CAPITAL STRUCTURE

Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital structure
means the arrangement of capital from different sources so that the long-term funds
needed for the business are raised.

Thus, capital structure refers to the proportions or combinations of equity share capital,
preference share capital, debentures, long-term loans, retained earnings and other long-
term sources of funds in the total amount of capital which a firm should raise to run its
business.

IMPORTANCE OF CAPITAL STRUCTURE:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and
securities which, in turn, lead to increase in the value of the firm.

2. Utilization of available funds:

A good capital structure enables a business enterprise to utilize the available funds fully.
A properly designed capital structure ensures the determination of the financial
requirements of the firm and raise the funds in such proportions from various sources for
their best possible utilization.

3. Maximization of return:

A sound capital structure enables management to increase the profits of a company in

the form of higher return to the equity shareholders i.e., increase in earnings per share.
This can be done by the mechanism of trading on equity i.e., it refers to increase in the
proportion of debt capital in the capital structure which is the cheapest source of capital.
If the rate of return on capital employed (i.e., shareholders’ fund + long- term
borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said to
be trading on equity.

4. Minimization of cost of capital:

A sound capital structure of any business enterprise maximizes shareholders’ wealth

through minimization of the overall cost of capital. This can also be done by
incorporating long-term debt capital in the capital structure as the cost of debt capital is
lower than the cost of equity or preference share capital since the interest on debt is tax
deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising of
debt capital because, at the time of poor earning, the solvency is disturbed for
compulsory payment of interest to .the debt- supplier.

6. Flexibility:

A sound capital structure provides a room for expansion or reduction of debt capital so
that, according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:

A good capital structure does not allow the equity shareholders control on business to be
diluted.

FACTORS DETERMINING CAPITAL STRUCTURE

The following factors influence the capital structure decisions:

1. Risk of cash insolvency:

Risk of cash insolvency arises due to failure to pay fixed interest liabilities. Generally,
the higher proportion of debt in capital structure compels the company to pay higher rate
of interest on debt irrespective of the fact that the fund is available or not. The non-
payment of interest charges and principal amount in time call for liquidation of the
company.
2. Risk in variation of earnings:
The higher the debt content in the capital structure of a company, the higher will be the
risk of variation in the expected earnings available to equity shareholders. If return on
investment on total capital employed (i.e., shareholders’ fund plus long-term debt)
exceeds the interest rate, the shareholders get a higher return.

On the other hand, if interest rate exceeds return on investment, the shareholders may not
get any return at all.
3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of funds. It is the
price paid for using the capital. A business enterprise should generate enough revenue to
meet its cost of capital and finance its future growth. The finance manager should
consider the cost of each source of fund while designing the capital structure of a
company.
4. Control:
The consideration of retaining control of the business is an important factor in capital
structure decisions. If the existing equity shareholders do not like to dilute the control,
they may prefer debt capital to equity capital, as former has no voting rights.
5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity as sources of
finance is known as trading on equity. It is an arrangement by which the company aims at
increasing the return on equity shares by the use of fixed interest bearing securities (i.e.,
debenture, preference shares etc.).
6. Government policies:

Capital structure is influenced by Government policies, rules and regulations of SEBI and
lending policies of financial institutions which change the financial pattern of the
company totally. Monetary and fiscal policies of the Government will also affect the
capital structure decisions.
7. Size of the company:

Availability of funds is greatly influenced by the size of company. A small company

finds it difficult to raise debt capital. The terms of debentures and long-term loans are
less favourable to such enterprises. Small companies have to depend more on the equity
shares and retained earnings.
On the other hand, large companies issue various types of securities despite the fact that
they pay less interest because investors consider large companies less risky.

8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of different
types of investors will have to be kept in mind. For example, a poor or middle class
investor may only be able to invest in equity or preference shares which are usually of
small denominations, only a financially sound investor can afford to invest in debentures
of higher denominations.

A cautious investor who wants his capital to grow will prefer equity shares.

9. Flexibility:

The capital structures of a company should be such that it can raise funds as and when
required. Flexibility provides room for expansion, both in terms of lower impact on cost
and with no significant rise in risk profile.
10. Period of finance:

The period for which finance is needed also influences the capital structure. When funds
are needed for long-term (say 10 years), it should be raised by issuing debentures or
preference shares. Funds should be raised by the issue of equity shares when it is needed
permanently.

