Capital Structure

Definition
 Capital structure of a company
refers to the composition or the
make-up of its capitalisation.

 It includes all long-term capital

resources I.e. loans,
reserves,shares and bonds
Capitalisation,Capital Structure and Financial Structure

 Capitalisation refers to the total amount

of securities issued by the company
 Capital structure refers to the kinds of
securities and the proportionate
amounts that make up the capitalisation
 Financial structure,generally is
composed of a specified percentage of
short term debt, long-term debt and
shareholder’s funds
Compute the (i) capitalisation (ii) Capital Structure (iii) Financial Structure

Liabilities Rs.

Equity share capital 10,00,000

Preference share capital 500,000
Long-term loans & debentures 200,000
Retained earnings 600,000
Capital surplus 50,000
Current liabilities 1,50,000
25,00,000
(i) Capitalisation refers to the total amount of securities issued by a company.

Rs.
Equity share capital 10,00,000
Preference share capital 500,000
Long-term loans and debentures 200,000
Capitalisation 17,00,000

(ii) Capital structure refers to the proportionate amount that makes up capitalisation
Rs. Prop./Mix
Equity share capital 10,00,000 58.82%
Preference share capital 500,000 29.41%
Long-term loans and debentures 200,000 11.77%
17,00,000 100%
(iii) Financial structure refers to all the financial resources, short as well as long-term.

Rs. Prop./Mix

Equity share capital 10,00,000 40%

Preference share capital 500,000 20%
Long-term loans & debentures 200,000 8%
Retained earnings 600,000 24%
Capital surplus 50,000 2%
Current liabilities 1,50,000 6%
25,00,000 100%
Forms/ Patterns of Capital Structure

 Equity shares only

 Equity and preferences shares
 Equity shares and debentures
 Equity shares,preference shares and
debentures
Financial Leverage
 The use of long-term fixed interest
bearing debt and preference share
capital along with equity shares is
called financial leverage.
 Also called trading on equity.
Optimal Capital Structure

 The combination of debt and equity

to maximum value of the firm.

 Optimal capital structure maximizes

the value of the company and hence
the wealth of the owners and
minimizes the company’s cost of
capital
Theories of Capital Structure

 To explain the relationship

between capital structure,cost of
capital and the value of the firm.
 Net income approach
 Net operating income approach
 The traditional approach
Net Income Approach

 A firm can minimise the weighted average

cost of capital and increase the value of
the firm as well as the market price of
equity shares by using debt financing to
the maximum possible extent.

 Increasing the proportion of debt in capital structure

Increase in value and reduces the firms cost of capital.

Assumption (NI Approach)

 Cost of debt is less than the cost of

equity
 There are no taxes
 The risk perception of investors is
not changed by the use of debt
Argument

 As the proportion of debt financing in capital

structure increases, the proportion of less
expensive funds increases.
 This results in the decrease in the overall cost
of capital leading to increase in the value of the
firm.
 The reasons for assuming cost of debt to be
less than the cost of equity are that interest
rates are usually lower than the dividend rates
due to the element of risk and the benefit of tax
as interest is tax deductible expense.
 Value of the firm on the basis of NI Approach
Where, V=Total market value of a firm
S=Market value of equity shares
V=S+D D=Market value of debt

Earnings available to equity share holders

S=
Equity capitalisation Rate

Overall cost of capital is:

EBIT
KO=
V
Net operating Income Approach

 Change in capital structure of a company

does not effect the value of the firm and
the overall cost of capital remains
constant irrespective of the method of
financing.
 Overall cost of capital remains constant
whether the debt-equity mix is 50:50 or
20:80 or 0:100.
 Thus,there is no optimal structure and
every capital structure is the optimum
capital structure.
Assumption (NOI Approach)

 The market capitalises the value of the

firm as a whole
 The business risk remains constant at
every level of debt equity mix
 There are no corporate taxes
Argument
 Increased use of debt increases the
financial risk of the equity shareholders
and hence the cost of equity increases.

 Thus the advantage of using the cheaper

source of funds,I.e.,debt is exactly offset
by the increased cost of equity.
Value of the firm on the basis
Where, of NOI Approach
V=Total market value of a
firm
EBIT EBIT=earnings before
V= Interest and taxes
KO KO =overall cost of capital

Where, V=Total market value of a

S=V-D firm
S=Market value of equity
shares
D=Market value of debt

EARNINGS AVAILABLE FOR EQUITY SHARE HOLDERS

KE=
TOTAL MARKET VALUE OF EQUITY SHARES

Where, KE is the equity capitalisation rate.

Traditional Approach

 Also known as intermediate approach

 The value of the firm can be increased initially or the

cost of capital can be decreased by using more debt
as debt is the cheaper source of funds than equity.

 Beyond a particular point, the cost of equity

increases because increased debt increases the
financial risk of of the equity share holders.

 The advantage of cheaper debt at this point of capital

structure is offset by increased cost of equity.
Traditional Approach

 A stage comes,when the increase

cost of equity cannot offset the
advantage of the low-cost debt.

 Thus, the overall cost of capital

decreases up to a certain point,
remains more or less unchanged for
moderate increase in debt
thereafter; and increases or rises
beyond a certain point.
 re

ra

rd

•The cost of debt, re remains more or less constant up to a certain degree

of leverage but rises thereafter at an increasing rate.
•The cost of equity, rd,remains more or less constant or rises only
gradually up to a certain degree of leverage and rises sharply thereafter.
•The average cost of capital , ra,(i) decreases up to a certain point
(ii)remains more or less unchanged for moderate increase in leverage.
(iii)rises beyond a certain point.
Capital Gearing
 Refers to the relationship between equity
capital(equity shares and reserves) and long term
term debt.
 Capital gearing means the ratio between different
types of securities.
 A company is said to be in high-gear, when it has a
proportionately higher issue of debentures and
preference shares for raising long-term resources.
 Low-gear for a proportionately large issue of equity
shares.