CAPITAL STRUCTURE

Meaning
Capital structure of a company
prefers to the makeup of its capitalization
company procure funds by issuing
various types securities that is preference
shares ordinary shares bonds and
debentures before issuing any of the
securities .a company decide about the
kinds of the securities to be issued .what
propositions will the various kinds of
securities to be issued should also be
consider.
Capital structure
refers to mix of sources from where the
long term funds required in a business
may be raised including loans, bonds,
share issues, reserves etc and the
components of the total capital.
Factors determining capital structure:
 Nature of industry
 Risk, cost and control considerations
 Gestation period
 Quantum of return on investment
 Lending policy of financial
institutions
 Certainty with which profits will
accrue
 Monetary and fiscal policies of the
government

OPTIMUM CAPITAL
STRUTURE:
 One of
the basic objectives of financial
management is to maximize the value
of wealth of firm. the capital structure
ism optimum when the firm has
combination of equity and debt so that
the wealth of the firm is maximum .at
this level cost of capital is minimum
and market price per share is
maximum

In theory one can speak of an

optimum capital structure but in
practice appropriate capital structure
is more realistic term then the former

FEATURES OF APPROPRIATE
CAPITAL STRUCTURE
 PROFITABILITY :- minimize
the cost of financing and maximize
earnings per share
 FLEXIBILITY :- capital
structure should be such that
company can raise funds whenever
needed
 CONTROL :- minimum
risk of loss or dilution of control of
the company .
 SOLVECY :- capital
structure should be such that the
firm does not run the risk of
becoming insolvent
 LEGAL REQUIREMENTS: -
the applicable legal provisions
should be borne in mind while
 deciding about the capital structure
some provisions relate to
maximum limit of borrowings by
company approvals required for
foreign direct investment….etc.
 MARKETIBILITY :-the
modes of obtaining finance
depends on the marketability of the
company shares or debt
instruments (debentures/bonds) in
case of restrictions in marketability
it is difficult to obtain public
subscription hence company has to
consider its ability to market
corporate securities
 MANEUVERABILITY: - is
required to have as many
alternatives as possible at the time
 of expanding or contracting the
requirements of funds it enables
use of proper type of funds
available at a given time & also
enhance the bargaining power
when dealing with prospective
supplier of funds .
 FLEXIBILITY :- DENOTES
capacity of business and its
management to adjust to expected
and unexpected changes in the
business environment the capital
structure should provide maximum
freedom to change at all times .

FACTORS AFFECTING
CAPITAL STRUCTURE:
TRADING ON EQUITY: when
the return on total capital
employed is more than the rate of
interest or borrowed funds or rate
of dividend or preference shares,
financial leverage can be used
favorably to maximize EPS.in
such a case, the company is said to
be’ TRADING ON EQUITY.’
loans or preference shares may be
preferred in such situations the
affect of financing decision on
EPS and roe should be analyzed.

Corporate taxation:
 Interest on
borrowed capital Is a tax
deductable expense but dividend is
not also the cost of raising finance
through borrowing is deductable in
the year in which it incurred due to
tax saving advantage debt has a
cheaper effective cost than
preference or equity capital. The
impact of taxation should be c
carefully analyzed.

Government policies:
Raising
finance by way of borrowing or
issue of equity 9is subject to
policies of the govt and its
regulatory bodies like
RBI,SEBIetc.the monetary lending
and fiscal policy as well as rules
and regulations stipulated from
time to time by these bodies

PERIOD OF FINANCE:
Funds
required for medium & long-term
periods say 8-10 years. May be
raised by way of borrowings. But
if the funds are for permanent
requirement, it will be appropriate
to raise than by the issue of equity
shares.

NATURE OF INVESTORS:
 Enterprises
which enjoy stable earnings and
dividend with the proven track
record may go for borrowings or
preference shares, since they are
having adequate profit to pay
interest/fixed changes. but
companies , which do not have
assured income, should preferably
relay on internal resources to large
extent since it may be difficult to
invest ors towards the issue.

Requirement of investors

Different types of securities are

issued to different class of
investors according to their
requirement sometimes the
investor may be motivated by the
option and advantages available
with the example double option,
convertibility, security of principle
of interest etc.

