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INTRODUCTION The decision in finance involves raising funds for the firms and designing and formulation of Capital structure.Two types of are raised by business enterprises, which are classified as long-term sources i.e. Capital ,term loans raised from financial institution and reserves . short- term consist of current liabilities and provision. Capital structure mainly concentrates on debt and equity funds of provision. A business enterprises has to maintain these funds in a manner , that both the cost and risk related and equity funds is minimum , so that it does not affect the earning of the organisation and the value of the firm .

2. MEANING OF CAPITAL STRUCTURE : It is the make up of a firms Capitalisation . it is a mix of different sources of long term i.e. equity shares , preference shares, long term loans etc.) in thetotal Capital of the company .It also refrred to as proportion of debt and equity in the total Capital of a company. Capital = total assets current liabilities . i.e. long term funds. The total Capital structure of a firm is represented as: Total Capital

Equity Capital

Debt Capital

Equity share capital Preference share capital Securities premium Retained Earning

Term loans debantures deferred payment liabilities Other long term debt

3.FINANCIAL STRUCTER AND CAPITAL STRUCTURE : a) Financial structure includes both long term sources and short term sources . It is entire left hand side of company s balance sheet . b) Capital structure is a part of financial structure and is a mix of the various types of long term sources of funds I.e. debt / equity.

4. RELATION OF COPMANYS PROFITABILITY TO CAPITAL STRUCTURE : It the company is new , capital structure may be of any of the following four patterns: a)capital structure with equity share only . b)capital structure with both equity and preference shares . c) capital structure with equity and debentures. d) capital structure with equity shares, preference shares and debentures . Appropriate capital structure depends on the number of factors like. a)companys nature of business.
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b)regularity of earning of the company . c)period of finanace. d)market sentiments. e)size of the company. f)requirement of investors. g)provision for future.

It is regarding the basic difference between debt and equity . debt is the liability on which intrest has to be paid. Increase in debt in the capital structure i.e. improvement of debt equity ratio implies greater payment of intrest amount than before. The company has to pay interest irrespective of its profits . hence , a company has to be sure enough of getting steady return to bear the interest amount. On the other hand equity consist of shareholder or owners funds on which payment of dividend depends on companys profits . the cost to raise debt is lower compared to cost to raise equity . this is because is allowed as an expanse so tax benefit. Dividend is considerd profits so no tax benefit.

5. OPTIMAL CAPITAL STRUCTURE : when the company is new ,it is difficult for it to collect debt as per its requirements as it has to establish its credit worthiness. Hence , it has to be dependent on equity very much. On the other hand, the establish companies have good track record of their profit earning capacity that help them their credit- worthiness. So lenders feel safe to invest in such companies , hence ,theses companies have no problem to raise debt. The company in this case raise debt in such a way that becomes beneficial for the company in terms of increase in EPS, profitability and of the firm. If the cost of capital is greater than the return , profitability of the company , EPS and value of firm is affected . the company if not able to repay its debt on time then it will affect the goodwill and create problem in future for collecting further debt . hence a company has to select an appropriate capital structure with due consideration . Capital structure varies from one firm to another firm from one industry to another . you might find similarly in capital structure of two firm of same industry , but it is almost impossible to precisely generate the modal capital structure for all business undertakings. Research suggests that financial planner should plan optimal capital structure.

In practice financial management literature does not provide specified methodology for designing a firms optimum capital structure . Hence its; financial manager has to plan capital structure of the firm inspite of many conflicting factors for the types of fuds to be sought .Hence ,it is not possible to find out possible to find out exact debt equity mix where capital structure is optimum . but of course a range can be determined . For optimal capital structure a perfect balance between the riska and retruns has to be struck : FEATURES: Following are the feature of an appropriate capital structure : 1.Profitablity It is that capital structure which minimises cost of financing and maximises earning per equity share . 2.solvency A firm should plan the capital structure in such a way that it does not run the risk of becoming insolvent .Excess use of debt threatens the solvency of the company . 3.flexbilty It should be such that it can provides funds whenever the company needs it, to finance profitable activities.
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4. conservatism Debt content in capital structure should be in limits so that the company can service the debt comfortable . 5. control It should be such that it involves minimum risk of loss of control of the company.

