CAPITAL

STRUCTURE
PRESENTED BY- PARNEET KAUR
CLASS- BBA 4TH SEM
ROLL NO.- 10542022063
 • In the capital structure decisions, it is
determined from which sources and how

INTRODUCTION
much finance should be raised. Thus, under
the capital structure, we determine the
proportion in which capital should be raised
from different securities. In this way, capital
structure decisions are related to the mutual
proportion of the long-term sources of
capital. In the long-term sources, we include
the owned funds and borrowed funds.
Owned funds include share capital and
reserves and surplus, whereas in the
borrowed funds we include debentures and
long-term loan som financial institutions
While determining the capital structure,
management should use proper proportion
of borrowed funds and owned funds
because it affects the cost of capital and total
value of firm.
 MEANING OF CAPITAL STRUCTURE

Capital structure
A financial manager
refer to the
choose that source of
proportion between
finance which include
the various long term
minimum risk as well
source of finance in
as minimum cost of
the total capital of
capital.
firm.
O C S • The main objective of the financial
management is to maximize the market
P A T price of the ordinary shares because it
maximizes the wealth of the shareholders. A
T P R firm should opt for such a capital structure
which can help meet the objectives of
I I U financial management. A Capital structure or
a combination of owned capital and debt
M T C which enables to maximize the value of the

U firm is called optimum capital structure.

A T Optimum capital structure, on the one hand,

M maximises the wealth of the shareholders

L U and on the other, reduces the cost of capital

of the firm. Due to the reduction in cost of
capital, firm gets new opportunities of
R investment. Thus, we see that capitał
structure and the value of firm are closely
E related. The capital structure of the firm
affects the expected earnings of the firm or
the cost of capital or both and, thus, affects
the value of the firm.
QUALITIES OF OPTIMUM
CAPITAL STRUCTURE

SIMPLICITY FLEXIBILITY MINIMUM ADEQUATE

COST OF LIQUIDITY
CAPITAL

MINIMUM RISK LEGAL MAXIMUM CONTROL

REQUIREMENTS RETURN
FACTORS AFFECTING CAPITAL
STRUCTURE
SIZE OF BUSINESS
FORMS OF BUSINESS ORGANISATIONS
STABILITY OF EARNINGS
DEGREE OF COMPETETION
STAGE OF LIFE CYCLE
CREDIT STANDING
CORPORATION TAX
STATE REGULATIONS
STATE OF CAPITAL MARKET
ATTITUDE OF MANAGEMENT
TRADING ON EQUITY
SIGNIFICANCE OF CAPITAL
STRUCTURE DECISIONS

Management can determine the optimum capital

structure by proper decision on the capital structure in
which the aggregated cost of capital is minimum and the
value of ordinary shares is maximum. Through the right
decision on the capital structure, management can
In the area of financial management, capital structure
increase the return for its shareholders by using
decisions are of utmost significance. But some
financial leverage. Management can determine the debt
companies do not plan their capital structure. These
capacity of the business. By not fully utilizing the debt
companies may be able to succeed in the short period,
capacity, firm can be saved from the financial distress. If
but they may feel difficulty to get necessary finance for
a company has growth opportunities in future,
their activities in future. Therefore, for the maximum
additional finance can be raised at right time. Firm can
profitable use of resources and to adjust according to
save itself from the restrictive conditions of the financial
changing requirements, planning of capital structure is
institutions at the time of loans, etc. If a company uses
necessary.
more debt in its financial structure, it increases financial
risk. As a result, the debt and share capital in future is
available at high cost. Financial risk can be kept at an
appropriate level by proper decision on the capital
structure.
 • There are different theories which explain the
relationship among capital structure or
financing mix (debt-equity ratio), cost of
capital and valuation of a company. the
capital structure affects cost of capital of a
company and its value. According to the other
STRUCTURE school of thought, there is no relationship
among the capital structure, cost of capital of

THEORIES
a company, and its value. There are four
CAPITAL

approaches which explain the relationship

between the capital structure and value of a
firm. These approaches are as follows:
• 1. Net Income Approach
• 2. Net Operating Income Approach
• 3. Modigliani - Miller Approach
• 4. Traditional Approach
 Capital Structure
Theory

Relevant Theory Irrelevant Theory

(capital structure (capital structures
affects the value does not affect
of firm) the value of firm)

Net Income Net operating

approach income approach

Traditional
MM approach
Approach
 • ASSUMPTIONS
3. The firm's total assets are
1. The company uses only two given and they do not change.
2. There are no corporate
sources of funds, that is debt In other words, the
taxes.
and equity. investmentdecisions are
assumed to be constant.