11. Nature of business:

It has great influence in the capital structure of the business, companies having stable and
certain earnings prefer debentures or preference shares and companies having no assured
income depends on internal resources.

12. Legal requirements:

The finance manager should comply with the legal provisions while designing the capital
structure of a company.

OPTIMAL CAPITAL STRUCTURE

Optimal capital structure is a financial measurement that firms use to determine the best
mix of debt and equity financing to use for operations and expansions. This structure
seeks to lower the cost of capital so that a firm is less dependent on creditors and more
able to finance its core operations through equity.

In general, the optimal capital structure is a mix of debt and equity that seeks to lower
the cost of capital and maximize the value of the firm. To calculate the optimal capital
structure of a firm, analysts calculate the weighted average cost of capital (WACC)
to determine the level of risk that makes the expected return on capital greater than
the cost of capital.
 THE DYNAMICS OF RISK-RETURN TRADEOFF
The graph below is a Risk-Return Trade off the graph. It shows the relationship
between these two variables while making an investment.

LOW RISK

The bottom-left corner of the graph shows that there is low return for low-risk financial
instruments. Government-issued bonds, for instance, US Treasuries, are considered to be
the lowest risk financial instruments because they are backed up by the federal
government. But due to the relatively non-speculative nature of the bonds, they have low
returns than bonds issued by corporations. In fact, while assessing the expected return of
instruments, the return on government bonds is considered to be the risk-free rate.

HIGH RISK

As we move along the upward sloping line in the graph, the risk rises and so does the
potential return. This is understandable as investors parting with their money for riskier
assets would demand better returns than a risk-free security; else they have no reason to
take that risk. This is the reason why the bonds issued by governments and corporations
for the same duration have different yields as with corporate bonds, there is also a default
risk priced into them which is not the case with federal bonds.
 THEORIES OF CAPITAL STRUCTURES

1. NET INCOME APPROACH

Net Income Approach was presented by Durand. The theory suggests increasing value of
the firm by decreasing the overall cost of capital which is measured in terms of Weighted
Average Cost of Capital. This can be done by having a higher proportion of debt, which
is a cheaper source of finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and
debts where the weights are the amount of capital raised from each source.

According to Net Income Approach, change in the financial leverage of a firm will lead
to a corresponding change in the Weighted Average Cost of Capital (WACC) and also
the value of the company. The Net Income Approach suggests that with the increase in
leverage (proportion of debt), the WACC decreases and the value of firm increases. On
the other hand, if there is a decrease in the leverage, the WACC increases and thereby the
value of the firm decreases.

ASSUMPTIONS OF NET INCOME APPROACH

Net Income Approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no sources of
finance like Preference Share Capital and Retained Earning.
 All companies have uniform dividend pay-out ratio.

 There is no flotation cost, no transaction cost and corporate dividend tax.

 Capital market is perfect, it means information about all companies are available
to all investors and there are no chances of over pricing or underpricing of
security. Further it means that all investors are rational. So, all investors want to
maximize their return with minimization of risk.
  All sources of finance are for infinity. There are no redeemable sources of finance.

2. Net Operating Income Approach

This approach was put forth by Durand and totally differs from the Net Income
Approach. Also famous as traditional approach, Net Operating Income Approach
suggests that change in debt of the firm or company or the change in leverage fails to
affect the total value of the firm/company. As per this approach, the WACC and the total
value of a company are independent of the capital structure decision or financial leverage
of a company.

ASSUMPTIONS OR FEATURES OF NET OPERATING INCOME APPROACH:

1. The overall capitalization rate remains constant irrespective of the degree of

leverage. At a given level of EBIT, the value of the firm would be “EBIT/Overall
capitalization rate”
2. Value of equity is the difference between total firm value less value of debt i.e.
Value of Equity = Total Value of the Firm – Value of Debt
3. WACC (Weightage Average Cost of Capital) remains constant; and with the
increase in debt, the cost of equity increases. An increase in debt in the capital
structure results in increased risk for shareholders. As a compensation of investing
in the highly leveraged company, the shareholders expect higher return resulting in
higher cost of equity capital.

