INTRODUCTION:

The capital structure choice has always assumed to be a crucial for any business
organization. The decision is vital because of the need to maximize returns to various
organizational constituencies, and also due to the impact such decisions have on a firm's ability
to deal with its competitive environment. The capital structure of a firm is actually a mix of
different securities. In general, a firm can choose among many alternatives of capital structures.
It can issue a hefty amount of debt or very little debt. It can arrange lease financing, use
warrants, issue convertible bonds, sign forward contracts or trade bond swaps. It can issue
dozens of distinct securities in numerous combinations; however, it attempts to find the
particular combination that maximizes its overall market value.
A number of theories have been advanced in elucidating the capital structure of firms.
Despite the theoretical appeal of capital structure, researchers in financial management have
not found the optimal capital structure. The best that academics and practitioners have been
able to achieve is a prescription that satisfies short-term goals. The lack of consensus about
what would qualify as optimal capital structure has stimulated the need for this research. A
better understanding of the issues at hand requires a look at the concept of capital structure
and its effect on firms profitability. This study examines the relationship between capital
structure and profitability of Pharmaceutical companies listed on National Stock Exchange
(hereinafter referred as NSE), Mumbai. The effect of capital structure on the profitability of
listed firms in Indian pharmaceutical companies has not been explored earlier in Indian finance
literature.
The management of a company should seek answers to the following questions while
making financing decisions; (i)how investment project be financed, (ii)does the way in which
the investment projects are financed really matters, (iii)how does financing affect shareholders
risk, return and value, (iv)does there exist an optimum financing mix in terms of the maximum
value to share-holders of a company, (v)can the optimum financing mix really be determined in
practice for a company, and (vi) what factors should a company consider in designing its
financing policy.
While analyzing capital structure of a company, mostly the proportion of short and long-term
debt is considered. When people refer to capital structure they are most likely referring to a
firm's debt-to-equity ratio.
Features of capital structure
Profitability: The capital structure of the company should be the most advantageous.
With constraints, maximum use of leverage at a minimum cost should be made.
Solvency: The use of excessive debt threatens the solvency of the company. Optimum
level of debt does not add significant risk. Firms should try to achieve only the optimum
level. If they are not achieving it they should better avoid the use of debt.
Flexibility: The capital structure should not be inflexible to meet the changing
conditions. It should be possible for a company to adapt its capital structure, with
minimum cost and delay.
Capacity: The capital structure should be determined within the debt capacity of the
company, and this capacity should never be overlooked. The debt capacity of a company
depends on its ability to generate future cash flow. It should have enough cash to pay
creditors fixed charges and principal sum.
Control: The capital structure should involve minimum risk of loss of control of the
company. The owners of closely-held companies are particularly concerned about
dilution of control.
Capital structure has gained much interest and controversy for the companies because
the propositions which contended that the value of a firm is independent of its capital structure
have been put to test and researched into time and again. Most of the studies, however, were
conducted in the USA hence doubts arise whether the conclusions would be applicable in the
Indian context or not. With this motivation, this study attempts to solve the dearth of research
on capital structure, particularly its effect on profitability, of local firms. Major sets of variables
can be used to indicate capital structure i.e. Debt/Equity Ratio, Debt Ratio, Financial Leverage
Ratio, Funded Capital Ratio, Funded Debt Ratio, Current Debt Ratio, Funded Assets Ratio and,
profitability ratios like Return On Equity, Earnings Per Share, Return On Investment, Profit
Before Tax, Net Income. For a number of reasons, we would expect capital structures to vary
considerably across industries. For example, pharmaceutical companies generally have very
different capital structures than airline companies. Moreover, capital structures vary among
firms within a given industry. What factors can explain these differences? In an attempt to
answer this question, academics and practitioners developed a number of theories, and the
theories have been subjected to empirical tests.
In order to achieve the goal of identification of an Optimum D/Mix, it is necessary to be
conversant with basic theories underlying the capital structure of corporate enterprise.
Existence of Optimum Capital Structure is not accepted by all. There exist extreme views:
View point I: - The financing or D/E mix has a major impact on Shareholders wealth
View point II: - The decision about financial structure is irrelevant as regards
maximization of Shareholders wealth
Capital structure theories:
1. Net income (NI) approach.
2. Net operating income (NOI) approach.
3. Modigliani- Miller hypotheses with and without corporate tax.
4. Traditional Approach
5. The Hamada equation
6. Pecking order theory
7. Trade-off theory
Assumptions:
There are only two kinds of funds used by a firm i.e. debt and equity.
Taxes are not considered
The payout ratio is 100%
The firms total financing remains constant
Business risk is constant over time
The firm has perpetual life.
1.1 NET INCOME APPROACH
Initiated by Durant David, this explains that change in capital structure causes changes
in overall cost of capital and total value of the firm. It says that if debt leverage is increased, the
financial leverage will also increase. This can lower the overall or weighted cost of capital which
again increases value of firm as well as its equity shares.
Assumptions
There are usually three basic assumptions in this approach:
Corporate taxes do not exist
Debt content does not change the risk perception of the investors.
Cost of debt is less than the cost of equity i.e., debt capitalization is less than the equity
capitalization rate.
According to the net income approach, the value of the firm and the value of the equity
are determined as given below:
Value of the firm (V) = S + B
Where, S = Market value of Equity
B = Market value of Debt
Market Value of Equity (S) = NI / Ke
Where, NI = Net income available for equity shareholders
Ke = Equity capitalization rate