6. ANALYSIS OF DEBT EQUITY RATIO: As seen above ,it is difficult to v=have a optional debt- equity mix same way it is difficult to have a standard debt equity ratio. Reasarch by B.K. Madan suggested that standard debt-equity ratio is 2:1 , but he also warned that it varies from company to company depending upon the nature of business. It doesnt mean that low debt equity ratio makes company dependent on equity issues . the company in this case may have sizeable portion of its profits in the reserve fund plus it may also be due to increase in the retained earnings i.e. the component of equity due to which a company doesnt need to rely on external debt meet requirement of the funds and hence debt-equity ratio may appear to be low. Debt equity ratio and cost of capital are inversely related . as debt equity ratio increases , cost of capital decreases and vice versa. When a firm higher debt, it result in payment of intrest to financer so the company has to pay

low and the overall cost of capital decreases. But , if the firm is not able to pay principal and intrest on loan it may result in bankruptcy costs. Particulars Equity capital Long term debt (14%) total Alternative -I 800 200 1000 Alternative-II 200 800 1000

The firms corporate tax rate is 35 % .It maintains a dividend of 16% on the equity capital . now the firms cost of capital is calculated as follows:

Particulars Dividend on equity Shares(@16%) Long term debt (14@) Less: tax (@35@)

Alternative -I 128 28.0 9.8 18.2 146.2 146.2*100 1000 =14.62%

Alternative-II 32 112.0 39.2 72.8 104.8 104.8*100 1000 =10.48%

From the analysis of the above we can observe that when debt equity ratio 1:4

The composit cost of capital is 14.62% . when the firms debt equity ratio is altred to 4:1 , the firms cost of capital has drastically reduced to 10.8% . this is because of tax shield and supply of debt at cheaper cost then the equity capital.

EBIT EPS ANALYSIS: it is important to design capital structure because it provides a simple picture of the consequences of alternative financing methods . EPS is a yardstick to evaluate the firms performance for the investor.

7. FINANCIAL BREAK- EVEN AND INDIFFERENCE ANALYSIS It is the minimum level of EBITneeded to satisfy all fixed financial charges i.e interest and preference dividends . It is the EBIT for which the firms EPS just equals zero. I f EBIT is less than financial break-even point ,EPS will be negative . if EBIT is more than financial break even point , more fixed cost financing instrument can be inducted in the capital structure . or the use of equity would be preferred.
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Point of Indifference It refers to that EBIT level at which EPS remains the same irrespective of the debtequity mix.

In case of two alternative financial that the leval of EBIT where is the same , this situation is referred to as indifferent point level. It can be calculated with the help of the following formula: (EBIT-I1)(1-T) =(EBIT- I2) (1-T) E1 E2 Where EBIT = Earnings before Interest and Taxes. I1= Interest Charges in Alternatives 1. I2 T = Interest charges in Alternatives 2.

= Rate of Tax.

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E1 E2

= =

Equity Shares in Alternative 1. Equity Shares in Alternative 2.

8.DIFFERENT TYPES OF CAPITAL STRUCTURES There are four types of capital Structures: 1.Capital Structures with Equity Shares Only: This types of Capital Structure includes equity shares only.Such a structure has the following merits and demits. Merits 1. Simplicity:It is simple to understand for all the investors. 2. Discretion in Dividend : Directors of the company get direction in declaration of dividend and building up reserves. 3. No Fixed charge : capital can be raised without creating any charges on the assets of the company . Hnce there is no danger of harassment by loan creditors. 4. Enhanced : creadit standing : the company depends on equity shares. There is no burden of payment of dividend . creditors sanction credit to such a company. 5. Full freedom of decision making: the management enjoys full freedom of decision making as the equity are issued. 6. Reduced cost : a large fixed company can raise additional capital by issue of shares . hence , the cost is reduced

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7. No refund: equity shares capital is not refundable during the life of the company.Hence a company can raise long term capital.

Demerit: 1.additional cost: issue of equity shares involves payment of brokerage, underwriting commission, printing and stationery etc. it is costly. 2. no benefit of trading: the company does not get benefir of trading on equity shares only. 3.fall in market price: due to large amount of capital the rate of dividend comes down and the markets price also falls 4. concentration of control: the exting sharesholders net right offer .Hence the control is concentrated in the hands of existing equity an ideal one.

1. Capital structure with equity and preference shares. This type of structure includes equity shares and preference shares .it has the following benefits. Merit:

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1.Appeal to different types of investors :the capital structure makes an appeal to investor having different moods. 2.Trading on Equity:preference share capital carries fixed rate of dividend Hence the company gets the benefits of trading on equity. 3.Economical: the capital structure is made more economical as the cost of preference shares is less. 4.Retained control:equity shareholder retain the control in their hands as additional capital is raised by preference shares. 5.No fixed burden:payment of dividend is not obligatory .hence it does not creates a fixed burden on income. 6.flexibility:capital structure can be kept flexible as preference share capital is redeemable.

Demerit: 1.Burdensome:the structure becomes burdensome during depression as the Cumulative preference dividend goes on increasing. 2.No tax benefit :dividend is not deductible for taxation purpose .hence tax Liability increasing. 3.No voting right: preference shareholder have no voting right. They cannot Participate in the management of the company.

