Capital Structure And Methods Of Capital Structure

AND METHODS OF CAPITAL
STRUCTURE
CAPITAL STRUCTURE

 BHANU PRATAP SINGH
 HARSH SHARMA
 GEETANJALI DUA
 MANAV
SYNDICATE-D

WHAT IS CAPITAL STRUCTURE?
OPTIMUM CAPITAL STRUCTURE
PATTERNS/ FORMS OF CAPITAL STRUCTURE
PRINCIPLE OF CAPITAL STRUCTURE DECISION
THE IMPORTANCE OR SIGNIFICANCE OF CAPITAL
STRUCTURE
FACTORS DETERMINING THE CAPITAL STRUCTURE
ASSUMPTION OF CAPITAL STRUCTURE THEORIES
THEORIES OF CAPITAL STRUCTURE
TABLE OF
CONTENTS
01
02
03
04
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06
07
08

The capital structure is the particular combination of debt and equity used by a
company to finance its overall operations and growth.
“Capital structure of a company refers to the make-up of its capitalization and it
includes all long-term capital resources viz., loans, reserves, shares and bonds.”—
Gerstenberg
Capital structure includes -:
1. Long term debts
2. Total stockholder Investment
What is Capital Structure?

An optimal capital structure is the best mix of debt and equity financing that
maximizes a company's market value while minimizing its cost of capital.
Appropriate capital structure should have the following features:
 Profitability/return
 Solvency/Risk
 Flexibility
 Conservation/capacity
 Control
Optimum capital structure

 Complete equity and share capital.
 Different proportion of equity and preference share
capital.
 Different proportion of equity and debenture capital.
 Different proportion of equity, preference and
debenture capital.
Patterns/ Forms of capital structure

 Cost principle
 Risk principle
 Control principle
 Flexibility principle
 Timing principle
Principle Of Capital Structure Decision

1. Increase in value of the firm: A sound capital structure of a company helps to
increase the market price of shares and securities which, in turn, lead to
increase in the value of the firm.
2. Utilization of available funds: A good capital structure enables a business
enterprise to utilize the available funds fully. A properly designed capital
structure ensures the determination of the financial requirements of the firm and
raise the funds in such proportions from various sources for their best possible
utilization. A sound capital structure protects the business enterprise from over-
capitalization and under-capitalization.
The importance or significance of Capital Structure

3. Maximisation of return: A sound capital structure enables management to
increase the profits of a company in the form of higher return to the equity
shareholders i.e., increase in earnings per share. This can be done by the
mechanism of trading on equity i.e., it refers to increase in the proportion of
debt capital in the capital structure which is the cheapest source of capital.
4. Minimization of cost of capital: A sound capital structure of any business
enterprise maximizes shareholders’ wealth through minimization of the overall
cost of capital. This can also be done by incorporating long-term debt capital in
the capital structure as the cost of debt capital is lower than the cost of equity or
preference share capital since the interest on debt is tax deductible.

5. Solvency or liquidity position: A sound capital structure never allows a
business enterprise to go for too much raising of debt capital because, at
the time of poor earning, the solvency is disturbed for compulsory payment
of interest to .the debt-supplier.
6. Flexibility: A sound capital structure provides a room for expansion or
reduction of debt capital so that, according to changing conditions,
adjustment of capital can be made.
7. Undisturbed controlling: A good capital structure does not allow the equity
shareholders control on business to be diluted.

1. Financial Leverage: Financial leverage which is also known
as leverage or trading on equity, refers to the use of debt to acquire additional
assets. The use of financial leverage to control a greater amount of assets (by
borrowing money) will cause the returns on the owner's cash investment to be
amplified. That is, with financial leverage:
2. Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay
fixed interest liabilities. Generally, the higher proportion of debt in capital
structure compels the company to pay higher rate of interest on debt
irrespective of the fact that the fund is available or not.
Factors Determining The Capital Structure

3. Risk in variation of earnings: The higher the debt content in the capital
structure of a company, the higher will be the risk of variation in the expected
earnings available to equity shareholders. If return on investment on total capital
employed (i.e., shareholders’ fund plus long-term debt) exceeds the interest
rate, the shareholders get a higher return.
4. Cost of capital: Cost of capital means cost of raising the capital from different
sources of funds. It is the price paid for using the capital. A business enterprise
should generate enough revenue to meet its cost of capital and finance its
future growth.