Present Position 50% increase 50% Decrease in debt
Capital
8% Debenture
NOI
I
NI
Equity
capitalization rate
Market value of
equity shares
6,00,000
1,50,000
40,000
1,02,000
10%

10,20,000
9,00,000
1,50,000
72,000
78,000
10%

7,80,000
3,00,000
1,50,000
24,000
1,26,000
10%

12,60,000
Market value of
debenture(B)
6,00,000 9,00,000 3,00,000
Total value of firm
V = S + B
Over cost of capital
16,20,000
9.26%
16,80,000
8.93%
15,60,000
9.62%

1.2 NET OPERATING INCOME APPROACH
According to this approach, also proposed by Durand, the valuation of the firm and its
cost of capital are independent of capital structure. Any change in the capital structure does not
affect the value of the firm or cost of capital, although, the further introduction of debt capital
may increase equity capitalization rate and vice versa. Market Value of a firm is not affected by
Capital Structure changes. Market Value of the firm is ascertained by capitalizing the net
operating income at the overall cost of capital, which is considered to be constant.
The NOI is based on certain assumptions:
The investors see the firm as a whole and thus capitalize the total earning of the firm to
find the value of the firm as a whole.
The overall cost of capital (k0) of the firm is constant and depends upon the business
risk which also is assumed to be unchanged.
The cost of debt (kd) is also constant.
There is no tax.
The use of more and more debt in the capital structure increases the risk of the
shareholders and thus results in the increase in the cost of equity capital (ke).
Value of the firm (V) = EBIT / K0
Where, EBIT = Earnings before interest and tax
K0 = Overall cost of capital
Value of equity (S) = V B
Where, V = Value of firm
B = Value of debt
In net operating income approach the cost of debt and the overall cost of capital are
constant for all level of leverage. As the debt proportion or the financial leverage increases, the
risk of the shareholders also increases and thus the cost of equity capital also increases.
However the increase in cost of equity capital does not affect the overall value of the firm and it
remains same. In case of an all equity firm the cost of equity capital is just equal to WACC. As
the debt proportion is increased the cost of equity also increases. However the overall cost of
capital remains constant because increase in cost of equity is just sufficient to offset the benefit
of cheaper financing. The NOI approach believes that leverage has no effect on the WACC and
the value of the firm. Hence every capital structure is optimal.

Present Position
(Rs.)
50% increase in
debt capita (Rs.)
50% decrease in
debt capital (Rs.)
8% Debenture 6,00,000 9,00,000 3,00,000
Over all
capitalization rate
10% 10% 10%
EBIT 1,50,000 1,50,000 1,50,000
Total value of firm 15,00,000 15,00,000 15,00,000
Over all cost of
capital
1,50,000 1,50,000 1,50,000
EBIT/V 10% 10% 10%
Market value of
debenture (B)
6,00,000 9,00,000 3,00,000
Market value of
Equity Share (S) i.e.
V- B
9,00,000 6,00,000 12,00,000
I 48,000 72,000 24000
Equity
capitalization rate
EBIT- I
V-B
1,02,000
9,00,000
11.3%
78,000
6,00,000
13%
1,26,000
12,00,000
10.5%

