4B

CHAPTER

CHAPTER OUTLINE
4B.1 Introduction
4B.2 Concept of Capital Structure
4B.3 Definition of Capital Structure
4B.4 Capitalisation and Capital Structure
4B.5 Financial Structure versus Capital Structure
4B.6 Classification of Capital Structure
4B.7 Importance of Capital Structure
4B.8 Factors Determining Capital Structure
4B.9 Optimum Capital Structure
4B.10 Capital Structure and Trading on Equity
4B.11 Capitalization; Undercapitalization and Overcapitalization
4B.12 Main Contentions of Capital Structure Theories
4B.13 Implications of Corporate Tax on Capital Structure Theories
4B.14 Additional Solved Problems
4B.15 Summary

4B.1 INTRODUCTION
Financing decision by a financial manager of a firm essentially involves three important
dimensions: cost of fund procurement, risk-return trade-off, and impact on the value of the
enterprise. While the first two dimensions are taken care of by areas like Cost of Capital,
Leverage analysis and EBIT-EPS analysis, the third dimension comes under the purview of
Capital Structure decisions. Capital Structure theories explain the relationship between the
chosen debt-equity mix and the value of the firm.

4B.2 CONCEPT OF CAPITAL STRUCTURE

The phrase ‘Capital Structure’ comprises of two terms—capital and structure. The term ‘capital’
is interpreted differently in different subjects. In Economics, ‘capital’ is the ‘produced means
4B.2 Financial Management

of production’. In Accounting, ‘capital’ is the amount contributed by the owners. However, in

Financial Management, ‘capital’ refers to the amount invested (irrespective of the source from
which it is actually procured) in a business.
Thus, under fund concept, Total Capital = Own Fund + Loan Fund
Alternatively, under asset concept, Total Capital = Fixed Asset + Current Asset
The term ‘structure’ is often used in engineering science. It connotes the arrangements of
the various parts of a construction.
Hence, ‘Capital Structure’ of a firm refers to the proportion of various long-term sources of
capital (such as long-term loan, preference shares and equity shares, and reserve and surplus)
in the total capital of the firm.
For example, if the total long-term capital of a firm comprises of `5,00,000 of equity share
capital, `3,00,000 of Preference Share Capital and `2,00,000 of Debt Capital, then, the relative
ratio 5:3:2 of all these three sources will denote the Capital Structure of the concerned firm.

4B.3 DEFINITION OF CAPITAL STRUCTURE

There is a good deal of debate on a unanimous definition of Capital Structure, though the basic
line of thinking remains the same.
According to J. J. Hampton, Capital Structure is the composition of debt and equity securities
that comprise a firm’s financing of its assets.
According to Gerstenberg, Capital Structure of a company refers to the make-up of its capital-
isation and it includes all long-term capital resources, viz. loans, reserves, shares and bonds.
According to James Mao, the term Capital Structure refers to the proportionate relationship
between the market values of the company’s outstanding debt and equity.
Therefore, the term ‘Capital Structure’ may be defined as the relative proportion of various
long-term sources in the aggregate long-term capital of a firm.

4B.4 CAPITALISATION AND CAPITAL STRUCTURE

Though sometimes used interchangeably, the two terms, ‘capitalisation’ and ‘Capital Structure’
differ in their meanings. Capitalisation refers to the total amount of fund or capital procured
by a firm from different sources (preferably long term). On the other hand, Capital Structure
refers to the respective proportion of various long-term sources in the aggregate long-term
capital of the firm. Therefore, if a firm procures `5,00,000 by issuing equity shares, `3,00,000
by issuing preference shares and `2,00,000 by issuing debentures, the capitalisation of the firm
would be `(5,00,000 + 3,00,000 + 2,00,000) = `10,00,000, while the respective proportion of 5:3:2
for equity shares, preference shares and debentures would be the Capital Structure.
Therefore, we may sum up the issue as follows:
1. Capitalisation refers to the quantitative aspect of financial planning while Capital
Structure refers to the qualitative aspect of financial planning.
2. Capitalisation is an absolute measure while Capital Structure is a relative measure.
 Capital Structure Decisions 4B.3

3. Capitalisation is the total capital arranged by the firm from various long-term sources
while Capital Structure is the relative proportion of various long-term sources in the
aggregate long-term capital of any firm.

