The introduction of debt capital in the capital

structure increase the earning per share of the

equity shareholders. At the same time it
increases the risk also, which is the risk of
insolvency due to non-availability of earning
available to equity shareholder.
As such increasing the debt component beyond
certain limit will not increase the earning per
share.
There are various theories of capital structure.
One view is that the valuation of a firm and its
cost of capital may be affected by the change in
financial mix. The other view is that it is
independent of its capital structure.
These views have been classified as following
four theories of capital structure:-
1. Net income approach
2. Net operating income approach
3. Traditional approach
4. Modigliani-Millar approach
For this purpose following assumptions have
been made:-
1. Firms use only long-term debt capital or
equity share capital to raise funds.
2. Corporate income tax does not exist.
3. Firms follow policy of paying 100% of its
earnings by way of dividend.
4. Operating earning are not expected to grow
Following definition and symbols are also used.
S = market value of equity shares
B = market value of Debt
V = Total market value of firm
NOI = Net operating Income
I = Total interest payment
NI = Net income available to shareholders.
EBIT
Overall cost of capital =
V
 1. Net Income approach:-

According to this approach as proposed by

Durand, there exists a direct relationship
between the capital structure and
valuation of the firm and cost of capital. By
the firm and cost of capital. By the
introduction of additional debt capital in
the capital structure, the valuation of the
firm can be increased and cost of capital
can be reduced and vice versa.
Example:-

Present Position 50% increase 50% Decrease in

debt Capital

8% Debenture 6,00,000 9,00,000 3,00,000

NOI 1,50,000 1,50,000 1,50,000
I 40,000 72,000 24,000
NI 1,02,000 78,000 1,26,000
Equity capitalization 10% 10% 10%
rate
Market value of 10,20,000 7,80,000 12,60,000
equity shares
Market value of 6,00,000 9,00,000 3,00,000
debenture(B)

Total value of firm 16,20,000 16,80,000 15,60,000

V=S+B

Over cost of capital 9.26% 8.93% 9.62%

It can be seen that by the increase in
debenture, the total value of the firm
increases and the cost of capital reduces and
vice versa. However it will hold good only if
the cost of debenture i.e. the ratio of
interest is less than the capitalization rate.
According to this approach, also proposed by
Durand, the valuation of the firm and its cost
of capital are independent of capital
structure. Any change in the capital
structure does not affect the value of the
firm or cost of capital, though, the further
introduction of debt capital may increase
equity capitalization rate and vice versa.
 Present Position 50% increase in 50% decrease in
(Rs.) debt capita (Rs.) debt capital (Rs.)
8% Debenture 6,00,000 9,00,000 3,00,000

Over all 10% 10% 10%

capitalization rate
EBIT 1,50,000 1,50,000 1,50,000

Total value of firm 15,00,000 15,00,000 15,00,000

Over all cost of 1,50,000 1,50,000 1,50,000

capital
EBIT/V 10% 10% 10%

Market value of 6,00,000 9,00,000 3,00,000

debenture (B)
Market value of 9,00,000 6,00,000 12,00,000
Equity Share (S) i.e.
V- B
I 48,000 72,000 24000