6. The company's total

4. The dividend payout ratio is financing remains constant.
100 per cent which means that The company can change its
5. The operating profits (EBIT)
whole of the earnings capital structureeither by
of the company are given and
aredistributed as dividends redeeming the debentures
not expected to grow.
and there are no retained with the help of issuing shares
earnings. or by raising more debt and
reducingthe equity capital.

8. All investors have the same

7. The business risk remains
probability distribution of
constant and is assumed to be
future expected operating 9. The firm has a perpetual life.
independent of capital
earnings (EBIT)for a given
structure andfinancial risk.
firm.
NET INCOME APPROACH
This approach was given by Durand. According to
this approach, capital structure decision affects
the value of the firm. A change in the capital
structure causes a change in the overall cost of
capital and the value of the firm. Use of higher
debt in the capital structure will decrease the
overall cost of capital and increase the value of
the firm and the market price of equity shares. On
the other hand, a decrease in the use of debt in
capital structure will lead to an increase in the
overall cost of capital and a decrease in the value
of the firm and the market price of equity shares. 

This approach is based on three assumptions:

(a) There are no taxes.
(b) The cost of debt is less than the cost of equity.
(c) The use of debt does not change the risk
In the given figure the degree of
leverage is plotted along the X-axis
while the percentage rate of cost of
capital is shown on Y-axis. The figure
shows that Ke in addition to Kd remain
unchanged. However as the degree of
leverage increases cost of capital
Ko decreases. Ko however cannot touch
Ko as there cannot be all debt firm. The
best possible capital structure is one at
which Kd is nearest to Kd. At this level
the firm's whole cost of capital would
be lowest and the market value of the
firm and market value per share is
highest.
N I
• This approach was also suggested by Durand but it is opposite to Net
Income approach. According to this approach, the value of the firm is
independent of its capital structure. The change in capital structure does

E N
not cause change in the value of the firm, market price of shares and
weighted average cost of capital.

T O C
• According to this approach, the market values the firm as a whole and

A
it does not split the value of the firm into value of the equity and value
of the debt. The overall cost of capital (Ko) is constant for all degrees of

P O
financial leverage. The value of the firm is ascertained as follows:

P • V= EBIT/Ko

E M P
• The value of equity is residual, which is calculated by deducting the
value of debt (B) from the total value of the firm (V).

R E R
• Thus, total value of equity (S) = V-B

A • When a company increases the proportion of debt in its capital

O
structure, it increases the financial risk for equity shareholders. As a
result of increase in the financial risk, the equity shareholders expect

T higher rate of return from the company to get compensated for higher

A
risk. It means, it increases the cost of equity Ke. In this way, the benefit
of using cheaper debt is neutralized by the implicit cost of equity, as a

I result of which overall cost of capital remains the same.

C • Equity capitalisation Rate Ke =EBIT-Interest/V-B

N
H
• According to NOI approach, there is nothing like optimum capital
structure as the total value of the firm and market price of shares are

G not affected by the level of financial leverage.

ASSUMPTIONS
This approach is based on the following assumptions:

1. The overall cost of captial Ko remains constant for all degrees of financial
leverage or debt-equity ratio.

2. There are no corporate taxes.

3. The investors values the firm as a whole and do not split the value of the firm into
value of equity and value of debt.
4. The increase of proportion of debt in the capital structure results in an increase in
the financial risk which causes an increase in the cost of equity Ke.

5. The weighted average or overall cost of capital (Ko) remains constant.

In the given figure the degree of
leverage is plotted beside the X-axis
while the percentage rate of cost of
capital is shown on Y-axis. The figure
shows that Kd as well as Ko remain
unchanged. Since the degree of
leverage is increased. However with
the increase in the leverage the cost
of equity increases in such a manner
so as to offset the advantage of
using cheaper debt. Consequently
Ko and the value of firm (V) remain
unchanged by the increase in the
financial leverage.
 • The Modigliani-Miller (MM) approach is also
similar to the net Operating Income
approach. However, the NOl approach does

MODIGLIANI-MILLER
not provide operational justification for
irrelevance of capital structure to the
valuation of the firm and it is of definitonal
nature while MM approach provides

(MM) APPROACH
behavioural justification for constant cost of
capital and value of the firm. In other words,
MM appraoch says that theweighted
average cost of capital and hence, the total
value of the firm does not change with the
change inthe capital structure. The
behavioural justification in MM approach
lies in the arbitrage process. Arbitrage
means buying an asset in one market at
lower price and selling the same in another
market at higherprice. This arbitrage process
restores equilibrium in both the markets.
A
S •

•
The MM approach is based on the following assumptions:

1. The dividend payout ratio is 100%, that is, there are no

S retained earnings.

U • 2. There are no corporate taxes.

M
• 3. The capital markets are perfect. It means:

(a) There are no transaction costs.

P (b) The investors are free to buy and sell the securities.

