C A P IT A L  S T R U C T U R E
C O N C E P T  O F  C A P IT A L
Capital
Funds raised from long-
term sources of
financing viz. long-term
debt, preferred stock and
common equity.
Debt Capital
Debt or borrowed capital
is long-term fund raised
from bond/debenture or
long-term loan.
Equity Capital
Equity capital is the long-
term fund provided by
the owner of the
company.
C A P IT A L  S T R U C T U R E  A N D  F IN A N C IA L  S T R U C T U R E
Capital Structure
Capital structure is the
composition of long-term
debt, preferred stock and
common equity.
  
The basic goal of a firm is to maximize the value of the firm or shareholder’s wealth. To
achieve this goal, the company should have sound investment and financing policy.
Company should acquire current assets such as inventory, marketable securities, etc. and
fixed assets such as land and building, plant and machinery, equipments, vehicles etc. To
finance these assets, a firm can use various sources of financing. These sources of
financing may be short term, and long term. Short-term sources of financing mature within
one year or less whereas fund raised from long-term sources of financing can be used for
several years or for ever. Thus, when a firm expands its business or activity, it needs
capital. The term capital denotes the long-term funds of the firm raised from long-term
debt, preferred stock and common equity. All of the items on the liabilities side of firm's
balance sheet, excluding current liabilities, are sources of capital. The total capital can be
divided into two components: debt/borrowed capital and equity/ownership capital.
Debt capital includes all long term borrowing incurred by the firm. Debenture/ bonds,
long-term loan etc. are major sources of debt or borrowed capital. A firm employs
substantial amount of debt capital because of tax deductibility of interest payment,
flexibility, and lower effective cost. However excess amount of debt exposes greater risk.
Equity capital consists of the long-term funds provided by the firm’s owners, the
stockholders. In other words, equity capital includes common stock, paid in capital (or
share premium), reserve and surplus, and retained earnings. Joint Stock Company cannot
be established without equity financing. In Nepal, the promoters must hold at least one
share for the incorporation of Joint Stock Company in accordance with Company Act 2063.
Preferred stock is neither it is purely a debt nor equity. Since it contains the characteristics
of both debt and equity, it is said to be a hybrid security. So there is no unanimous practice
about the treatment of preferred stock. However, it is said to be equity from legal point of
view since the company is not obliged to pay dividends on preference shares.
Our concern here is the relationship between debt and equity capital. One should be
cleared about key differences between these two types of capital, relative to voice in
management, claim on income and assets, maturity and tax treatment. Debt holder and
preferred stockholder do not have voice in management. However in default, they may
receive a voice in management. Otherwise, only common stock holders have voting rights.
Debt holders have a higher priority of claim against any earning or asset available for
payment. Generally, life of debt capital is stated. But equity capital remains in the firm for
an indefinite period of time. Tax can be saved in interest payment where as payment of
dividend is non-tax deductible expenditure. Tax must be paid before payment of dividend
to the shareholder. Due to its secondary position (in income and asset) relative to debt,
suppliers of equity capital take greater risk and therefore must be compensated with
higher expected return than suppliers of debt capital.
Capital structure refers to the combination of long-term sources of funds, such as, long-
term debt, preference stock and common equity including reserves and surpluses (i.e.
retained earnings). Capital structure represents the relationship among different kinds of
long-term sources of capital and their amount. Normally, a firm raises long-term capital
through the issue of common shares, sometimes accompanied by preference shares. The
share capital is often supplemented by debt securities and other long-term borrowed
capital. In a going concern, retained earnings or surpluses too form a part of capital
structure. Except for the common shares, different kinds of external financing i.e.
preference shares as well as the borrowed capital carry fixed return to the investors.
Capital structure of a firm can be shown in Equation 1.1.
 INTRODUCTION • Chapter 1 2

Capital structure = Long-term debt + Preferred stock + Common equity ... (1.1)

Financial Structure Financial structure refers to the composition of all sources and amount of funds
Financial structure is the collected to use or invest in business. In other words, financial structure refers to the
composition of both
‘Capital and Liabilities side of Balance Sheet’. Therefore, it includes shareholder’s funds,
short-term and long-term
sources of financing. long-term loans as well as short-term loans. It is different from capital structure as capital
structure includes only the long-term sources of financing while financial structure includes
both long term and short-term sources of financing. Thus, a firm's capital structure is only
a part of its financial structure.
The financial structure of a firm can be shown in Equation 1.2.
Financial structure = Current Liabilities + Long-term debt + Preferred stock
+ Common equity ... (1.2)

The relationship between financial and capital structure can be expressed in Equation 1.3.
Financial structure = Current Liabilities + Capital structure ... (1.3)
Figure 1.1
Capital Structure and
Financial Structure on
Capital and Liabilities Capital and Liabilities
Side of Balance Sheet Current liabilities (Short-term financing)
of a Firm. Accruals
Trade credit
Short-term bank loans
Commercial papers etc

Long-term debt:
Long-term loan
Financial Structure Bond/debentures

Preferred equity
Capital Structure
Common equity:
Share capital/Common stock
Share premium/Additional paid-in capital
Retained earnings

To illustrate capital structure and financial structure, let us take balance sheet of SS
Company as of December 31, 2007 presented in Table 1.1.

