CAPITAL

STRUCTURE
Name-Tanisha Doshi
ROLL-111
TYBFM
 Debt comes in the
form of bond issues or
Short-term debt is
loans, while equity
also considered to be
may come in the form
part of the capital
of common stock,
structure.
preferred stock, or
retained earnings. Equity capital arises
from ownership
shares in a company
and claims to its
future cash flows and
Capital structure is the profits.
particular
combination of debt
and equity used by a
company to finance its
overall operations and
growth.
 TOTAL
CAPITAL

EQUITY CAPITAL DEBT CAPITAL

 TYPES OF CAPITALIZATION STRUCTURES

High leverage Low leverage

debt, 0.1,

Firms can either issue either more debt or

debt, 40% equity to fund its operations. By issuing
equity, firms give up some ownership in the
company without the need to pay back
asset, 50% investors; by issuing debt, companies
increase their leverage by needing to pay assets, 0.5,
back investors. A company's debt-to-equity equity, 0.4,
ratio is a measure of risk for investors.

equity, 10%
Meaning of capital
structure
Capital structure refers to the
specific mix of debt and equity
used to finance a company's assets
and operations. ... Capital structure
is also the result of such factors as
company size and maturity, which
influence the financing options a
company may have available.
FINANCIAL STRUCTURE
Financial structure refers to the mix of
debt and equity that a company uses CAPITAL
to finance its operations.
. This
composition directly affects the risk STRUCTURE
.
Capital structure in corporate
and value of the associated business.
finance is the mix of various forms
The financial managers of the
of external funds, known as capital,
business have the responsibility of
used to finance a business. It
deciding the best mixture of debt and
consists of shareholders' equity,
equity for optimizing the financial
debt, and preferred stock, and is
structure.
detailed in the company's balance
sheet.
How Does a Company's
Capitalization Structure Affect Its
Profitability?
• The capitalization of a business is its foundation.
From its first sale to the projects it invests in down
the road, everything begins with the way it
finances its operations. The capitalization
structure can have a huge impact on a company's
profitability.
• Business ownership is shared, so the proverbial
pie of profits must be divided into a greater
number of pieces. A company funded fully by debt
may have hefty interest payments each month, but
when all is said and done, the profits belong
entirely to the business owners. Without
shareholder dividends to pay, the profits can be
reinvested in the business through the purchase of
new equipment or by opening a new location,
generating even greater profits down the road.
OPTIMAL CAPITAL
STRUCTURE

The optimal capital structure of a firm is the best mix of debt and equity
financing that maximizes a company’s market value while minimizing its cost of
capital. In theory, debt financing offers the lowest cost of capital due to its tax
deductibility. However, too much debt increases the financial risk to
shareholders and the  return on investment that they require. Thus, companies
have to find the optimal point at which the marginal benefit of debt equals the
marginal cost.
FINANCIAL BREAK
EVEN POINT AND
INDIFFERENCE
LEVEL
Financial break-even (BEP) represents a point at which
before tax earnings are equal to the fixed financial
charges of a firm. The EBIT level at which the EPS is the
same for two alternative financial plans is known as the
indifference level/point.
In other words, financial breakeven point refers to that level of
EBIT at which the firm can satisfy all fixed financial charges.
EBIT less than this level will result in negative EPS. Therefore
EPS is zero at this level of EBIT. Thus financial breakeven point
refers to the level of EBIT at which financial profit is nil.
 Financial Indifference Point:

When two alternative financial plans do produce the level of EBIT where EPS is the
same, this situation is referred to as ‘in different point’. In case, the expected level of
EBIT exceeds the indifference point, the use of debt financing would be advantageous
to maximize the EPS. The indifference point may be defined as the level of EBIT beyond
which the benefits of financial leverage begins to operate with respect to earnings per
share.

The indifference point between the two financing alternatives

can be ascertained as follows:

Where, EBIT = Earnings before interest and taxes

T = Corporate rate of tax

I1 = Interest charges in Financing alternative 1

N1 = Number of equity shares in Financing alternative 1

I1 = Interest charges in Financing alternative 2

N2 = Number of equity shares in Financing alternative 2

Illustration Financial Indifference Point

American Express Ltd. is setting up a project with a capital outlay of Rs. 60,00,000. 6 2 0.60 EBIT x 2 = (0.6 EBIT x 6) – [(0.6 x 7.2) x 6]

It has the following two alternatives in financing the project cost: 0.60 x 7.2 x 6 = (0.60 EBIT x 6) – (0.60 EBT x 2)

Alternative 1: 100% Equity finance 25.92 = 3.6 EBIT-1.2 EBIT

Alternative 2: Debt-equity ratio 2: 1 2.4 EBIT = 25.92

EBIT = 25.92/2.4 = 10.80 say Rs. 10,80,000

The rate of interest payable on the debt is 18% p.a. The corporate rate of tax is 40%.
Calculate the indifference point between two alternative methods of financing.