1.3 TRADITIONAL APPROACH
The traditional view of capital structure theory, which has been popularized by Ezra
Solomon, is a compromise between the two extreme views regarding the relationship between
the cost of capital, leverage and value of a firm. This approach suggests that through a judicious
use of both debt and equity capital, the cost of capital of a firm can be minimized and
consequently the value of the firm can be maximized. According to this approach, the overall
capital structure movements due to change in capital structure can be divided into three
stages.
The main propositions of the traditional approach are:
The Cost of debt capital remains constant up to a certain degree of leverage but rises
afterwards with an increasing rate.
The Cost of equity capital remains constant or rises only gradually up to a certain degree
of leverage and rises sharply thereafter.
The average cost of capital decreases up to a certain point, remains constant for
moderate increase in leverage afterwards, and rises beyond certain point.
No Debt 5% Debenture
Rs. 3,00,000
8% Debenture Rs.
6,00,000
EBIT 1,50,000 1,50,000 1,50,000
Less interest on
debenture
- 15,000 48,000
NI 1,50,000 1,35,000 1,02,000
Cost of equity
capital
10% 11% 12%
Market value of
equity shares
(S)
15,00,000 1,35,000 1,02,000
Market value of
debenture (B)
- 3,00,000 6,00,000
Total value of
firm i.e. V=S+B
15,00,000 15,27,273 14,50,000
Overall capital 10% 9.82% 10.34%
cost i.e. EBIT
V

According to the traditional view, the value of the firm can be increased or the cost of
capital can be reduced with the help of a judicious mix of debt and equity capital. This approach
very clearly implies that the cost of capital decreases with reasonable limit of debt and
increases with leverage. Thus an optimum capital structure exists when either the cost of
capital is minimum or the value of the firm is maximum. The cost of capital declines with
leverage because debt capital is cheaper than equity capital within reasonable or acceptable
limit of debt. The statement that debt funds are cheaper than equity funds carries the clear
implication that the cost of debt and the increased cost of equity together, on a weighted basis,
will be less than the cost of equity which existed on equity before debt financing. In other
words, the weighted average cost of capital will decrease with the use of debt.
Firms can borrow at a low rate of interest in the beginning. With the increase in
leverage, lenders begin to worry about the repayment of interest and principal and the security
available to them. The interest rate will be higher on additional loans. Therefore, average cost
of debt begins to rise. Simultaneously, the equity holders will not much bother when the debt
levels of the company are lower. But with increase in leverage, the equity holders are much
more concerned about the levels of interest payments affecting the volatility of cash flow for
equity, than the equity holders demand for more rates of return for taking an additional risk.
Thus, with a combination of both the sources of finance, and the increase in leverage, the
overall cost of capital will also start rising after the optimum level of gearing. WACC is
undoubtedly an important tool in determining optimal capital structure. To maximize the value
of the firm as well as the market value of the stock, the firm should strive to minimize WACC.
Thus considerable weight is placed on WACC for achieving the ultimate objective of increasing
the shareholders worth by choosing an appropriate capital mix. Other conditions, likely cash
flow, ability of the firm to meet fixed charges, degree of leverage, fluctuations of EBIT and its
likely impact on EPS for alternative methods of financing etc. should also be taken into
consideration with due weight- age for the purpose Therefore, a firm should identify and
maintain capital structure at its optimum level.
1.8 FRANCO MODIGLIANI AND MERTON MILLER APPROACH
Modern capital structure theory began in 1958, when Professors Franco Modigliani and
Merton Miller (hereafter MM) published what has been called the most influential finance
article ever written. MM proved, under a very restrictive set of assumptions, that a firms value
is unaffected by its capital structure. In other words, MMs results suggest that it does not
matter how a firm finances its operations and hence capital structure is irrelevant. However,
MMs study was based on some unrealistic assumptions, including the following:
There are no brokerage costs.
There are no taxes.
There are no bankruptcy costs.
Investors can borrow at the same rate as corporations.
All investors have the same information as management about the firms future
investment opportunities.
EBIT is not affected by the use of debt.
Despite the fact that some of these assumptions are obviously unrealistic, MMs
irrelevance result is extremely important. By indicating the conditions under which capital
structure is irrelevant, MM also provided us with clues about what is required for capital
structure to be relevant and hence to affect a firms value. MMs work marked the beginning of
modern capital structure research, and subsequent research has focused on relaxing the MM
assumptions in order to develop a more realistic theory of capital structure. Research in this
area is quite extensive, but the highlights are summarized in the following sections.
MM Approach without tax:
1.4.1 PROPOSITION I:
The value of the firm is established by capitalizing its expected net operating income
(EBIT) at a constant overall cost of capital
V(L) = V(U) = EBIT/WACC = EBIT/K0
Here L is the levered and U is unlevered firm Here as per the proposition I, both L and U
firms have the same business risk and the standard deviation is the same
The cost of equity to a levered firm is equal to the cost of equity to an unlevered firm in
the same risk class plus a risk premium whose size depends on both the differentials between
an unlevered firms cost of debt and equity and the amount of debt used.
K0(L) = K0(U) +Risk premium
= Ke(U) +(Ke(U) Kd)(D/S)
Here D is the market value of debt and S is the market value of equity and Kd is the cost
of debt
Taken together the two MM propositions imply that the inclusion of more debt in the
capital structure will not increase the value of the firm, because the benefit of cheap debt will
be exactly offset by an increase in the risk factor, hence the cost of equity will move up. So, MM
argues that in the world of no tax, both firms value and its WACC would be unaffected by its
leverage decision.
MMS ARBITRAGE PROOF:
MM used an arbitrage proof to support their propositions. They proved that if the
values of two firms are different and the ways of financing are different, the investors can sell
the shares of overvalued firm and buy the shares of undervalued firm continuously than the
value of both the firms will be the same.
MM APPROACH WITH CORPORATE TAX:
MMs original work, published in 1958, assumed zero taxes. In 1963, they published a
second article that incorporates corporate taxes. With corporate taxes, they conclude that
leverage would increase a firms value. This is because interest is tax-deductible and hence
more of a leveraged firms operating income flows through the investors.
1.4.2 PROPOSITION II:
The value of a levered firm is equal to the value of an unlevered firm in the same risk
class plus the gain from leverage. The gain from the leverage is the value of the tax savings,
found as the product of the corporate tax rate (T) times the amount of debt the firm used (D):
V (L) = V(U) + TD
When the corporate taxes are introduced, the value of the levered firm exceeds that of
the unlevered firm by the amount, TD. With zero debt the value of the firm is its equity value
Limitation of MM approach
Personal leverage impractical
No transaction cost not in reality
Personal and corporate borrowing rate is different in the practical market place
Financial distress
The offsetting advantage of debt is grouped under the term financial distress. Financial
distress occurs when the firm finds it difficult to honour the obligations of creditors, which
may lead to insolvency also. The financial distress also introduces inflexibility of raising funds
by firm when needed. The financial distress reduces the value of the firm, on account of
insolvency costs like legal costs, arranging the funds at higher cost of capital, etc. Hence:
Value of leveraged firm = Value of unleveraged firm+ PV of tax shield benefit PV of financial
distress.
The costs of financial distress increases as more and more debt is introduced in the capital
structure of the firm.

