Capital Structure and its Theories

Bushra Shazli
• Financial planning and decision play a major role in the field of
financial management which consists of the major area of financial
management such as, capitalization, financial structure, capital
structure, leverage and financial forecasting.
• Financial planning includes the following important parts:
• ● Estimating the amount of capital to be raised.
• ● Determining the form and proportionate amount of securities.
• ● Formulating policies to manage the financial plan
• MEANING OF CAPITAL The term capital refers to the total investment
of the company in terms of money, and assets. It is also called as total
wealth of the company. When the company is going to invest large
amount of finance into the business, it is called as capital. Capital is
the initial and integral part of new and existing business concern.
• The capital requirements of the business concern may be classified
into two categories:
• (a) Fixed capital
• (b) Working capital.
• Fixed Capital Fixed capital is the capital, which is needed for meeting the
permanent or long-term purpose of the business concern. Fixed capital is
required mainly for the purpose of meeting capital expenditure of the
business concern and it is used over a long period. It is the amount
invested in various fixed or permanent assets, which are necessary for a
business concern
• Characteristics of Fixed Capital
• ● Fixed capital is used to acquire the fixed assets of the business concern.
• ● Fixed capital meets the capital expenditure of the business concern. ●
Fixed capital normally consists of long period.
• ● Fixed capital expenditure is of nonrecurring nature.
• ● Fixed capital can be raised only with the help of long-term sources of
finance
• Working Capital Working capital is the capital which is needed to
meet the day-to-day transaction of the business concern. It may cross
working capital and net working capital. Normally working capital
consists of various compositions of current assets such as inventories,
bills, receivable, debtors, cash, and bank balance and prepaid
expenses
• CAPITALIZATION Capitalization is one of the most important parts of
financial decision, which is related to the total amount of capital
employed in the business concern.
• Understanding the concept of capitalization leads to solve many
problems in the field of financial management. Because there is a
confusion among the capital, capitalization and capital structure.
• Meaning of Capitalization Capitalization refers to the process of
determining the quantum of funds that a firm needs to run its
business. Capitalization is only the par value of share capital and
debenture and it does not include reserve and surplus
• TYPES OF CAPITALIZATION Capitalization may be classified into the following three
important types based on its nature:
• Over Capitalization
• Under Capitalization
• Water Capitalization
Over Capitalization Over capitalization refers to the company which possesses an excess of
capital in relation to its activity level and requirements. In simple means, over capitalization
is more capital than actually required and the funds are not properly used.
Causes of Over Capitalization Over capitalization arise due to the following important
causes:
• Over issue of capital by the company.
• Borrowing large amount of capital at a higher rate of interest.
• Providing inadequate depreciation to the fixed assets.
• Effects of Over Capitalization
• Over capitalization leads to the following important effects:
• • Reduce the rate of earning capacity of the shares.
• • Difficulties in obtaining necessary capital to the business concern.
• • It leads to fall in the market price of the shares.
• • It creates problems on re-organization.
• • It leads under or misutilisation of available resources.
• Remedies for Over Capitalization Over capitalization can be reduced with the help
of effective management and systematic design of the capital structure. The
following are the major steps to reduce over capitalization. • Efficient
management can reduce over capitalization. • Redemption of preference share
capital which consists of high rate of dividend. • Reorganization of equity share
capital. • Reduction of debt capital
• Under Capitalization Under capitalization is the opposite concept of
over capitalization and it will occur when the company’s actual
capitalization is lower than the capitalization as warranted by its
earning capacity. Under capitalization is not the so called inadequate
capital.
• Causes of Under Capitalization Under capitalization arises due to the
following important causes: • Under estimation of capital
requirements. • Under estimation of initial and future earnings. •
Maintaining high standards of efficiency. • Conservative dividend
policy. • Desire of control and trading on equity
• Remedies of Under Capitalization
• Under Capitalization may be corrected by taking the following remedial
measures:
• 1. Under capitalization can be compensated with the help of fresh issue of
shares.
• 2. Increasing the par value of share may help to reduce under
capitalization.
• 3. Under capitalization may be corrected by the issue of bonus shares to
the existing
• shareholders.
• 4. Reducing the dividend per share by way of splitting up of shares.
• Watered Capitalization If the stock or capital of the company is not
mentioned by assets of equivalent value, it is called as watered stock. In
simple words, watered capital means that the realizable value of assets of
the company is less than its book value. Causes of Watered Capital
• Generally watered capital arises at the time of incorporation of a company
but it also arises during the life time of the business.
• The following are the main causes of watered capital:
• 1. Acquiring the assets of the company at high price.
• 2. Adopting ineffective depreciation policy.
• 3. Worthless intangible assets are purchased at higher price
Capital is the major part of all kinds of business activities, which are decided by the size,
and nature of the business concern. Capital may be raised with the help of various sources.
If the company maintains proper and adequate level of capital, it will earn high profit and
they can provide more dividends to its shareholders.
Meaning of Capital Structure
Capital structure refers to the kinds of securities and the proportionate amounts that make
up capitalization. It is the mix of different sources of long-term sources such as equity
shares, preference shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source
financing such as equity capital, preference share capital and debt capital. Deciding the
suitable capital structure is the important decision of the financial management becauseit
is closely related to the value of the firm.
Capital structure is the permanent financing of the company represented primarily by long-
term debt and equity.
• FINANCIAL STRUCTURE The term financial structure is different from the capital structure.
Financial structure shows the pattern total financing. It measures the extent to which total funds
are available to finance the total assets of the business
• 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.
• Objectives of Capital Structure
• 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
 Capital Gearing
It refers to the proportion of relationship
between equity share capital and other fixed
interest bearing funds.
common stockholder equity
Capital Gearing Ratio= ____________________________