3.capital structure with equity shares and debenture:it consist of

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Equity shares and debentures.it has the following benefit:

Merits: 1.Trading on equity:it offer the benefit of trading on equity as the company depend on debentures. 2.Economical:the cost of issuing debenture is low. Hence the capital structure becomes economical. 3.Tax benefit:Interest on debenture is deductible for taxation purpose. HenceThe structure reduce tax burden 4.No interference in Management:Debenture holder have no voting rights Hence there is no interference with management 5.Appeal to difference investor:This type of capital structure make an appeal to investor who are venturesome as well as caution. 6.Flexiblity:the structure is flexible debenture can be refunded after a certain period

Demerits: 1.burdensome: the structure becomes burdensome during depression as the cumulative preference didvidnd goes on increasing. 2. No Tax Benefit: dividend is not deductible for taxation purpose .Hence , tax liability increases . 3.No voting RightL: preference shareholder have no voting right. They cannot participating in the management of the company. 3.capital strcture with equity shares and debentures:
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It consist of equity shares and debentures. It has the following benefits.

Merits: 1.trading on equity: It offers the benefits of trading on equity as the company depends on debentures. 2, economical: the cost of issuing debenture is low .Hence,the capital strcture becomes economical. 3.tax benefits: Intrest on debenture is deductible for taxation purpose .Hence, the structure reduced tax burden. 4.no Interference in management: debenture holders have no voting right Hence, there is no interference with management. 5.appeal to Difference Investors: this type of capital structure makes an appeal to investors who are venture as well as cautions. 6.Flexiblity : The structure is flexible debenture can be refunded after a certain period.

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Demerits: 1.burdnsome:payment of interst is obligatly.Hence,if becomes a burden to the company during the perod of depression. 2.risky:In case of default the debenture holders can drag the company in the court of law . the company may be liquidated. 3.freedom affected: the directors freedom to frame policies is affected because of debenture finance. Capital structure with equity shares preference shares and debentures: This type of structure consist of equity shares preference shres and debentures .It has the following benefits.

Merit: Advantages of the pattern: The company is benefited by the pattern of capital strture. 2.Attracts All Types of Investors : The capital makes an appeal to various types equity i.e. venturesome ,cautionsand very cautions.

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3. trading on Equity : the company can get full benefits trading on equity rate of dividend can be offered to equity shareholders. 4. Flexbilty : The structure is highlt excess capital can be refunded by redemption of debentures.

Demerits: 1.Burden : it shares a burden an account of preference dividend and intrest . 2.Complicated: It makes financial administration complicated. 3. Riskey: heavy burden of debt attracts more risk .Debenture holders may drag the company in the court of law case of default. 4. Less dividend On Equity : Equity shareholders get less dividend as the profits are distributes among the equity shareholders , preference shareholders and debenture holders . CAPITAL STRUCTURE THEORIES: There are following assumption to be before we study the capital structure theories: a)All the earning of the company are distributed as dividend to the shareholders and there is no consideration of dividend and retention polices.

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b) there are no corporate taxes and its effect on cost of capital is ignored. c) the firms business risk does not changes and is independent of capital structure and financial risks. d) the companys capital structure can alter without any transaction cost. e) the EBIT are not expected to grow.

Weighted average cost of capital (Traditional Approach) It is nothing but weight average cost of various sources of finance .Weight being the market value of each source of fianc outstanding , cost of various sources of finance refers to the return expected by the respective from the project to pay off the expected return of the investors .It is as required of return. Optimal cost of capital is the process of raising debt in the capital strcture upto the level where the wacc of the firm is at the lowest. This also increases returns to equity holders . After optimal level any increase, will increase the risk to the equity holders . Weighted average cost of optimal and optimum leverage:

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Degree of leverage Hence , from the above digram it can be asen be seen thet of debt then cost of equity. Initially firms borrow at lower interest rates . As the debt amount increases, lenders feel increased about the repayment of intrest and principal amount , so they charges higher intrest on additional loans .Hence , the cost of debt raise as seen in figure as debt increases. Similarly , equity holders wikk not bother when the debt level of the comapnay is lower but as the debt level increases equity holders are concerned intrest payments affecting the volatilly of each flow of cash flow for equity .So, the equity holders will demand more rates of return for taking an additional risk . Hnece , as the debt level increases the overall cost of capital will also start increasing after optimum point.
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WACC is an important tool in determing optimal capital strcture .One has to see that wacc of the firm is minimum, so that value of the firm should be maximum .The diagram shows how the value of the firm changes with the increases in debt level of the capital strctucture.

