CAPITAL STUCTURE

Compiled to Fulfill the Duties of Marketing Management Courses

Lecturer :
Prof. Dr. Isti Fadah, M.Si.

Authored By:

Izzah Mariami Sechimil

190810201004

DEPARTMENT OF MANAGEMENT
FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITY OF JEMBER
 2020
Issues Baground
The capital structure relates to the amount of debt and equity used to finance company assets. An
effective capital structure can create a company with a strong and stable financial position. In
line with the development of public knowledge in the field of capital markets and the availability
of funds for potential investors who are interested in investing, the capital structure becomes an
important factor to consider. This is related to the risk and income that will be received. In
looking at the company's capital structure, investors cannot be separated from company
information in the form of annual financial reports. Investors will use the information to carry
out various analyzes related to investment decisions in the company, one of which comes from
the company's financial statements.
Problem Formulation
Based on the research background that has been stated above, the problem can be formulated as
follows:
1. What is Theoretical Approach to Capital Structure?
2. What is Approaches to the Concept of Capital Structure Assessment?
3. How Capital Structure Decisions in Practice ?

Purpose
The purpose of discussing the problem formulation of this paper is to know more clearly
what is capital stucture.
Theoretical Approach to Capital Structure
1.1 Definition of capital and capital structure
Capital is the right or part of the owner of the company in the position of capital (share
capital), retained earnings or rights or a part of all debts owned by the company (Munawir,
2001). Capital is basically divided into two parts, namely active capital (borrowers) and
passive capital (creditors).
Capital structure is a balance or comparison between foreign capital and own capital.
Foreign capital is defined as long-term and short-term debt. At the same time, capital itself
can be divided into retained earnings or company ownership.
Capital structure is an important issue that determines company spending. To measure the
capital structure, several theories can be used to explain the capital structure of a company.

1.2 Capitalization theories

A. Capitalization theory is divided into two groups, namely:
1. Based on income or earnings
The value of a company can be determined based on the annual income multiplied by a
certain multiplayer.
2. Based on expenses or costs
Company capitalization is based on the cost of the fixed capital used in a company.
B. Over and under capitalization
Over capitalization will occur if :
1. Earning is not big enough to get a fair of return from the amount of invested capital,
or in other words, the average rate of return is smaller than the fair rate of return.
2. The total value of securities in circulation is greater than the real value compared to
the value of their assets.
Under capitalization occurs when :
1. The average rate of return of the company is much higher than the rate of return of
capital invested in other similar companies.
2. The total security value stated in the nereca is much smaller than the real value of the
assets.
1.3 Factors Affecting Capital Structure
 Sales rate
Companies with stable sales and relatively stable cash flow can use relatively large debt
 Asset structure
Companies with a large amount of fixed assets (as collateral) can use relatively large debt
 The company's growth rate
The faster the company grows, the greater the need for funds for expansion.
 Profitability
The pecking order theory shows the order of financing; retained earnings → debt → sale of
new shares (to avoid external reviews)
 Variable profit and tax protection (tax protection)
If the volatility of earnings is small, the ability to bear debt burdens will still be greater. The
use of debt can provide tax protection benefits.
 Company size
Large companies have a great opportunity to enter the capital market, so that there is a
positive correlation between company size and the ratio of debt equity and book value.
 Internal and macroeconomic conditions of the company
When is the right time to sell stocks / bonds; low market interest rates and falling stock
market (as opposed to bearish)

Approaches to the Concept of Capital Structure Assessment

1. Theory of the Net Income Method (NI)
It can be assumed that this method is where investors capitalize or evaluate the company's
profits at a fixed capitalization (Ko) level, and the company can increase the amount of
debt it owes at a fixed cost of debt (Kd). It can also be explained as, because the
capitalization rate and cost of debt are constant or fixed, the greater the amount of debt
the company owes, the smaller the weighted average cost of capital.
2. NOI net operating income method theory
The theory assumes that the weighted average cost of capital (Ke) is constant and has
nothing to do with the company's outstanding debt. In this theory, investors have different
views.
 a. The cost of debt remains the same as the net profit method.
b. With the increase in corporate debt, the company's risk also increases. Therefore,
management requires that the company's profits also increase, as a result, the
weighted average cost of capital is fixed, and the decision on capital structure is
trivial.
3. Traditional Methodology
This theory assumes that under a certain leverage, the firm's risk remains unchanged (Kd
& Ke remains unchanged), and after a certain leverage or debt risk, the cost of debt and
the cost of own capital either increase or increase. The substantial cost of capital is even
greater than the reduction in costs resulting from the use of cheap debt. As a result, after
increasing leverage, the weighted average cost of capital falls. In other words, the initial
increase will be lower due to the increase in debt.
4. Modigliani and Marton Miller Methodology (MM Theory).
MM's theoretical assumptions include:
a. The business risk of a company can be measured by the standard deviation of profit
before tax (δEBIT), and companies with the same business risk are called the same
category.
b. All investors and potential investors have the same estimates of the company's future
earnings before interest and taxes, or have the same expectations for the company's
earnings and the company's risk level.
c. Stocks and bonds traded in the perfect capital market. Effective capital market criteria
are:
d. Information is always available to all investors (symmetrical information) and can be
obtained free of charge.