Equity 1,02,000 78,000 1,26,000

capitalization rate 9,00,000 6,00,000 12,00,000
EBIT- I 11.3% 13% 10.5%
V-B
The above shows that market value of the firm
remains unaffected by change in the capital
structure. However, the introduction of
additional debenture increases the equity
capitalization rate and vice versa.
This is the mean between two extreme
approaches of net income approach on the
one hand and net operating income on the
other hand. It believes the existence of what
may be called ‘Optimal Capital Structure’. It
believes that up to a certain point, additional
introduction of debt capital, in spite of
increase in cost of debt capital and equity
capitalization rate individually, the over all
cost of capital will reduce and total value of
firm will increase. Beyond the point, the
overall cost of capita will tend to rise,
and total value of the firm will tend to
reduce. Thus with judicious mix of debt and
equity capital, it is possible for the firm to
minimize the overall cost of capital and
maximize the total value of the firm. Such a
capital structure where overall cost of
capital is minimum and total value of the
firm is maximum is called Optimal Capital
Structure.
Example:-
No Debt 5% Debenture 8% Debenture
Rs. 3,00,000 Rs. 6,00,000
EBIT 1,50,000 1,50,000 1,50,000
Less interest on - 15,000 48,000
debenture
NI 1,50,000 1,35,000 1,02,000
Cost of equity 10% 11% 12%
capital
Market value of 15,00,000 1,35,000 1,02,000
equity shares (S)
Market value of - 3,00,000 6,00,000
debenture (B)
Total value of 15,00,000 15,27,273 14,50,000
firm i.e. V=S+B
Overall capital 10% 9.82% 10.34%
cost i.e. EBIT
V
It is evident that in the no debenture position
and in a position where debenture are issued
to the extent of 6 lacs the cost of capital is
not the minimum but when debentures are
issued to the extent of 3 lacs the cost of
capital is minimum and value of the firm is
maximum, hence that is the optimal capital
structure.
This approach closely resembles the net
operating income approach. According to this
approach, the net value of the firm and cost
of capital is independent of its capital
structure. The argument is that overall cost
of capital is the weighted average of cost of
debt capital and cost of equity capital. The
cost of equity capital depends on
shareholders expectations. Now if the
shareholders expect 10% from a certain
company, they already take into
consideration debt capital in the capital
structure.
For every increase in debt capital the
expectation of shareholders also increase as
in the eyes of shareholders, risk in the
company also increase. Thus each change in
the mix of debt capital and equity capital is
automatically offset by change in the
expectations of the shareholders, which in
turn is attributable to change in risk
element. As such they argue that, leverage
i.e. mix in debt capital and overall cost of
capital is equal to the capitalization rate of
pure equity stream of risk class. Hence
leverages has no impact on share market
prices or cost of capital.
 Capital structure decision

Capital structure means max of long-term sources of funds i.e., the % of

various items that can
constitute the capital of the firm
It means deciding how much percentage of :
•Preference share
•Debenture
•Loan from financial institutions & from banks
•Equity shares including reserves and surplus

Companies plan their capital structure to maximize their use of funds

and also to adopt more easily to changing conditions

The optimum capital structure is the one which maximize the market
value of shares, everything else remaining the same
 The goal of the capital should be to
maximise the wealth of the share holders
maximising the long term price per share
 The aim of capital structure should be to
minimize the cost of financing and
maximize earning per share.

 Debt is cheaper, interest is a deductible

expense and therefore there is savings in
income tax,rate of interest is fixed, and
expectation of returns by provider of debt
is limited as compared to equity
shareholder but it increases the risk of
the equity shareholders.
 Dividend is not considered as an
expense.Dividend distribution tax is to be
paid by the company as per the latest
income tax rules. Raising small amount is not
easy and condition of capital marke tis to be
seen for raising capital through equity.
 The capital structure should not increase
unduly risk for the equity share holders.
 Equity: less risky, no contractual payment
so as to bring insolvency.

 Debt: contractual payment of interest and

principal irrespective of profit and loss of
the company. This leads to the risk of
insolvency and brings bad reputation in
case of default in repayment.
 Paying dividend is not a contractual payment
and therefore there is no risk of insolvency in
case of non-payment.
 If dividend is paid to equity share holders the
preference shareholders have first right. In
the case of winding up also they have first
right as compared to the equity
shareholders. This does not increase the risk
in anyway.
 While planning capital structure it should be
seen that the control of owners should not
be diluted. Right issue will not dilute the
control as it is issued in the same ratio as
existing shares, but the public issue may
dilute the control.
 Ideal capital structure should be able to
cater to additional fund requirements in
the future.
 The provider of debt always look at::
 Debt equity ratio.
 Availability of assets as security.
 If the company is risky,the debt will be
costly and may contain lot of restrictive
clauses like not to declare dividend
beyond certain limit etc.
 The ideal capital structure should be able to
seize the market opportunities like
 Boom period :able to raise equity at good
premium.
 Depression: debt at lowest interest rate.
 Before deciding the capital structure of a
company one should have a look at various
factors ,which affects the capital structure.
 The factors are:
 1.Internal
 2.External and
 3.General.
 Cost factor: cost is one of the most important
factors. Borrowed capital is cheaper as
expectation of lenders is less and interest is
deductible expense and thus brings in savings in
taxes.
 Risk factor: debt is more risky as it is contractual
obligation irrespective of profit or loss of the
company while dividend to equity/preference
shareholders is not contractual obligation.
 Control factor: If large amount of equity is
issued It will dilute the control, sometimes
lenders also want their representative in the
board of directors.
 To maximize the returns to equity
shareholders.
 To issue securities which are easily
transferable and marketable.
 To issue securities in such a way that profit
and control of promoters not adversely
affected.
 General economy Conditions in the country And
abroad whether it is boom our depression or
market is recovering from depression our moving
toward depression.
 Behavior of interest rate ,future trends in india
and abroad.
 Policy of lending institution if it is too harsh our
rigid conditions are imposed the it is better to
move for other alternatives.
 Taxation policy – dividend , loans.
 Statutory restrictions like restriction in the
matter of foreign direct investment and foreign
institutional investment etc.
 Constitution of company.
If company is private limited our closely held
company ,the control of management is of
paramount importance. If company is public
limited company our widely held company
the control will not be diluted easily and cost
will be more important.
Characteristics of the company in terms of
age , size, credit standing play an important
role . Venture capital company may go for
equity, as returns are uncertain.
Very small companies do not have bargaining
power and may have to depend on equities
in the beginning . As they grow they
improve the mix of capital of having debts.
Credit standing of the companies have a
bearing on what source they want to tap for
raising funds.
 Companies who have stability of earning can
have better bargaining power. They can
borrow cheap and can take risk. If earning in
not stable, then equity is better as it does
not have contractual obligatio.
If attitude of management is conservative, the
control and risk factor becomes more
important and equity is preferred.
If aggressive the cost factor become more
important and debt will be preferable.
The capital structure of a company planned
initially when the company is incorporated.
The capital structure should be designed very
carefully.
Whenever fresh funds are required by the
company the finance manager should see
that capital structure should not deviate
from the target set by the top management.
 The following are the three approaches to
optimum capital structure:-