TIMING:
Proper timing of a
security of issue often brings
substantial savings because of the
dynamic nature of the capital
market. Hence, the issue should be
made at the right time so as to
minimize effective cost of capital.
the management should constantly
 study the trend in the capital
market & time. it issue carefully

PURPOSE OF FINANCEING:
Funds required for long term
productive purposes like
manufacturing setting up new
plant etc.. may be raised through
long term sources but if the funds
are required for non productive
purpose like welfare facilities to
employees such as schools
hospital etc. internal financing
may have to be resort to.
Conservation :
 The debt contact should not
exceed the maximum which company
bear .
TYPE OF RISK COST CONTROL
FUND
EQUITY Low risk MOST Dilution
CAPITAL – no expensive of
question dividend control;
of re expectati since the
payment on of capital
of capital share base
except holder might be
 when are higher expand
the than and new
company interest share
is under rate also holders/p
liquidati dividend ublic are
on are not involved.
deductibl
e
PREFERE Slightly Slightly No
NCE higher cheaper dilution of
CAPITAL risk cost than control.
when equity but since
compare higher voting
d to than rights
equity interest restricted
capital. rates on
loan
 funds.
LOAN High risk Compara No
FUNDS capital tively dilution of
should cheaper control
repaid as prevail but
per interest financial
agreeme rates are institution
nt. considere s
interest d after tax nominatio
should impact n of
be paid respective
irrespec board of
tive of directors
perform
ance or
profit
Capital structure:
The objective of a firm should be
directed towards the maximization of the
value of the firm, the capital structure, or
leverage decision should be examined
from the point of view of its impact on
the value of the firm. If the value of the
firm can be affected by capital structure
or financing decision, a firm would like
to have a capital structure which
maximizes the market value of the firm.

There are broadly four

approaches in this regard. These are:
1. Net Income Approach ( N.R.
approach)
2. Net Operating Income
Approach ( N.O.I. approach)
3. Traditional Theory
 4. Modigliani and Millar
Approach

These approaches analyses

relationship between the leverage, cost
of capital and the value of the firm in
different ways. However, the following
assumptions are made to understand this
relationship.

1. These are only two sources of

funds viz., debt and equity.
2. The total assets off firm are given.
The degree of leverage can be
changed by selling
debt repurchases shares or selling
shares to retire debt
 3. There are no retained earnings. It
implies that entire profits are
distributed among
shareholders.
4. The operating profit of firm is
given and expected to grow.
5. The business risk is assumed to be
constant and is not affected by the
financing mix decision.
6. There are no corporate or personal
taxes.
7. The investors have the same
subjective probability distribution of
expected earnings.
Net Income
Approach (NI-approach)
This
approach has been suggested by Durand.
According to this approach a firm can
increase its value or lower the overall
cost of capital by increasing the
proportion of debt in the capital structure.
In other words, if the degree of financial
leverage increases the weighted average
cost of capital will decline with every
increase in the debt content in total funds
employed, while the value of firm will
increase. Reverse will happen in a
converse situation.

Net income
approach is based on the following three
assumptions :
(i) There are no corporate taxes
(ii)The cost of debt is less than cost
of equity capitilisation rate.
 (iii) The use of debt content does
not change the risk perception of
investors as a result both the Kd
(debt capitalization rate) remains

constant.
The value of the firm
on the basis of Net Income Approach can
be ascertained as follows:

V =S+D
Where V = Value of the firm.
S = Market value of equity.
D = Market value of debt.

Market value of equity (S) = NI/ke

Where. NI = Earnings available for
equity shareholders.
 K e = Equity Capitalisation
rate
Under, NI approach, the value of
the firm will be maximum at a point
where weighted average cost of capital is
minimum. Thus, the theory suggests total
of maximum possible debt financing for
minimizing the cost of capital. The N.I.
Approach can be illustrated with help of
the following example.
The overall cost of capital under
this approach is :

Overall cost of
capital=E.B.I.T/Value of the firm
1. Net operating Income (NOI)
Approach :
This approach has been
suggested by Durand. According to
this approach, the market value of the
firm is not affected by the capital
structure changes. The market value
of the firm is ascertained by
capitalising the net operating income
at the overall cost of capital which is
constant.
The market value of the firm is
determined as follows:

Market value of the

firm (V) = Earnings before interest
and tax/Overall cost of capital
The value of equity can be determined
by the following equation
Value of equity(S) = V (Market value
of firm) – D (Market value of debt)