5. Control: The consideration of retaining control of the business is an important
factor in capital structure decisions. If the existing equity shareholders do not
like to dilute the control, they may prefer debt capital to equity capital, as former
has no voting rights.
6. Trading on equity: If the existing capital structure of the company consists
mainly of the equity shares, the return on equity shares can be increased by
using borrowed capital. This is so because the interest paid on debentures is a
deductible expenditure for income tax assessment and the after-tax cost of
debenture becomes very low.
7. Government policies: Capital structure is influenced by Government policies,
rules and regulations of SEBI and lending policies of financial institutions which
change the financial pattern of the company totally.

8. Size of the company: Availability of funds is greatly influenced by the size of
company. A small company finds it difficult to raise debt capital. The terms of
debentures and long-term loans are less favorable to such enterprises. Small
companies have to depend more on the equity shares and retained earnings.
9. Needs of the investors: While deciding capital structure the financial
conditions and psychology of different types of investors will have to be kept in
mind.

► Two types of capital, viz., debt and equity, are employed;
► Total assets of the firms must be presented;
► Regularity of paying 100% dividends to the shareholders;
► The operating incomes may not be expected to grow further;
► Business risk should be constant;
► There will not be any income tax;
► Investors should bear the same subjective probability distribution relating
to future operating income
Assumption Of Capital Structure Theories

1. Net Income Approach (NI)
2. Net Operating Income Approach (NOI)
3. Traditional Approach
4. Modigliani And Miller Approach (Mm Approach)
Theories Of Capital Structure

Net Income Approach
This approach was suggested by Durand and he was in favor of financial leverage
decision. According to him, a change in financial leverage would lead to a change in
the cost of capital. In short, if the ratio of debt in the capital structure increases,
the weighted average cost of capital decreases and hence the value of the firm
increases.
Firm Total Value of the Firm (V) = S + D
Where,
S = Market value of Shares = EBIT-I/ Ke = E/Ke
D = Market value of Debt = Face Value
E = Earnings available for equity shareholders
Ke = Cost of Equity capital or Equity
capitalization rate.

Net Operating Income Approach
This approach is also provided by Durand. It is opposite of the Net Income Approach
if there are no taxes. This approach says that the weighted average cost of capital
remains constant. It believes in the fact that the market analyses a firm as a whole
and discounts at a particular rate which has no relation to debt-equity ratio. If tax
information is given, it recommends that with an increase in debt financing WACC
reduces and value of the firm will start increasing.
Computation of the Total Value of the Firm
V = EBIT/Ko Where
, Ko = Overall cost of capital

Traditional Approach
This approach does not define hard and fast facts. It says that the cost of capital is a
function of the capital structure. The special thing about this approach is that it believes
an optimal capital structure. Optimal capital structure implies that at a particular ratio of
debt and equity, the cost of capital is minimum and value of the firm is maximum
Computation of Market Value of Shares &
Value of the Firm
S = EBIT – I /Ke
V = S + D
Ko = EBIT /V

Modigliani and Miller Approach (MM Approach)
It is a capital structure theory named after Franco Modigliani and Merton Miller. MM
theory proposed two propositions.
Proposition I: It says that the capital structure is irrelevant to the value of a firm. The
value of two identical firms would remain the same and value would not affect by the
choice of finance adopted to finance the assets. The value of a firm is dependent on the
expected future earnings. It is when there are no taxes.

Proposition II: It says that the financial leverage boosts the value of a firm and reduces
WACC. It is when tax information is available.
Computation Value of Unlevered Firm
Vu = EBIT(1 – T)/Ke
Value of Levered Firm VL = Vu + Dt
Where, Vu : Value of Unlevered Firm
VL :Value of Levered Firm
D : Amount of Debt
t : tax rate

Capital Structure And Methods Of Capital Structure

Capital Structure And Methods Of Capital Structure

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