Capi

talSt
ruct
ureandi
tsTheor
ies

CapitalSt r
ucturemeansacombi nationofalll
ong-term sour
cesoff inance.Iti
ncl udes
Equit
yShar eCapital
,ReservesandSur pl
us,PreferenceSharecapi t
al ,Loan,Debent ur
es
andot hersuchl ong-
term sourcesoff i
nance.Acompanyhast odeci dethepr oporti
onin
whichi tshouldhaveitsownf inanceandout si
der’sfinanceparti
cularlydebtfinance.Based
onthepr oport
ionoffi
nance,WACCandVal ueofaf i
rm areaff
ected.Ther earef ourcapit
al
str
uctur etheori
esforthi
s,viz.netincome,netoper ati
ngincome,t r
adi ti
onalandM&M
approach.

CAPI
TALSTRUCTURE

Capi
talst
ruct
urei
st heproport
ionofalltypesofcapi
talvi
z.equi
ty,debt,pr
efer
enceetc.I
t
i
ssynonymouslyusedasf i
nanciall
everageorfi
nanci
ngmi x.Capit
alstr
uctur
eisalso
r
efer
redtoasthedegr eeofdebtsinthef i
nanci
ngorcapit
alofabusinessfir
m.

Financialleverageistheext entt
owhi chabusi nessfi
rm employsborrowedmoneyordebt s.
Infinancialmanagement ,i
tisasi gnif
icantter
m andi ti
saver yimportantdecisi
onin
business.I nthecapitalstr
uctureofacompany,br oadl
y,therearemai nl
ytwot ypesof
capitali.
e.Equi t
yandDebt .Outoft het wo,debtisacheapersour ceoffinancebecauset
he
rateofinterestwillbelessthant hecostofequi t
yandt heint
erestpayment sareatax-
deduct i
bleexpense.

Capi
talSt
ruct
ureTheor
ies

Capitalstructureorf i
nanci
alleveragedealswithaver yimpor t
antf i
nancialmanagement
question.Thequest i
onis–‘whatshoul dbetherati
oofdebtandequi ty?’Befor
escratching
ourmi ndst ofindtheanswert ot hisquesti
on,weshoul dknowt heobj ectiveofdoingallthi
s.
Inthef i
nancialmanagementcont ext
,theobject
iveofanyf i
nancialdecisi
oni st
omaxi mize
theshar eholder’
sweal thorincreasethevalueofthef i
rm.Theot herquest i
onwhichhit
st he
mindi nthef i
rstplaceiswhet herachangei nthefinancingmi xwoul dhaveanyi mpacton
thevalueoft hef i
rm ornot.Thequest ionisavali
dquest ionast herearesomet heories
whichbel ievethatfinanci
almi xhasani mpactont heval ueandot hersbelievei
thasno
connect i
on.

HOW CANFI
NANCI
ALLEVERAGEAFFECTTHEVALUE?

Onethingissur et hatwher everandwhateverwayonesour cesthefi

nancefrom,itcannot
changet heoper ati
ngi ncomel evel
s.Fi
nancialleveragecan,atthemax,haveani mpacton
thenetincomeort heEPS( EarningperShare).Ther easonwear ediscussi
nglater.
Changingt hefinancingmi xmeanschangi ngthel evelofdebts.Thischangeinlevelsofdebt
canimpactt hei nt
er estpayablebythatfi
rm.Thedecr easeinint
erestwouldincreasethenet
i
ncomeandt herebyt heEPSandi ti
sagener albeliefthatt
heincreaseinEPSl eadstoan
i
ncr
easei
ntheval
ueoft
hef
ir
m.

Apparently,underthi
svi
ew,financi
alleveragei sausef ultooltoi
ncreaseval
uebut
,att
he
samet i
me,not hingcomeswithoutacost .Financialleverageincr
easestheri
skof
bankr
upt cy.Iti
sbecausehigherthelevelofdebt ,higherwoul dbethef i
xedobl
i
gati
ont
o
honorthei nt
erestpayment
stot hedebtspr oviders.

Di
scussi
onoffinanci
all
everagehasanobviousobj
ect
iveoffi
ndi
nganopt i
mum capi
tal
st
ruct
ureleadi
ngtomaximizati
onoftheval
ueofthefi
rm.I
fthecostofcapi
tali
shigh

Impor
tanttheor
iesorappr
oachest
ofi
nanci
all
ever
ageorcapi
talst
ruct
ureorf
inanci
ngmi
x
areasfol
lows:

NETI
NCOMEAPPROACH

Thi
sappr oachwassuggestedbyDurandandhewasi nf avoroff i
nanci
all
everagedeci
sion.
Accordingtohim,achangeinfi
nanci
alleveragewoul dleadt oachangei nthecostof
capi
tal.Inshort
,ift
herat
ioofdebti
nthecapi talst
ructur
ei ncreases,t
heweightedaver
age
costofcapitaldecr
easesandhencethevalueoft hefi
rmi ncreases.

NETOPERATI
NGI
NCOMEAPPROACH

Thisappr oachi salsoprovi

dedbyDur and.Itisopposi
teoftheNetI ncomeApproachi f
therearenot axes.Thisapproachsayst hattheweightedaveragecostofcapit
alremains
constant.Itbelievesinthefactthatthemar ketanal
ysesafirm asawhol eanddiscountsat
apar t
icul
arr atewhi chhasnor elat
iontodebt -
equit
yrati
o.Iftaxinf
ormati
onisgiven,i
t
recommendst hatwithanincreaseindebtf i
nancingWACCr educesandvalueofthefir
m
willst
artincreasing.

TRADI
TIONALAPPROACH

Thisapproachdoesnotdef i
nehardandf astfacts.Itsaysthatt
hecostofcapitali
sa
functi
onofthecapitalstruct
ure.Thespecialthi
ngaboutt hi
sapproachisthati
tbeli
evesan
optimalcapi
talst
ructure.Optimalcapi
talstr
uctureimpl i
esthatataparti
cularr
ati
oofdebt
andequi t
y,t
hecostofcapi t
alismini
mum andval ueofthef i
rmismaximum.
MODI
GLI
ANIANDMI
LLERAPPROACH(
MM APPROACH)

I
tisacapi
talst
ructuretheorynamedaf
terFr
ancoModi
gli
aniandMer
tonMi
l
ler
.MM t
heor
y
pr
oposedtwopr oposit
ions.

Proposi
ti
onI:Itsaysthatt
hecapitalstr
uctureisi
rr
elevantt
othevalueofafirm.Theval
ue
oftwoident
icalfi
rmswouldr emai
nt hesameandval uewouldnotaffectbythechoiceof
fi
nanceadoptedt ofi
nancetheassets.Thevalueofaf i
rmisdependentontheexpected
fut
ureearni
ngs.Itiswhentherearenot axes.

Pr
oposi
ti
onII
:Itsayst
hatthef
inanci
all
ever
ageboost
stheval
ueofaf
ir
m andr
educes
WACC.Iti
swhent axi
nfor
mati
onisavail
abl
e.

Tosummarize,itisessentialf
orfi
nancepr
ofessi
onal
stoknowaboutt
hecapi
talst
ruct
ure.
Accur
ateanalysisofcapitalstr
uct
urecanhelpacompanybyopti
mizi
ngt
hecostofcapital
andhenceimpr oveprofi
tabili
ty