4B.5 FINANCIAL STRUCTURE VS. CAPITAL STRUCTURE

Financial structure refers to the respective proportion of all items on the liabilities side of the
balance sheet. In other words, financial structure represents the relative proportion of different
long-term as well as short-term capital. For example, if a firm procures `5,00,000 equity share
capital, `4,00,000 Preference Share Capital, `3,00,000 Debt Capital and also has `2,00,000 Current
Liabilities, then, the proportion of all these sources, i.e. 5:4:3:2 is the financial structure of the
firm.
On the other hand, Capital Structure refers to the respective proportions of long-term capital
sources only. Thus, in the above example, 5:4:3 represents the Capital Structure of the firm.

Tutorial Note:
Since financial structure considers all sources of capital including the short-term sources, it is
a broader concept and includes Capital Structure as one of its subset. Hence, students should
be careful while using these two terms. They must not be used interchangeably.

4B.6 CLASSIFICATION OF CAPITAL STRUCTURE

1. Nature-based classification: According to nature, a Capital Structure can be either (i)
simple or (ii) complex.
● Simple Capital Structure: When a firm procures capital only from one source (e.g.

equity share capital and retained earnings), the resulting Capital Structure is said to
be a simple Capital Structure. An example is given in Table 4B.1.

Table 4B.1 Balance Sheet of M Ltd.

Liabilities Amount (`) Assets Amount (`)
Equity share capital 5,00,000 Fixed assets 5,00,000
Retained earnings 2,00,000 Current Assets 5,00,000
Current Liabilities 3,00,000
10,00,000 10,00,000

The above Capital Structure is simple as capital is procured only from the equity
shareholders (retained earnings represent the undistributed profit distributable to
equity shareholders).
● Complex Capital Structure: When a firm procures capital from more than one source,
the resulting Capital Structure is called complex Capital Structure. An example is
given in Table 4B.2.
4B.4 Financial Management

Table 4B.2 Balance Sheet of N Ltd.

Liabilities Amount (`) Assets Amount (`)
Equity share capital 5,00,000 Fixed assets 8,00,000
Retained earnings 2,00,000 Current Assets 8,00,000
10% Preference Share Capital 2,00,000
8% debentures 3,00,000
Public deposit 2,00,000
Bank loan 1,00,000
Current Liabilities 1,00,000
16,00,000 16,00,000

In the above example, the firm has procured capital from different sources including
shareholders, debenture holders and financial institutions, etc. Thus, the Capital
Structure is considered complex.

Firm Ownership and Composition of Capital Structure

The composition of a firm’s Capital Structure largely depends on the ownership structure
of the firm. Because of the legal limitations, a sole proprietorship firm or a partnership
firm cannot issue any structured debt instruments. As a result, institutional loans or
loans from relatives are left as the sole option for them. On the other hand, corporate
form of organisations enjoys a whole lot of options. This flexibility, in a great way, affects
the Cost of Capital of those firms favourably.

Table 4B.3 depicts the comparison of Capital Structure under different forms of firm
ownership.
Table 4B.3 Capital Structure under Different Forms of Firm Ownership—a Comparison
Sole Proprietorship Firm Partnership Firm Joint Stock Company
Balance Sheet of Balance Sheet of Balance Sheet of
M/S X (Liab. Side) XY & Co. (Liab. Side) X Ltd. (Liab. Side)
Particulars ` Particulars ` Particulars `
Capital A/C 2,00,000 Partners’ capital A/C: Equity share capital 3,00,000
Loan from relatives 1,00,000 X 1,00,000 6% Preference Share Capital 1,00,000
Bank loan 1,00,000 Y 1,00,000 8% debentures 1,00,000
Current Liabilities 1,00,000 Partners’ current A/C: Public deposits 50,000
X 30,000 Bank loan 1,50,000
Y 20,000 Current Liabilities 1,00,000
Loan from X 50,000
Bank Loan 2,00,000
Current Liabilities 1,00,000
5,00,000 6,00,000 8,00,000
 Capital Structure Decisions 4B.5