And the cost of equity = Earnings

afterInterestandbeforetax/Market
value of firm(V) – Market value of
debt(D)
The Net Operating Income
Approach is based on the
following assumptions :
(i) The overall cost of capital remains
constant for all degree of debt
equity mix.
(ii)The market capitalises the value of
firm as a whole. Thus the split
 between debt and equity is not
important.
(iii) The use of less costly debt
funds increases the risk of
shareholders. This causes the
equity capitilisation rate to
increase. Thus, the advantage of
debt is set off exactly by increase
in equity capitalisation rate.
(iv) There are no corporate taxes.
(v) The cost of debt is constant.
Under NOI approach since
overall cost of capital is constant,
therefore there is no optimal
capital structure rather every
capital structure is as good as any
other and so every capital structure
is optimal one.
3. Traditional Approach :
The traditional approach is also
called an intermediate approach as it
takes midway between NI approach
(that the value of the firm can be
increased by increasing financial
leverage) and NOI approach(that the
value of firm constant irrespective of
the degree of financial leverage).
According to this approach the firm
should strive to reach the optimal
capital structure and its total valuation
through a judicious use of the both
debt and equity in capital structure. At
the optimal capital structure the
overall cost of capital will be
minimum and the value of the firm is
maximum. It further states that the
value of the firm increases with
financial leverage upto a certain point.
Beyond this point the increases in
financial leverage will increase its
overall cost of capital and hence the
value of firm will decline. This is
because the benefits of use of debt
may be so large that even after off
setting the effect of increases beyond
an acceptable limit the risk of debt
investor may also increase,
consequently cost of debt also starts
increasing. The increasing cost of
equity owing to increased financial
risk and increasing cost of debt makes
the overall cost of capital to increase.
 Thus as per the traditional
approach the cost of capital is a
function of financial leverage and the
value of firm can be affected by the
judicious mix of debt and equity in
capital structure. The increase of
financial leverage upto a point
favourably affects the value of firm.
At this point the capital structure is
optimal and the overall cost of capital
will be the least.

Modigliani and Miller Approach

(MM Approach)
According to this approach the
total cost of capital of particular firm
is independent of its methods and
level of financing. Modigliani and
Miller argued that the weighted
average cost of capital of a firm
completely independent of its capital
structure. In other words, a change in
the debt equity mix does not affect the
cost of capital. They gave a simple
argument in support of their approach.
They argued that according to the
traditional approach, cost of capital is
the weighted average of cost of debt
and cost of equity, etc. The cost of
equity, they argued, is determined
from the level of shareholder`s
expectations. Now, if shareholders
expect 16% from a particular
company, they do take into account
the debt-equity ratio and they expect
16% merely because they find t%
covers the particular risk which this
Company entails. Suppose, further
that the debt Content in the Capital
Structure of this company increases :
this means that in the eyes of
shareholders, the risk of the company
increases, since debt if a more risky
mode of finance. Hence, each change
in the debt equity mix is automatically
offset by a change in the expectations
of the shareholders from the equity
share capital. This is because a change
in the debt equity ratio changes the
risk element of the company, which in
turn changes the expectations of the
shareholders from the particular
shares of the company. Modigliani
and Miller, therefore, argued that
financial leverage has nothing to do
with the overall cost of capital a
company is equal to the capitalisation
rate of pure equity stream of its class
of risk. Hence, financial leverage has
no impact on share market neither on
share market prices nor on the cost of
capital.

Assumptions
1. The capital markets are assumed to
be perfect. This means that investors
are free to buy and sell securities.
They are well informed about the
 risk-return on all type of securities.
There are no transaction costs. The
investors behave rationally. They
can borrow without restrictions on
the same terms as the firms do.
2. The firms can be classified into
`homogenous risk class’. They
belong to this class if their expected
earnings is having identical risk
characteristics.
3. All investors have the same
expectations from a firm`s net
operating income (EBIT) which are
necessary to evolute the value of a
firm.
4. The dividend payment ratio is
100%. In other words, there are no
retained earnings.
5. There are no corporate taxes.
However this assumption has been
removed later.
Modigliani and Miller agree that
while companies in different
industries face different risks which
will result in their earnings being
captalised at differntrates, it is not
possible for these companies to
affect their market value, and
therefore their overall capitilisation
rate by use of leverage. That is, for a
company in a particular risk class,
the total market value must be same
irrespective of proportion of debt in
company`s capital structure. The
support for this hypothesis lies in the
presence of arbitrage in the capital
market. That contend that arbitrage
will substitute personal leverage for
corporate leverage. This is
illustrated below:
Suppose there are two
companies A&B in the same risk
class. Company A is financed by
equity and company B has a capital
structure which includes debt. If
market price of share for company
B is higher than company A, market
participants would take advantage of
difference by selling equity shares
of company B, borrowing money to
equate there personal leverage to the
degree of corporate leverage in
company B, and use these funds to
invest in Company A. The sale of
Company B share will bring down
its price until the market value of
company B debt and equity equals
the market value of the company
financed only by equity capital.