CHAPTER SIX

CAPITAL STRUCTURE
Learning Objectives:
After completing this chapter, you will be able to:
• Define capital structure with reference to the basic typical-types.
• Analyse the effects of capital structure on financial risk with business
risk assumed constant.
• Pin-point the linkage of capital structure, risk, return and value, and
• Describe the important factors to be considered in determining the
capital structure.
• Planning the capital structure is one of the complex areas of financial decision making
because of the interrelationships among components of the capital structure and also its
relationship to risk, return and value of the firm.
• Capital structure refers to the kinds of securities and the proportionate amounts that make
up capitalization.
• Hence, Capital structure is defined as the process of mix of long-term debt and equity
maintained by the firm.
• Deciding the suitable capital structure is the important decision of the financial
management because it is closely related to the value of the firm.
Optimum capital structure
• Optimum capital structure is the capital structure at which the weighted average
cost of capital is minimum and thereby the value of the firm is maximum.
• Optimum capital structure may be defined as the capital structure or combination of
debt and equity that leads to the maximum value of the firm.
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
• Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and long term bonds
• Equity shares, preference shares and bond.
Factors determining capital structure
The following factors are considered while deciding the capital structure of the firm.
Leverage
It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing
such as debt, equity and preference share capital. It is closely related to the overall cost of capital.
 Leverage: It is the basic and important factor, which affect the capital structure. It uses the
fixed cost financing such as debt, equity and preference share capital. It is closely related to
the overall cost of capital.
Cost of Capital: When the cost of capital increases, value of the firm will also decrease.
Hence the firm must take careful steps to reduce the cost of capital.
Nature of the business: Use of fixed interest/dividend bearing finance depends upon the
nature of the business. If the business consists of long period of operation, it will apply for
equity than debt, and it will reduce the cost of capital.
Size of the company: It also affects the capital structure of a firm. If the firm belongs to
large scale, it can manage the financial requirements with the help of internal sources. But if
it is small size, they will go for external finance. It consist high cost of capital.
Legal requirements: are also one of the considerations while dividing the capital structure
of a firm. For example, banking companies are restricted to raise funds from some sources.
Requirement of investors: In order to collect funds from different type of investors, it will
be appropriate for the companies to issue different sources of securities.
Government policy: Promoter contribution is fixed by the company Act. It restricts to
mobilize large, long term funds from external sources. Hence the company must consider
government policy regarding the capital structure.
• Capital structure is the major part of the firm’s financial decision which affects the value
of the firm and it leads to change EBIT and market value of the shares.
• There is a relationship among the capital structure, cost of capital and value of the firm.
• The aim of effective capital structure is to maximize the value of the firm and to reduce
the cost of capital.
There are four major theories explaining the relationship between capital structure,
cost of capital and value of the firm.
Net Income (NI) Approach
• Net income approach suggested by the Durand, According to this approach, the capital
structure decision is relevant to the valuation of the firm. In other words, a change in the
capital structure leads to a corresponding change in the overall cost of capital as well as
the total value of the firm.
• According to this approach, use more debt finance to reduce the overall cost of capital
and increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.
Market value of the equity can be ascertained by the following formula:
S = NI
Kc
Where
S = Market value of equity
NI = Earnings available to equity shareholder
KC= Cost of equity/equity capitalization rate
Illustration
(a) A Company expects a net income of Br. 100,000. It has Br. 250,000, 8% bond. The equality
capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization
rate according to the net income approach (ignoring income tax).
(b) If the bond debts are increased to Br. 400,000. What shall be the value of the firm and the overall
capitalization rate?
Thus, it is evident that with the increase in debt financing, the value of the firm has
increased and the overall cost of capital has decreased.
Net Operating Income (NOI) Approach
• Is another modern theory of capital structure, suggested by Durand.
• This is just the opposite of the Net Income approach.
• According to this approach, Capital Structure decision is irrelevant to the valuation of the firm.
• The market value of the firm is not at all affected by the capital structure changes. Hence, the
change in capital structure will not lead to any change in the total value of the firm and market
price of shares as well as the overall cost of capital.
• NI approach is based on the following important assumptions;
• The overall cost of capital remains constant;
• There are no corporate taxes;
• The market capitalizes the value of the firm as a whole
Value of the firm (V) can be calculated with the help of the following formula:
V = EBIT
Kc
Where,
V = Value of the firm
EBIT = Earnings before interest and tax
Kc = Overall cost of capital
 Illustration
XYZ expects a net operating income of Br. 200,000. It has 800,000, 6% bond. The overall capitalization rate
is 10%. Calculate the value of the firm and the equity capitalization rate (Cost of Equity) according to the net
operating income approach. If the bond debt increased to Br.1,000,000. What will be the effect on volume of
the firm and the equity capitalization rate?