T (c) The investors can borrow without restrictions on the same

terms as the firm. 
I (d) All investors have the same information without cost.
O (e) The investors are rational in behaviour.

N • 4. All investors have the same expectatiaon of a firm‘s net

operating income (EBIT) and evaluate the firm on that basis.
S • 5. All firms can be divided into equivalent or homogeneous
risk class. It means that the excpected earning have similar
risk characteristics.
BASIC PROPOSITIONS
The MM approach has the following three
propositions:
• 1. The overall cost of captial (Ko) and the value of
the firm (V) are independent of the capitalstructure
of the firm. It means that for all levels of debt-equity
mix, the overall cost of capital and value of the firm
will remain constant.
• 2. The cost of equity (Ke) is equal to capitalisation
rate of a free equity stream plus a premium
forfinancial risk. The financial risk increases as the
proportion of debt is increased in the capital
structure.
• 3. The cut off rate for investment purposes is totally
independent of the manner in which aninvestment
is financed.
 ARBITRAGE PROCESS
The operational justification in MM approach is provided by the ‘arbitrage
process’. As explained earlier, arbitrage means buying an asset or security in
one market at lower price and selling it in another market at higher price. This
activity will increase the price in the market where it is low due to more demand
and decrease the price in the market where it is higher due to increase in supply.
This will make the price in the two markets equal. On the same basis, the market
price of the securities of the two firms exactly similar in all respects except the
capital structures (debt-equity ratio) cannot remain different in different markets
for long. It implies that a security cannot sell at different prices in different
markets. Arbitrage process will bring the price into equilibrium. The total value of
the homogeneous firms which differ only in terms of capital structure will be the
same due to arbitrage. By selling the shares of the over valued firm (higher
price) and buying the shares of the undervalued firm (lower price) the investor
can earn the same return at lower investment without bearing additional risk.
He will borrow additional funds personally to purchase the shares of the
undervalued firm. The use of personal debt, by the investor is called personal
leverage or home made leverage.
LIMITATIONS OF MM APPROACH
THE EXTENT OF RISK
COST OF
IS NOT SAME FOR
BORROWING IS
THE INVESTOR TRANSACTION
NOT SAME FOR
WHEN HE HIMSELF COSTS ARE THERE
INDIVIDUALS AND
BORROWS OR THE
FIRMS
FIRM BORROWS

CORPORATE TAXES
INSTITUTIONAL
DISTORT THE MM
RESTRICTIONS
HYPOTHESIS
T
R A • Traditional Approach is a compromising
viewpoint between Net Income Approach and
A P Net Operating Income Approach. Partly it has
the features of both the approaches. Therefore,

D P it is a mid-way approach. The Traditional

Approach is similar to the NI Approach to the

I R extent that it says that leverage affects the

overall cost of capital and total value of the
firm. However, it does not accept the viewpoint
T O of NI Approach that the value of the firm will
necessarily increase for all degrees of financial
I A leverage. it is similar to the viewpoint of NOI
Approach that beyond a certain degree of
O C
leverage, the overall cost of capital increases,
as a result of which the total value of the fim

N H
decreases. But it is different from the NOI
Approach as it does not accept the view that
the overall cost of capital is constant for all
A degrees of leverage.

L
The essence of the Traditional Approach is that a firm by making a judicious use of debt
and equity in its Capital structure can increase its total value and decrease the overall
cost of capital. This is because debt is a cheaper source of finance due to tax
deductibility of interest in comparison to equity shares. The use of cheaper source of
funds (debt) by replacing equity capital will reduce the overall cost of capital. However,
if the debt is raised further, it will increase financial risk for the investors, leading to an
higher equity capitalisation rate (Ke). But the increase in equity capitalisation rate (Ke)
may not be so high as to offset the benefit of cheaper debt. But, if the debt is increased
further, it will increase financial risk both for equity shareholders and creditors. They
will demand higher rate of return from the firm. In other words, it will increase the
equity capitalisation rate (Ke) as well as the cost of debt (Ki). Thus, the use of debt
beyond a certain point will raise the overall cost of capital and decrease the value of
the firm. Hence, the use of debt upto a certain point will increase the value of the firm
and beyond that point it will decrease the value of the firm. At this level of debt-equity
mix, the capital structure of the firm would be optimum. At this level, the overall cost of
capital would be the minimum. At this level, the marginal real cost of debt would be
equal to the real cost of equity.
 Y
Ke

Cost Of Capital
Ko

Stage1 Stage3 Kd
Stage2

0 X
R R
Degree of Leverage

TRADITIONAL APPROACH
CONCLUSION
• Thechoice of capital structure matters to a
private company. It directly influences a
company's ability to create shareholder value
because the balance sheet sets the minimum
threshold for a company's cost of capital.
Investments in the business must meet this
threshold, or value is destroyed.
THANKYOU