance sector at present has undergone many structural changes in 2000. The Government of India has liberalized the insurance sector in 2000 with IRDA (Insurance Regulatory and development authority) lifting all entry restriction of foreign players with a specific limit on direct foreign ownership. Under the current guideline 26% of equity cap is there for foreign players in an insurance company and proposal is being given to increase this limit to 49%. Post liberalization insurance industry in India have come a long way and today it stands as one of the most competitive, challenging and exploring industry in India. Increased use of new distribution channels are in limelight today due to entry of private players. In the long run the use of these distribution channels and modern IT tools has increased scope of the insurance industry. Also the changing economics patterns, changing political scenario, modern IT tools will eventually help in reshaping future of Indian financial market and Life Insurance business in the country.

Milestones

March 2008 IDBI Federal starts operations with two products – Homesurance & Wealthsurance.

August 2008 IDBI Federal becomes one of the fastest growing new life insurers to collect premiums worth Rs 100 crores.

October 2008 IDBI Federal launches Bondsurance

January 2009 IDBI Wealthsurance Cup 2009 – India v/s Sri Lanka held in Sri Lanka.

March 2009 collected premium of over 328 corers and 87,000 policies and a

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Sum assured of Rs 2825 crores since inceptionLaunches Retirements & Termsurance Grameen Suraksha

November 2009 IDBI Federal launches Incomesurance

March 2010 Launches Incomesurance Endowment & Money Back Plan, Termsurance Protection Plan & Termsurance Grameen Bachat Yojana

September 2010

Launches Loansurance Group Life Plan & Healthsurance Hospitalization and Surgical Plan

March 2011 Launches Retirements Guaranteed Pension planLaunches TV Campaigns for Wealthsurance – jinse bhi suna, khaeed liya, Incomesurance – guaranteed income ki bhavishyavani and Retiresurance – Monthly pension, zindgi bhar

3.2 VISION, MISSION AND VALUESVisionTo be the leading provider of wealth management, protection and retirement solutions that meets the needs of our customers and adds value to their lives.

MissionTo continually strive to enhance customer experience through innovative product offerings, dedicated relationship management and superior service delivery while striving to interact with our customers in the most convenient and cost effective manner.

To be transparent in the way we deal with our customers and to act with integrity.To invest in and build quality human capital in order to achieve our mission.

Values Transparency: Crystal Clear communication to our partners and stakeholders

Value to Customers: A product and service offering in which customers perceive value

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Rock Solid and Delivery on Promise: This translates into being financially strong, operationally robust and  having clarity in claims

  Customer-friendly: Advice and support in working with customers and partners Profit to Stakeholders: Balance the interests of customers, partners, employees,

shareholders and the community at large

3.3 COMPETITORS OF IDBI FEDERAL LIFE INSURANCE CO. LTD

1. AEGON Religare Life Insurance2. Aviva India3. Shriram Life Insurance4. Bajaj Allianz Life Insurance5. Bharti AXA Life Insurance Co Ltd6. Birla Sun Life Insurance7. Canara HSBC Oriental Bank of Commerce Life Insurance8. Star Union Dai-ichi Life Insurance9. DLF Pramerica Life Insurance10. Edelweiss Tokio Life Insurance Co. Ltd11. Future Generali Life Insurance Co Ltd12. HDFC Standard Life Insurance Company Limited13. ICICI Prudential14. IDBI Federal Life Insurance15. IndiaFirst Life Insurance Company16. ING Vysya Life Insurance17. Kotak Life Insurance18. Max Life Insurance19. PNB MetLife India Life Insurance20. Reliance Life Insurance Company Limited21. Sahara Life Insurance22. SBI Life Insurance Company Limited23. TATA AIA Life Insurance24. Oriental insurance company25. L&T general insurance company26. Universal sampo general insurance company

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27. National insurance company limited28. Apollo Munich health insurance company29. United India insurance company limited30. Export credit and guarantee corporation of India Limited.

3.4 ORGANIZATION STRUCTURE

3.5 PRODUCTS OF IDBI FEDERALAt IDBI Federal, it’s our constant endeavor to create innovations that create value for our customers. These innovations are brought to life through our wide array of products that fit the varying financial and investment needs at different stages of life.

LIFESURANCE CHILDSURANCE

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CEO VIGNESH SHAHANE

Marketing & Promotion Under

writingFinance Human

ResourceProduct

North Zonal Support Manager

South Zonal Support Manager

West Zonal Support Manager

East Zonal Support Manager

INCOMESURANCE TERMSURANCE WEALTHSURANCE LOANSURANCE MICROSURANCE

LIFESURANCE:

Often, the first step towards a long and arduous journey is the toughest. However, once you have taken that first stride, the rest of the journey seems easier and more enjoyable. With your investments, it is the same approach that will ensure you build the right corpus to fulfil your dreams for yourself and your family – start small, save big!

HOW IT WORKS

CHILDSURANCE:

Whether your child wants to be a doctor, an engineer, an MBA, a sportsman, a performing artist, or dreams of being an entrepreneur, the IDBI Federal Childsurance Dream builder Insurance Plan will keep you future-ready against both, changing dreams and life’s twists. It allows you to create build and manage

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wealth by providing several choices and great flexibility so that your plan meets your specific needs. However, what makes Childsurance a must-have for any parent who is looking to make their child’s future shock-proof is its powerful insurance benefits. Childsurance allows you to protect your child plan with triple insurance benefits so that your wealth-building efforts remain unaffected by unforeseen events and your child’s future goals can be achieved without any hindrance.

HOW IT WORKSThis second illustration below explains how the product works for a limited premium policy with a policy term of 20 years

INCOMESURANCE:

IDBI Federal Incomesurance Endowment and Money Back Plan is loaded with lots of benefits which ensure that you get Guaranteed Annual Payout along with insurance protection which will help you to reach you goals with full confidence.

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Incomesurance Plan is very flexible and allows you to customise your Plan as per your individual and family’s future requirements. Moreover it also allows you to choose Premium Payment Period, Payout Period, Payout Options and more.

HOW IT WORKS

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Age Payout Age Payout

18-30 138% 47 131%

31-36 137% 48 131%

37-39 136% 49 130%

40 135% 50 130%

41 135% 51 130%

42 134% 52 128%

43 134% 53 128%

44 133% 54 127%

45 133% 55 126%

46 132%

3.6 SWOT ANALYSIS OF IDBI FEDERAL LIFE

SWOT analysis of IDBI Federal Life Insurance represents analyzing strength, weakness, opportunities, and threat of the company which are as follows:-

STRENGTH:-

The major strength of IDBI Federal Life is its sponsor companies which are IDBI bank, Federal bank and Fortis. Because of its innovative ideas it is the first insurance company to collect 100cr within five months of its commencement of business. One major strength of IDBI Federal is its combined network of more than 1600 branches of IDBI bank and Federal bank.