2. Based on composition and resultant risk: Based on the composition, i.e. relative share
of own capital and fixed charge capital1 and resultant risk, Capital Structure (necessarily
complex Capital Structure) can be divided into (i) Highly-geared, (ii) Low-geared and
(iii) Evenly-geared Capital Structure.
Here, Gearing ratio is defined as the ratio of fixed charge bearing securities, i.e. fixed
interest bearing Debt Capital and Preference Share Capital to equity shareholders’ fund.
That is, Capital Gearing Ratio
Fixed charge bearing securities
=
Equity shareholders’ fund
Fixed interest bearing debt capital + Preference Share Capital
=
Equity share capital + Retained Earnings net of fictititious assets
● Highly geared Capital Structure: A Capital Structure is called highly geared when the
proportion of fixed charge bearing securities is higher than the equity shareholders’
fund. In other words, a Capital Structure is said to be highly geared if,
Fixed charge bearing securities
Gearing ratio = >1
Equity shareholders’ fund
A highly geared Capital Structure is generally considered to be highly risky, however,
at the same time, it offers the benefits of Trading on Equity which helps to maximise
the return to shareholders.
● Low-geared Capital Structure: A Capital Structure is called low geared when the
proportion of fixed charge bearing securities is lower than the equity shareholders’
fund. In other words, a Capital Structure is said to be low geared if,
Fixed charge bearing securities
Gearing ratio = <1
Equity shareholders’ fund
A low geared Capital Structure is considered to be conservative rather than risky.
● Evenly geared Capital Structure: A Capital Structure is called evenly geared when
the proportion of fixed charge bearing securities and equity shareholders’ fund are
same. In other words, a Capital Structure is said to be evenly geared if,
Fixed charge bearing securities
Gearing ratio = =1
Equity shareholders’ fund
An evenly geared Capital Structure shows that the firm is depended equally on
equity shareholders’ fund and fixed charge capital and hence represents a balanced
financial risk profile.

1
Fixed charge capital refers to Debt Capital and Preference Share Capital.
4B.6 Financial Management

Illustration 4B.1
Problem
The financing mix of three public limited companies is given as follows:

Particulars A Ltd. (`) B Ltd. (`) C Ltd. (`)

Equity share capital 4,00,000 2,00,000 2,00,000
Retained earnings 3,00,000 3,00,000 1,00,000
10% Preference Share Capital 2,00,000 2,00,000 2,00,000
12% debentures 1,00,000 1,00,000 1,00,000
9.5% Bank loan 2,00,000 2,00,000 2,00,000

Comment on the nature of Capital Structure based on Capital Gearing Ratio.

Solution
Calculation for Capital Gearing Ratio
Particulars A Ltd. (`) B Ltd. (`) C Ltd. (`)
Fixed Charge Bearing Securities:
10% Preference Share Capital 2,00,000 2,00,000 2,00,000
12% debentures 1,00,000 1,00,000 1,00,000
9.5% Bank loan 2,00,000 2,00,000 2,00,000
5,00,000 5,00,000 5,00,000
Equity shareholders’ fund:
Equity share capital 4,00,000 2,00,000 2,00,000
Retained earnings 3,00,000 3,00,000 1,00,000
7,00,000 5,00,000 3,00,000
Capital Gearing Ratio 0.71 1.00 1.67
Fixed charge bearing securities
=
Equity shareholders’ fund
Type of Capital Structure Low-geared Evenly geared High-geared

4B.7 IMPORTANCE OF CAPITAL STRUCTURE

Capital Structure decision of a firm has far reaching impact on different aspects of a firm’s
operation and long-term growth. Capital Structure significantly affects the return to
shareholders, cost of financing and most importantly, the value of the firm. In addition, it casts
great impact on the existing ownership structure and associated control. The importance of
Capital Structure may be summarised as follows:
1. Maximisation of returns to owners: A properly designed Capital Structure offering
a judicious use of fixed charge capital and owned capital can maximise the return on
equity. This is because, a firm with Rate of Return on assets higher than the cost of debt
 Capital Structure Decisions 4B.7