 EBIT- EPS approach

 Valuation approach
 Cash flow approach
This mean examining the effect of leverage on
earning per share.

The companies with high level of earnings

before interest and taxation (EBIT) can make
good use of leverage ( use of fixed cost
securities ) to increase return to
shareholders.
Example:-
ABC Ltd. Wanted to purchase fixed assets
worth Rs. 80 lacs for execution of a project.
The company has a number of options for
financing its project. we take two options as:
 Rising entire Rs. 80 lacs as equity
 Raising Rs. 30 lacs as equity capital and Rs. 50
lacs as debt @18%
 Raising Rs. 30 lacs as equity and Rs. 50 lacs as
preferance shares at 18% divident.
The company is required to pay dividend @20% to
equity shareholders as other companies of this type
were paying this much return and investors will
subscribe to their shares only if they hope to get this
much return. The taxation rate for the company is
40%.
The earning power of ABC Ltd. Is 40%( before taxes and
interest).
 Rs. 80 lacs as share Rs. 30 lacs as 30 lacs are equity
capital sharecapital plus Rs. share capital and
50 lacs as debt @ 50 lacs as
preference share
18%
@18%
Earning on assets of Rs. 32 32 32
80 lacs @40%
Less Interest : 18% on - 9 -
Rs. 50 lacs
Earning after Interest 32 23 32
Taxes @ 40 % 12.8 9.20 12.8
Earning after taxes 19.2 13.80 19.2
Less preference - - 9
dividend
Earning available to 19.2 13.80 10.2
equity shareholders
Earning after interest 24% 46% 34%
and taxes as % of share
capital
If we analysis the result it is seen that the net
return on equity is 24% when no debt is used
but it is 46% when debt is used and it is 34%
when preference share capital is used.

Why it has come down even when the cost of

debt and preference capital is same. It is
because the interest on debt is an expense and
therefore tax deductible while the preference
dividend is not an expense and is not tax
deductible.
 Supposing in the above example the earning
power of ABC Ltd. Is only 15%.
 Rs. 80 lacs as share Rs. 30 lacs as 30 lacs are equity
capital sharecapital plus Rs. 50 share capital and 50
lacs as debt @ 18% lacs as preference
share of Rs.10 each
at 12%
Earning on assets of Rs. 12 12 12
80 lacs @15%
Less Interest : 18% on - 9 -
Rs. 50 lacs
Earning after Interest 12 3 12
Taxes @40% 4.8 1.20 4.8
Earning after taxes 7.2 1.8 7.2
Less preference - - 6
dividend

Earning available to 7.2 1.8 1.2

equity shareholders

Earning after interest 9% 6% 4%

and taxes as % of share
capital
 In the above case the use of debt has
reduced the earning % of shareholders.
 Because:-
in this case the earning power (15%) of the company is
less than the cost of debt (18%), therefore the return
to the shareholder has been reduced as the company
has not able to earn the cost of debt. So if the chances
of earning more than the cost of debt is there then
the use of debt will be beneficial to the share holder
and if it not then it will reduce the earning available to
shareholders.