Superior customer service with huge network and innovative products High level of customer (both internal & external) satisfaction because of its

management policy. Large pool of technically skilled workforce with deep knowledge of

insurance market.

WEAKNESS:-

The major weakness of IDBI Federal is the constraint sectorial growth due to low unemployment level.

Low confidence of people in private insurance company. The corporate clients under group schemes and salary savings schemes are

captured by other major players.

OPPORTUNITIES:- Only 10% of Indian population is covered by insurance policy out of 30%

insurable population. Due to liberalization it can operate globally. Fast track carrier development opportunities on an industrial wide basis. After liberalization it is expected that insurance business is roughly 400

billion rupees per year now which shows big opportunities and market for IDBI Federal Life Insurance.

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The existing LIC and GIC, have created a large group of dissatisfied customers due to the poor quality of service. Hence there will be shift of large number of customers for other players.

THREATS:-

Big public insurance companies like LIC, National Insurance Companies Limited, Oriental Life Insurance etc are the biggest threats to IDBI Federal Life Insurance.

Large potential market attracts new rivals.

Latest market share of all insurance companies as of march 2013:

3.7 COMPETITOR ANALYSIS:Competitor analysis in marketing and strategic management is a judgment of strength and weakness of the competitors. Companies generally do this analysis to understand the strength and weakness of their current and potential competitors. This analysis provides both offensive and defensive strategy to identify both opportunity and threats. IDBI federal Life Insurance is one of emerging insurance company. It is one of the few companies that have shown rapid growth since the day of its inception. In order to gain higher market Share Company has to understand its competitors that is their strength and weakness .Competitor analysis will help IDBI to understand strength and weakness of their competitors. This

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analysis will help IDBI to come up with offensive or defensive strategy to identify both opportunity and threats.

Some of the main competitors of IDBI federal are:1. Life Insurance Corporation of India (LIC)2. ICICI prudential3. SBI Life4. HDFC standard Life5. Bajaj Alliance

1. Life Insurance Corporation of India ( LIC): LIC was founded in 1956 with the merger of 243 insurance company and provident societies. It is the largest insurance and investment company in India. It is a state owned with 100% stake owned by government of India.

Products offered by LIC are:

1. Jeevan Arogya plan:Jeevan arogya plan is a unique non-linked health insurance plan which provides health insurance against certain specified health risk. LIC’s jeevan arogya plan is a direct competition to IDBI’s Healthsurance plan.

2. Bima Account plan:Under this plan the premiums payed by the customer after deduction of all charges, will be credited to the policyholders account maintained separately for each policyholder. If all premiums are paid the amount held in policyholder’s account will earn an annual interest rate of 6% p.a

3. Endowment plan:It’s a unit linked endowment plan which offers investment cum insurance cover during the term of the policy.

4. Children Plans5. Plan for Handicapped Dependents6. Endowment assurance plans7. Plans for high worth Individual8. Money Back Plans9. Special Money Back Plan for Women10.Whole Life Plans

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11.Term assurance plans12. Joint Life Plan

1.1 SWOT Analysis of LIC:SWOT Analysis is a strategic planning method used to analyze strength, weakness, opportunity and threat involved in a business or a project.1. Strength:

LIC is India’s largest state-owned company and also India’s largest investors

LIC has over 2000 branches all across India and more than 1, 00,000 agents.

LIC is the largest investor in India with largest fund base. LIC has over 1, 15,000 employees across India. LIC is the 8th most trusted brand of India. LIC has subsidiaries like LIC card services Ltd, LIC Housing

finance Ltd, LIC Nomura mutual fund.2. Weakness:

It lacks imagination since it has an image of a government company

Red tape, bureaucracy causes the problem since it is a government company.

During the economic crises managing a he workforce is a lot of burden.

2. ICICI Prudential:ICICI prudential Life Insurance Company is the joint venture of ICICI bank and Prudential Plc, one of the leading financial service groups in UK.Products offered by ICICI prudential:1. ICICI pru care:

It is an insurance plan that protects family’s future and ensures they lead their life comfortably.

2. Save n Protect3. Cash back4. Home Assure5. Life Guard

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6. ICICI pru iprotect7. Smartkid Regular premium8. ICICI pru Elite Life9. Group term insurance plan10.Group Gratuity plan11.Annuity solution12. ICICI pru life link pension SP13.Forever Life14.Immediate annuity15.ICICI pru heath saver16.ICICI pru Hospital care17.ICICI pru crisis cover18.ICICI pru Mediassure

SWOT Analysis of ICICI prudential:

STRENGTHS:1.Strong tie up2.Brand Equity3.Strong network4.Huge customer database5.Strong financial base

Weaknesses:1.Low customer awareness2.Less promotion3.Untouched Rural Population

OPPORTUNITIES:1.Untouched Rural market2.Large Uninsured population3.Network Building

Threats:1.Competitors2.Customer beliefs in LIC3.Fast turnover of employees

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4. ECONOMIC INDUSTRY ANALYSIS

4.1. INTRODUCTION TO INSURANCE INDUSTRY:Insurance is a form of risk management that shields insured from the risk of any uncertain of unfortunate events. In simple terms insurance can be defined as transfer of risk from one entity to another in exchange of the payment. The transaction consists of insured assuming a guaranteed small loss in the form of payment to the insurer in exchange of the promise to compensate insured in case of any kind of financial loss to insured. In a layman’s term, insurance is a guard against monetary loss arising on the happening of an unforeseen event. In developing countries like India insurance sector still holds lot of potential which need to be tapped.

4.2TYPES OF INSURANCE:Insurance can be classified into three categories:

1. Life Insurance:Life Insurance is a concord between the insurer and the policyholder, where insurer promises to pay beneficiary designated sum of money upon death of the insured person. Life Insurance covers number of contingencies like Death, Disability, and Disease.

2. General Insurance:General Insurance is a non-life insurance policy including automobile and homeowner policy. General insurance specifically consist of non- life insurance. It includes property insurance, liability insurance and other forms of insurance. Fire and Marine insurance are called property insurance.

3. Social Insurance:Social insurance is another type of insurance for weaker section of the society. It provides protection to weaker section of the society who are unable to pay premium. Industrial Insurance, sickness insurance, pension plan, disability benefits, unemployment benefits are some the type of social insurance.

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4.3 INSURANCE SECTOR IN INDIA:Indian insurance sector has gone through different phases of competition, from being an open competitive market to a nationalized market and then again getting back to liberalized market. Indian insurance sector has witnessed complete dynamism in past few centuries.

Insurance sector in India has a deep- rooted history. Its mention has been found in writings of Manu (Manusmriti), Yagnavalkya (dharmashastra) and Kautilya (Arthshastra). Ancient Indian history has preserved traces of insurance in the form of marine trade loans and carrier contracts.

