Capital Structure Decision

FIN501
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Capital Structure Decision
Optimum Capital Structure
 Optimal capital structure

• Optimal capital structure

• The optimal capital structure of a firm is often
defined as the proportion of debt and equity
that results in the lowest weighted average cost
of capital (WACC) for the firm.
• Risk Return tradeoff is done to reach at
optimum capital structure.
Capital Structure
Investors’ perspective
 Cost of capital

• A firm’s total cost of capital is a weighted

average of the cost of equity and the cost of
debt, known as the 
weighted average cost of capital (WACC).
 Cost of capital
• The formula is equal to:
• WACC  =  (E/V x Re)  +  ((D/V x Rd)  x  (1 – T))
• Where:
• E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
 Question WACC
• Total Capital =Rs.300
• Equity=Rs.100 @5%
• Debt=Rs200@10%
• Corporate Tax Rate=40%
WACC=(100/300)*5%+(200/300)*10%(1-40%)
WACC=(1/3)*5%+(2/3)(10%)(60%)
WACC=5%/3+(2/3)6%
WACC=5%+12%/3
WACC=17%/3
WACC=5.67%
 Second Solution
•Total Capital =Rs.300
•Equity=Rs.100 @5%
•Debt=Rs200@10%
•Corporate Tax Rate=40%
Amt. Rate Cost Tax Net Cost
100* 5%= 5 0 5
200* 10%= 20 8 12
WACC=(17/300)*100=5.67%
 Factors affecting Capital Structure
• Some of the Inter Factors affecting the capital
structure decisions of a company are: –
• 1. Financial Leverage
• 2. Risk
• 3. Growth and Stability
• 4. Retaining Control
 Factors affecting Capital Structure
• 5. Cost of Capital
• 6. Cash Flows
• 7. Flexibility
• 8. Purpose of Finance
• 9. Asset Structure.
Factors affecting Capital Structure
• And some of the External Factors affecting the
capital structure decisions of a firm are:-
• 1. Size of the Company
• 2. Nature of Industry
• 3. Investors
• 4. Cost of Floatation
• 5. Legal Requirements
 Factors affecting Capital Structure
• 6. Period of Finance
• 7. Level of Interest Rate
• 8. Level of Business Activity
• 9. Availability of Funds
• 10. Taxation Policy
• 11. Level of Stock Prices
 Factors affecting Capital Structure
• Additionally, some of the general factors in
this regard could be summed as:- 
• 1. Control 
• 2. Risk 
• 3. Income
• 4. Tax Consideration
• 5. Cost of Capital
 Factors affecting Capital Structure
• 6. Trading on Equity
• 7. Investors’ Attitude
• 8. Flexibility
• 9. Timing
• 10. Legal Provisions
 Factors affecting Capital Structure
• 11. Profitability
• 12. Growth Rate
• 13. Government Policy
• 14. Marketability
Factors affecting Capital Structure
• 15. Company Size
• 16. Maneuverability
• 17. Financing Purpose
 MCQ
Capital structure is related with mix of debt or
equity.
a.Yes
b.No
 MCQ
Capital structure is related with mix of debt or
equity.
a.Yes
b.No
 MCQ
The basic sense from bringing debt into capital
structure is:
A.Interest
B.Leverage
C.Risk
D.All of the above
 MCQ
The basic sense from debt into capital structure
is:
A.Interest
B.Leverage
C.Risk
D.All of the above
 MCQ
There exist something like Optimum capital
structure:
A.Yes
B.No
C.May be
D.Can’t say
 MCQ
There exist something like Optimum capital
structure:
A.Yes
B.No
C.May be
D.Can’t say
 MCQ
Highly leveraged company is in trouble when
there is fall in the sales level.
A.Yes
B.No
 MCQ
Highly leveraged company is in trouble when
there is fall in the sales level.
A.Yes
B.No
 MCQ
In comparison to highly leveraged company;
unleveraged company is in less trouble when
there is fall in the sales level.
A.Yes
B.No
 MCQ
In comparison to highly leveraged company;
unleveraged company is in less trouble when
there is fall in the sales level.
A.Yes
B.No
 MCQ
In comparison to highly leveraged company;
unleveraged company is in less trouble when
there is fall in the sales level.
A.Yes
B.No