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Business Finance
Capital Structure
• Capital Structure concept • Capital Structure theories –
• Capitalization and Capital ▪ Net Income
Structure
▪ Net Operating Income
• Financial structure and capital
structure ▪ Modigliani-Miller
• Forms of capital structure ▪ Traditional Approach
• Capital structure can be defined as the mix of owned capital and borrowed
capital
• Maximization of shareholders’ wealth is prime objective of a financial manager.
• In financial management, capital structure theory refers to a systematic approach
to financing business activities through a combination of equities and liabilities.
• There are several competing capital structure theories, each of which explores
the relationship between debt financing, equity financing, and the market
value of the firm slightly differently.
▪ Capitalization refers to the total amount of long-term funds employed by the firm.
▪ Capital structure signifies the kinds of securities and their proportion in the total capitalization
of a firm.
Financial structure and capital structure.
• Financial structure is different from capital structure.It means the composition of
the entire liabilities side of the balance sheet.
• It shows the way in which the firm’s assets are financed. Financial structure
includes long-term as well as short-term sources of finance.
• Capital structure signifies the proportion of long-term sources of finance in the
capitalization of the firm.
• It is represented by shareholders’ funds and long-term loans. Capital structure is a
part of the financial structure.
Faculty: Mr . Abdul Wajid Program: BBA (FIA)
SCHOOL OF FINANCE AND COMMERCE
a) Equity shares
b) Preference shares
c) Debentures or Bonds
d) Long-term loans
The total market value of the firm (V) under the Net Income Approach is ascertained by the
following formula.
V = S+D
• V = Total market value of the firm
• S = Market value of equity shares
• D = Market value of debt
The overall cost of capital (Ko) Or Weighted average cost of capital is calculated under
Cost
As the proportion
of debt (Kd) in
ke, ko ke capital structure
increases, the
kd
ko
kd WACC (Ko)
reduces.
Debt
• According to the M-M approach, the value of an unlevered firm (Which does not use debt
) can be calculated as follows.
• Value of unlevered firm, Vu = EBIT/ Ke (1-T)
Where EBIT = Earnings Before Interest an Taxes
T = Tax rate Ke = Cost of equity
VL = Vu = (T x D)
Value of levered firm = Value of unlevered firm = (Tax rate x Debt)
Criticism of MM Approach
1. Markets are not perfect
2. Higher interest for individuals
3. Personal leverage is no substitute for corporate leverage
4. Transaction costs
5.Corporate taxes
Cost
▪ Cost of capital (Ko) is ke
reduces initially.
▪ At a point, it settles ko