CAPITAL STRUCTURE

According to Gerestenbeg, “Capital structure of a

company refers to the composition or make-up of
its capitalisation and it includes all long-term
capital resources viz : loans, reserves, shares and
books.”
The capital structure is made up of debt and
equity securities and refers to permanent
financing of a firm. It is composed of long-term
debt, preference share capital and shareholder’s
funds.
FORMS/PATTERNS OF CAPITAL
STRUCTURE
Equity
Shares
only

Equity
Shares,
Equity and
A new
Preferences company Preferenc
Shares and consists of: es shares
Debentures

Equity
Shares and
Debentures
IMPORTANCE OF CAPITAL STRUCTURE
The term capital structure refers to the
relationship between the various long-term forms
of financing such as debentures, preference share
capital & equity share capital. The use of long-
term fixed interest bearing debt & preference
share capital along with equity shares is called
financial leverage or trading on equity. This debt
is employed by a firm to earn more from the use
of these sources then their cost so as to increase
the return on owners equity.
FINANCIAL BREAK-EVEN POINT
Financial break even point may be defined as
that level of EBIT which is just equal to pay the
total financial charges, i.e. interest and
preference dividend. At this point EBIT = 0. If
EBIT< financial break even point, the EPS shall
be –ve. If EBIT exceeds the financial break
even point, more of such fixed cost funds may
be inducted in the capital structure. The
financial break even point can be calculated
as:
(a) When the capital structure consists of equity
share capital and debt only no preference share
capital is employed:
Financial Break Even Point = Fixed Interest
Charges
(b) When capital structure consists of equity share
capital, preference share capital and debt:
Financial Break Even Point = I+ Dp
(1-t)
Where, I= Fixed Interest Charges
Dp= Preference Dividend
t= Tax Rate
 POINT OF INDIFFERENCE AND
UNCOMMITED EARNINGS PER SHARE
Point of indifference refers to that EBIT level at
which earnings per share(EPS) remains the
same irrespective of different alternatives of
debt-equity mix. However, sinking fund
appropriations for redemption of debt
decrease the amount of earnings available for
equity shareholders.
The equivalency point for uncommitted earnings per
share can be calculated as below:
(X-I) (1-T)- PD- SF = (X-I) (1-T)- PD- SF
Where,
X= Equivalency point or point of indifference or break
even EBIT level.
I= Interest under alternative financial plan1.
I= Interest under alternative financial plan2.
T= Tax rate.
PD= Preference dividend.
SF= Sinking fund obligations.
S= Number of equity shares or amount of share capital
under plan1.
S== Number of equity shares or amount of share capital
under plan2.
 OPTIMAL CAPITAL STRUCTURE
The capital structure is said to be an optimal
capital structure when a company selects such a
mix of debt and equity which:
(a) Minimises the overall cost of capital;
(b) Maximises the earning per share(EPS);
(c) Maximises the value of company;
(d) Maximises the market value of the company’s
equity shares;
(e) Maximises the wealth of the shareholders.
 RISK- RETURN TRADE OFF
The financial or capital structure decision of a
firm to use a certain proportion of debt or
otherwise in the capital mix involves two
types of risk:
(a) Financial Risk:
(b) Non-Employment of Debt Capital (NEDC)
Risk:
1. Financial Risk: The financial risk arises on
account of the use of debt or fixed interest
bearing securities in its capital. A company
with no debt financing has no financial risk.
The extent of financial risk depends on the
leverage of the firms capital structure.
2. Non-employment of Debt Capital(NEDC)
Risk: The NEDC risk has an inverse
relationship with the ratio of debt in its total
capital. Higher the debt-equity ratio or the
leverage, lower is the NEDC risk and vice
versa.
 CAPITAL STRUCTURE DECISIONS

DEBT-EQUTY MIX

NON-EMPLOYMENT OF DEBT
FINANCIAL RISK
CAPITAL(NEDC) RISK

RISK-RETURN TRADE OFF

MARKET-VALUE OF TE FIRM

(RISK-RETURN TRADE OFF)