From fr

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From the above ,it is seen that value of the firm decreases with the increases in debt level. Hence , the firm has to maintain capital strtucture at the opyimum level so that value of the firm is maximum. Steps = 1.compute market value of equity (s) = NOI- Intrest/ke 3.Compute market value of debt (D)=Interest/ rate of interest 4.compute total value of the firm (v)=mv of equity (S) + mv of debt (D) Compute WACC ko Ko =ke x s/v+kd x d/v Statement of computation of total value of the fir, and WACC A ltd levered NOI Less: interest on debt Earning to equity shareholder (NI) Equity capitalisation Rate (Ke) M.V. equity Ni/ Ke M.V. of debt Total value (S+D) WACC ko XX Xx XX XX XX XX XX XX B ltd unlevered XX Nil XX XX XX XX XX XX
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Net Income Approach: Net income approach is suggested by Durant david . According to this approach the capital structure decision is relevant to the valuation of the firm . hence , a change in capital structure will cause an overall change in the cost of capital and also in the total value of the firm .Higher debt content in capital structure will lead to increases in fianacial leverage, which result into decline in the overall or weight average cost of capital . This increases the value of the firm and also increases the value of equity shares . conversely the decreases in debt content will increases WACC leading to decline in value of the firm and also decline in the value of the equity shares. This approach is based on three basic assumptions: a)corporate taxes do not exit. b)debt content does not changes the risk perception of the investors. c) cost of debt is less than cost of equity i.e. debt capitlazation rate is less than the equity capitalisation rate.

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Optimum capital structure: As per this approach the firm can evolve a capital strcture of which the weighted average cost of capital is lowest and value of the firm is maximum .This can be achived by judicious mix of debt and equity. Process: The process involves following steps: 1.compute market value of equity =NOI-Interest/ke 2. compute market value of debt = M.v of debt = interest / rate of interest 3.compute total value of the firm Total value of the firms= market value of equity + market value of debt 4.compute weighted average caost of capital W.A.C.C = NOI/ total value of the firm. Net operating Income Approach: This was another theory suggest by Durant David for capital structure .According to this theory , capital structure decision is independent to the valuation of the firm. It is assumed that WACC is unchanged irrespective of the level of debt . It is opposite to that of net income approach. This theorysuggest that of the market value of the firm depends upon the net operating capital or EBIT and the overall cost of capital i.e. weighted average cost of capital. The optimal capital structure does not exit as average cost of capital remains constant for different types of

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financing mix. The financing mix or the capital structure is irrelevant and does not affect the value of the firm. This theory is based on the following assumptions: A)Here , to find the value of the firm as a whole , investors see the firm as a whole and thus capitalise the total earning of the firm. b) The overall cost of capital (ko) is constant. c) The cost of debt (ko) is alos constant. d) There is no tax. e) As the debt increases in the capital strcture it increases the of the shareholder and result on the increases in the cost of equity capital i.e.ke value of the firm and value of equity are determined as follows by the above approach: Optimum Capital Strcture: According To NOI approach there is nothing like optimum capital strcture .Every capital strcture is an optimum capital strcture. Procedure: The proceding of approach of equity capitalisation rate is as follows: Step-1.:compute taotal value of the firm
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Total value of firm = NOI/KO Step-2. Compute market value of debt Market value of debt = Interest / rate of Interest Step-3. Compute market value of equity as follows : Total value of the firm(v) market value of debt (D) Step-4: compute equity capitalisation rate (ke) Equity capitalisation rate = net Income / market value of equity = NOI-Interest /market value of equity

Statement showing Equity capitalisation Rate : Total value of the firm and WACC: A ltd levered XX XX XX XX M.V of Equity Ni/ke
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B ltd Unlevered XX XX XX XX

NOI Less: Interest on Debt Earning to Equity shareholder (NI) Equity capitalisation rate (ke)

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M.V. of Debt Total value (S+D) WACC ko

XX XX XX XX

XX XX XX XX

Net Income Approach : Net income approach is suggested by Durant david . According to this value approach the capital structure decision is relevant to the valuation of the firm. Hence , change in capital strcture will cause an overall change in the cost of capital and also in the total value of the firm . higher debt contenet in capital strcture will lead to incresase in financial leverage , which result into decline in the overall or weighted average cost of capital . this increases the value of the firm and also increases the value of equity shares . Conversely the decreases in debt content will increases WACC leading to decline in value of the firm and also decline in the value of the equity shares. This approach is based on three basic assumption : a) Corporate is based on three do not exist. b) Debt content does not changes the risk perception of the investors. c) Cost of debt is less than cost of equity i.e. debt capitalisation rate is less than the equity capitalisation rate. Optimum capital structure:
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As per this approach the firm can a capital structure of which the weighted average cost of capital is lowest and value of the firm is maximum . this can be achieved by judicious mix of debt and equity. Process: The process involves following ateps: 1.compute market value of equity = NOI- Interest/ke 2.compute market value of debt M.V. of debt = Interest / rate of interest 3. compute Total of the firm Total value of the firm = Market value of equity + Market value of debt 4.compute weighted average cost of capital W.A.C.C= NOI/ total value of the firm