Fixed cost bearing funds

 Types of Capital Gearing
• Highly Geared capital:- Equity capital, reserves and
surplus less then preference capital and fixed
interest bearing securities.
• Low Geared capital:- Equity capital, reserves and
surplus greater then preference capital and fixed
interest bearing securities.
• Equally Geared capital:- Equal proportion of Equity
and Debt.
Theories
• 2 school of Thoughts
 Capital Structure Theories/Approaches
1. Net Income Approach:- Given by David Durand.
Under this approach the value of firm increases or
cost of capital decreases by increasing the debt
proportion in capital structure.
Assumptions:
• There are no taxes.
• Cost of debt is less then cost of equity.
• Use of debt does not change the risk perception of
investors.
 Net Income (NI) Approach
The degree of leverage is plotted along the X-axis
where as Ke, Kw and
Kd are on Y- axis.
• It reveals that Ke and
Kd are independent to
Capital structure; they
remain constant regardless
Of how much debt the firm
Uses.
As a result overall cost of capital declines and
firm value increases with debt.
•This approach has no basis in reality; the
optimum capital structure would be 100%
debt financing under NI approach.

•Kd = Interest . = i .
Market value of debt D
2. Net Operating Income Approach:- Also
propounded by David Durrand.

•Under this approach changes in Capital

Structure does not affect the value of firm and
overall cost of capital remains constant
irrespective of the method of financing.
•There is no relation between capital structure
and Ko and V.
Assumptions:-
•Overall cost of capital remains unchanged for all
degrees of leverages.
• Cost of debt remains unchanged.
•There are no corporate taxes.
•The use of debt funds increases the received risk
of equity investors, thereby Ke increases.
•The market value of equity is residue i.e., total
value of the firm minus(-)market value of debt
•Cost of Capital (Ko) is constant.

•As the proportion of debt

Increases, (Ke) increases.

•No effect of total cost of

capital.
3. Modigliani and Miller Approach:- They have
given two approaches:-
➢ In the absence of Corporate Taxes.
➢ When Corporate Taxes Exists.