and cost of Preference Share Capital can significantly increase the return to shareholders
by increasing the proportion of debt and Preference Share Capital in its total capital even
in the absence of taxes. In the presence of tax, the increase is found to be even higher as
interest on debt is a tax deductible item and as a result, the resultant tax savings goes to
the equity shareholders.
2. Minimisation of Cost of Capital: Cost of debt is generally found to be cheaper than cost
of equity. Moreover, it is also range bound, that is to say, it remains relatively constant
within a given range. As a result, an increase in the proportion of Debt Capital keeping
the total capital unaltered contributes significantly to reduce the overall Cost of Capital.
Hence, an optimal debt equity mix in a Capital Structure can minimise the overall Cost
of Capital.
3. Minimisation of risks: A business is subject to two types of risks: business risk and
financial risk. Business risk arises from factors like sudden fall in demand, falling prices
of goods, non-availability of raw materials, etc. On the other hand, financial risk arises
due to inclusion of fixed charge capital in the Capital Structure. Since a proper balance
must be maintained between these two risks to minimise their overall impact, Capital
Structure can play an important role here. Thus, a firm with high business risk resulting
into higher variability in operating income may use lesser debt to reduce the impact of
financial risk and vice-versa to balance the overall risk profile of the firm.
4. Increasing value of the firm: Value of the firm or more precisely market value of the
firm largely depends on its performance. Since properly designed Capital Structure can
significantly reduce the overall Cost of Capital , return to shareholders increases. This,
when recognised by the market, improves the market price of shares and accordingly
the total value of the firm.
5. Ensuring liquidity: The Capital Structure of any firm has significant bearing on a firm’s
short-term and long-term liquidity in terms of buyback of equity shares, redemption
of preference shares and debentures, repayment of loan and payment of dividend and
interest. A properly designed Capital Structure, commensurate with earnings and cash
availability, takes care of these factors and ensures liquidity.
6. Preservation of control: In many situations, large borrowings come with certain debt
covenants (i.e. restrictions imposed by lenders). As a result, debt providers interfere in
major company decisions and absolute control by equity shareholders is compromised.
A well planned Capital Structure keeps a balance between equity and Debt Capital and
thereby preserve the control of owners in the company.
7. Proper utilisation of funds: An ideal Capital Structure always takes into account
the actual reason behind a fund procurement decision thereby establishes proper
coordination between the quantum of capital and financial need of the business. As a
result, both undercapitalisation and overcapitalisation can be avoided.
8. Financing long-term growth: Firm’s existing Capital Structure plays an important role in
attracting finance for long-term expansion and growth programmes. A firm with sound
4B.8 Financial Management

Capital Structure gets finances (both in form of issue of shares or raising new debt) easily
as compared to a firm with unplanned Capital Structure.

4B.8 FACTORS DETERMINING CAPITAL STRUCTURE

Since Capital Structure of a firm has significant impact on aspects like return to shareholders,
Cost of Capital and value of a firm, many factors are required to be taken into consideration
while framing the Capital Structure of a firm. These are known as the determinants of Capital
Structure. These can be classified into internal factors and external factors as follows:

4B.8.1 Internal Factors

The internal factors affecting Capital Structure include the following:
1. Nature of the business: Capital Structure of a firm largely depends on the nature of
the business a firm undertakes. Firms that operate in monopoly or oligopoly markets
generally have stable income and low business risk as compared to perfectly competitive
firms. As a result, they may employ higher proportion of Debt Capital in their Capital
Structure. On the other hand, perfectly competitive firms face high risk and hence relies
more on Equity Capital.
2. Size of the business: Small scale firms generally have lower capital requirement and
hence rely mostly on own capital. Moreover, many a times, financial institutions impose
strict lending conditions on such firm, as a result of which they are forced to avoid
Debt Capital. On the other hand, large firms get easy access to institutional credit and
hence can depend on Debt Capital. Moreover, they also have higher capital requirement
which can hardly be made by new issues always. For this reason, they also depend
equally on Debt Capital.
3. Stability of income: The Capital Structure of a firm also depends on the stability of its
income. Firms which can maintain stable income can easily bear the fixed charges like
interest on debt and preference share dividend. Hence, they may depend more on Debt
Capital or Preference Share Capital. However, firms with fluctuating income can hardly
manage the burden of fixed charge capital and hence should try to avoid them.
4. Cost of Capital : Generally, Debt Capital is associated with lower cost as compared to
Equity Capital. Hence, increase in Debt Capital can significantly reduce the overall or
average Cost of Capital . Hence, a firm that intends to minimise their Cost of Capital has
to increase the share of Debt Capital in the total capital of the firm.
5. Objective of financing: Capital Structure also depends on the objective of financing.
In order to finance the normal operating activities, a firm may rely on Debt Capital
or Preference Share Capital as the fixed charges can easily be funded from the regular
income. On the other hand, expansion projects which will take time to materialise should
preferably be financed by equity share capital or from retained earnings.
6. Duration of the project: This is another important factor determining the Capital
Structure of a firm. A firm should finance the projects with fixed completion period
 Capital Structure Decisions 4B.9

