Capital Structure Decision

Dr. Sandeep Malu

Associate Professor, SVIM, Indore
Email: malu.sandeep123@gmail.com
 Capital Structure Decision

• The objective of any company is to mix the permanent

sources of funds in a manner that will maximize the
market price of company. In other words, companies want
to minimize their cost of capital. The proper mix of funds
is referred to as the optimum capital structure.
• The capital structure decision is a significant managerial
decision which influences the risk and return of the
investors. The company should plan its capital structure at
the time of promotion and subsequently whenever it has
to raise additional funds for various new projects.
 Capital Structure Decision

Debt-Equity Mix Dividend Decision

Existing Capital Structure

Effect on Earning Per Share Effect on risk of Investors

Effect on Cost of Capital

Optimum Capital Structure

Value of the Company

Determinates of Capital Structure
Initially the capital structure is to be determined at the time of
promotion of a company. Once a company has been formed and existed
for some years, the financial manager has to deal with the existing
capital structure. Every time the funds have to be procured, the
financial manager compares the various sources of finance and selects
the most advantageous sources. Thus the capital structure decision is a
continuous process and has to be followed whenever a firm needs
additional finance.

The factors which affect the capital structure decision may be classified as :
a) Internal Factors
b) External Factors
c) General Factors
 Internal Factors

 Risk Factors
 Cost of Capital
 Control
 Trading on Equity
 External Factors

 General Economic Condition

 Level of Interest Rates
 Policy of lending Institution
 Taxation policy
 Government Policies
 General Factors

 Nature of Enterprise
 Size of the Company
 Purpose of Financing
 Period of Finance
 Provision for future
 Marketing
 Requirement of investors
Capital Structure Theories
Capital Structure can affect the value of a company by
affecting either its expected earnings or the cost of capital
or both. Every financial manager tries to have an
optimum capital structure. In order to explain the
relationship between capital structure and the value of the
firm, different theories have been suggested like-

1. Net Income Approach (NI)

2. Net Operating Income Approach (NOI)
3. Modigliani-Miller (MM) Approach
4. Traditional Approach.
 Net Income (NI) Approach
Net income approach was suggested by Durand. According to
this approach, the capital structure decision is relevant to the
valuation of the firm.
If the ratio of debt to equity is increased, the weighted average
cost of capital will decline and the value of the firm will
increase. On the other hand, if the leverage is decreased, the
cost of capital will increase and the overall value of the firm
will reduce.
The implied over all capitalization rate now is :
Ko = O/V
Net Operating Income (NOI) Approach

This approach was also suggested by Durand. The net

operating income approach is just opposite to the NI approach.
According to this approach, the capital structure decision of a
firm is irrelevant. Any changes in combination of debt and
equity will not change the total value of the firm and the
overall cost of capital is independent of the degree of leverage.

The value of the firm is determined as follows :

V = EBIT/Ko
Modigliani- Miller (MM) Approach
Modigliani and Miller argue that the average cost of capital of
a firm is completely independent of its capital structure. In
other words, a change in the debt-equity ratio does not affect
the cost of capital. They give a simple argument in support of
their approaches.
Now, if there is any increase in risk, the shareholders will
expect a higher rate of return from the shares of the company.
Modigliani and Miller, therefore argue that leverage has
nothing to do with the overall cost of capital and the overall
cost of capital of a company is equal to the capitalization rate
of pure equity.
 Traditional Approach
The traditional view is also known as an intermediate approach.
It is a compromise between the net income approach and the net
operating approach. According to this approach the value of the
firm can be increased or the cost of capital can be reduced by a
proper mix of debt and equity capital. This approach clearly
indicates that the cost of capital decreased within the reasonable
limit of debt and then increases with leverage.
According to the traditional position, the manner in which the overall cost
of capital reacts to changes in capital structure can be divided into 3 stages-
• First Stages : Increasing Value
• Second Stage : Optimum Value
• Third Stage : Declining Value