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.

COST OF CAPITAL
MEANING: - The term cost of capital refers to the minimum rate of return which a
firm must earn on its investment. In economic sense, it is the cost of raising funds
required to finance the proposed project borrowing rate of return. Thus, under
economic terms, the cost of capital may be defined as the weighted average cost of
each type of capital.
According
to
Hapton.John.J cost of capital is the rate of return the firm requires from investment
in order to increase the value of the firm in the market place.

CAPITALISATION
The term Capitalization is derived from the word Capital. Capital in the business
aspect means the actual wealth or assets of a concern. But in accounting aspect
Capital means the net worth of a business. i.e. assets liabilities.

Thus, the term Capitalization refers to the total amount in securities issued by a
company. It consists of share capital, reserves, debenture capital and long-term
borrowings of the company. It is a quantitative aspect of financial planning.
Share Capital= Equity shares +Preference shares
Capitalization= Share capital+ Debenture capital + Long-term
Borrowings+
Free Reserves.

LEVERAGE ANALYIS

LEVERAGES:
James Horne has defined leverage as the employment of funds for which the firm has to pay
a fixed cost or fixed return if the firm is not required to pay a fixed cost or fixed return there
will be no leverage.
Generally, leverage is used to increase the return to share holders.
Another words increasing leverage increases the size of the return &increase the
risk. The risk refers to the degree of uncertainty associated with the firms ability to
pay the fixed payment obligatio

Factors affecting capital structure

1. Nature of business:
Public utilities having assured market and freedom from competition
stability of income may find debentures as suitable medium of financing.
Manufacturing concern do not enjoy these advantages and therefore, they
have to relay on equity share capital .services and merchandising concern
Having fewer fixed assets cant afford to raise funds by debentures because
of their inability offer their assets in mortgage for the loans.

2. Size of company:
Small concerns may have to depend on equity because of instability of
income .Large concerns may be mostly stable and generate more debts or
debentures.
3. Purpose of financing:
The funds may be required either for betterment expenditure or for some
productive purpose. The betterment expenditure may be done by issue of
shares. Funds required for expansion, purchase of new fixed assets etc. may
be raised through debentures if assets contribute to the earning capacity of
the company.
4. Trading on equity:
Trading on equity means taking advantage of equity share capital to
borrowed funds on reasonable basis. It prefers to the additional profits that
equity shares earn because of issuing preference shares and debentures. It is
based on the theory that if the rate of interest on borrowed capital is lower
than the general rate of the companys earning .The equity share holders will
get additional profits.
5. Desire to control the business:
If the management wants to retain effective control of the company, they
may raise funds from debentures and preference shares. They are usually not
given any voting rights as enjoyed by the equity shareholders. But if the
equity shares are issued then the promoters may loose their control in the
management.
6. Elasticity of the capital structure:
The capital structure should be as elasticity as possible so as to provide for
expansion for future development or reduce it when it is not needed. Too
much dependence on debentures and performance shares from the initial
stage makes the capital structure rigid because of payment of fixed interest

or dividend. These sources should be used for emergency and expansion

purposes only.
7. Need of investors:
An ideal capital structure is one which suits the need of different types of
investors. some of them prefer stability of income usually go in for
debentures . Preference shares will be preferred by those who want a higher
and stable income with safety of investment.
Equity shares will be taken up by risky investors. Those who want to acquire
control over the business like equity shares.
8. Cost of financing:
The cost of various financing should be estimated to decided which of the
alternatives is the cheapest interest, dividends underwriting commissions,
brokerage, stamp duty, listing charges etc constitute the cost of financing.
These securities which involve minimum costs should be preferred. The
company incurs lowest expense in selling debentures and highest in raising
equity capital. The capital structure therefore should be diversified with
suitable mix so as to minimize the aggregate costs of financing.
9. Legal requirements:
Preference shares and debentures. It cant exceed such prescribed limit.
some companies are not allowed to issue debentures or bonds.
10. Market conditions:
The prevailing market sentiments play a vital role in deciding the capital
structure. In times of depression, investors will look more for safety than to
income and will be willing to invest in debentures and not in shares. During
boom period, equity can have a better market.
11. Period of finance:
When funds are required for permanent investment, equity shares should be
issued. But for expansion program me and it feels that it will be able to

redeem the funds within the life time, it may issue redeemable performance
shares or debentures obtain long term loans.
12. Provision for future:
Financial planners always think of keeping their best security to the lost
instead of issuing all types of securities at one stretch.

CAPITAL OF 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.
2.
3.
4.

Net Income Approach ( N.R. approach)

Net Operating Income Approach ( N.O.I. approach)
Traditional Theory
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)
(ii)
(iii)

There are no corporate taxes

The cost of debt is less than cost of equity capitilisation rate.
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.

Ke = 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

2. 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)
(v)

3.

There are no corporate taxes.

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.

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 riskreturn 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.
Criticism:
These propositions have been criticized by numerous authorities.
Mostly criticism is about perfect market assumption and the arbitrage
assumption. MM hypothesis argue that through personnel arbitrage
investors would quickly eliminate any inequalities between the value of
leveraged firms and value of unleveragers, firms in the same risk class.
The basic-argument here is that individual arbitrages, through the use of
personal leverages can alter corporate leverage. This argument is not
valid in the practical world, for it is extremely doubtful that personnel
investors would substitute personal leverage for corporate leverage, since
they do, not have the same risk characteristics. The MM approach

assumes availability of free and upto date information. This also is not
normally valid.
To conclude, one may say that the controversy between the
traditionalists and the supporters of Modigliani and Miller approach
cannot be resolved due to lack of empirical research. Traditionalists argue
that the cost of capital of affirm can be lowered and the market value of
the shares can be increased by a careful use of financial leverage.
However after certain stage as the company becomes highly geared, it
becomes too risky for investors and lenders. Hence, beyond a point
overall cost of capital begins to rise. This point indicates the optimal
capital structure. Modigliani and Miller argue that in the absence of
corporate income taxes, overall cost of capital is independent of the
capital structures of the firm.