Capital Structure

The Capital Structure Decision in a

Firm’s Decision Making Chain
 Introduction
• Capital structure 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 sources financing
such as equity capital, preference share capital and
debt capital.
• Deciding the suitable capital structure is the
important decision of the financial management
because it 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
The company should select a capital structure,
which will help in attaining the objectives of
maximization of the shareholders wealth.

Value of the firm = EBIT

Overall Cost of Capital
Patterns Of Captial Structure

The capital structure of a company may

be of any one of the following four
patterns:
i) issuing only equity shares
ii) issuing equity and preference shares
iii) issuing equity and debentures
iv) issuing equity, preference and
debentures
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.
 FACTORS DETERMINING CAPITAL STRUCTURE

1. Trading on Equity- Trading on equity means taking

advantage of equity share capital to borrowed funds on
reasonable basis. It refers to additional profits that equity
shareholders earn because of issuance of debentures and
preference shares.

2. Degree of control- In a company, it is the directors who are

so called elected representatives of equity shareholders. These
members have got maximum voting rights in a concern as
compared to the preference shareholders and debenture
holders.
3. Flexibility of financial plan- In an enterprise,
the capital structure should be such that there is
both contractions as well as relaxation in plans.
Debentures and loans can be refunded back as the
time requires.
4. Capital market condition- In the lifetime of the
company, the market price of the shares has got an
important influence. During the depression period,
the company’s capital structure generally consists of
debentures and loans. While in period of boons and
inflation, the company’s capital should consist of
share capital generally equity shares
5. Period of financing- When company wants to
raise finance for short period, it goes for loans from
banks and other institutions; while for long period it
goes for issue of shares and debentures.

6. Cost of financing- In a capital structure, the

company has to look to the factor of cost when
securities are raised. It is seen that debentures at the
time of profit earning of company prove to be a
cheaper source of finance as compared to equity
shares where equity shareholders demand an extra
share in profits.
 8. Stability of sales- An established business which has a growing
market and high sales turnover, the company is in position to meet fixed
commitments. Interest on debentures has to be paid regardless of profit.
Therefore, when sales are high, thereby the profits are high and company
is in better position to meet such fixed commitments like interest on
debentures and dividends on preference shares. If company is having
unstable sales, then the company is not in position to meet fixed
obligations. So, equity capital proves to be safe in such cases.

 9. Sizes of a company- Small size business firms capital structure

generally consists of loans from banks and retained profits. While on the
other hand, big companies having goodwill, stability and an established
profit can easily go for issuance of shares and debentures as well as
loans and borrowings from financial institutions. The bigger the size, the
wider is total capitalization.
 OPTIMAL CAPITAL STRUCTURE

 Optimal capital structure refers to the combination of debt

and equity in total capital that maximizes the value of the
company. An optimal capital structure is designated as one at
which the average cost of capital is the lowest which
produces an income that leads to maximization of the market
value of the securities.
Value of the firm = EBIT
Overall Cost of Capital
 Features Of Optimal Capital Structure

a) The relationship of debt and equity in an optimal capital

structure is made in such a manner that the market value per
equity share becomes maximum.
b) Optimal capital structure maintains the financial stability of
the firm.
c) Under optimal capital structure the finance manager
determines the proportion of debt and equity in such a manner
that the financial risk remains low.
d) The advantage of the leverage offered by corporate taxes is
taken into account in achieving the optimal capital structure.
e) Borrowings help in increasing the value of company
leading towards optimal capital structure.
f) The cost of capital reaches at its minimum and market
price of share becomes maximum at
optimal capital structure
Capital Structure Theories
 Capital structure theories can be of two categories:
◦ Relevant theories
◦ Irrelevant theories

 The relevant view states that capital structure decisions

are relevant for firm value. They affect the value of the
firm.
 The irrelevance group theories state that the firm’s
capital structure does not affect its value. The firm’s
value is independent of its capital structure. The firm’s
value depends upon its investment decision rather than
its financing decisions.
 Assumptions of theories
 Only 2 kinds of funds: Debt and Equity
 Cost of Debt is less than Cost of Equity
 Total financing remains constant. i.e. one source can be
substituted for the other but there is no additional financing.
 The total assets of the organization remain constant.
 No corporate tax
 Dividend payout is 100%, no retention of funds.
 EBIT is given and not expected to grow
 Business risk remains constant
 Firm has perpetual life
Relevant Theories
◦ Net Income Approach
◦ Traditional Approach

