FINANCIAL

MANAGEMENT
CAPITAL STRUCTURE
Its meaning, patterns of capital
structure, theories of capital
structure, factors determining capital
structure, difference between capital
structure and financial structure
SUBMITTED BY

MAHESH CHANDER
APG 12010012009
BBA (sem V)

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a
firm as long-term finance. The capital structure involves two decisions

Type of securities to be issued are equity shares, preference shares and long
term borrowings (Debentures).

Relative ratio of securities can be determined by process of capital gearing.

On this basis, the companies are divided into two1. Highly geared companies - Those companies whose proportion of equity
capitalization is small.
2.

Low geared companies - Those companies whose equity capital

dominates total capitalization.

For instance - There are two companies A and B. Total capitalization amounts
to be INR 200,000 in each case. The ratio of equity capital to total capitalization
in company A is INR 50,000, while in company B, ratio of equity capital is INR
150,000 to total capitalization, i.e., in Company A, proportion is 25% and in
company B, proportion is 75%. In such cases, company A is considered to be a
highly geared company and company B is low geared company.

OR
Capital structure describes how a corporation finances its assets. This structure
is usually a combination of several sources of senior debt, mezzanine debt and
equity. Wise companies use the right combination of senior debt, mezzanine
debt and equity to keep their true cost of capital as low as possible. Depending
on how complex the structure, there may in fact be dozens of financing sources
included, drawing on funds from a variety of entities in order to generate the
complete financing package. Capital structure is what describes the relationship
of these financing sources as they appear on the corporations balance sheet.

Examples

of capital sources that may be included in a corporations capital

structure are:
Working Capital

 Equity
Senior Debt
Mezzanine Debt

PATTERNS OF CAPITAL STRUCTURE

The composition of capital structure can be recalled as follows:
1. On the basis of sources of funds,

2.

Preference share capital

Equity share capital
Debenture capital
Long-term debt
Reserve and surplus
Current liability
Share premium
P/L account

On the basis of ownership capital,

Equity share capital
Preference share capital
Reserve and surplus

3.

On the basis of borrowed capital,

4.

Debenture capital
Long-term debts
Cash credit
Current liability

On the basis of cost of capital,

Fix cost of capital
Variable cost of capital

5.

On the basis of nature and type of capital,

Simple capital structure (when the capital structure is composed of
a single source for e.g. Equity capital including retained earnings )

 Complex capital structure (when the capital structure is composed

of more than one source not of identical nature for e.g. debenture,
preference share, current liabilities)

CAPITAL STRUCTURE THEORIES

1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure

This theory gives the idea for increasing market value of firm and decreasing
overall cost of capital. A firm can choose a degree of capital structure in which
debt is more than equity share capital. It will be helpful to increase the market
value of firm and decrease the value of overall cost of capital. Debt is cheap
source of finance because its interest is deductible from net profit before taxes.
After deduction of interest company has to pay less tax and thus, it will decrease
the weighted average cost of capital.
For example if you have equity debt mix is 50:50 but if you increase it as 20:
80, it will increase the market value of firm and its positive effect on the value
of per share.
High debt content mixture of equity debt mix ratio is also called financial
leverage. Increasing of financial leverage will be helpful to for maximize the
firm's value.

2nd Theory of Capital Structure

Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing
the financial leverage under NI approach. It means to change the capital
structure does not affect overall cost of capital and market value of firm. At each
and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure

Name of Theory = Traditional Theory of Capital Structure

This theory or approach of capital structure is mix of net income approach and
net operating income approach of capital structure. It has three stages
1st Stage
In the first stage which is also initial stage, company should increase debt
contents in its equity debt mix for increasing the market value of firm.
2nd Stage
In second stage, after increasing debt in equity debt mix, company gets the
position of optimum capital structure, where weighted cost of capital is
minimum and market value of firm is maximum. So, no need to further increase
in debt in capital structure.
3rd Stage
Company can gets loss in its market value because increasing the amount of
debt in capital structure after its optimum level will definitely increase the cost
of debt and overall cost of capital.

4th Theory of Capital Structure

Name of theory = Modigliani and Miller

MM theory or approach is fully opposite of traditional approach. This approach
says that there is not any relationship between capital structure and cost of
capital. There will not effect of increasing debt on cost of capital.
Value of firm and cost of capital is fully affected from investor's expectations.
Investors' expectations may be further affected by large numbers of other factors
which have been ignored by traditional theorem of capital structure

Factors Determining Capital Structure

1.

Trading on Equity- The word equity denotes the ownership of the

company. 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. It is based on the thought that if the rate of dividend on preference
capital and the rate of interest on borrowed capital is lower than the general

rate of companys earnings, equity shareholders are at advantage which

means a company should go for a judicious blend of preference shares,
equity shares as well as debentures. Trading on equity becomes more
important when expectations of shareholders are high.
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. Preference shareholders have reasonably
less voting rights while debenture holders have no voting rights. If the
companys management policies are such that they want to retain their
voting rights in their hands, the capital structure consists of debenture
holders and loans rather than equity shares.

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. While
equity capital cannot be refunded at any point which provides rigidity to
plans. Therefore, in order to make the capital structure possible, the company
should go for issue of debentures and other loans.

4.

Choice of investors- The Companys policy generally is to have different

categories of investors for securities. Therefore, a capital structure should
give enough choice to all kind of investors to invest. Bold and adventurous
investors generally go for equity shares and loans and debentures are
generally raised keeping into mind conscious investors.

5.

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 companys capital structure generally consists of debentures and loans.
While in period of boons and inflation, the companys capital should consist
of share capital generally equity shares.

6.

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.

7.

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.\

10. Legal Requirements-The structure of capital of a company is also

influenced by the statutory requirements. For instance, banking companies
have been prohibited by the Banking Regulation Act to issue any type of
securities except equity shares.

DIFFERENCE BETWEEN CAPITAL

AND FINANCIAL STRUCTURE
CAPITAL STRUCTURE

FINANCIAL
STRUCTURE

It refer to the permanent

financing of the company.

It refer to the way in which the

firms assets are financed

II

It comprise long-term debt and

shareholders funds but exclude
short-term borrowings

II

It comprises the total net worth

and all liabilities as concern

II
I

Capital structure treated as asset

structure depends on nature of
investment

II
I

Financial structure depends on

sources of capital

iv

In capital structure, there are 4

main items

iv

Long term liabilities : Current

Liabilities

Equity share capital : Pref. share

capital : Long term debt :
Retained earning
v

Financial Structure is the base of

capital structure. Whole capital
structure is the part of financial
structure.

In financial structure, there are 2

main items

There are lots of basis of

financial structure. Nature of
business, type of business,
investment requirement, long
term and working capital
requirement, cost of capital, and
leverage are its main factor which
affects it.