Goal\principle of capital structure
The goal of the capital should be to maximize the wealth of the share holders
maximizing the long term price per share
The aim of capital structure should be to minimize the cost of financing and maximize
earning per share.
Debt is cheaper, interest is a deductible expense and therefore there is savings in
income tax,rate of interest is fixed, and expectation of returns by provider of debt is
limited as compared to equity shareholder but it increases the risk of the equity
shareholders.
Dividend is not considered as an expense.Dividend distribution tax is to be paid by the
company as per the latest income tax rules. Raising small amount is not easy and
condition of capital marke tis to be seen for raising capital through equity.
The capital structure should not increase unduly risk for the equity share holders.
Equity: less risky, no contractual payment so as to bring insolvency.
Debt: contractual payment of interest and principal irrespective of profit and loss of
the company. This leads to the risk of insolvency and brings bad reputation in case of
default in repayment.
Paying dividend is not a contractual payment and therefore there is no risk of
insolvency in case of non-payment.
If dividend is paid to equity share holders the preference shareholders have first right.
In the case of winding up also they have first right as compared to the equity
shareholders. This does not increase the risk in anyway.
While planning capital structure it should be seen that the control of owners should
not be diluted. Right issue will not dilute the control as it is issued in the same ratio as
existing shares, but the public issue may dilute the control
Ideal capital structure should be able to cater to additional fund requirements in the
future.
The provider of debt always look at::
Debt equity ratio.
Availability of assets as security.
If the company is risky,the debt will be costly and may contain lot of restrictive clauses
like not to declare dividend beyond certain limit etc.
The ideal capital structure should be able to seize the market opportunities like
Boom period :able to raise equity at good premium.
Depression: debt at lowest interest rate.
Factors affecting capital structure
Before deciding the capital structure of a company one should have a look at various
factors ,which affects the capital structure.
The factors are:
1.Internal
2.External and
3. General.
Cost factor: cost is one of the most important factors. Borrowed capital is cheaper as
expectation of lenders is less and interest is deductible expense and thus brings in
savings in taxes.
Risk factor: debt is more risky as it is contractual obligation irrespective of profit or
loss of the company while dividend to equity/preference shareholders is not
contractual obligation.
Control factor: If large amount of equity is issued It will dilute the control, sometimes
lenders also want their representative in the board of directors.
General economy Conditions in the country and abroad whether it is boom our
depression or market is recovering from depression our moving toward depression.
Behavior of interest rate, future trends in India and abroad.
Policy of lending institution if it is too harsh our rigid conditions are imposed the it is
better to move for other alternatives.
If company is private limited our closely held company ,the control of management is of
paramount importance. If company is public limited company our widely held company the
control will not be diluted easily and cost will be more important