through sources like Debt Capital or Preference Share Capital (which are compulsorily
redeemable) by properly aligning the maturity profile of the instruments with the period
of the projects. On the other hand, projects, which do not have any fixed completion
period, should preferably be financed by equity share capital which is not associated
with compulsory redemption.
7. Control over the firm: Since preference shareholders and debt providers do not have any
voting right, procurement of additional capital through these sources does not hamper
the controlling interest of the existing shareholders. But if additional capital is financed
by issuing new shares to investors other than the existing shareholders, it may dilute
the proportionate shareholding and accordingly the controlling interest of existing
shareholders, especially the promoter group. As a result, firms with high promoter
shareholding may prefer Debt Capital to Equity Capital. However, at times, large
borrowings come with strict debt covenants which may invite unnecessary interfere by
the debt providers. Hence, this aspect also needs to be taken care of.
8. Flexibility: Capital Structure of a firm should be flexible. Flexibility means the ease
of changing the components of Capital Structure as and when needed. In order to
ensure flexibility, a firm may prefer structured debt instruments or preference shares
to traditional equity shares, because convertibility, callability, etc. can be attached only
with these structured instruments and not with equity shares.
9. Structure of assets: Capital Structure decisions are closely associated with the structure
of assets of any firm. A firm should avoid financing Current Assets by long-term capital
sources. Moreover, a part of the fixed assets may be financed by long-term Debt Capital
with matching maturity.
10. Trading on Equity: Capital Structure of a firm also depends on the possibility and intention
of undertaking Trading on Equity. When a firm has its Rate of Return higher than the
cost of fixed charge capital, it can increase the return to shareholders by increasing the
share of fixed charge capital in the total capital. Hence, in such cases, Capital Structure
comprises more Debt Capital and less Equity Capital.
11. Attitude of the management: Capital Structure of a firm also depends on the attitude and
outlook of management towards financial risk. Firms with aggressive management are
found to rely more on debt than those with conservative management.
12. Age of the company: Newer companies with uncertain future generally face hardship in
getting institutional finance. As a result, they rely more on unconventional funding like
private equities, venture capital funds, etc. mostly in form of equity investments. Thus,
their Capital Structure include higher share of owned capital than Debt Capital.

4B.8.2 External Factors

These are factors beyond the control of any firm. External factors include the following:
1. Capital market conditions: Capital market conditions do not remain uniform
throughout the year. As a result, while in a buoyant capital market, new issues are often
oversubscribed, at times of slump, companies hardly find buyers for the new shares.
4B.10 Financial Management

