Page 205 - DCOM508_CORPORATE_TAX_PLANNING

Corporate Tax Planning

Notes 9.1.2 Need for Capital Structure Planning

For the real growth of the company the Financial Manager of the company should plan an
optimum capital for the company. The optimum capital structure is one that maximises the
market value of the firm. In practice the determination of the optimum capital structure is a

formidable task and the manager has to perform this task properly, so that the ultimate objective
of the firm can be achieved.

There are significant variations among industries and companies within an industry in terms of

capital structure. Since a number of factors influence the capital structure decision of a company,
the judgment of the person making the capital structure decisions play a crucial part. A totally
theoretical model can’t adequately handle all those factors, which affects the capital structure
decision in practice. These factors are highly psychological, complex and qualitative and do not
always follow accepted theory, since capital markets are not perfect and decision has to be taken
under imperfect knowledge and risk.
An appropriate capital structure or target capital structure can be developed only when all those
factors, which are relevant to the company’s capital structure decision, are properly analysed
and balanced. The capital structure should be planed generally keeping in view the interest of

the equity shareholders and financial requirements of the company. The equity shareholders
being the owner of the company and the providers of risk capital (equity), would be concerned

about the ways of financing a company’s operations. However, the interest of other groups,
such as employee, customers, creditors, society and government, should be given reasonable
consideration when the company lays down its objective in terms of the shareholders wealth
maximisation, it is generally compatible with the interest of other groups. Thus, while developing

an appropriate capital structure for a company the finance manager should inter alia aim at
maximising the long-term market price per share. Theoretically, there may be precise point or
range within which the market value per shares is maximum. In practice, for most companies
within an industry there may be a range within which there would not be great differences in the
market value per share. One way to get an idea of this range is to observe the capital structure
patterns of company’s vis-à-vis their market prices of share. The management of companies may
fi x its capital structure near the top of this range in order to make maximum use of favourable
leverage, subject to other requirements such as flexibility, solvency, control and norms set by the

financial institutions – The Security Exchange Board of India (SEBI) and Stock Exchanges.

9.1.3 Guidelines for Capital Structure Planning

The following are the guidelines of capital structure planning:

1. Avail or Tax advantage of Debt: Interest on debt finance is a tax-deductible expense. Hence,

finance scholars and practitioners agree that debt financing gives rise to tax shelter which

enhances the value of the firm. What is the impact of this tax shelter on the value of the
firm? In this 1963 paper Modigilani and Miller argued that the present value of the interest

tax shield is:
t D
c
where, t = corporate tax rate on a unit of marginal earnings and D = Debt fi nancing.
c
2. Preserve Flexibility: The tax advantage of debt should not persuade one to believe
that a company should exploit its debt capacity fully. By doing so, it loses fl exibility.
And loss of flexibility can erode shareholder value. Flexibility implies that the fi rm

maintains reserve borrowing power to enable it to raise debt capital to respond to
unforeseen changes in government policies, recessionary conditions in the market place,
disruption in supplies, decline in production caused by power shortage or labour market,
intensification in competition, and, perhaps most importantly, emergence of profi table

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