Solution
Net operating income = Br. 200,000
Overall cost of capital = 10%
Market value of the firm (V) = EBIT
Kc
= 200,000×100 = Br. 2,000,000
10
Market value of the firm =Br. 2,000,000
Less: market value of bond = Br. 800,000
1,200,000
Ke = EBIT-I
V-D
V= Value of the firm
D= Value of debt of capital
200,000 – 48,000 x 100
2,000,000 - 800,000
=12.67%
If the debentures bond debt is increased to Br. 1,000,000, the value of the firm shall remain
changed to Br. 2,000,000. The equity capitalization rate will increase as follows b/c the
firm value constant
= EBIT- I
V-D
= 200,000 – 60,000
2,000,000- 1,000,000 ×100
= 140,000
1,000,000 ×100
= 14%.
Traditional Approach
• It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach.
• According to the traditional approach, mix of debt and equity capital can increase the value of
the firm by reducing overall cost of capital up to certain level of debt.
Assumptions
Capital structure theories are based on certain assumption to analysis in a single and convenient
manner:
• There are only two sources of funds used by a firm; debt and shares.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.
Illustration
Awash Agro industry PLc. needs Br. 3,000,000 for the installation of a new factory. The
new factory expects to yield annual earnings before interest and tax (EBIT) of Br.500, 000.
In choosing a financial plan, Awash Agro PLC., has an objective of maximizing earnings
per share (EPS). The company proposes to issuing ordinary shares and raising debit of Br.
300,000 and Br.1, 000,000 of Br. 1,500,000. The current market price per share is Br. 250
and is expected to decrease to Br. 200 if the funds are borrowed in excess of Br. 1,200,000.
Funds can be raised at the following rates.
–up to Br. 300,000 at 8%
–over Br. 300,000 to Br. 1, 500, 000 at 10%
–over Br. 1,500,000 at 15%
Assuming a tax rate of 50% advice the company
Solution
Earnings before Interest and Tax (BIT) less Interest Earnings before Tax less: Tax@50%.
Alternatives
I II III
(Br. 300,000 debt). (Br. 1,000,000 debt (Br. 1,500,000 debt)
EBIT 500,000 500,000 500,000
interest 24,000 100,000 225,000
EBT 476,000 400,000 275,000
tax 238,000 200,000 137,500
EAIT 238,000 200,000 137,500
Equity 2,700,000 2,000,000 1,500,000
MKT price 250 250 200
No of shares 10800 8,000 7,500
EAIT 238,000 200,000 137,500
No. of shares 10,800 8,000 7,500
Earnings per share 22.03 25 18.33
The security alternative which gives the highest earnings per share is the best. Therefore, the company is advised
to revise Br. 1,000,000 through debt amount and Br. 2,000,000 through ordinary shares.
Modigliani and Miller Approach
Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a
firm in a perfect capital market. In other words MM approach maintains that the average cost of capital does not
change with change in the debt weighted equity mix or capital structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
⚫ Capital markets are perfect and investors are free to buy, sell, & switch between securities. Securities are
infinitely divisible.
⚫ Investors can borrow without restrictions at par with the firms.
⚫ Investors are rational & informed of risk-return of all securities
⚫ No corporate income tax, and no transaction costs.
⚫ 100 % dividend payout ratio, i.e. no profits retention
 EBIT
Kc Where
EBIT = Earnings before interest and tax
Kc = Overall cost of capital
t= Tax rate
Illustration
There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any
debt in its financing, while B has Br. 250,000 , 6% bond in its financing. Both the firms have
earnings before interest and tax of Br. 75,000 and the equity capitalization rate is 10%.
Assuming the corporation tax is 50%. Calculate the value of the firm.
Solution
The market value of firm A which does not use any debt
Vu= EBIT= 75,000 =75,000×100/10
Ko 10/100 = Rs. 750,000
Concept and practical question
1. 1. Define capital structure.
2. What is optimum capital structure?
3. Discuss the various factors affecting the capital structure.
4. Explain the capital structure theories and suggest your idea.
5. Which types of capital structure theory is more relevant acceptable by business. Illustrate
critically and clearly by using a model example.
THE END