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Statement showing value of the firm : Levered co. Net operating income (NOI) Less: Interest on Debt (D) Earring to Equity Shareholder (NI) Equity capitalisation rate (ke) Market value of equity (NI)/ke (s) Total value of the firm (S+D) W.A.C.C (ko)= NOI/ total value XX XX XX XX XX XX XX Unlevered co. XX XX XX XX XX XX XX

Net operating Income approach: This was another theory suggested by Durant David for capital strcture .according to this theory capital strcture decision is Independent to the valuation of the firm .it is assumed that WACC is unchanged irreapective of the level of debt . it is opposite to that of the net income approach . thistheory suggehts that the market value of the firm depends upon the net operating profit or EBIT and the overall cost of capital i.e. weighted average cost of capital . the optimal capital structure does not exist as average cost of capital remains constant for different types of financing mix the financing mix or the capital structure is irrelevant and does not affect the value of the firm. This theory is based on the following assumptions:
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a) Here, to find the value of the firm as a whole , investors see the firm as a whole and thus capitalisation the total earning of the firm b) The overall cost of capital (ko)is constant c) The cost of debt (ko) is also costant. d) As the debt increases in the capital structure it increases the risk of the shareholder and thus results in the inreases in the equity capital i.e. ke. Value of the firm and value of equity are determined as follows by the above approach: Optimum capital structure: According to noi approach there is nothing like optimum capital structure . every capital structure is an optimum capital structure. Procedure The procedure of capitalisation of equity capitalisation rate is as follows: Step-1:compute total value of the firm Total value of firm = NOI/ko Step-2: compute market value of debt Market value of debt = Interest /rate of interest Step-3: compute market value of quity as follows: Market value of equity (S) = total value of the firm(v)- market value of the debt (D) Step-4:compute equity capitalisation rate (ke) Equity capitalisation rate = net income /market value of equity
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= NOI- Interest/ market value of equity Levered co. Net operating income (noi) Overall capitalisation rate (ko) Total value of the firm =noi/ ko Less : market value of debt (D) Interest / rate of interst Market value of equity (s) (iiiIv) Earning for equity shareholder (noi-interest) Equity capitalisation rate(ke)= ni/s XX XX XX XX XX XX XX XX XX XX XX Unlevered co. XX XX XX

So we can are financing mix does not affect the value of the firm . there will be a change in the risk of the financing shareholder due to change in the debt equity mix , therefore , ke will be changing directly with change in debt proportions.

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The net operating income approach can be explained from the diagram given below. We can see from the digram that as the level of gearing increases ,cost of debt remains constant even weighted average cost of capital remains constant and hence does not affect the value of the firm the other observation is as the level of gearing increases the this does not affect the value of the firm , even the overall cost of capital remains constant , as increases in cost of equity is just sufficient to those the benefit cheaper debt financing.

Modiglinal and miller theory (m-m) approach: Modigliani and miller suggest that cost of capital is independent of capital structure according to this approach, weighted average cost of capital does not change with the change in debt equity mix hence , there

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is no optimal value i.e. capital structure is not important for value of the firm. Thistheory is based on the following assumption : a)there exist a perfect capital market , so a company can borroe amount of no limit at same interest rate . the interest rate doesn,t vary with increasing amount . b) the cash flows of the firm and investment are doesn,t very with increasing amount . c) firms are grouped into equivalent risk classes on the basis of their business risk . d) there exist no taxes. e) stock markets are perfectly competitive. f)investors hold identical expectations about future profits. g) the dividend payout ratio is 100 percent.

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Calculation of total market value (M-M) Approach (No Taxes): Levered co. Net Operating Income Less: Interest on Debt Earning for Equity shareholders Overall capitalisation rate (ko) Total value of a firm NOI/ko Less: market value of debt interest/ Rate of Interest Market value of equity (s) Equity capitalisation rate XX XX XX XX XX XX XX XX XX XX XX Unlevered co. XX XX XX XX XX

Computation of total market value (M-M) Approach (where Taxes exist) : Levered Value of unlevered firm :[NOI(l-t)/ke] P.V. of tax saving on interest on debt (dt) Total value of firm (v) (i+ii) Less: market value of debt I/ rate of interest Market value of equity (s) Equity capitalisation rate (NOI-I) (I-t)/s XX XX XX XX XX XX

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Pecking order Theory: This theory proposed by Donaldson in 1961. It was further developed by Myer in 1984. As per this theory the firm may not have a particular target or optimum capital structure . The theory says that capital structure of a company is more dependent on internal cash flows , cash dividend and acceptable investment opportunities. As per this theory the firm links its dividend policy with its capital gearing and investment decision. It gives emphasis on cost involved in raising of funds.