Solution:
The EBIT at indifference point explains that the EPS for two
Alternatives in financing and its financial charges methods of financing is equal.
Now we can calculate the indifference point of the above two financing alternatives
as follows:
 TYPES OF CAPITAL STRUCTURE

The meaning of capital structure can be

described as the arrangement of capital by using
different sources of long term funds which
consists of two broad types, equity and debt. The
different types of funds that are raised by a firm
include preference shares, equity shares,
retained earnings, long-term loans etc. 

EQUITY CAPITAL
Equity capital is the money owned by
the shareholders or owners. It
consists of two different types
Retained earnings-Retained earnings
are part of the profit that has been
kept separately by the organization
and which will help in strengthening
the business.
. as a low levered firm.
FINANCIAL
DEBT CAPITAL
Debt capital is referred to as the borrowed
LEVERAGE
money that is utilized in business. There
are different forms of debt capital. Financial leverage is defined as the
1.Long Term Bonds: These types of bonds
are considered the safest of the debts as proportion of debt that is part of the total
they have an extended repayment period, capital of the firm. It is also known as
and only interest needs to be repaid while
capital gearing. A firm having a high level
the principal needs to be paid at maturity.
2.Short Term Commercial Paper: This is a of debt is called a highly levered firm while
type of short term debt instrument > a firm having a lower ratio of debt is known
 Weighted average cost of capital The Modigliani-Miller theorem

The Modigliani-Miller theorem states that a

The weighted average cost of capital (WACC)
is the rate that a company is expected to pay on
average to all its security holders to finance its
assets. The WACC is commonly referred to as the
firm's cost of capital. Importantly, it is dictated by
the external market and not by management.
company's capital structure is not a factor in its
value. Market value is determined by the present
value of future earnings, the theorem states. The
theorem has been highly influential since it was
introduced in the 1950s.

CAPITAL STRUCTURE THEORY

In financial management, capital

structure theory refers to a
systematic approach to financing
business activities through a
combination of equities and
liabilities.
Net Income Approach Modigliani miller theorem arbitrage
The Modigliani and Miller hypothesis
The Net Income Approach suggests that the was based on the assumption that a
value of the firm can be increased by company's shares trade in a perfect
decreasing the overall cost of capital (WACC) market. ... Arbitrage is a financial term used
through a higher debt proportion. Capital to describe a situation where a security (or a
structure is the proportion of debt and equity in similar security) trades at two different
which a corporate finances its business. . prices in two different markets.
 NET INCOME APPROACH
ILLUSTRATION

 A manufacturing company is expecting the Net Operating Income of is Rs. 200,000. The
company has debenture lending of Rs 6,00,000 at 10% interest payable. The overall capitalization
rate is 20%. Calculate the value of the firm and the equity capitalization rate as per the NOI
approach.

What will be the impact on value of the firm and equity capitalization firm if the debenture
amount is increased to Rs. 7,50,000? Here, the value of firm is irrespective of the capital
mix. The benefit of adding the debt fund of Rs.
1,50,000 is nullified by the increase in equity
Capitalization rate from 35% to 50%.
Solution
Net Operating Income                                                                            Rs. 2,00,000
Interest                                                                                                    Rs.    60,000

Value of the firm                                 = EBIT/Ko = 2,00,000/.20 = Rs. 10,00,000

Equity Capitalization Rate                =(EBIT-I)/(V-D)
= (2,00,000-60,000)/(10,00,000-6,00,000)
= 35%
If the debenture amount is increased,
Value of the Firm                                  = EBIT/Ko = 2,00,000/0.20 = Rs. 10,00,000
Equity Capitalization Rate                  = (EBIT-I)/(V-D)
                                                             = (2,00,000-75,000)/(10,00,000-7,50,000)
                                                             = 50%
 MODIGILIAN-MILLER (MM) APPROACH
ILLUSTRATION I
Company A and B are engaged in the same line of activity with similar business risk. Company A
is unlevered and Company B is levered with Rs. 2,00,000 debentures carrying 5% rate of interest.
Both the firms have income before interest and taxes of Rs. 50,000. The company’s tax rate is
40% and capitalization rate 10% for purely equity firms. Compute the value of firm U and L using
the NI and NOI approach.

