Capital structure and theories

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 Introduction
Importance of Funds and role of Finance.

Inadequate funds / Excess funds – Both Harmful.

Capital Structure is made up of Debt and Equity securities.

It refers to permanent financing of a firm.

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 CAPITALIZATION & CAPITAL STRUCTURE

Capitalization refers to the total amount of securities issued

by a company.
Capital structure refers to kinds of securities and
proportionate amounts that make up capitalization.

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 Pattern of capital structure
1. Equity shares only
2. Equity and Preference shares
3. Equity shares and Debentures
4. Equity shares, Preference shares and Debentures

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 Financial break even point
It may be defined as that level of EBIT which is just equal to pay the total financial

charges.
Financial charges includes: Interest on Debentures and Dividend on Preference shares.

At this point level of EBIT , Earning per share (EPS) = 0.

Financial Break Even Point = I + D p

• (1 – T)
Where I = Interest Charges

D p = Preference Dividend

T = Tax Rate

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 POINT OF INDIFFERENCE / RANGE OF EARNINGS

Point of Indifference refers to that EBIT level at which EPS

remains the same irrespective of different alternatives of

Debt – equity mix.
In other words at this level of EBIT, the rate of return on

capital employed is equal to the cost of debt .

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 OPTIMAL CAPITAL STRUCTURE

It may be defined as that capital structure or combination of

debt and equity that leads to maximum value of the firm and
minimizes the company’s cost of capital.
Maximization of Value of Firm will automatically lead to

Maximization of Shareholder’s wealth.

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 Theories of capital structure

Theories explaining the relevance of Capital structure are called

relevance theories and theories saying opposite are known as
irrelevance theories.

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Net Income Approach

According to this approach, capital structure decision is

relevant to the value of the firm. This approach is based on

the following assumptions
Cost of debt is less than cost of equity

Use of debt does not change the risk perception of the

shareholders
There are no corporate Taxes.

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Explanation
On the basis of the assumptions explained in the previous this
theory is saying that because cost of debt (Kd) is less than
cost of equity (Ke) so if we increase level of debt in total
capital which is less costly source overall cost of capital will
go down and hence value of the firm will go up.

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Net Operating Income approach
According to this approach, capital structure decision is
irrelevant to the value of the firm. This approach is based on
the following assumptions
Cost of debt is less than cost of equity
But Use of debt does change the risk perception of the
shareholders
There are no corporate Taxes.

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Explanation
On the basis of assumptions explained in the previous slide this
theory is saying that because use of debt affect the risk
perception of shareholders so increase in the level of debt
will increase cost of equity so benefit of use of debt will be
neutralized be increased cost of equity so overall cost of
capital will remain constant.

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Traditional Approach
This approach is mix of Net Income and Net Operating
Income approach explained in three stages
Increasing Value stage: Initially use of debt helps in
lowering overall cost of capital.
Constant Value Stage: Then in the second stage cost
of equity starts rising which neutralize the benefit of
use of debt so overall cost of capital remains
constant.
Declining Value Stage: Then in the third stage cost
of debt and cost of equity both starts rising which
leads to increase in overall cost of capital.

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Modgilani and Miller Approach

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 Modigilani and Miller Without Taxes

Assumptions
Capital markets are perfect. All information is freely
available and there are no transaction costs.
All investors are rational.
Firms can be grouped into ‘Equivalent risk classes’ on the
basis of their business risk.
Non-existence of corporate taxes.

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Proposition 1
Arbitrage Process: Miller and Modigliani approach is explaining
that two firms in the same business risk categories cannot
command different value in the market just because their capital
structure is different.
It means
Value of levered firm= Value of unlevered firm
Levered firms are the firms which are using debt
Unlevered firms are the firms which are not using debt.
Value of both types of firms will always remain same and even
if value is different investors will indulge in arbitrage process to
bring the value at same level.
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arbitrage process
Let’s suppose that initially value of Levered Firm is higher
than unlevered firm
Investors will dispose of the shares of levered firm, will
borrow themselves and would invest in a firm which is
unlevered.
The reason is investors always prefer their personal leverage
over the corporate leverage.
They would themselves take risk of borrowing rather than
investing into a levered firm.

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M & M approach with taxes
The MM contend that with corporate taxes, debt has a
definite advantage as interest paid on debt is tax-deductible
and leverage will lower the overall cost of capital.
The value of the levered firm (V1) would exceed the value
of the unlevered firm (Vu) by an amount equal to levered
firm's debt multiplied by tax rate.

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 Factors affecting capital structure
1. Growth and stability of sales
2. Cost of capital
3. Risk
4. Cash flow ability to service debt
5. Nature and size of firm
6. Control
7. Flexibility
8. Capital market conditions
9. Purpose & Period of financing
10. Legal requirements
11. Corporate tax rate
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 Principles of capital structure decisions
1. Cost principle
2. Risk principle
3. Control principle
4. Flexibility principle
5. Timing principle

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