Insurance industry in India is governed by Insurance Act of 1938, Life Insurance Corporation Act of 1956 and General Insurance business Act, 1972, Insurance Regulatory and Development Authority (IRDA) Act of 1999 and other related acts. Insurance industry in India is considered as an industry with big potential market. One of the reason that India is seen as huge potential market is because of its huge population and untapped market area of this population. In terms of population India has an immense potential expanding their life insurance cover. Majority of people in India are unaware of the functions and benefits of Insurance because of which insurance sector has a bright future in India. But it is relevant to consider factors like different varieties of social structure, urban and rural composition other than very important factors like age, sex, income level, literacy level. Making assessment of Life Insurance potential of India is very difficult task due to wide variance in every aspect of Indian circumstances and without a refined analysis any estimate would be meaningless.

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4.4 INDIAN INSURANCE INDUSTRY AT PRESENT: Life Insurance Corporation (LIC) had the monopoly over the market till the late 90’s when the insurance sector in India was opened for private players. Before that there were only two state insurer, one was LIC (Life Insurance Corporation of India) and GIC (General Insurance corporation of India).

Indian insurance sector at present has undergone many structural changes in 2000. The Government of India has liberalized the insurance sector in 2000 with IRDA (Insurance Regulatory and development authority) lifting all entry restriction of foreign players with a specific limit on direct foreign ownership. Under the current guideline 26% of equity cap is there for foreign players in an insurance company and proposal is being given to increase this limit to 49%. Post liberalization insurance industry in India have come a long way and today it stands as one of the most competitive, challenging and exploring industry in India. Increased use of new distribution channels are in limelight today due to entry of private players. In the long run the use of these distribution channels and modern IT tools has increased scope of the insurance industry. Also the changing economics patterns, changing political scenario, modern IT tools will eventually help in reshaping future of Indian financial market and Life Insurance business in the country.

4.5 REGULATORY ISSUES:Insurance Regulatory and Development Authority (IRDA) is a national agency of government of India. It was formed by an act of Indian Parliament known as IRDA Act 1999 which was amended in 2002 to incorporate some upcoming requirement. It is responsible for protecting the interest of policy holders, to regulate and promote orderly growth of Insurance Industry in India. To achieve this objective IRDA has taken following steps:

1. IRDA has notified protection of policyholders Interest Regulation 2001 to provide for: policy proposal document is in easily understandable language; claims procedure in both life and non-life; setting up grievance redress machinery; speedy settlement of claims and policy holders servicing. The regulation also provides for payment of interest by insurer for delay in settlement of claims.

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2. Solvency margins are to be maintained by the insurer so that they can be in a position to meet their obligation towards the policyholder with respect to payment of claims.

3. The Insurance Company has to clearly disclose the benefits, terms and condition under the policy.

4. The advertisement issued by the insurer should not mislead the insuring public.

5. Proper grievance redress machinery should be set up in the head office and all the other offices by the insurer.

6. If any complaints are received by the policyholder with respect to the services provided by the insurer under the insurance contact, then the authority takes up with the insurer.

7. Insurer has to maintain separate account related to the fund of Policyholder. The funds of the policyholder should be retained within the country.

8. According to the new regime, Insurance companies will have to exposure to rural and social sector.

4.6 CRITICAL SUCCESS FACTORS: Post Liberalization Insurance industry in India has become very competitive. With

private players entering into the India market making the market lot more competitive. Insurance industry in India has become highly competitive with different companies and individual agents competing against each other to gain higher market share. In order to gain higher market share companies have to differentiate themselves from others. Companies can differentiate themselves in the market by using a number of critical success factors:

1. Product Quality:One the most important factor that differentiates companies is by the quality of product it offers. Quality of product instills a confidence in the customer that the product offered by the company is better. Better the quality of product, more successful is the company.

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2. Developing relationships with the customer:Insurance Industry is a highly competitive industry. In order to gain the market share first priority is to be given to the customer. Range of product and services should be designed to give the customer what he desires.

3. Market Segmentation:Greater market segmentation should be done in which target audience should be divided into homogenous groups and products and services should be targeted towards such market. This would tie company to their client by customized combination of coverage, easy payment plan, risk management advice and quick claim handling.

4. Designing new strategies:Insurance Industry cannot be satisfied with consolidation of their existing market, but have to achieve future growth and penetration. Companies must focus on new distribution channels, strengthening their existing point of services, direct contact with their ultimate customer, refresh their marketing setup, new comers should focus on tapping the market which is left unexploited by public sector companies.

5. Shift towards Rural market:Rural market is India is still uncovered by this sector. Insurance penetration can be achieved by tapping the untapped rural market of India.

6. Motivating sales force:Sales force is one the major strength that the company has that could differentiate them from their competitors. A good sales force can do wonders to the future of the company, because of which a proper motivation of sales force is very important for the company. Life Insurance Company should constantly involve in motivating their sales force so that they can meet their target on time.

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7. Use of technology:Technology plays a very important role in the success of the company. Internet based Life insurance will help companies to reduce time and transaction cost and also improves quality of services to its customer.

4.7 DOMESTIC ECONOMIC CONDITIONS:Domestic economic conditions play a major role in growth or downfall of an Insurance company, No matter how financially stable an insurer is; none is immune to the slow economic growth. In an Indian economy double digit inflation is one the uncomfortable factor and RBI which is the central bank of India has a huge task of controlling the inflation without hampering the economic growth. Trade off between Interest rates and Inflation has been the core the business of the RBI and the past one year has been very difficult for the RBI. In an attempt to manage inflation, RBI has been constantly raising repo rate and reverse-repo rates every quarter but it has not succeeded in moderating inflation. This simply implies that inflation is more of a supply side issue than a monetary implication. The implications of this relatively high interest rates and high inflation regime are unlikely to be positive for insurance industry. It would be difficult for an Insurance industry to manage return expectations as they are likely to be high. While competing with a fixed income product higher assured returns are required for high.Interest rates in order to increase penetration. There may be some reductions in actual growth rates, but Indian’s long term fundamentals remain intact as life Insurance being an industry with long time horizon, it would be able to tide over economic cycle.

Inflation on the other hand means lower disposal incomes in the hand of the consumer leading to lower household savings which currently stands at 34.7%, though significantly lower than china which is 50%.

4.8 GLOBAL ECONOMIC ENVIRONMENT:

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According to the Swiss Re’s newly appointed Economist, Kurl Karl low interest rates and euro debt crisis will prove to be a problem for insurance industry. According to Kurt karl momentum of growth has been slowed down due to this two factors, but the only bright spot according to him is the ongoing growth in the emerging market. However Kurl is lot more optimistic looking forward to 2013 forecasting a pick-up in investment yield and premium in a modest improvement in economic conditions.

1. Political Development:Political developments are the more serious threat in Europe and US. In Europe this can lead to serious sovereign defaults and also exit from the euro monetary union.

2. Emerging markets has been negatively impacted by faltering growth in the developed economy. Also tighter monetary policies on the part of several emerging economies also slowed down growth.