Assumption: The theory is based on the following assumption: 1)There is no cost involved in internally generated funds. 2)It is costly to issue external funds. 3)Cost of raising debt is cheaper than that of equity. 4)cost of loan is less than the cost of issuing debt securities. 5)issue of equity shares involves higher cost. 6) servicing of debt fund is cheaper than that of equity fund. The theory it has suggest that wherever a company raises finance for its long term investment it has set order of preference for raising the funds by issue of diffirent securities.

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Initially the firm prefers to use internally genrrated fund. If internally generated funds are not sufficient to meet the requirement then it prefers to raise by external fund in the form of term loans . nonconvertible debentures and then by after exhausting all the previous sources , it will raise funds by issue of equity shares. The theory says that: 1.dividend policy is sticky. 2.firms prefer internal to external financing. 3.If the firm requires external financing it will issue debt before equity. 4.If the firm seek more external financing it will work down the pecking order of securities from safe to risky debt.

Modified pecking order theory: In 1984 , myer suggested that the firm follows modified pecking order theory to financing . he suggested that the order of preference stemps from the existence of asymmetry on information between the company and the market . due to this the firms heavily depend on internally henretaed funds . due to asymmentry of information the projects may be under valued by the market. Hence, the manager prefers to finance the projects by internal financing . if internal funds are insufficinnt , the projects may be financed by debt because due to asymmetric information the projects may be under valued
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by the market . in such a case issue of new equity shares is considred bad by the market . if the projects is over valued by the market they will raise new shares at overvalued price. May aegued that a levered firm takes a sub optimal investment decision because of the burden of fixed interest .optimum capital structure is obtained at a point where the expected value of tax shield on additional debt is equal to the epected value of investment given up. Leverage and cost of capital (MM Approach ): So we can infer that of a firm remains constant with increasing level of gearing. MM theory is based on the following three preposition: Preposition I: The value of the firm is independent of its capital ratio. It does not change with the change in the level of gearing. The market value of a firm depends on assets in which the company has invested and not how those are financed. Preposition- II: as the debt / equity ratio increases with increasing debt , the expectation of shareholder also increase libearly with increase debt . In other way, the cost of equity rises with increasing debt but it precisely offsets any benefits conferred by use of apparently cheap debt.

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Modigliani and Miller Theory Arbitrage : Under this process , the average cost of capital remains constant . According in this theory , the investor who originally a part of the levered firm will be better off selling the holding in levered firm and buying the holding in unlevered firm using his home made leverage . For example , there are two say firm A and firm B. these firms are equal in all respects like business risk etc. But have different levels of gearing . firm A has no debt only equity in its. firmB has both debt and equity in its finance . As the value of firm B is higher than that of firm A. so the investore will sell his holdings form firm B and invest in the firm , a which has lower .As firm A has no debt the financial risk for investor is less in firm A than B . Investor do this as they can earn same return but at lower outlay with same perceived risk or lower risk . This behaviour of the investor will have effect on firm A and frim B. Firm As value is increased as its shares are purchased while firm Bs value decreases as its shares are sold . this investor continuing till the market value of both the firms is equal and which are equal in all other aspects .in return the investor would increases their income through this method while maintaining their net investment and risk at tha same level.

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Effect of Arbitrage process: 1.The prices of equity shares of the overvalued firm shares are sold will decrease. 2.the prices of equity shares of the under the valued firm whose shares are purchased will increases. 3. the process centimes till the market prices of two firms become id

Arbitration process when the levered firm is over valued. Present position on overvalued firm i)market value of investment ii)dividend income II. i)sale of present equity shares ii)borrowing proportion ate to share debt iii)total Amount available (I+II) III.purchase of same % of equity holding of undervalued firm IV. net Income after switch over i)Dividend income ii)less Intersst on personal borrowing XX XX XX XX XX XX XX XX

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net income (i-ii) v)amount by which the investor should reduce outlay through arbitrage (II-II)

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Modiglianl and miller theory corporate taxation: According to this theory , when a company has debt in its capital structure , the tax burden on the company is reduced . this is because tax on interest paid on the debt is waived of , that makes the cost of debt cheaper.

Benefits of corporate tax: a)tax deductibility of debt intrest creates value for shareholders. b)the WACC of capital reduce as tha debt content in capital structure increases. c)the rate of return required by the geared company shareholder is less than that where the company has only equity in capital structure.