TRADITIONAL APPROACH TO CAPITAL STRUCTURE:

The traditional approach to capital structure advocates that there is a right combination
of equity and debt in the capital structure, at which the market value of a firm is
maximum. As per this approach, debt should exist in the capital structure only up to a
specific point, beyond which, any increase in leverage would result in the reduction in
value of the firm.
ASSUMPTIONS UNDER TRADITIONAL APPROACH:

1. The rate of interest on debt remains constant for a certain period and thereafter
with an increase in leverage, it increases.
2. The expected rate by equity shareholders remains constant or increase gradually.
After that, the equity shareholders starts perceiving a financial risk and then from
the optimal point and the expected rate increases speedily.
3. As a result of the activity of rate of interest and expected rate of return, the WACC
first decreases and then increases. The lowest point on the curve is optimal capital
structure.

LEVERAGE

 Leverage refers to the use of debt (borrowed funds) to amplify returns from an
investment or project.
 Investors use leverage to multiply their buying power in the market.
 Companies use leverage to finance their assets: instead of issuing stock to raise
capital, companies can use debt to invest in business operations in an attempt to
increase shareholder value.

FINANCIAL GEARING
In financial management the term financial gearing (leverage) is used to describe the
way in which owners of the firm can use the assets of the firm to gear up the assets
and earnings of the firm. Employing debt allows the owner to control greater volume
of assets than they could if they invested their own money only. The higher the debt
equity ratio, the higher the firm equity and therefore the firm level of financial risk.
Financial risk occurs due to the higher proportion of financial obligations in the
firms cost structure. The degree to which the firm is financially geared can be
measured by the degree of financial gearing given by:
 % change∈ EPS
Degree of Financial Gearing (DFG) =
% change∈ EBIT

Q ( SP−VC ) −FC
DFG=
PD
Q ( SP−VC )−FC−I −
1−T

Where:

Q is the Quantity

SP is the selling price

VC is the variable cost

FC is the fixed cost

I is the interest

PD is the preferred dividend

T is the tax rate

OPERATING GEARING
Financial gearing is related to the proportion of fixed financial cost in the firm’s
overall cost structure. Operating gearing however relate to the proportion of fixed
operating cost in the firm’s overall cost structure. Operating gearing mainly considers
the relationship between changes in EBIT and changes in Sales. The degree to which
a firm is operationally geared can be measured as follows:

% Change ∈EBIT
D.O.G = % Change ∈Sales

Q(SP−VC)
DOG=
Q ( SP−VC ) −FC
 Where:

Q is the Quantity

SP is the selling price

VC is the variable cost

FC is the fixed cost

D.O.G. therefore measures the sensitivity or vulnerability of EBIT to changes in

Sales. It can also be used to measure Business Risk. If D.O.G is more than one, then
the business is operationally geared.

TOTAL GEARING
It’s possible to obtain an assessment of the firms total gearing by combining its
financial gearing and operating gearing so that the degree of total gearing (D.T.G)
is equal to degree of operating gearing (D.O.G) multiplied by degree of financial
gearing (D.F.G)

D.T.G = D.O.G × D. F.G

% Change ∈EPS
=
% Change ∈Sales

D.T.G. therefore measures the sensitivity (vulnerability) of EPS to changes in

company’s Sales.

ILLUSTRATION
The following data is available for Firm A
 Firm A
Quantity 20,000 units
Selling price Sh. 20
Variable cost Sh. 15
Fixed cost Sh. 40,000
Interest Sh. 10,000
Preferred dividend Sh. 5,000
Tax rate 30%

Required:
i. Degree of operating leverage
ii. Degree of financial leverage
iii. Degree of total leverage
iv. Overall breakeven point

Solution
i. Degree of operating leverage =
Q(SP−VC ) 20,000(20−15) 100,000
= = =1.67
Q ( SP−VC )−FC 20,000 ( 20−15 )−40,000 60,000

ii. Degree of financial leverage =

Q ( SP−VC )−FC 20,000 ( 20−15 )−40,000 60,000
= = =1.4
PD 5,000 42,857.1429
Q ( SP−VC )−FC−I − 20,000 ( 20−15 ) −40,000−10,000−
1−T 1−0.3

iii. Degree of total leverage = D .O . L× D . F . L=1.67 × 1.4=2.338

FC+ I 40,000+10,000
iv. Overall breakeven point =
SP−VC
= 20−15
=10,000 Units