3. Both global in-force and new business life insurance fell in 2011, but it again recovered. According to the economist in order to return to the pre-crisis profitability short- term factors like low investment returns, high hedging cost and more onerous capital requirement. Life Insurance industry’s capitalization has improved markedly and it is in the better shape to cope up with the future challenges.

4. Because of some Regulatory changes in China and India, coming two years will see life insurance business in emerging market returning to its long term trend of around 8%.

4.9 DEMAND DRIVERS:Insurance industry in India has become lot more competitive in recent years. With private players entering into the market, competition level has significantly increased with more private players trying to gain more market share. Some of the demand drivers that give change

to the smaller companies to compete against giants like Life Insurance Corporation of India Ltd (LIC) which has 70% market share are:

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1. Rural market: According to the Mckinsey report, titled India Insurance 2012: Fortune Favors the Bold, finds that the sector is still in a dissident with different players in different stage of development and market presence. According to the Mckinsey’s report the rural penetration is likely to increase from about 25% at present to around 35-40% in 2012. With 65% of the Life insurance coming from rich urban class, smaller companies can look for rural and low income group as potential demand driver.

2. Product Mix;A better product mix would also drive growth of insurance companies, with companies making a move to lower the share of single premium products.

Life insurance product can also fill the gap that is created by growing demand for investment products and long-term savings

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5 LITERATURE REVIEW

5.1 LITERATURECapital structure is defined as the specific mix of debt and equity a firm uses to finance its operations. Four important theories are used to explain the capital structure decisions. These are based on asymmetric information, tax benefits associated with debt use, bankruptcy cost and agency cost. The first is rooted in the pecking order framework, while the other three are described in terms of the static trade-off choice. These theories are discussed in turn.

The concept of optimal capital structure is expressed by Myers (1984) and Myers and Majluf (1984) based on the notion of asymmetric information. The existence of information asymmetries between the firm and likely finance providers causes the relative costs of finance to vary among different sources of finance. For example, an internal source of finance where the funds provider is the firm will have more information about the firm than new equity holders, thus these new equity holders will expect a higher rate of return on their investments. This means it will cost the firm more to issue fresh equity shares than to use internal funds. Similarly, this argument could be provided between internal finance and new debt-holders. The conclusion drawn from the asymmetric information theories is that there is a certain pecking order or hierarchy of firm preferences with respect to the financing of their investments (Myers and Majluf, 1984). This “pecking order” theory suggests that firms will initially rely on internally generated funds, i.e., undistributed earnings, where there is no existence of information asymmetry; they will then turn to debt if additional funds are needed, and finally they will issue equity to cover any remaining capital requirements. The order of preferences reflects the relative costs of various financing options. Clearly, firms would prefer internal sources to costly external finance (Myers and Majluf, 1984). Thus, according to the pecking order hypothesis, firms that are profitable and therefore generate high earnings are expected to use less debt capital than those that do not generate high earnings.

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Capital structure of the firm can also be explained in terms of the tax benefits associated with the use of debt. Green, Murinde and Suppakitjarak (2002) observe that tax policy has an important effect on the capital structure decisions of firms. Corporate taxes allow firms to deduct interest on debt in computing taxable profits. This suggests that tax advantages derived from debt would lead firms to be completely financed through debt. This benefit is created, as the interest payments associated with debt are tax deductible, while payments associated with equity, such as dividends, are not tax deductible. Therefore, this tax effect encourages debt use by the firm, as more debt increases the after tax proceeds to the owners (Modigliani and Miller, 1963; Miller, 1977). It is important to note that while there is corporate tax advantage resulting from the deductibility of interest payment on debt, investors receive these interest payments as income. The interest income received by the investors is also taxable on their personal account, and the personal income tax effect is negative. Miller (1977) and Myers (2001) argue that as the supply of debt from all corporations expands, investors with higher and higher tax brackets have to be enticed to hold corporate debt and to receive more of their income in the form of interest rather than capital gains. Interest rates rise as more and more debt is issued, so corporations face rising costs of debt relative to their costs of equity. The tax benefits arising from the issue of more corporate debt may be offset by a high tax on interest income. It is the trade-off that ultimately determines the net effect of taxes on debt usage (Miller, 1977; Myers, 2001).

Bankruptcy costs are the costs incurred when the perceived probability that the firm will default on financing is greater than zero. The potential costs of bankruptcy may be both direct and indirect. Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy process. Haugen and Senbet (1978) argue that bankruptcy costs must be trivial or nonexistent if one assumes that capital market prices are competitively determined by rational investors. Examples of indirect bankruptcy costs are the loss in profits incurred by the firm as a result of the unwillingness of stakeholders to do business with them. Customer dependency on a firm’s goods and services and the high probability of bankruptcy affect the solvency of firms (Titman, 1984). If a business is perceived to be close to bankruptcy, customers may be less willing to buy its goods and services because of the risk that the firm may not be able to meet its warranty

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obligations. Also, employees might be less inclined to work for the business or suppliers less likely to extend trade credit.

These behaviours by the stakeholders effectively reduce the value of the firm. Therefore, firms that have high distress cost would have incentives to decrease outside financing so as to lower these costs. Warner (1977) maintains that such bankruptcy costs increase with debt, thus reducing the value of the firm. According to Modigliani and Miller (1963), it is optimal for a firm to be financed by debt in order to benefit from the tax deductibility of debt. The value of the firm can be increased by the use of debt since interest payments can be deducted from taxable corporate income. But increasing debt results in an increased probability of bankruptcy. Hence, the optimal capital structure represents a level of leverage that balances bankruptcy costs and benefits of debt finance. The greater the probability of bankruptcy a firm faces as the result of increases in the cost of debt, the less debt they use in the issuance of new capital (Pettit and Singer, 1985).

The use of debt in the capital structure of the firm also leads to agency costs. Agency costs arise as a result of the relationships between shareholders and managers, and those between debt-holders and shareholders (Jensen and Meckling, 1976). The relationships can be characterized as principal-agent relationships. While the firm’s management is the agent, both the debt-holders and the shareholders are the principals. The agent may choose not to maximize the principals’ wealth. The conflict between shareholders and managers arises because managers hold less than 100% of the residual claim (Harris and Raviv, 1990). Consequently, they do not capture the entire gain from their profit-enhancing activities but they do bear the entire cost of these activities. Separation of ownership and control may result in managers exerting insufficient work, indulging in perquisites, and choosing inputs and outputs that suit their own preferences. Managers may invest in projects that reduce the value of the firm but enhance their control over its resources. For example, although it may be optimal for the investors to liquidate the firm, managers may choose to continue operations to enhance their position. Harris and Raviv (1990) confirm that managers have an incentive to continue a firm’s current operations even if shareholders prefer liquidation.

