Capital Structure

Capital Structure is referred to as the ratio

of different kinds of securities raised by a
firm as long-term finance.
 Capital Structure
• The capital structure involves two decisions:
Type of securities to be issued are equity shares,
preference shares and long term borrowings (Debt).
Relative ratio of securities can be determined by
process of capital gearing. On this basis, the
companies are divided into two:
Highly geared companies - Those companies whose
proportion of equity capitalization is small.
 Low geared companies - Those companies whose equity
capital dominates total capitalization.
 Factors Determining Capital Structure

• Trading on Equity
• Degree of control
• Flexibility of financial plan
• Choice of investors
• Capital market condition
• Period of financing
• Cost of financing
• Stability of sales
• Sizes of a company
 THEORIES OF CAPITAL STRUCTURE
Equity and debt capital are the two major sources of long-term
funds for a firm. The theories of capital structure suggests the
proportion of equity and debt in the capital structure.
Factors Determining Capital Structure
(1) Minimization of Risk:
(a) Capital structure must be consistent with business risk.
(b) It should result in a certain level of financial risk.
(2) Control: It should reflect the management’s philosophy of control
over the firm.
(3) Flexibility: It refers to the ability of the firm to meet the
requirements of the changing situations.
(4) Profitability: It should be profitable from the equity shareholders
point of view.
(5) Solvency: The use of excessive debt may threaten the solvency of
the company.
 Assumptions Of Capital Structure Theories

• There are only two sources of funds, i.e., the equity and the perpetual
riskless debt.
• The total assets of the firm are given and there would be no change in
the investment decisions of the firm.
• EBIT (Earnings before Interest & Tax)/NOP (Net Operating Profits) of
the firm are given and is expected to remain constant.
• Retention Ratio is NIL, i.e., total profits are distributed as dividends.
[100% dividend pay-out ratio]
• The firm has a given business risk which is not affected by the financing
decision.
• There are no corporate or personal taxes.
• The investors have the same subjective probability distribution of
expected operating profits of the firm.
• The capital structure can be altered without incurring transaction costs.
 Theories of Capital Structure
In discussing the theories of capital structure, we will consider the
following notations:
• S = Market value of the Equity
• B = Market value of the Debt
• V = Market value of the Firm
• I = Total Interest Payments
• T = Tax Rate
• EBIT= Earnings Before Interest and Tax or Net Operating Profit
• NI = Net Income available to equity shareholders
• Kd = Cost of Debt after Tax
• Ke= Cost of Equity
• Ko= Overall Cost of Capital
 Formulae for Capital Structure Theories

• V= B+S
• B= I/ Kd; Kd = I/B
• S= D/ Ke; S=NI/ Ke; S= (EBIT-I)/ Ke; Ke =
NI/S
• Ko = [(B/V) Kd]+ [(S/V) Ke]
• Ko =[(B/B+S) Kd]+ [(S/B+S) Ke]
• Ko = (I+NI)/V; Ko = EBIT/V
• V= EBIT/ Ko
Theories of Capital Structure
Net Income Approach
Net Income Approach
Net Income Approach
Net Operating Income Approach
Net OPERATING Income Approach
Net OPERATING Income Approach
Traditional Approach
Traditional Approach
Traditional Approach
 M-M Approach
Modigliani – Miller (MM) Hypothesis
• The Modigliani – Miller hypothesis is identical
with the Net Operating Income approach.
• Modigliani and Miller argued that, in the
absence of taxes the cost of capital and the
value of the firm are not affected by the changes
in capital structure. In other words, capital
structure decisions are irrelevant and value of
the firm is independent of debt – equity mix.
 M-M Approach: Assumptions
• There is a perfect capital market.
• Firms can be classified into homogeneous risk classes.
All the firms in the same risk class will have the same
degree of financial risk.
• All investors have the same expectation of a firm’s net
operating income (EBIT).
• The dividend payout ratio is 100%, which means there
are no retained earnings.
• There are no corporate taxes. This assumption has
been removed later.
 M-M Approach
• Preposition- I
According to M – M, for the firms in the same risk
class, the total market value is independent of capital
structure and is determined by capitalizing net
operating income by the rate appropriate to that risk
class. Proposition-I can be expressed as follows:
V = S +B = EBIT/ Ko = NO+ I/ Ko
According the proposition I the average cost of
capital is not affected by degree of leverage.
 Arbitrage Process
• According to M –M, two firms identical in all respects
except their capital structure cannot have different market
values or different cost of capital. In case, these firms have
different market values, the arbitrage will take place and
equilibrium in market values is restored in no time.
• Arbitrage process refers to switching of investment from
one firm to another. When market values are different, the
investors will try to take advantage of it by selling their
securities with high market price and buying the securities
with low market price. The use of debt by the investors is
known as personal leverage or homemade leverage.
 Proposition II
M – M’s proposition-II defines cost of equity, for any firm
in a given risk class, the cost of equity is equal to the
constant average cost of capital (K o) plus a premium for
the financial risk, which is equal to debt – equity ratio
times the spread between average cost and cost of debt.
Thus, cost of equity is:
Ke = Ko +(Ko − Kd) B/S
M – M argue that Ko will not increase with the increase in
the leverage, because the low – cost advantage of debt
capital will be exactly offset by the increase in the cost of
equity as caused by increased risk to equity shareholders.
M-M Approach
 M – M Hypothesis Corporate
Taxes
The value of the firm will increase or the cost
of capital will decrease with the use of debt
due to tax deductibility of interest charges.
Thus, the optimum capital structure can be
achieved by maximizing debt component in
the capital structure.
 Value of Levered Firm will be greater than
Unlevered Firm.
M – M Hypothesis Corporate Taxes
M-M Approach