THEORIES OF CAPITAL STRUCTURE
The main contributors to the theories are
Durand, Ezra, Solomon, Modigliani and Miller.
The important theories are:
1. Net Income Approach.
2. Net Operating Income Approach.
3. The Traditional Approach.
4. Modigliani and Miller Approach.
1. Net Income Approach:
This approach has been developed by
Durand. The main findings are:
 Capital structure decisions are relevant to
the valuation of the firm: According to Net
Income Approach, if a firm makes any change
in its capital structure, it will cause a
corresponding change in the overall cost of
capital as well as the total value of the firm.
Thus, the capital structure decisions are
relevant to the valuation of the firm.
Increased use of debt will increase the
shareholders’ earning: According to this
approach a firm can increase its total value(V)
and lower the overall cost of capital
(Ko) by increasing the proportion of debt in its
capital structure. In other words, the
increased use of debt will cause increase in
the value of the firm as well as in the earnings
of the shareholders. As a result, the market
value of equity shares of the company will also
increase.
 ASSUMPTIONS
(a) Capital structure consists of debt and equity.
(b) Cost of debt is less than cost of equity
(i.e. Kd<Ke).
(c) Cost of debt remains constant for all levels of
debt to equity.
(d) The use of debt content does not change the
risk perception of investors.
CALCULATION OF THE VALUE OF THE
FIRM
According to Net Income Approach the value
of the firm can be ascertained as follows:
V = S+ D
where, V= Value of the firm
S= Market value of equity=Earnings
available for equity shareholders/ Equity
capitalisation rate.
D= Market value of debt.
CALCULATION OF OVERALL COST OF
CAPITAL
According to Net Income Approach the overall
cost of capital can be calculated as follows:
(Ko) = EBIT X 100
v
where, (Ko)= Overall cost of capital
EBIT= Earnings before interest and tax
V= Value of firm
 2. NET OPERATING INCOME (NOI)
APPROACH
Another theory of capital structure, suggested
but Durand, is the Net Operating Income
approach. This approach is simply opposite to the
Net Income approach. The main findings are:
 Capital structure decisions are irrelevant to the
valuation of the firm: According to Net Operating
Income approach, the capital structure decisions
are irrelevant to the valuation of the firm. Thus, if
a firm makes any change in its capital structure, it
will not affect the total value of firm.
Increased use of debt will increase the
financial risk of the shareholders: The
increased use of debt in the capital structure
would lead to an increase in the financial risk
of the equity shareholders. To compensate for
the increased risk, the shareholders would
expect a higher rate of return and hence the
cost of equity will increase. Thus the
advantage of use of debt is offset exactly by
the increase in the cost of equity.
 ASSUMPTIONS
(a) The market capitalises the value of firm as a
whole.
(b) Cost of debt (Kd) is constant.
(c) Increases use of debt increases the financial
risk of equity shareholders which, in turn,
raises the cost of equity (Ke).
(d) Overall cost of capital (Ko) remains constant
for all levels of debt equity mix.
(e) There is no corporate income tax.
 Various calculation under Net Operating Income
approach are explained below:
1. Value of Firm (V):
V = EBIT
Ko
where, V = Value of firm
EBIT= Earnings before interest ant tax
(Ko)= Overall cost of capital