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On the other hand, the conflict between debt-holders (creditors) and shareholders is due to moral hazard. Agency theory suggests that information asymmetry and moral hazard will be greater for smaller firms (Chittenden et al., 1996). Conflicts between shareholders and creditors may arise because they have different claims on the firm. Equity contracts do not require firms to pay fixed returns to investors but offer a residual claim on a firm’s cash flow. However, debt contracts typically offer holders a fixed claim over a borrowing firm’s cash flow. When a firm finances a project through debt, the creditors charge an interest rate that they believe is adequate compensation for the risk they bear. Because their claim is fixed, creditors are concerned about the extent to which firms invest in excessively risky projects. For example, after raising funds from debt-holders, the firm may shift investment from a lower-risk to a higher-risk project.

According to Jensen and Meckling (1976), the conflict between debt-holders and equity-holders arises because debt contract gives equity-holders an incentive to invest sub optimally. More specifically, in the event of an investment yielding large returns, equity-holders receive the majority of the benefits. However, in the case of the investment failing, because of limited liability, debt-holders bear the majority of the consequences. In other words, if the project is successful, the creditors will be paid a fixed amount and the firm’s shareholders will benefit from its improved profitability. If the project fails, the firm will default on its debt, and shareholders will invoke their limited liability status. In addition to the asset substitution problem between shareholders and creditors, shareholders may choose not to invest in profitable projects (under invest) if they believe they would have to share the returns with creditors.

The agency costs of debt can be resolved by the entire structure of the financial claim. Barnea et al. (1980) argue that the agency problems associated with information asymmetry, managerial (stockholder) risk incentives and forgone growth opportunities can be resolved by means of the maturity structure and call provision of the debt. For example, shortening the maturity structure of the debt and the ability to call the bond before the expiration date can help reduce the agency costs of underinvestment and risk-shifting. Barnea et al. (1980) also

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demonstrate that both features of the corporate debt serve as identical purposes in solving agency problems.

5.2 THEORIES OF CAPITAL STRUCTURE

5.2.1 INTRODUCTION:The Capital Structure or financial leverage decision should be examined from the point of its impact on the value of the firm. If capital structure decision can affect a firm’s value, then it would like to have a capital structure, which maximizes its market value. However, there exist conflicting theories on the relationship between capital structure and the value of a firm. The traditionalists believe that capital structure affects the firm’s value while Modigliani and Miller (MM), under the assumptions of perfect capital markets and no taxes, argue that capital markets and no taxes, argue that capital structure decision is irrelevant. MM reverses their position when they consider taxes. Tax savings resulting from interest paid on debt create value for the firm. However, the tax advantage of debt is reduced by personal taxes and financial distress. Hence, the tradeoff between costs and benefits of debt can turn capital structure into a relevant decision. There are other views also on the relevance of capital structure; we first discuss the traditional theory of capital structure followed by MM theory and other views.

The capital structure of a company refers to a contamination of the long-term finances used by the firm. The theory of capital structure is closely related to the firm’s cost of capital. The decision regarding the capital structure or the financial leverage or the financing wise is based on the objective of achieving the maximization of shareholders wealth.

To design capital structure, we should consider the following two propositions :

1) Wealth maximization is attained2) Best approximation to the optimal capital structure.

What is capital Structure?

Since capital is expensive for small businesses, it is particularly important for small business owners to determine a target capital structure for their firms. The capital

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structure concerns the proportion of capital that is obtained through debt and equity. There are tradeoffs involved: using debt capital increases the risk associated with the firm's earnings, which tends to decrease the firm's stock prices. At the same time, however, debt can lead to a higher expected rate of return, which tends to increase a firm's stock price. As Brigham explained, "The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of the stock and simultaneously minimizes the cost of capital."

Capital structure decisions depend upon several factors. One is the firm's business risk—the risk pertaining to the line of business in which the company is involved. Firms in risky industries, such as high technology, have lower optimal debt levels than other firms. Another factor in determining capital structure involves a firm's tax position. Since the interest paid on debt is tax deductible, using debt tends to be more advantageous for companies that are subject to a high tax rate and are not able to shelter much of their income from taxation.

A third important factor is a firm's financial flexibility, or its ability to raise capital under less than ideal conditions. Companies that are able to maintain a strong balance sheet will generally be able to obtain funds under more reasonable terms than other companies during an economic downturn. Brigham recommended that all firms maintain a reserve borrowing capacity to protect themselves for the future. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.

SOURCES OF CAPITAL

DEBT CAPITAL Small businesses can obtain debt capital from a number of different sources. These sources can be broken down into two general categories, private and public sources. Private sources of debt financing, according to W. Keith Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, include friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit,

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insurance companies, factor companies, and leasing companies. Public sources of debt financing include a number of loan programs provided by the state and federal governments to support small businesses.

There are many types of debt financing available to small businesses—including private placement of bonds, convertible debentures, industrial development bonds, and leveraged buyouts—but by far the most common type of debt financing is a regular loan. Loans can be classified as long-term (with a maturity longer than one year), short-term (with a maturity shorter than two years), or a credit line (for more immediate borrowing needs). They can be endorsed by co-signers, guaranteed by the government, or secured by collateral—such as real estate, accounts receivable, inventory, savings, life insurance, stocks and bonds, or the item purchased with the loan.

When evaluating a small business for a loan, Jennifer Lindsey wrote in her book The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year operating history, a stable management group, a desirable niche in the industry, a growth in market share, a strong cash flow, and an ability to obtain short-term financing from other sources as a supplement to the loan. Most lenders will require a small business owner to prepare a loan proposal or complete a loan application. The lender will then evaluate the request by considering a variety of factors. For example, the lender will examine the small business's credit rating and look for evidence of its ability to repay the loan, in the form of past earnings or income projections. The lender will also inquire into the amount of equity in the business, as well as whether management has sufficient experience and competence to run the business effectively. Finally, the lender will try to ascertain whether the small business can provide a reasonable amount of collateral to secure the loan.

EQUITY CAPITAL Equity capital for small businesses is also available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as "angels"), employees, customers and suppliers, former employers, venture capital firms,

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investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs).

There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms; and public stock offerings. Private placement is simpler and more common for young companies or startup firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.

In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for startup firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.

Factors determining capital structure

1) Minimization of Risk: a> capital structure must be consistent with business risk b> It should result in a certain level of financial risk.

2) Control: It should reflect the management’s philosophy of control over the firm.3) Flexibility: It refers to the ability of the firm to meet the requirement of the

changing situation.4) Profitability: It should be profitable from the equity shareholders point of view.5) Solvency: The use of excessive debt may thereafter the solvency of the

company.

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Process of capital structure decision

MEANING OF CAPITAL STRUCTURE:

A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

Assumptions:

1) There are only two sources of funds i.e. the equity and debt, having a fixed interest

2) The total assets of the firm are given and there would be no change in the investment decision of the firm

3) EBIT (Earnings before Interest & Tax)/ NOP (Net Operating Profits) of the firm are given and is expected to remain constant.