Company A Company B

Net Income 50,000 50,000 Under NOI Approach (Taxes are under consideration)
Interest on debenture – 10,000
Value of unlevered Firm (Vu) = [EBIT (1-Tc)]/Ke = [50,000*(1-0.4)]/0.10
Profit before taxes 50,000 40,000
Taxes (40%) 20,000 16,000 =Rs. 3,00,000
Profit after taxes 30,000 24,000
Value of levered Firm (VL) = Rs. 3,00,000+ Rs. 2,00,000*0.40
After-tax Capitalization Rate 10% 10%
= Rs. 3,80,000
Total market value of the equity(S) 3,00,000 2,40,000

Market value of debt (B) – 2,00,000

Total Value (V) 3,00,000 4,40,000

COST OF FINANCIAL DISTRESS

Distress cost refers to the expense that a firm in financial distress faces beyond
the cost of doing business, such as a higher cost of capital. Companies in
distress tend to have a harder time meeting their financial obligations, which
translates to a higher probability of default.

Distress cost refers to the greater expense that a firm in financial

distress incurs beyond the cost of doing business.

Distress costs can be tangible, such as having to pay higher interest

rates or more money to suppliers upfront.

Distress costs can also be intangible, such as a loss of employee

morale and productivity.

Distress costs are broken down into two categories: ex-ante

(before the event) and ex-post
(after the event—e.g., bankruptcy).
 CAPITAL ASSET PRICE MODEL

The Capital Asset Pricing Model (CAPM) describes the

Understanding the Capital Asset Pricing Model (CAPM)
The formula for calculating the expected return of an asset
given its risk is as follows:
relationship between systematic risk and expected
returns for assets, particularly stocks. CAPM is widely
used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of
those assets and cost of capital
 CAPM FORMULA EXPLAINATION

Expected Return
The “Ra” notation above Beta
represents the expected return of The beta (denoted as “Ba” in the
a capital asset over time, given all CAPM formula) is a measure of a
of the other variables in the stock’s risk (volatility of returns)
equation.  “Expected return” is a reflected by measuring the
long-term assumption about how fluctuation of its price changes
an investment will play out over its relative to the overall market.
entire life.

Risk-Free Rate Market Risk Premium

The “Rrf” notation is for the risk- From the above components of
free rate, which is typically equal CAPM, we can simplify the
to the yield on a 10-year US formula to reduce “expected
government bond.  The risk-free return of the market minus
rate should correspond to the the risk-free rate” to be simply
country where the investment is the “market risk premium”.  
being made, and the maturity .
 Profitability

Ca
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C o al M p ita
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FACTORS CAPITAL

AFFECTING
STRUCTURE

Na
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Firm fB

CAPITAL
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STRUCTURE Cash Flows

1. Profitability:
The basic objective of financial management of a firm is to maximize
shareholders’ wealth. The management should select such a capital
structure that maximizes EPS for a given EBIT. If operating profits are
higher, debt capital can be used in larger proportion, as chances of default
on interest on debt are small.

2. Cost of Capital:
Each source of capital has its specific cost. Debt requires interest
payments and share capital holders are paid dividends. The relative
advantage incurred in employing different sources in the project in
reducing the overall cost of capital will help in deciding the capital
structure of a firm.

3. Nature of Business of Firm:

The nature of business of a firm is a decisive factor in the capital structure.
If the firm operates in a perfect competitive market, there are chances of
suffering loss. 
 Capital Market Conditions:
The capital structure of a firm is affected by the prevailing market
conditions at the time of raising the funds. When the securities
market bears an optimistic outlook, the issue of equity shares
and preference shares might get a better response from
investors.

Cash Flows:
The operating profit should not only cover the interest payments,
it should also be sufficient to meet routine obligations and
expenditures. The irregular cash flow may cause the requirement
of borrowing.

Control of Firm:
If control of the firm has to be in few hands, then low proportion
of capital should be raised by issue of equity capital and a larger
portion of capital should be raised through issue of debt.
03