CHAPTER 6

CAPITAL STRUCTURE

Graham, Steve, Rob Brown

Seventh Edition
 INTRODUCTION
• At the time of preparing financial plan, not only
the capitalization is determined but the nature
and type of the capital is also decided. In the
capital structure decision, it is determined from
which sources and how much finance should be
raised. Thus under capital structure we
determine the proportion in which capital
should be raised from different securities.
 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.”
• Capital structure refer to the proportion between
the various long term source of finance in the total
capital of firm
• Management should determine the capital
structure in such a manner that the cost of capital
of the firm is minimum and the value to the
shareholder is maximum.
• The value of the firm to shareholder is maximum
when the market price of the ordinary shares is
maximum.
• The capital structure of the firm can have the
following pattern:
 To acquire the funds only by issuing ordinary
shares
 To acquire the funds by issuing preference
shares.
 To acquire the funds only by issuing equity
shares, preference 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.
 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
capitalization 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