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Long-term sources of funds

Capital Budgeting decision

Capital Structure Decision

Dividend Decision

Debt Equity

Existing Capital structure

Effect On

Investor Risk

Effect On Cost

Of Capital

Effects On Earnings Per Share (EPS)

Value of Firm

4) Retention ratio is NIL,, i.e., total profits are distributed as dividends. [100% dividend pay-out ratio]

5) The firm has a given business risk which is not affected by the financing wise.

6) There is no corporate or personal taxes7) The investors have the same subjective probability distribution of expected

operation profits of the firms8) The capital structure can be altered without incurring transaction costs.

Elements of Capital Structure:-

A company formulating its long term financial policy should, first of all analyze its current financial structure, the following are the important elements of the company’s financial structure that need proper scrutiny and analysis.

1) Capital Mix:- Firms have to decide about the mix of debt and equity capital, debt capital can be mobilized from a variety of sources, How heavily does the company depend on debt? What is the mix of debt instruments? Given the company’s risks, is the reliance on the level and instruments of debt reasonable? Does the firm’s debt policy allow its flexibility to undertake strategic investments in adverse financial condition? Ther firms and analysts use debt ratios, debt service coverage ratios, and the funds flow statement analyze the capital mix

2) Maturity and priority:- The maturity of securities used in the capital mix may differ. Equity is the most permanent capital. Within debt, commercial paper has the shortest maturity and public debt has the longest, Similarly, the priorities of securities also differ. Capitalized debt like lease or hire purchase finance is quite safe from the lender’s point of view and the value of assets backing the debt provides the protection to the lender. Collateralized or secured debts are relatively safe and have priority over unsecured debt in the event of insolvency. Do maturities of the firm’s assets and liabilities match? If not, what trade off is the firms making? A firm may obtain a risk neutral position by matching the maturity of assets and liabilities that is it may use current liabilities to finance current assets and short medium and long term debt for financing the fixed assets in that order of maturities. In practise,

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firms do not perfectly match the sources and uses of funds. They may show preference for retained earnings. Within debt, they may use long term funds to finance current assets and assets with shorter life. Some firms are more aggressive, and they use short term funds to finance long term assets.

3) Terms & Condition:- Firms have choices with regard to the basis of interest payments. They may obtain loans either at fixed or floating rates of interest. In case of equity, the firm may like to return income either in the form of large dividends or large capital gains. What is the firm’s preference with regard to the basis of payments of interest and dividend? How do the firm’s interest and dividend payments match with its earnings and operating cash flows? The firm’s choice of the basis of payments indicates the management’s assessment about the future interest rates and the firm’s earnings. Does the firm have protection against interest rates fluctuations? The financial manager can protect the firm against interest rates fluctuations through the interest rates derivatives. There are other important terms and conditions that the firm should consider. Most loan agreements include what the firm can do and what it can’t do. They may also state the schemes of payments, pre-payments, renegotiations, etc. What are the lending criteria used by the suppliers of capital? How do negative and positive conditions affect the operations of the firm? Do they constraint and compromise the firm’s competitive position? Is the company level to comply with the terms and conditions in good time and bad time?

4) Currency:- Firms in a number of countries have the choice of raising funds from the overseas markets. Overseas financial markets provide opportunities to raise large amounts of funds. Accessing capital internationally also helps company to globalize its operations fast. Because international financial markets may not be perfect and may not be fully integrated, firms may be able to issue capital overseas at lower costs than in the domestic markets. The exchange rates fluctuations can create risk for the firm in servicing it foreign debt and equity. The financial manager will have to ensure a system of risk hedging. Does the firm borrow from the overseas markets? At what terms and condition? How has firm benefited operationally and or financially in raising funds overseas? Is there a consistency between the firm’s foreign currency obligations and operating inflows?

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5) Financial innovation:- Firms may raise capital either through the issue of simple securities or through the issues of innovative securities. Financial innovations are intended to make the security issue attractive to investors and reduce cost of capital. For example, a company may issue convertible debentures at a lower interest rate rather than non convertible debentures at a relatively higher interest rate. A further innovation could be that the company may offer higher simple interest rate on debentures and offer to convert interest amount into equity. The company will be able to conserve cash outflows. A firm can issue varieties of option linked securities it can also issue tailor made securities to a large suppliers of capital. The financial manager will have to continuously design innovative securities to be able to reduce the cost. An innovation introduced once does not attract investors any more. What is the firm’s history in arms of issuing innovative securities? What were the motivations in issuing innovative securities and did the company achieve intended benefits?

6) Financial market segments:- There are several segments of financial markets from where the firm can tap capital form example, a firm can tap the private or the public debt market for raising long terms debt. The firm can raise short term debt either from banks or by issuing commercial papers or certificate deposits in the money market. The firm also has the alternative of raising short term funds by public deposits. What segments of financial markets have the firm tapped for raising funds and why? How did the firm tap and approach these segments.

In Discussing the theories of capital structure we will consider the following notations:

E= Market value of equity.

D= Market value of the Debt.

V= Market value of the firm = E+D

I= Total interest Payment

T= Tax Rate

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EBIT/ NOP= Earnings Before interest and tax or Net Operating Profit

PAT= Profit after tax

Do= Dividend at time (i.e. now)

D1= Expected dividend at the end of Year 1

Po= Current Market Price Per Share.

P1= Expected Market Price per share at the end of year 1

Kd= Cost of debts after tax 1(1-T)/d

Ke= Cost of Equity D1/P0

Ko= overall cost of capital i.e. WACC

=Kd (D/D+E) + Ke (E/D+E)

=kd (D/V) + Ke (E/V) = Kd D/ V + Ke E/V = Kd D+ Ke E/V

=EBIT/V

5.3 DIFFERENT THEORIES OF CAPITAL STRUCTURE1> Net Income (NI) Approach2> Net Operating Income (NOI) Approach.3> Traditional Approach4> Modigliani-Miller Model

a> without taxes.b> with taxes.

5.3.1 NET INCOME APPROACHA firm that finances its assets by equity and debt is called a levered firm. On the other hand, a firm that uses no debt and finances its assets entirely by equity is called and unlevered firm. Suppose firm L is levered firm and it expected EBIT or net operating Income of Rs 100- and interest payment of Rs 300. The firms cost of equity (or equity capitalization rate), ke, is 9.33 and the cost of debt, kd, is 6 percent. What is the firm’s value? The value of the firm is the sum of the values of all of its securities. In this case, firm L’s securities include equity and debt;

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therefore the sum of the values of equity and debt is the firm’s value. The value of a firm’s value. The value of a firm’s share (equity), I, is the discounted value of shareholders NOI-Interest 1000-300= Rs 700, and the cost of equity is 9.33 percent. Hence the value of L’s equity is 700/0.0933=Rs 7500

Value of equity= discounted value of net income

E= Net Income/cost of equity =NI/ke

= 700/0.0933= Rs 7,500

Similarly the value of a firm’s debt is the discounted value of debt-holders interest income. The value of L’s debt is: 300/0.06 = Rs 5000

Value of debt=discounted value of interest

D=Interest/Cost of debt=INT/kd

=300/0.06= Rs 5000

The value of firm L is the sum of the value of equity and the value of debt:

Value of firm=value of equity + Value of debt

V= E+D

= 7,500+5,000= Rs 12,500

Firm’s L’s value is Rs12,500 and its expected net operating income is Rs 1,000. Therefore the firm’s overall expected rate of return or the cost of capital is:

Firm’s cost of capital= Net operating income/ Value of firm.