The Hypothesis was made under the

assumption of no corporate taxes and is
referred to as MM without taxes.
•In 1963, the corrected their research to show the
impact of including corporate taxes on the firm’s
value and is referred a MM with taxes.
•It supports the NOI approach which states that
capital structure is irrelevant and Ko is constant.
•The basic concept of MM hypothesis is that the
value of the firm is independent of its capital
structure and determined solely its investment
decisions.
Assumptions:-
• There is perfect competitive capital market.
• There are no retained earnings.
• The investors act rationally.
• The business consists of the same level of business risk.
• There are no transection cost.
• Cent-Percent distribution of the earnings to the
shareholders.
• No corporate tax, but later on in 1969 they removed
this assumption.
The MM hypothesis can be explained in terms of their
two propositions:-
• Proposition 1 states that, for firm in the same risk
class, the market value is independent of the debt –
equity mix and is given by capitalizing the expected
NOI by the capitalization rate appropriate to risk class.
• Investment in any kind of firm gives the same result
and what matters is the earnings generated.
 Arbitrage Process
Arbitrage is a technical term referring to a
situation where two identical commodities are
selling in the same market for different prices
then the market will reach equilibrium when
the dealers start buying at the lower price and
sell at the higher price thereby making profit.
• Suppose two identical firms, except for their capital
structures, have different market values. In this
situation Arbitrage or Switching will take place to
enable investors to engage in the personal leverage as
against the corporate leverage, to restore equilibrium in
the market.
• On the basis of Arbitrage process, MM conclude that
the market value of the firm is not affected by leverage.
Thus, the financing decision is irrelevant.
Proposition 2:- States that the cost of equity is a
linear function of the firm’s equity ratio.
•The rate of return required by shareholders
increases linearly as the debt equity ratio is
increased i.e., the cost of equity rise exactly in line
with any increase in gearing to precisely offset any
benefits conferred by the use of apparently cheap
debt.
•The cost of equity in the geared company is the cost
of equity in the ungeared company plus a premium
for financial risk.
4. Traditional Approach:- This Approach is given by
Ezra Solomon.
•Also known as intermediate approach, is a
compromise between the NOI and NI approach
• It states that cost of capital is the function of
leverage.
•Under this approach, the average cost of capital
curve is saucer or u-shaped and there is a point at
which the cost of capital is minimum. It also
represents optimum capital structure.
•This approach states that, Value of firm can be
increased or the cost of capital can be reduced by
judicious mix of debt and equity capital can
increase the value of firm by reducing overall cost
of capital up to certain level of debt.
•The value of firm can be increased initially by using
more debt but beyond a particular point the cost of
equity increases because increased debt increases
the financial risk of equity shareholders.
•Cost of capital is reduced
Initially.
•At a point it settles.
• After this point Ko increases,
due to increase in Ke.
Assumptions:-
•There are only two sources of funds (debt and
shares).
•100% payout ratio.
•The total assets are given and do not change.
•EBIT are not expected to grow.
•Business risk remains constant.
•The firm has a perpetual life.
•The investors behave rationally.
• The term "capital structure" refers to:
• a) long-term debt, preferred stock, and common stock equity.
• b) current assets and current liabilities.
• c) total assets minus liabilities.
• d) shareholders' equity.
• The term "capital structure" refers to:
• a) long-term debt, preferred stock, and common stock equity.
• b) current assets and current liabilities.
• c) total assets minus liabilities.
• d) shareholders' equity.
• A critical assumption of the net operating income (NOI) approach to
valuation is:
• a) that debt and equity levels remain unchanged.
• b) that dividends increase at a constant rate.
• c) that ko remains constant regardless of changes in leverage.
• d) that interest expense and taxes are included in the calculation.
• A critical assumption of the net operating income (NOI) approach to
valuation is:
• a) that debt and equity levels remain unchanged.
• b) that dividends increase at a constant rate.
• c) that ko remains constant regardless of changes in leverage.
• d) that interest expense and taxes are included in the calculation.
• The traditional approach towards the valuation of a company
assumes:
• a) that the overall capitalization rate holds constant with changes in
financial leverage.
• b) that there is an optimum capital structure.
• c) that total risk is not altered by changes in the capital structure.
• d) that markets are perfect
• The traditional approach towards the valuation of a company
assumes:
• a) that the overall capitalization rate holds constant with changes in
financial leverage.
• b) that there is an optimum capital structure.
• c) that total risk is not altered by changes in the capital structure.
• d) that markets are perfect
• Two firms that are virtually identical except for their capital structure
are selling in the market at different values. According to M&M
• a) one will be at greater risk of bankruptcy.
• b) the firm with greater financial leverage will have the higher value.
• c) this proves that markets cannot be efficient.
• d) this will not continue because arbitrage will eventually cause the
firms to sell at the same value
• Two firms that are virtually identical except for their capital structure
are selling in the market at different values. According to M&M
• a) one will be at greater risk of bankruptcy.
• b) the firm with greater financial leverage will have the higher value.
• c) this proves that markets cannot be efficient.
• d) this will not continue because arbitrage will eventually cause the
firms to sell at the same value
• The proposition that the value of the firm is independent of its capital
structure is called:
a) the capital asset pricing model.
b) MM Proposition I.
c) MM Proposition II.
d) the law of one price.
e) the efficient markets hypothesis
• The proposition that the value of the firm is independent of its capital
structure is called:
a) the capital asset pricing model.
b) MM Proposition I.
c) MM Proposition II.
d) the law of one price.
e) the efficient markets hypothesis
• The firm's capital structure refers to:
a) the way a firm invests its assets.
b) the amount of capital in the firm.
c) the amount of dividends a firm pays.
d) the mix of debt and equity used to finance the firm's assets.
e) how much cash the firm holds
• The firm's capital structure refers to:
a) the way a firm invests its assets.
b) the amount of capital in the firm.
c) the amount of dividends a firm pays.
d) the mix of debt and equity used to finance the firm's assets.
e) how much cash the firm holds
• A general rule for managers to follow is to set the firm's capital
structure such that:
a) the firm's value is minimized.
b) the firm's value is maximized.
c) the firm's bondholders are made well off.
d) the firms suppliers of raw materials are satisfied.
e) the firms dividend payout is maximized.
• A general rule for managers to follow is to set the firm's capital
structure such that:
a) the firm's value is minimized.
b) the firm's value is maximized.
c) the firm's bondholders are made well off.
d) the firms suppliers of raw materials are satisfied.
e) the firms dividend payout is maximized.
• A manager should attempt to maximize the value of the firm by:
a) changing the capital structure if and only if the value of the firm
increases.
b) changing the capital structure if and only if the value of the firm
increases to the benefits to inside management.
c) changing the capital structure if and only if the value of the firm
increases only to the benefits the debtholders.
d) changing the capital structure if and only if the value of the firm
increases although it decreases the stockholders' value.
e) changing the capital structure if and only if the value of the firm
increases and stockholder wealth is constant.
• A manager should attempt to maximize the value of the firm by:
a) changing the capital structure if and only if the value of the firm
increases.
b) changing the capital structure if and only if the value of the firm
increases to the benefits to inside management.
c) changing the capital structure if and only if the value of the firm
increases only to the benefits the debtholders.
d) changing the capital structure if and only if the value of the firm
increases although it decreases the stockholders' value.
e) changing the capital structure if and only if the value of the firm
increases and stockholder wealth is constant.