CAPITAL STRUCTURE

Capital Structure
• In order to run and manage a company, funds
are needed.
• If funds are inadequate, the business suffers
and if the funds are not properly managed
then entire organization suffers.
• So, It is necessary that correct estimate of the
current and future need of capital be made to
have an optimum capital structure which shall
help the organisation to run its work smoothly.
 Meaning of Capital Structure

• It refers to the relationship between

the various long-term forms of
financing such as debenture,
preference share capital and equity
share capital.
• A decision about the proportion
among these type of securities refers
to the capital structure of an
enterprise.
 Forms of Capital Structure

• Equity Shares only.

• Equity and preference shares.

• Equity and Debt.

• Equity shares, preference shares and

debentures.
 What are the advantages of Capital
Structure?
• To Determine Optimum capital Structure
Combination of debt and equity
that leads to the maximum value of the firm

That maximises the wealth of owners

That minimises the company’s over all cost of

capital
Optimal Capital Structure
Optimum Capital Structure is
the capital structure at which
the weighted average cost of
capital is minimum and thereby
maximum value of the firm.
 Assumptions of Capital Structure
• There are only two sources of funds used by a firm:
perpetual riskless debt and equity shares.
• Perpetual life of the firm
• Investment decision of the firm remain same.
• Maximisation of value of the firm is consistent with
maximisation of shareholders’ wealth
• Optimal capital structure is one that minimises WACC
• No retained earnings
 Theories of Capital Structure

• Net Income Approach

• Net Operating Income Approach

• The Traditional Approach

• Modigliani and Miller Approach

 Net Income Approach
• This theory propounds that a company can
increase the value of a firm as well as market
price of equity shares and can decrease the
overall cost of capital by increasing the
proportion of debt in its capital structure
Assumptions:
• Cost of debt is less than the cost of equity
• The risk perception of investors is not changed
by the use of debt.
• No Corporate Tax.
 Net Operating Income approach
• Suggested by Durand
• Totally Opposite of Net Income Approach
• It implies that the overall cost of capital remains
constant irrespective of the method of financing.
Assumptions:
• The market capitalizes the value of the firm as
whole
• No corporate taxes
• Business risk remains constant at every level of
debt-equity mix
Example – Net Operating Income Approach
Scenario Scenario Scenario
A B C
Project Cost 1,000.00 1,000.00 1,000.00

Sources of Finance
Equity (Book Value) 900.00 500.00 100.00
Debt (Book Value) 100.00 500.00 900.00
Capitalisation Rate
Debt 10% 10% 10%
Overall 20% 20% 20%
EBIT 500.00 500.00 500.00

Interest (I) 10.00 50.00 90.00

EBT 490.00 450.00 410.00

Solution
EBT 490.00 450.00 410.00

Taxes Assumed no taxes

Earnings available to 490.00 450.00 410.00

shareholders (EAT)

Market value of debt 100.00 500.00 900.00

(I/rd)

Market value of firm 2,500.00 2,500.00 2,500.00

(EBIT/r)

Value of equity (E) 2,400.00 2,000.00 1,600.00

Equity capitalisation rate 20.42% 22.50% 25.63%

(EAT/E)
 Traditional Approach
• Also known as intermediate approach
• Is a compromise between the two extremes of net
income approach and net operating income
approach.
• According to this theory the value of the firm can be
increased and overall cost of the capital can be
decreased by using debt-equity combination upto a
certain point only.
• After that point the increased cost of equity cannot
be offset by the advantage of low cost debt.
 Modigliani and Miller approach (MM Approach)

STATES : It is a combination of NOI approach and NI

approach
If taxes are ignored this theory is similar to NOI
approach
If taxes are not ignored then this theory is similar to
NI approach
 .
ASSUMPTION

 Investors act rationally

 There are no corporate taxes
 There is a perfect market
 All the earnings are distributed among shareholders

THE FINDINGS OF THEORY CAN BE CLASSIFIED INTO 2 PARTS

1. When corporate taxes are assumed to exist
2. When corporate taxes does not exist
 Formulas

• Value of the Firm = EBIT/ overall cost of capital

• Total market Value of a Firm= Value of Equity +

Value of Debt

• Market-Value of equity= PBT/Cost of equity

• Market Value of Debt= Interest/ cost of debt