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Modigliani and Miller Theory personal Taxtion: This theory considered only personal taxes .According to Miller , when he analysed there is a tax relif on debt interest but not on equity dividends paid to shareholders this would make debt fund more attractive than equity fund to corporate . the corporates in order to attract debt pay greater to suppliers of debt . when the corporate offers an after personal tax return on debt at least equal to the after personaltax return on equity supply willswitch over to supply debt to the corporate so from the point view of corporate , there will be no difference between raising debt or equity as the effective cost of eqch will be the same and there is no advantage to leverage . He analysed that tha corporate as a whole will debt upto the point where the extra interest paid is exactly compensated for the tax shield on the debt interest. In realty if we see as debt is favourable fund in capital strcture due to its tax implication vecause of which the average cost of capital reduces. This whole concept is based on the fact that interest payment on debt is allowed as a tax deduction whereas dividend on equity capital are not allowed for tax deduction.

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BANKIRUPTING COST TO COMPANY AND FINACIAL DISTRESS COSTS: When a company takes high debt , it is more likely that the company may run into financial distress and bankruptcy cost . this is because at some point of time , due to high debt the company will not be able to make annual interest payments and principal loan amount . If the company is not able to pay dividends this can be bypassed but if the company is not able to pay interest and principal loan amount often gives the supplier right to claim on company operating assets thereby the companys continuity of activity. Cost of bankrupting: This cost can be indirect costs of trying to manage a company in liquidation or direct coats of court fees. When a firm debt is increasing it has a bene fits of tax saving but I also has an increased probability of running into bankruptcy and financial distress . the value of the geared firm is its capitalised value after tax saving incorporating the anticipated cost of bankruptcy and financial distress.

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V= value of the geared firm X=Anticipated net Operational cash flows R= capitalisation Rate D=Market value of Debt T= corporate tax rate Bc= Anticipated tax rate V= X +dt-bc The optimal capital strcture is to be found out where the market value of the firm is maximised plus there has to be existence of tax benefit for modest amount of debt and the firm has to avoid the costs financial distress and bankruptcy. This way a firm can enhance its market share price . the optimal capital structure is shown as follows:

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COST OF FINANCIAL DISTRESS: a) Borrowing at higher levels of interest. b) Market rate of shares falls as there is a failure or cut in dividend . c) Suppliers lose faith and before loss of trade credit. d) D) highely profitables products sale in distress. e) New projects abandomment . f) Credit period reduced so loss of business g) Warning given to firm to withdraw loans.

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h) Reduction on sales due to reduction in stocks. i) Company borrows beyond its target debt- equity ratio.

CAPITAL STRUCTURE HYPOTHETICAL VIEW: Mr. Durand put forward another approach . according to this the average cost of capital will reduced with greater use of debt and the equity shareholder will not insit on higher return with increased gearing caused by the use of increasing level of debt .It is also assumed that the lenders will not insist for higher return with increased debt . hence, the average cost of capital fals until the level of debt is reached. The above situation is illustrated by the following digram:

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CAPITAL ASSET PRICING MODEL: As per this ,odel , it is assumed that an increases in the debt equity rqtio result into a simultaneous increases in the expected return on stock and the systematic risk as measured by beta . in perfect capital market , both risk and return increase proportionately.

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FACTORS AFFECTING CAPITAL STRUCTURE : Following are the important factors affecting capital structure : 1)tax advantage: Interest on debt deductible for taxation purpose . it reduce the firms liability. Hence , debt has a tax advantages over equity . by increasing the amount of debt earning to shareholders are increased.

ii)attitude of investors to risk return: attitude of the investors toward risk and return an impact on apital structure. If the attitude of the investors is venturesome , additional capital will be raised by equity shares and the capital structure will include more amount of equity capital . if the attitude of the investors is very cautions , debt will be more in capital structure. iii) control of firm: if the promoters do not wish to dilute , the company may depend on debenture or loans . if the promoters want to dilute the control , the capital structure will include larger amount of equity capital . iv)flexibility : it is a very important factore in designing capital structure . if the structure includes equity capital and debts , the structure becomes more flexible , if it includes only equity capital . the strcture becomes very rigid.