2. Market Value of Equity (S):

S =V–D
where, S= Market value of equity
V= Value of firm
D = Market value of debt.
3. Cost of Equity Capitalisation Rate: the
increased use of debt in the capital structure
would lead to an increase in the financial risk
of the equity shareholders. To compensate for
the increased risk, the shareholders would
expect a higher rate of return and hence the
cost of equity will increase.
Cost of Equity (Ke) or Equity Capitalisation
Rate =
Earnings available for equity shareholders
Market value of equity (S) X 100.
3. THE TRADITIONAL APPROACH
Traditional approach also known as intermediate approach Is a
mix of both the net income approach and the net operating
income approach. According to this approach, the prudent
use of debt equity mix can lower the firm’s overall cost of
capital and thereby increase its market value.
This approach states that initially a firm can increase its value
of reduce the overall cost of capital by using more debt.
However, the increase in the value of firm or reduction in the
overall cost of capital is possible only up to a particular level
of debt equity mix. Beyond that level, the value of firm start
declining and the cost of capital start increasing.
Thus, the manner in which the value of firm and the cost of
capital reacts to change in capital structure can be divided
into 3 stages as follow:
Stage 1: Increase in the value of firm and
decrease in the cost of capital
In the first stage, both the cost of debt and
cost of equity remain constant. As a result, the
increased use of debt in the capital structure
will cause increase in the value of firm and
decrease in the overall cost of capital. This is
based on the assumption that cost of debt is
less than cost of equity (i.e. Kd< Ke).
Stage 2: Optimal debt equity mix
In the second stage, the firm reaches at an
optimal level. Optimal level means the ideal
debt equity mix, which minimises the cost of
capital and maximises the value of the firm.
Stage 3: Decrease in the value of firm and
increase in the cost of capital
In the third stage the value of firm start
declining and the cost of capital start
increasing. This happens because use of debt
beyond optimal level will increase the risk of
investors, so both Kd and Ke will rise sharply.
 4. MODIGLIANI AND MILLER (MM)
APPROACH
Part I: If there are no corporate taxes:
Modigliani and Miller argue that in the absence of
corporate taxes, the capital value of the firm (V) and the
overall cost of capital (Ko) is not affected but changes in
capital structure. In other words, debt equity mix is
irrelevant in the determination of the total value of the
firm. The reason argued is that the increased use of debt in
the capital structure would lead to an increase in the
financial risk of equity shareholders. To compensate for the
increased risk, the shareholders would expect a higher rate
of return and hence the cost of equity will increase. Thus
the advantage of use of cheaper source of finance (i.e.
debt) is offset exactly by the increase in the cost of equity.
Assumptions: MM approach is based upon the
following assumptions:
There is a perfect capital market.
Companies distributes all earnings to the
shareholders.
Business risk is same among all firms.
Investors are rational and choose a
combination of risk and return that is most
beneficial to them
Part II: If there are corporate taxes:
According to MM Approach, if there are
corporate taxes, the total value of the firm (V)
and the overall cost of capital (Ko) will be
affected by changes in capital structure.
According to this approach a firm can increase
its total value (V) and lower the overall cost of
capital (Ko) by increasing the proportion of
debt in its capital structure.
Calculation of Value of Firm (V):
When taxes are applicable to corporate
income, the value of firm is determined by the
following formulas suggested by MM.
Value of Unlevered Firm (Vu) = EBIT(1-t)
Ke
Value of Levered Firm (VL) = Vu + (D X T)
[where, D= Debt. t = Tax rate]
 ESSENTIAL FEATURES OF A SOUND /
OPTIMAL CAPITAL MIX
 Maximum possible use of leverage.
 The capital structure should be flexible so that it can be easily
altered.
 To avoid undue financial/business risk with the increase of debt.
 The use of debt should be within the capacity of a firm. The firm
should be in a position to meet its obligations in paying the loan
and interest charges as and when due.
 It should involve minimum possible risk of loss of control.
 It must avoid undue restrictions in agreement of debt.
 It should be easy to understand and simple to operate to the extent
possible.
 It should minimise the cost of financing and maximise earnings per
share.
 FACTORS DETERMINING THE CAPITAL
STRUCTURE