Ko=NOI/V

= 1000/12,500=0.08 or 8%

The firm’s overall cost of capital is the weighted average cost of Capital (WACC). There is an alternative way of calculating WACC. WACC is the weighted average of costs of all of the firm’s securities Firm L’s securities include debt and equity. Therefore, firm’s L’s WACC or Ko is the weighted average of the cost of equity

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and the cost of debt firm L’s value is Rs 12,500, Value of its equity is Rs 7,500 and value of its debt is Rs 5000. Hence the firm’s debt ratio (D/V) is 5000/12500 =0.40 or 40 percent and equity ratio (E/V) is 7,500/12,500 = 0.60 or 60 percent. Firm’s L’s weighted average cost of capital is:

WACC= Cost of equity x equity weight + cost of debt x debt weight

Ko = ke x E/V + Kd x D/V

Ko = 0.0933 x 7,500/12,500 + 0.60 x 5000/12,500

Ko = 0.0933 x 0.60 + 0.06 x 0.40

= 0.56 + 0.025 = 0.08 or 8 percent

As suggested by David Durand, this theory states that there is a relationship between the capital structure and the value of the firm.

Assumption

1> Total capital requirement of the firm are given and remain constant2> Kd< Ke3> Kd and Ke are constant4> Kd decreases with the increase in leverage.

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Cost Of Capital(%)

O Degree Of Leverage

Ke

KoKd

Illustration

Particulars Firm A Firm B

Earnings Before interest of Tax (EBIT) 2,00,000 2,00.000

Interest 50,000

Equity earnings (E) 2,00,000 1,50,000

Cost Of Equity 12% 12%

Cost of Debt 10% 10%

Market Valu of Equity =E/Ke 16,66,667 12,50,000

Market value of debt = I/Ke Nil 5,00,000

Total value of the firm [E+D] 16,66,667 17,50,000

Overall cost of capital (Ko) = EBIT/E+d 12% 11.43%

5.3.2 NET OPERATING INCOME (NOI) APPROACH:According to David Durand, under NOI approach, the total value of the firm will not be affected by the composition of capital structure.

Assumption:-

1) Ko and Kd is constant.2) Ke will change with degree of leverage3) There is no tax.

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Illustration

A firm has an EBIT of Rs 5,00,000 and belongs to a risk class of 10%. What is the cost of equity if it employs 8% debt to the extent of 30%, 40% or 50% of the total capital fund of Rs 20,00,000?

Solution

Particulars 30% 40% 50%

Debt (Rs) 6,00,000 8,00,000 10,00,000

Equity (Rs.) 14,00,000 12,00,000 10,00,000

EBIT (Rs.) 5,00,000 5,00,000 5,00,000

Ko 10% 10% 10%

Value of the Firm (V) (Rs.) 50,00,000 50,00,000 50,00,000

(EBIT/Ko)

Value of Equity (E) (Rs.) 44,00,000 42,00,000 40,00,000

(V-D)

Interest @ 6% (Rs.) 36,000 48,000 60,00043 | P a g e

Cost OfCapital (%)

O Degree Of Leverage

Ke

Ko

Kd

Net Profit (EBIT-Int..) (Rs.) 4,64,000 4,52,000 4,40,000

Ke (NP/E) 10.54% 10.76% 11%

5.3.3 TRADITIONAL APPROACH:It takes a mid-way between the NI approach and the NOI approach

Assumption

1> The value of the firm increases with the increase in financial leverage. Upto a certain limit only.

2> Kd is assumed to be less than Ke

(Part 1) (Part 2)

Traditional viewpoint on the Relationship

between Leverage, cost of capital

and the value of the firm.

5.3.4 MODIGLIANI – MILLER (MM) HYPOTHESISThe Modigliani- Miller hypothesis is identical with the net operation Income approach, Modigliani and Miller argued that, in the absence of taxes the cost of capital and the value of the firm are not

affected by the changes in capital structure. In other words, capital structure decision are irrelevant and value of the firm is independent of debt-equity mix.

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CostOf Capital(%)

Optimal Capital Structure

O Leverage (Degree)

KeKoKd

Basic propositions

M- M Hypothesis can be explained in terms of two propositions of Modigliani and Miller They are:

1) The overall cost of capital (Ko) and the value of the firm are independent of the capital structure. The total market value of the firm is given capitalising the expected net operating income by the rate appropriate for that risk class.

2) The financial risk increases with more debt content in the capital structure. As a result cost of equity (Ke) increases in a manner to offset exactly the low- cost advantage of debt. Hence overall cost of capital remains the same.

Assumptions of the MM Approach

1) There is a perfect capital market. Capital markets are perfect whena) Investors are free to buy and sell securitiesb) They can borrow funds without restriction at the same terms as the firms

do,c) They behave rationallyd) They are well informed, ande) There are no transaction costs.

2) Firms can be classified into homogeneous risk classes. All the firms in the same risk class will have the same degree of financial risk

3) All investors have the same expectation of a firm’s net operating income (EBIT)

4) The dividend payout ratio is 100% which means there are no retained earnings

5) There are no corporate taxes. This assumption has been removed later.

Preposition 1

According to M-M for the firms in the same risk class, the total market value is independent of capital structure and is determined by capitalising net operating by the rate appropriate to that risk class. Preposition 1 can be expressed as follows

V = S+D = X/Ke =NOI/Ke

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Range of OptimalCapital Structure

O P Leverage(Degree)

Where V = the market value of the firm

S = the market value of equity

D = the market value of debt

According the preposition 1 the average cost of capital is not affected by degree of leverage and determined as follows

Ke = X/V

According to M-M the average cost of capital is constant as shown in the following firms

5.4 ARBITRAGE PROCESSAccording to M-M two firms identical in all respects except their capital structure, cannot have different market values or different cost of capital. In case, these firms have different market values, the arbitrage will take place and equilibrium in market values restored in no time. Arbitrage process refers to switching of investment of investment from one firm another. When market values are different, the investors will try to take advantage of it by selling their securities with high market price and buying the securities with low market price. The use of debt by the investors is known as personal leverage or home made leverage.