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v)timing: the timing at which capital structure decision is taken has an impact on capital structure . if the decision is taken during boom period , issue or equity will attract more response and hence the capital structure will include lergaer amount of equity capital. During recession ,debt will attraect more response . hence , the capital structure will include larger amount of debt. vi)Legality : various legal provision also affect capital structure planning .raising equity capital is more complicated than debt because of legal complication. vii)profitability: profitability has a direct impact on capital structure planning . A company , which is having rate of profitability , depends less on debt . it can meet its capital requirments from internal sources. viii)nature of business: Nature of business decides the extent of debt and equity if the earning of the company are stable , the company can bear the burden Of debt . hence , it may depends on debt to a greater extent , if the earning are fluctuating it may depends on equity. ix)marketing conditions: the marketing conditions prevailing in the market has impact on capital structure marketing conditions are dynamic . due to changing marketing conditions the
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company has to make changes in the type of securities to be issued. During boom period issue of equity shares should be made , during depression period funds may be raised by debt x): cost of floation: flotation cost includes cost of printing & stationary , commission to brokers , issue managers commission atc. Floatation cost is an important factor in deciding the issue of securities xi) Tax rate : corporate has an impact on capital structure planning .dividend on shares is not deductible for taxation has impact on capital strcture is deductible for taxation purpose . Issue expenses of shares are deductible for deciding taxable income. xii) purpose of financing: the purpose has an impact on capital structure . fianc required for productive purpose may be raised by issue of shares . internal funds may be used when fianc is required for non productive purpose. xiii) Government polices: government policies, provision of law , SEBI Guidelines , should be considered for deciding the source of finace A sound capital structure will be achived by balancing the various consideration viz. flexibility , risk, income, control and timing.

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Q1.one-up ltd has equity share capital rs. 5,00,000 dividend into shares of rs. 100 each it whish to raise further rs. 3,00,000 for expansion cum modernisation . the company plans the following financing alternatives: a)By issuing equity shares only . b) Rs. 1,00,000 by equity shares and Rs. 2,00,000 through debentures or term loan @10 per annum. c)By raising term loan at 10%per annum. d) Rs.1,00,000 by issuing wquity shares and Rs.2,00,000 by issuing 8% Preference Shares You are required to suggest the best alternative giving your comment assuming that the estimated earning before interest and taxes (EBIT) after expansion is Rs.1,50,000 and corporate rate of tax is 35%.

Calculation of EPS Finanancial Alternative

I Rs Equity -Existing -new 8% Preference Shares 10% Term Loan/Debentures Total Investment

5,00,000 3,00,000 8,00,000

II III Rs Rs 5,00,000 5,00,000 1,00,000 2,00,000 3,00,000 8,00,000 8,00,000

IV Rs 5,00,000 1,00,000 2,00,000 8,00,000

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Finanancial Alternative
I Rs

II Rs ---

III Rs --

IV Rs --6,000 1,50,000 -1,50,000 52,500 97,500 16,000 81,500 13.58

Preference Dividend Interest on Term Loan Or Debentures No of Equity Shares (i) EBIT Less:Interest EBT Less:Tax@35% EAT Less: Preference Dividend Earnung Available for Equity Shareholders (ii) (ii) EPS (i)

-8,000 1,50,000 -1,50,000 52,000 97,500 -97,500 12.9

20,000 30,000 6,000 5,000 1,50,000 1,50,000 20,000 30,000 1,30,00 1,20,000 45,500 42,000 84,500 78,000 --84,500 14.08 78,000 15.60

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Q.2The modern chemicals ltd requires rs. 25,00,000 for new plant . this plan
expected to yelid earning before interest and taxes of rs. 5,00,000 while deciding about the financial plan the company considerd the objective of maxising earning per share . it has there alternative to finance the project by raising debt rs.2,50,000 rs.10,00,000 rs.15,00,000 and the balance in each case , by issuing equity share the company share is currently selling 150 but is expected to decline to rs.125 in case the funds are borrowed in excess of rs. 10,00,000 the fund borrow the rate 10% upto rs. 2,50,000 at 15% over rs.2,50,000 and upto rs. 10,00,000 and at 20% over rs. 10,00,000 the ta applicable to the company is 50% which from financing should company choose. I Total investment Less: debt finance Equity financing 25,00,000 2,50,000 22,50,000 II 25,00,000 10,00,000 15,00,000 III 25,00,000 15,00,000 10,00,000

Market price per share No. of equity share Alternative I

150 15,000

150 10,000

150 8,000

2,50,000*10/100 = 25,000 Alternative-II

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2,50,000*10/100 =25,000 75,000*15/100 =1,12,500 1,37,500 Alternative III 2,50,000*10/100 =25,000 7,50,000*15/100 1,12,500 5,00,000 *20/100=1,00,000 2,37,500 Calculation EPS EBIT Less: interest on debt EBI Less:tax5@50% EAT No. of equity share I 5,00,000 25,000 4,75,000 2,37,500 2,37,500 15,000 15.83 II 5,00,000 1,37,500 3,62,500 1,81,250 1,81,250 10,000 18.125 III 5,00,000 2,37,500 2,62,500 1,31,250 1,31,250 8,000 16.41

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BIBLOGRAPHY BOOK 1. FINANCIAL MANAGEMENT BY L.N. CHOPDE 2. FINACIAL MANAGEMENT BY AINAPURE.

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