1. Financial Leverage or Trading on Equity 10. Capital Market Conditions

2. Growth and Stability of Sales 11. Assets Structure

3. Cost of Capital 12. Purpose of Financing

4. Risk 13. Period of Finance

5. Cash Flow Ability to Service Debt 14. Costs of Floatation

6. Nature and Size of a Firm 15. Personal Considerations

7. Control 16. Corporate Tax Rate

8. Flexibility 17. Legal Requirements

9. Requirements of Investors
 PRINCIPLES OF CAPITAL
STRUCTURE DECISIONS

Cost Risk Control Flexibility Timing

Principle Principle Principle Principle Principle
 CAPITAL GEARING
A company can raise finance by issuing three types of
securities- (i) Equity Shares, (ii) preference Shares, (iii)
Debentures. Equity shares are considered as variable return
securities because the dividend on equity shares is not
fixed and may vary from year to year. On the other hand,
preference shares and debentures are considered as fixed
return securities because the dividend/interest on
preferences shares/debentures is always fixed. The use of
preference share capital and debentures along with the
equity share capital in the capital structure with a view to
increase earnings available to equity shareholders is known
as “capital gearing” or “trading on equity”. Thus, the term
capital gearing refers to the proportion between equity
shareholders funds and fixed interest bearing securities.
Formula:
Capital gearing = Equity Shareholders Funds
(Equity Share Capital+ Reserves& Surplus)
Preference Share Capital + Long Term Debt
(Debentures).
Alternatively,
Capital Gearing Ratio =
Equity Shareholders Funds
Total Capitalisation (Eq. Share Capital + Pref.
Share Capital + Debentures) X 100
 SIGNIFICANCE OF CAPITAL GEARING
Capital gearing has a direct impact on the earnings available
or equity shareholders. Hence the fixation of a proper ratio
between two or more types of securities is essential for
maximising the earnings available for equity shareholders.
(1) Trading on equity:
The use of fixed income bearing securities along with
equity with a view to increase earnings available to equity
shareholders is known as “trading on equity”. The benefits
of trading on equity is enjoyed by the company only if the
rate of earnings of the company is higher than the fixed
interest/dividend charges. Thus, capital gearing helps in
generating additional profits for the equity shareholders
at the expense of other forms of securities.
(2) Retention of Control:
Equity shareholders are considered to be the real
owners of the company. They enjoy voting rights
and participate in decision making process. If a
company needs funds for expansion it can
exercise various options for raising finance.
However, if the existing shareholders do not want
to dilute control over the company, the company
should prefer funds to be raised by issue of
preference shares or debentures. This is because
the preference shareholders and debentures-
holders are not given any voting rights and as up
o a certain level they also do not participate in
decision making process of the company.
(3) Trade Cycles:
In order to improve profitability as well as
financial position, the companies usually
follow the policy of low gearing during
depression period and the policy of high
gearing during boom period.
CAPITAL GEARING AND TRADE CYCLES
The effect of high and low gearing on the financial
position of a company during various phases of
trade cycles are:
(1) During Boom Period:
During boom period, the return on investments
(ROI) of the company is usually higher than the
fixed rate of interest/dividend prevailing on
debentures/preference shares. Thus, during
boom period, the company should follow the
policy of high gearing. This will improve the EPS
as well as the financial position of the company.
(2) During Depression Period:
During depression period, the rate of earnings of the
company is usually lower than the fixed rate of
interest/dividend prevailing on debentures/preference
shares. Hence, it becomes difficult for the company to
pay fixed costs of debentures and preference shares.
Thus, during depression period, the company should
follow the policy of low gearing otherwise both the
earnings per share (EPS) as well as the financial
position of the company will suffer adversely.
 REASONS FOR CHANGES IN
CAPITALISATION
To Capitalise
To Write –off
Retained
the Deficit
Earnings To Clear
To Fund
Default on
Current
Fixed Cost
Liabilities
Securities

To Suit To Fund
Investors Accumulated
Needs Dividends

To Simplify To Facilitate
the Capital Merger and
Structure Expansion

To restore
To Meet Legal
Balance In REASONS Requirements
Financial Plan
Thank You !!!