Capital Structure Decisions in Practice

3.1 EBIT - EPS analysis
Through this analysis, management can see the impact of various financing methods at
various levels of EBIT (earnings before interest and tax) on EPS (earnings per share).
Earnings per share refers to the net profit after tax or profit after tax (EAT) divided by the
company's outstanding shares.
In this analysis, the relationship between EBIT and EPS can be found in the following ways:
1. Calculate earnings per share from various financing methods for a particular EBIT, and
2. Repeat the first step for a different EBIT. Then plot the results on an EBIT-EPS graph.

The point of indifference provides important input for management to choose other
expenses. If the expected EBIT is greater than the point of indifference, the company
should use debt. If not, the use of shares will be more profitable. It should be noted that if
the actual EBIT is not as great as expected this decision may be wrong. Therefore, in
making decisions, management must also pay attention to the standard deviation of the
company's EBIT (level of variability). By formulating various plans for future EBIT and
their likelihood of occurring, the expected deviation and standard deviation of EBIT can
be found. If the standard deviation of EBIT is large, management should be extra careful
because the expected EBIT is not very reliable. Management should only decide to use
debt when the EBIT estimate is well above the point of indifference.

EAT (shares) EAT (debt)

= Number of shares Number of shares
(EBIT * - C1) (1 - T) (EBIT * - C2) (1 - T)
= S1 S2

Where:
EBIT* = Indifferent point
C1 = Interest costs on alternative purchases 1
C2 = Interest costs on alternative purchases 2
S1 = Number of shares in alternative purchases 1
S2 = Number of shares in alternative purchases 2
T = Tax rate
3.2 Comparison of Leverage Ratios
 The purpose of this analysis is to determine the effect of each method of financing on
the leverage ratio (use of debt). Management can then compare the existing ratios and
the ratios of specific funding alternatives with similar industry ratios. The leverage
ratio consists of (1) debt ratio and (2) guarantee ratio (coverage ratio).
 The debt ratio shows the company's ability to meet long-term debt, while the
guarantee ratio shows its ability to pay interest and principal that are due. To calculate
the debt ratio, management uses the information on the balance sheet. To calculate
the guarantee level, the information in the income statement is used.
Management can use the following ratio calculation methods:
1. Debt ratio:
o One of a kind. Total debt / total assets
o Long-term debt / (long-term debt + own funds)
o Total debt / equity
2. Guarantee Ratio:
o Time interest earned = EBIT / Interest expense
o Debt service coverage = EBIT / [interest expense + (loan principal payment /
1- tax)]
 The debt ratio and guarantee ratio can be calculated based on the following conditions:
(1) the company's current financial status,
(2) the company's financial status and existing alternative financing methods, such as
100% equity, 100% debt, etc. Then compare that ratio with the industry ratio. Through
this comparison, management can determine the most suitable alternative funding for the
company. This does not mean that management has to keep the same ratio as the industry
ratio. The use of industrial ratios and ratios is that if the debt ratio and guarantee ratio
chosen by the company deviates from the industry ratio, it must have a strong reason.
3.3 Company Cash Flow Analysis
• This method analyzes the effect of capital structure decisions on the company's cash
flow. This method is simple, but very useful. This method involves preparing a series of
cash budgets in the following situations: (1) different economic conditions, (2) different
capital structures can analyze net cash flow in these different situations to determine the
company's fixed expenses (principal, interest, rent and dividends. preferred stock faced
by the company) is not very high. The company's inability to pay fixed costs can lead to
"financial bankruptcy."

• Gordon Donaldson of Harvard University believes that a company's fixed-load capacity

should depend on the company's net cash flow, which is expected to materialize during a
recession. In other words, the objective of the capital structure is determined by
formulating a plan for dealing with the "worst possible scenario".

• The following formula defines CBr, which is the cash balance that the company expects
at the end of a recession.
CBr = Cobalt + NCFr-FC
where is it:
Co = equilibrium ka at the start of a recession
NCFr = Net cash flow from operations during a recession
FC = firm fixed costs