Hence, in such a situation, there remain no other alternative than to resort to institutional
financing in form of loan. Thus, it can be said that capital market conditions do have a
significant impact on the Capital Structure a company plans.
2. Level of interest rates: The current level of interest rates is an important determinant of
the Capital Structure of a firm. A firm with relatively low Rate of Return cannot afford to
pay high interest and hence may avoid loan financing in periods of high interest rates.
3. Investors’ attitude: Capital Structure of a firm also depends on the attitude of the
investors in the capital market. In an economy where investors are mostly risk averse,
companies will find it difficult to issue securities in the market and should depend on
institutional loans to meet their requirement of funds. On the other hand, in economies
with risk taker investors, new issue of shares, debentures and other innovative products
will be the most favoured route.
4. Regulatory requirements: Market regulators of each country issue various regulations
to be abided by the issuers of securities. For example, in India, companies cannot issue
irredeemable preference shares or rights issue can be made only after a minimum gap
from the initial public offering. Similarly, banking companies are not allowed to issue
securities other than equity shares. Thus, a firm’s Capital Structure must be planned
taking into consideration all the regulatory requirements of the concerned country.
5. Tax policy: Tax policy often plays an important role in determining the Capital Structure
of a firm. For example, in India, dividend payment by domestic companies attracts
dividend distribution tax resulting into higher Cash Outflow for financing through
equity shares. On the other hand, interest payments are tax deductible and hence offer
tax savings. Therefore, other things being unchanged, a company with higher sensitivity
towards tax rates may favour debt financing over equity financing.
6. Government policies: Many a times, monetary and fiscal policy measures undertaken by
the government significantly affects the Capital Structure of a firm. When government
follows a liberal policy and allows foreign institutional investors to participate in the
capital market, companies find it easier to raise required funds by issuing new shares.
Similarly, domestic companies, when allowed to raise finance from international capital
markets, enjoy better options to form a sound Capital Structure.

4B.9 OPTIMUM CAPITAL STRUCTURE

Since Debt Capital offers relatively lower cost, a company significantly reduces its average
Cost of Capital by increasingly employing higher proportion of Debt Capital. This leads to
continuous increase in the return available for equity shareholders in the form of increased
EPS and return on equity up to a certain level of debt. Beyond this level, however, cost of
equity rises sharply to offset the benefit of cheaper debt and average Cost of Capital starts
rising leading to fall in EPS and ROE. The level where Cost of Capital becomes the minimum
and EPS or ROE becomes the maximum is considered to be the optimum Capital Structure.
At this level, the market price per share also becomes maximum and thus firm value becomes
the maximum.
 Capital Structure Decisions 4B.11

Hence, an optimum Capital Structure may be defined as the best combination of debt and
equity which maximises the value of the firm.
Achieving an optimum Capital Structure is considered to be very important for every firm.
This is because an optimum Capital Structure helps a firm in maximising its long-term growth
potential with a balanced risk profile.

4B.9.1 Features of Optimum Capital Structure

In order to be optimum, a Capital Structure should preferably have the following features:
profitability, economy, solvency, flexibility, conservatism, control, and reasonable risk.
1. Profitability: The Capital Structure of the company should be most profitable. It must max-
imise earnings per equity share and return on equity at a given level of operating income.
2. Economy: The Capital Structure must minimise the overall cost of financing by using an
appropriate mix of different sources of capital including debt and equity.
3. Solvency: The Capital Structure should be so designed as to ensure that the firm does not
run the risk of becoming insolvent. Excessive use of Debt Capital limits the solvency of
the company. Hence, the debt content of capital should never be allowed to go beyond
manageable limits.
4. Flexibility: The Capital Structure should be flexible enough to meet the requirements
of changing conditions, both internal and external. While internally it should also be
possible for the company to raise additional funds whenever needed to finance its
profitable activities, externally it should be possible for the firm to take advantage of
situations like decrease in the interest rates through measures like debt restructuring.
5. Conservatism: The Capital Structure should be conservative in the sense that the pro-
portion of Debt Capital in the total capital does not exceed the limit which the company
can normally bear. In other words, debt servicing2 requirements should be commensu-
rate with the company’s ability to generate future Cash Flows.
6. Control: The Capital Structure should be so devised that it involves minimum risk of
loss of control of the company. Hence, additional loan financing should be avoided
when debt covenants are likely to invite unnecessary interfere by the debt providers in
the decision-making process.
7. Reasonable Risk: The Capital Structure should offer a balanced risk which is manageable
within the capacity of the company. It should not create unnecessary burden on the
operating income of the firm.

4B.10 CAPITAL STRUCTURE AND TRADING ON EQUITY

In financial literature, one of the most important concepts associated with Capital Structure is
Trading on Equity. It is so important that some of the experts of this field consider it to be the
basic or fundamental principle underlying the Capital Structure.

2
Debt servicing refers to payment of interest along with the instalment of principal amount regularly.