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Capital Structure

Definition 

Capital structure of a company refers to the composition or the make-up of its capitalisation. It includes all long-term capital resources I.e. loans, reserves,shares and bonds 

Capitalisation,Capital Structure and Financial Structure   

Capitalisation refers to the total amount of securities issued by the company Capital structure refers to the kinds of securities and the proportionate amounts that make up the capitalisation Financial structure,generally is composed of a specified percentage of short term debt, long-term debt and shareholder¶s funds

Compute the (i) capitalisation (ii) Capital Structure (iii) Financial Structure

Liabilities
Equity share capital Preference share capital Long-term loans & debentures Retained earnings Capital surplus Current liabilities

Rs.
10,00,000 500,000 200,000 600,000 50,000 1,50,000 25,00,000

(i) Capitalisation refers to the total amount of securities issued by a company.

Rs. Equity share capital Preference share capital Long-term loans and debentures Capitalisation 10,00,000 500,000 200,000 17,00,000

(ii) Capital structure refers to the proportionate amount that makes up capitalisation Rs. Equity share capital Preference share capital Long-term loans and debentures 10,00,000 500,000 200,000 17,00,000 Prop./Mix 58.82% 29.41% 11.77% 100%

(iii) Financial structure refers to all the financial resources, short as well as long-term. Rs. Equity share capital Preference share capital Long-term loans & debentures Retained earnings Capital surplus Current liabilities 10,00,000 500,000 200,000 600,000 50,000 1,50,000 25,00,000 Prop./Mix 40% 20% 8% 24% 2% 6% 100%

Forms/ Patterns of Capital Structure 
  

Equity shares only Equity and preferences shares Equity shares and debentures
Equity shares,preference shares and debentures

Financial Leverage  

The use of long-term fixed interest bearing debt and preference share capital along with equity shares is called financial leverage. Also called trading on equity.

Optimal Capital Structure 

The combination of debt and equity to maximum value of the firm. Optimal capital structure maximizes the value of the company and hence the wealth of the owners and minimizes the company¶s cost of capital 

Theories of Capital Structure  

 

To explain the relationship between capital structure,cost of capital and the value of the firm. Net income approach Net operating income approach The traditional approach

Net Income Approach 

A firm can minimise the weighted average cost of capital and increase the value of the firm as well as the market price of equity shares by using debt financing to the maximum possible extent.
Increasing the proportion of debt in capital structure Increase in value and reduces the firms cost of capital. 

Assumption (NI Approach)  



Cost of debt is less than the cost of equity There are no taxes The risk perception of investors is not changed by the use of debt

Argument   

As the proportion of debt financing in capital structure increases, the proportion of less expensive funds increases. This results in the decrease in the overall cost of capital leading to increase in the value of the firm. The reasons for assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than the dividend rates due to the element of risk and the benefit of tax as interest is tax deductible expense.

Value of the firm on the basis of NImarket value of a firm Approach Where, V=Total

V=S+D

S=Market value of equity shares D=Market value of debt

S=

Earnings available to equity share holders Equity capitalisation Rate

Overall cost of capital is:

KO=

EBIT V

Net operating Income Approach   

Change in capital structure of a company does not effect the value of the firm and the overall cost of capital remains constant irrespective of the method of financing. Overall cost of capital remains constant whether the debt-equity mix is 50:50 or 20:80 or 0:100. Thus,there is no optimal structure and every capital structure is the optimum capital structure.

Assumption (NOI Approach)   

The market capitalises the value of the firm as a whole The business risk remains constant at every level of debt equity mix There are no corporate taxes

Argument 

Increased use of debt increases the financial risk of the equity shareholders and hence the cost of equity increases. Thus the advantage of using the cheaper source of funds,I.e.,debt is exactly offset by the increased cost of equity. 

Value of the firm on the basis of NOI Approach of a Where, V=Total market value

V=

EBIT KO

firm EBIT=earnings before Interest and taxes KO =overall cost of capital Where, V=Total market value of a firm S=Market value of equity shares D=Market value of debt

S=V-D

EARNINGS AVAILABLE FOR EQUITY SHARE HOLDERS

KE=

TOTAL MARKET VALUE OF EQUITY SHARES

Where, KE is the equity capitalisation rate.

Traditional Approach 

Also known as intermediate approach The value of the firm can be increased initially or the cost of capital can be decreased by using more debt as debt is the cheaper source of funds than equity. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of of the equity share holders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity.   

Traditional Approach 

A stage comes,when the increase cost of equity cannot offset the advantage of the low-cost debt. Thus, the overall cost of capital decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter; and increases or rises beyond a certain point. 

re

ra rd

The cost of debt, re remains more or less constant up to a certain degree of leverage but rises thereafter at an increasing rate. The cost of equity, rd,remains more or less constant or rises only gradually up to a certain degree of leverage and rises sharply thereafter. The average cost of capital , ra,(i) decreases up to a certain point (ii)remains more or less unchanged for moderate increase in leverage.(iii)rises beyond a certain point.

Capital Gearing   

Refers to the relationship between equity capital(equity shares and reserves) and long term term debt. Capital gearing means the ratio between different types of securities. A company is said to be in high-gear, when it has a proportionately higher issue of debentures and preference shares for raising long-term resources. Low-gear for a proportionately large issue of equity shares.