Because of this arbitrage process, the market price of securities in higher valued market will come down and the market price of securities in the lower valued

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Cost OfLeverage

O Average Cost Of CapitalX

Ko

Y

market will go up, and this switching process is continued until the equilibrium is established in the market values, so M-M argue that there is no possibility of different market value for identical firms

Reverse Working Of Arbitrage Process

Arbitrage process also works in the reverse direction, Leverage has neither advantage nor disadvantage. If an unlevered firm (With debt Capital) has higher market value than a levered firm (With debt capital) arbitrage process works in reverse direction. Investors will try to switch their investments from unlevered firm to levered firm to levered firm so that equilibrium is established in no time

Thus M-M proved in terms of their proposition 1 that the value of the firm is not affected by debt equity mix.

Preposition 2

M-M argue that Ko will not increase with the increase in the leverage because the low-cost advantage of debt capital will be exactly offset by the increase in the cost of equity as caused by increased risk to equity shareholders. The crucial part of the M-M thesis is that an excessive us of leverage will increase the risk to the debt holders which results in an increase in cost of debt (Ko). However this will not lead to a rise in Ko, M-M maintain that in such a case Ke, will increase at a decreasing rate or even it may decline. This is because of the reason that at an increased leverage. The increased risk will be shared by the debt holders. Hence Ko remain constant. This is illustrated in the figure given below.

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Y

O Leverage XKd

KeKo

MM Hypothesis and Cost Of Capital

5.5 CRITICISM OF MM HYPOTHESISThe arbitrage process is the behavioral and operational foundation for M M Hypothesis. But this process fails the desired equilibrium because of the following limitation.

1) Rates of interest are not the same for individuals and firms. The firms generally have a higher credit standing because of which they can borrow funds at a lower rate of interest as compared to individuals

2) Home- Made leverage is not a perfect subsititute for corporate leverage. If the firm borrows, the risk to the shareholders is limited to hi shareholding in that company. But if he borrows personally, the liability will be extended to his personal property also. Hence, the assumption that personal home-made leverage is a perfect substitute for corporate leverage is not valid.

3) The assumption that transactions costs do not exist is not valid because these costs are necessarily involved in buying and selling securities

4) The working of arbitrage is affected by institutional restrictions, because the institutional investors are not allowed to practise home-made leverage.

5) The major limitation of M-M hypothesis is the existence of corporate taxes. Since the interest charges are tax deductible, a levered firm will have a lowes cost of debt due to tax advantage when taxes exist

5.6 M-M HYPOTHESIS CORPORATE TAXESModigliani and Miller later recognized the importance of existence of corporate taxes. Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the optimum capital structure can be achieved by maximizing debt component in the capital structure.

According to this approach, value of a firm can be calculated as follows

Value of Unlevered firm (Vu) = EBIT/Ke (I-t).

Where EBIT = Earnings before interest and taxes48 | P a g e

Ke = overall cost of capital

T = tax rate

I = interest on debt capital.

5.7 AGENCY COSTSIn practice, there may exist a conflict of interest among shareholders, debt holders and management. These conflicts give rise to agency problems, which involve agency costs. Agency costs have their influence on a firm’s capital structure.

1) Shareholders-Debt holder conflict:- Debt holders have a preferential, but fixed claim over the firm’s assets. Shareholders, on the other hand, have a residual, but unlimited claim on the firm’s assets. They also have limited liability for the firm’s obligations. In financial crisis, shareholders can simply opt out from owing the firm. In a highly geared (levered) firm, the debt holders risk is very high since shareholders have limited liability. They are not compensated for the added risk of default, which tantamount to transfer of wealth from debt-holders to shareholders. The conflict between shareholders (or managers working on behalf of shareholders) and debt holders arise because of the possibility of shareholders transferring the wealth of debt holders in their favor. The debt holders may lend money to invest in low risk projects while the firm may invest it in high risk projects while the firm may invest it in high risk projects. Firm may also raise substantial risky new debt and thus, increase the debt holder’s risk.

2) Shareholders- Managers Conflict:- Shareholders are the legal owners of a company, and management is required to act in their best interest as their agents. The conflict between shareholders and managers may arise on two counts. First, managers may transfer shareholders wealth to their advantage by increasing their compensation and perquisites. Second, managers may not act in the best interest of shareholders in order to protect their jobs. Managers may not undertake risk and forego profitable investments

3) Monitoring and agency costs:- The agency problems arising from the conflicts between shareholders, debt-holders and managers are handled through monitoring and restrictive covenants. External invertors know that managers

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may not function in their interests, therefore, they have a tendency of discounting the prices of the firm’s securities. These investors require monitoring and restrictive covenants to protect their interests. Debt holders put restrictions on the firm in terms of new debt. They also involve experts and outsiders to evaluate the soundness of the firm and monitor the firms subsequent actions. Similarly, shareholders create many monitoring mechanisms to ensure that managers raise and invest funds keeping in mind the principle of Shareholder’s Wealth Maximization. The costs of monitoring and restrictive covenants are called agency costs. Agency costs of debt take account of the likelihood of the shareholders attempt to expropriate wealth. Agency costs of equity comprise incentives to managers to motivate them to act in the best interests of shareholders by maximizing their wealth. The implications of agency costs for capital structure are that management should use debt to the extent that it maximizes the shareholders wealth agency costs reduce the tax advantage of debt.

5.8 PECKING ORDER THEORYThe Pecking Order theory is based on the assertion that managers have more information about their firms than investors. This disparity of information is referred to as asymmetric information. Other things being equal, because of asymmetric information, managers will issue debt when they are positive about their firms future prospects and will issue equity when they are unsure. A commitment to pay to fixed amount of interest and principal to debt-holder implies that the company expects steady cash flows. On the other hand, an equity issue would indicate that the current share price is overvalued. Therefore, the manner in which managers raise capital vies a signal of their belief in their firm’s prospects to investors. This also implies that firms always use internal finance when available, and choose debt over new issue of equity when external financing is required. Myers has of equity when external finance is required. Myers has called it the “ Pecking Order” theory since there is not a well-defined debt equity target, and there are two kinds of equity, internal and external, one at the top of pecking order and one at the bottom, debt is cheaper than the costs of internal and external equity due to interest deductibility, internal equity is cheaper and easier to use than external equity. Internal equity is cheaper because

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1) Personal taxes might have to be paid by shareholders on distributed earnings while no taxes are paid on retained earnings, and

2) No transaction costs are incurred when the earnings are retained

Managers avoid signaling adverse information about their companies by using internal finance. The profitable firms have lower debt ratios not because they have lower targets but because they have internal funds to finance their activities, they will issue equity capital when they think that shares are overvalued. Because of this, it has been found that the announcement of new issue of shares generally causes share prices to fall. Thus the pecking order theory implies that managers raise finance in the following order

1) Managers always prefer to use internal finance.2) When they do not have internal finance, they prefer issuing debt. They first

issue secured debt and then unsecured debt followed by hybrid securities such as convertible debentures.

3) As a last resort, managers issue shares to raise finances.

The pecking order theory is able to explain the negative inverse relationship between profitability and debt ratio within an industry. However, it does not full explain the capital structure differences between industries.

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