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Subject: Financial Management 
Chapter no. 9: Capital Structure
Chapter No. 9 – Capital structure and cost of capital
Contents
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Need for capital structure
♦
Components of a capital structure – exclusion of current liabilities and reasonsthereof
♦
Factors influencing capital structure
♦
Optimal mix of debt and equity – practical discussion
♦
Costs associated with different components of capital structure – prime costs andadditional costs
♦
 Weighted average cost of capital (WACC) of a given capital structure
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Numerical exercises in WACCAt the end of the chapter the student will be able to:
♦
Construct a capital structure for a given debt to equity ratio
♦
Select the various components of a capital structure with the objective of keeping thecost of capital at an optimum level and getting the required funds in time
♦
Map the various factors influencing selection of capital structure
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Calculate the prime and additional costs of different components of capital structure
♦
Calculate the WACC of a given capital structure
Need for a capital structure What is a capital structure?
Capital means “funds” employed in business for a period of twelve months and above. Capital excludes short-termfunds employed in funds, i.e., working capital. Working capital is employed for a short time and hence ignored.Capital structure gives us the various components of capital – both debt capital and share capital. In short, capitalstructure tells us about how much funds have been brought into business and in what form? It gives us therelationship between debt and equity, known as “debt to equity” relationship.
 What is the need for a capital structure?
Punjab Technical University, Online Virtual Campus1
 
Subject: Financial Management 
Chapter no. 9: Capital Structure
Why do we need a capital structure? Can’t we do without it? In other words, can’t we only have equity or debtinstead of both the components? We can, especially equity. One can have a business enterprise only with equityfunds without taking any loans. However, the financial risk that he will be taking would be tremendous, withoutanybody to share it with. Referring to debt we cannot have a business enterprise only with debt. It is impossible as nolender would be willing to give entire amount by way of loan. Any lender wants the owner to put in some money byway of equity share capital so that the balance funds can be given in the form of loans. The market norm for lendingis debt to equity not to exceed 2:1. There would be very few exceptions when this would be higher than 2:1.To sum up, any business enterprise would have what is known as “capital structure”. It is advisable for a businessenterprise to have both debt and equity components in its capital structure although it is possible to run the businessentirely on equity. Further as we have seen in the Chapter on “leverages”, it is beneficial to have a mix of debt andequity as it increases the “Earnings Per Share” (EPS) to the shareholders. At the same time, having regard toincreasing risk due to increasing debt, it is better to be within the lending norms of 2:1. (Example – Rs. 100 lacs byways of equity and Rs. 200 lacs by way of debt).
Components of a capital structure – exclusion of current liabilities and reasons thereof
Share capital:
Equity share capitalRetained earningsPreference share capital
Debt capital:
DebenturesLoansFixed deposits from the publicMedium term acceptances for capital goodsBondsUnsecured loans from promoters, friends and relativesDeferred Payment GuaranteesHire Purchase FinancingNote: The above list is not exhaustive. It is only illustrative.
Exclusion of current liabilities and reasons thereof
1.They are employed in business for a short period and cannot be considered as part of capital2.Some of them do not have any cost attached to them – advances received, provision for outstanding expenses,provision for tax, creditors outstanding etc. whereas all the items of debt capital have interest cost attached tothem.3.In a healthy business enterprise, they are fully covered by current assets and met out of current assets – examplecreditor gets paid out of realisation of sale bill outstanding as a “debtor”. Hence strictly speaking, currentliabilities are not considered as “capital”
Factors influencing capital structure or “determinants” of capital structure
1.The profitability of the organisation – the higher the profits more the chances for debt capital because of ability toservice higher debt – both by way of interest and repayment of principal amount. This is reflected in a verycritical ratio called “Interest coverage ratio”. EBIT/I. The higher the ratio, the more the chances of debt in thecapital structure.
Punjab Technical University, Online Virtual Campus2
 
Subject: Financial Management 
Chapter no. 9: Capital Structure
2.Reliable cash flows – the more they are reliable the more the lenders are willing to give debt capital to theenterprise. Once debt is taken cash outflows get fixed for the future. Accordingly the reliability of firm’s cashflows assumes great significance here.3.Degree of risk associated with the enterprise – the higher the risk less the chances of debt capital and more thechances of equityExample – IT industry (at least in the late 90’s in India) run predominantly on equity4.Management’s risk aversion attitude – conservative managements take less of external debt and try to utiliseinternal accruals to maximum extent and equity to the extent necessary; on the contrary aggressivemanagements go in for debt to a larger extent.Examples – Sundaram group of companies in Chennai in general and Sundaram Claytons in particular –conservative attitude towards debt and debt to equity ratio being less than 1:1. On the contrary, Essar oils havevery high debt to equity ratio – close to 3:1.5.Whether the business enterprise enjoys tax concessions in a big way like till recently the IT industry? Owing tohigh level of exports till recently the IT sector was enjoying 100% tax concession on the exports profits. Therewas no difference in cost of debt (interest) and cost of equity (primarily dividend) in the absence of taxes. Pleaserefer to the Chapter on “Leverages”. Such enterprises are indifferent to debt and have more of equity only.6.Availability of different kinds of debt instruments like “deep discounted” bonds, floating rate notes (where therate of interest is adjusted to the market rates) etc. that are attractive to the enterprises to go in for maximumdebt within the debt to equity ratio norms specified by the lenders or the market. These instruments haveentered the market only in the 90s and hence the debt market is getting more and more attractive and limitedcompanies have started using them instead of only depending upon institutional finance.7.Attitude of the promoters towards financial and management control - if this is high, first preference would begiven for debt and then preference shares. Last preference would be given for public equity where financialcontrol gets diluted because of larger number of shareholders and managerial control is likely to be affected.8.Nature of the industry – more competitive = higher equity and less debt; more monopolistic = less equity andmore debt. Further depending upon the nature of industry the lenders do have different lending norms. Thismeans that the leverage ratios in a particular industry are more or less uniform. These serve as the benchmarkfor determining the capital structure for any unit in the industry
Optimal mix of debt and equity – a discussion
Is there an optimal mix of debt and equity for a business enterprise? The answer to this question has been dauntingFinancial Analysts and Academicians and Theoreticians for a long time now. The perfect answer has so far beenelusive. This indicates that the best capital structure or the most suitable capital structure for a business enterprise isstill a “dream”. In the meanwhile, the business enterprise and “Finance experts” keep trying to evolve a perfectcapital structure model.In this discussion it is better to remember that while
“equity”
is
cushion
available to a business enterprise,
debt
is a
“sword”
. Debt has to be paid back and hence risk increases. However the advantage of debt is that the enterprise getsexposed to professional approach of the lenders and market; besides “external debt” would force financial disciplinein the enterprise. The process of discipline is automatic although not dramatic. The moment the firm so far in thehold of owners only exposes itself to market, discipline improves.The objective of optimal debt to equity mix should be to “maximise the firm value”. This involves the followingsteps:
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Identify the economic and financial market conditions facing the firm and analyze the competitive features of thebusiness
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Invest in projects that yield a return greater than the minimum acceptable hurdle rate (cost of capital)
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Manage financial risks that investors cannot easily manage, to maximise the firm’s debt and investment capacity
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Choose a capital structure and financing mix that minimises the hurdle rate and matches the assets beingfinanced
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