Irrelevant Theories
◦ Net Operating Income
◦ Modigliani and Miller (MM) Approach
 Capital Structure Relevant Theories
THE NET INCOME (NI) APPROACH:
 The net income approach states that the capital structure of any
given firm creates an impact on the value of the firm.
 Thus capital structure is important as a determinant of a given
firm’s value.
 The significance of the NI approach is that a firm can lower its
overall cost of capital continuously by increasing the
proportion of cheaper debt capital in its capital.
 It leads to an increase in the total value of the firm. If this
process continues, the firm will be able to achieve the optimum
capital structure.
 The debt equity ratio of a firm affects its value and its stock
price. Therefore, the use of debt (leverage) creates an impact
both in the overall cost of capital (WACC, Ko) and the value of
the firm.
Assumptions
 Cost of debt is less than cost of equity
(Ki<Ke)
 Cost of debt remains constant
 Cost of equity remains constant
 Capital Structure Relevant Theories
(Contd)
Graphical representation of the net income approach:

As per NI approach, higher use of debt capital will result in reduction of

cost of capital. As a consequence, value of firm will be increased.
Capital Structure Relevant Theories (Contd)
THE TRADITIONAL VIEW
 The traditional view holds that there is an optimal capital
structure.
 At this optimum capital structure the weighted average cost of
capital (WACC) is minimized thereby maximizing the firm’s
market value.
 The traditional theory is in continuation with the views of the
net income approach.
 Like net income approach it argues that there exists benefit to
the firm as well as the shareholders of the firm that employs
high leverage/debt.
 However, the Traditional Approach is midway between the NI
and NOI approaches. It, in fact, adopts some features of both the
NI and NOI approaches. It compromise between the two
approaches, therefore it is known as Intermediate Approach
Capital Structure Relevant Theories (Contd)
Capital costs and the traditional approach to capital structure:

According to traditional approach, through judicious use of debt, the value of firm
increases and overall cost of capital decreases. The rationale behind it is debt are
cheaper source of finance than equity. But if debt equity ratio is further raised firm
would become more risky and investors demand higher equity returns hence ke
increases. But increase in ke may not be so high to neutralise the benefit of cheaper
debt. Hence benefit of cheaper debt is still available.
 Stage I:
 The first stage starts with introduction of debt in the firm’s capital structure. As a result of
the use of low cost debt the firm’s net income tends to rise; cost of equity capital (Ke)
rises with addition of debt but the rate of increase will be less than the increase in net
earnings rate. Cost of debt (Kd) remains constant. Combined effect of all these will be
reflected in increase in market value of the firm and decline in overall cost of capital (K0).
 Stage II:
 In the second stage further application of debt will raise costs of debt and equity capital so
sharply as to offset the gains in net income. Hence the total market value of the firm would
remain unchanged.
 Stage III:
 After a critical turning point any further dose of debt to capital structure will prove fatal.
The costs of both debt and equity rise as a result of the increasing riskiness of each
resulting in an increase in overall cost of capital which will be faster than the rise in
earnings from the introduction of additional debt. As a consequence of this market value of
the firm will tend to depress.
 The overall effect of these stages suggests that the capital structure decision has relevance
to valuation of firm and cost of capital. Up to favorably affects the value of a firm. Beyond
that point value of the firm will be adversely affected by use of debt.
Irrelevance of Capital Structure
The irrelevance group theories state that the
firm’s capitals structure does not affect its value.
The firm’s value is independent of its capital
structure.
The firm’s value depends upon its investment
decision rather than its financing decisions. Thus
financing and investment decision of the firm are
supposed to be independent of each other
 Net Operating Income (NOI)
Approach
 According to the net operating income approach, there is no optimal
capital structure for any firm.
 In other words, capital structure is irrelevant for a given firm.
 The financing decision does not affect the average cost of capital of
the company; and hence the total value of the firm remains unchanged
with changes in the debt proportion
 The use of higher debt component (borrowing) in the capital structure
increases the risk of shareholders. Increase in shareholders’ risk causes
the equity capitalization rate to increase, i.e. higher cost of equity (Ke).
 A higher cost of equity (Ke) nullifies the advantages gained due to
cheaper cost of debt (Kd ). This approach implies that there is no one
optimum capital structure as the cost of capital remains the same for all
debt-equity ratios
Assumptions:
 There are no corporate taxes.
 The cost of debt(Ki) remains constant.
 Cost of debt is less than cost of equity
(Ki<Ke)
 Debt increases, leverage increases. Ke
starts increasing if the value of debt
increase
 Net Operating Income Approach
Capital cost and financial leverage: net operating income
approach:

Under the NOI approach, the cost of equity, Ke, increases but the cost of debt,
Kd decreases the weighted average cost of capital, Ko, and the total value of
the firm, V all remain constant as leverage is changed. Thus the advantage of
having cheaper debt capital is lost to the company as there will be an offsetting
increasing in its cost of equity.
 The Modigliani-Miller (MM) Theory
The assumptions of the MM model:
 There are perfect capital markets, with perfect information available to all investors
and no transaction costs.
 The investors are rational.
 There is a zero-tax environment.
 Earnings are perpetual. Future earnings are known and definite.
 Investment decision are known and are definite.
 Only debt and equity are issued in case the firm needs funds and debt is riskless
 There are no costs of financial distress (A condition where a company cannot meet or
has difficulty paying off its financial obligations to its creditors) and liquidation. Under
liquidation condition the shareholders receive an amount equivalent to the market
value of their share before liquidation.
 Individuals can borrow as cheaply as corporations, i.e., r = k. if investors and firms
can borrow at same rate, then the investors can neutralize any capital structure
decision of the firm by creating home made leverage.
 There are no transaction costs in the arbitrage process.
The Modigliani-Miller (MM) Theory
(Contd)
The arbitrage argument:
 MM Proposition I states that firms of same risk class
have similar types of assets. Now firms having similar
types of assets will also have similar value.
 Their value will not be affected by their financing
decisions.
 They argue that there is no influence of the capital
structure of a firm on its cost of capital and market
value. In other words, the overall cost of capital and the
value of the firm are independent of the capital
structure.
 The Modigliani-Miller (MM) Theory
(Contd)
 According to MM approach if two companies under the same business
environment have the same EBIT but have different capital structure( one
may be levered and un levered) yet the value of the two firms will be equal.
 But if there is a small difference in the value, it will be for a temporary
period only. The investors will analyse the investment and returns they get
in two different companies. They would find some economic benefits if
they shift from high value firm to low value firm. The process of shifting
from one firm to the other is called arbitrage process
 MM in their model argued that arbitrage opportunities exist for the investor
in perfect capital markets under the assumption that the value of a firm is a
function of its financing decisions.
 MM refers to the arbitrage process with reference to valuation in terms of
two firms one who has used leverage and the other is unlevered. The
investors can switch from one firm to another for their benefit.
 Limitations of MM Approach:
 1.Perfect market conditions need not exist:
  All investors are not rational.
  Complete information may not be available to all
investors
  Transaction cost will exist
Flotation cost will exist.
 2. Investors may not like to borrow money for making
investment on securities.
 3. In practice the investors borrow money for the interest
rate which would definitely more than the company' s
borrowing rate.
 4.There need not be only equity and debentures for
financing. Preference shares will also exists.
 5.Taxes may exist.
 6.The total financing need not be constant
Cost of Equity as per MM Model
 Cost of equity depend upon three factors
◦ Overall Cost of Capital
◦ Cost of Debt
◦ Debt Equity Ratio

In MM Model, there is linear relationship between the cost of equity

and leverage (as measured by Debt/Equity ratio). When the leverage
is increased, the cost of equity will also increase as a result of
increase in financial risk. The benefit of increasing leverage is
completely offset by the increase in the cost of equity capital and
market value of the firm remains same.

Ke = Ko + (Ko – Kd)(Debt / Equity)

MM Approach
It was later criticized and its validity was
doubted. Hence they introduced the corporate
taxes to show that there is a tax shield and debt
is useful in increasing the EBIT level and
earnings of shareholder.
MM Model (Value of Levered and
Unlevered Firm) after incorporation of taxes
Value of the firm
Value of unlevered firm:
◦ Vu = EBIT (1-t) / Ko

Value of levered firm:

◦ VL = Vu + Debt x tax
Major factors to be considered planning
and designing capital structure

Profitability (EBIT-EPS Analysis)

Control
Flexibility
Risk
Liquidity (cash flow analysis)