STRUCTUR

Presentation by:
JEENIA(2)
AARTI (32)
NEHA(34)
SHEENU(36)
MEANING OF CAPITAL STRUCTURE

Capital structure refer to the proportion between the

various long term source of finance in the total capital of
firm

A financial manager choose that source of finance which

include minimum risk as well as minimum cost of
capital.
 Sources of
long term
finance

Proprietor’s Borrowed
funds funds

Preference Reserve and Long term

Equity capital
capital surplus debts
 Importance
 Capital structure determine the risk assumed by the firm

 Capital structure determine the cost of capital of the firm

 It affect the flexibility and liquidity of the firm

 It affect the control of the owner of the firm

DETERMINANT OF CAPITAL
STRUCTURE
 Nature and Size of the firm

 Stability of the earning

 Stages of life cycle of the firm

 Cash flow ability of the firm

 Cost of capital
 Rate of corporate tax

 Retaining control

 Flexibility

 Trading on equity

 Legal requirement

 Assets structure

 Nature of investor
Point of indifference
It refer to that EBIT level, at which EPS remain same
irrespective of different alternatives of debt-equity mix.

At this level of EBIT return on capital employed is equal

to cost of debt this is also known as break even level of
EBIT for alternative financial plan
Point of indifference is calculated as :
(X-I1)(1-T)-PD = (X-I2)(1-T)-PD
S1 S2

Where
 X = point of indifference

 I1 = int. under alternative financial plan 1

 I 2= int. under alternative financial plan 2

 T = tax rate
 PD = pref. dividend
 S1 = amount of equity share under financial plan 1
 S2= amount of equity share under financial plan 2
 approach Net operating income
Net income approach

Capital
structure
theories

approach
and miller
Traditional approach Modigliani
NET INCOME (NI) THEORIES
 This theory is suggested by “David Durand”

 Acc. to this approach the value of the firm is increase

and decrease overall cost of capital by increasing the
proportion of debt financing in capital structure

 It is due to the fact that debt is generally a cheaper

sources of finance because:
1. Interest rate are lower than the dividend rate

2. Benefit of tax because int. is deductible expense

ASSUMPTION OF NET INCOME
APPROACH
 The cost of debt is lower than cost of equity

 The risk perception of the investor is not changed by the

use of debt

 There is no corporate tax

The effect of leverage on the cost of
capital under NI approach

 hg
NET OPERATING INCOME APPROACH

 This theory was propounded by “David Durand” and is

also known as irrelevant theory.

 Acc. to this theory, the total market value of the firm is

not affected by the change in the capital structure and the
overall cost of capital remain constant irrespective of
debt-equity ratio.
ASSUMPTION OF NET OPERATING
INCOME APPROACH

 The market capitalizes the value of the firm as a whole.

Thus, the split between debt and equity is not important

 The cost of debt is lower than cost of equity

 The risk perception of the investor is not changed by the

use of debt

 There is no corporate tax

The effect of leverage on the cost of
capital under NOI approach
 TRADITIONAL APPROACH
 This approach is the midway of NI approach and NOI approach.
And also known as intermediate approach.

 Acc. to this, the value of firm can be increased initially or cost of

capital can be decreased by using more debt as the debt is a
cheaper source of fund than equity
After that optimum capital structure can be reached by a proper
debt-equity mix
But after a particular point if the proportion of debt is increased,
then the overall cost of capital start increasing and market value
begin to decline
MODIGLIANI-MILLER
APPROACH

 They have given two approach

1. In the absence of corporate taxes

2. When corporate taxes exist

Assumption :-

 Capital market are perfect

 Homogeneous risk classes of firm

 Expectations about the net operating income

 100% payout ration

 No corporate tax
IN THE ABSENCE OF CORPORATE
TAXES

Acc. To this theory total value of a firm must be constant

irrespective of degree of leverage, i.e. debt-equity ratio.
This can be justified by arbitrage process .
This approach is similar to the net operating income
approach when taxes are ignored
It means capital structure decision of a firm is not affect
its market value.
WHEN CORPORATE TAX ARE ASSUMED
TO EXIST

Acc. to this value of the firm increase and cost of capital

decrease with the use of debt if corporate tax are
considered. This is because of Benefit of tax because int.
on tax is deductible expense
Optimum capital structure

 Optimum capital structure is a capital

structure at which market value per
share is maximum and the cost of
capital is minimum
Quality of a sound capital
structure
Simplicity

flexibility

Minimum risk

Minimum cost of capital

Sufficient liquidity

Retaining control

Avoidance of unnecessary restriction

EBIT-EPS analysis
EPS = (EBIT-I)(I-t)-PD
n
Where :
EPS = earning per share
EBIT = earning before int. and tax
I = int. charged per annum
t = tax rate
PD = preference dividend
n = no. of equity shares
Q-ABC company has currently an all equity structure consisting of
15000 equity shares of rs.100 each. The management is planning
to raise another rs.25 lakhs to finance a major programme of
expansion and it consider three alternative method of financing
 To issue 25000 equity share of rs.100 each

 To issue 25000, 8% debenture of rs.100 each

 To issue 25000, preference share of rs.100 each

the company EBIT will be 8 lakhs. Assuming a corporate tax of

50%, determine earning per share in each alternative
 Alternative 1 equity Alternative 2 debt Alter. 3 pref. share
financing financing financing

EBIT 8.00 8.00 8.00

Less int. - 2.00 -
Earning after int. but 8.00 6.00 8.00
before tax
Less tax @50% 4.00 3.00 4.00
EAT 4.00 3.00 4.00
Less pref. dividend - - 2.00

E available to equity 4.00 3.00 2.00

shareholders

No. of equity share 40000 15000 15000

400000 300000 200000
EPS Rs.10 Rs.20 Rs.13.33
Reference
 Goel DK, Management accounting and financial
management, APC
 Gupta Shashi K., financial management and policy,
kalyani publication
Thank you