Table 1.1 Liabilities and capital Amount Assets Amount

Balance Sheet of
SS Company as on
December 31, 2007
(Rs in thousand)
Accounts payable .....................
Rs. 2,000 Cash at bank............................Rs 2,000
Accruals.........................................
1,000 Account receivables .......................
4,000
Notes payable ................................
2,000 Inventories....................................
2,500
Total current liabilities ..........5 ,000 Total current asses ................ 8,500
Long-term debt ..............................
5,000 Net fixed assets...........................
11,500
Preferred stock.............................. 2,000
Common stock (20,000 shares) ......2,000
Share premium............................. 1,000
Retained earnings .........................
5,000
Total .............................. Rs 20,000 Total ..............................
Rs 20,000

Table 1.1 shows that SS Company’s total asset is Rs 20,000,000 which is financed by
current liabilities, long-term debt, preferred stock and common equity. Table 1.2 shows the
structure of entire sources of financing, which is known as financial structure.

Sources of financing Amount Percenta

Table 1.2 ge
Financial Structure Current liabilities:
of SS Company Accounts payable .............................................
Rs 2,000
Accruals................................................................
1,000
Notes payable ........................................................
2,000 Rs 5,000 25
Long-term debt ................................................................... 5,000 25
Preferred stock ................................................................... 2,000 10
Common equity:
Com mon stock .......................................................
2,000
Share prem ium.....................................................1,000
Retained earnings ..................................................
5,000 8,000 40
Total .................................................................... Rs 100
20,000

Table 1.3
Capital Structure
of SS Company
O P T IM A L  C A P IT A L  S T R U C T U R E  A N D  IT S  F E A T U R E S
Optimal Capital
Structure
The proportionate mix
of debt and equity capital
at which weighted
average cost of capital is
minimum.
Target Capital
Structure
The target capital
structure is the mix of
debt, preferred stock,
and common equity with
which the firm plans to
raise capital.
Table 1.4
Debt Ratio and Cost
of Capital

Companies normally do not distinguish in their capital structure between whether common equity is obtained by retained earnings or new common
stock. In other words, only the total common shareholders' equity is considered, not the relative amounts in the common stock, contributed capital in excess of
par, and retained earnings accounts.
INTRODUCTION • Chapter 1 3
As depicted in Table 1.2, financial structure of SS Company comprises of 25 percent
current liabilities, 25 percent long-term debt, 10 percent preferred stock and 40 percent
equity capital. Thus, current liability is included in the financial structure of the firm.
However, financial manager sometimes may have to analyze the structure of long-term
financing which is called capital structure. Hence, capital structure of the company does
not include the current liabilities. SS Company’s capital structure is shown in Table 1.3.
Sources of Finance Amount Percenta
ge
Long-term debt ...................................................................Rs 5,000 33.33
Preferred stock ................................................................... 2,000 13.33
Common equity:
Com mon stock .......................................................
2,000
Share prem ium ......................................................
1,000
Retained earnings .................................................
5,000 8,000 53.34
Total .................................................................... Rs 100
15,000
Table 1.3 shows the capital structure of SS Company. As discussed earlier, capital structure
excludes current liabilities. In our example, the SS Company’s current capital structure is
said to be 33.33 percent long-term debt, 13.33 percent preferred stock and 53.34 percent
∗
common equity. Hence, we can say that capital structure is a part of financial structure of
the firm.
Financial manager should be very much careful while designing capital structure of the
firm because capital structure decision affects the cost of capital and value of the firm.
Company’s financial manager should try to minimize the cost of capital and maximize the
shareholders wealth/value. The structure of long-term financing which minimizes the
overall cost of capital or maximizes the value of firm is called optimal capital structure.
At optimal capital structure market price per share is also maximized. As a result,
shareholder’s wealth is maximized and goal of the firm is achieved. Optimal capital
structure is also called target capital structure. Target capital structure is the structure
at which the firm ultimately plans to operate.
Now let us consider an example; how optimal or target capital structure is set. Table 1.4
shows alternative capital structure denoted by debt ratio and corresponding cost of debt,
cost of equity and the weighted average cost of capital. The weighted average cost of
capital is calculated by multiplying the specific costs (the cost of debt or cost of equity) by
their proportions in the capital structure and summing them. For example, the weighted
average cost of capital at 20 percent debt ratio is 6 × 0.2 + 15 (1 − 0.2) = 13.2 percent.
Note that in this example, the cost of debt is given as before-tax. Therefore, at first we
should compute cost of debt after-tax because interests on debt are tax deductible. After-
tax cost of debt is computed by multiplying cost of debt before-tax by (1 − Tax rate). For
example, if before-tax cost of debt is 10 percent and the tax rate is 40 percent, the after-
tax cost of debt would be 6 percent i.e. 10% (1 - 0.4).
Debt Before-tax After-Tax W eighted Average Cost of
Cost of
Ratio, Cost of Cost of Capital,
Equity, ks
Wd Debt, kd Debt, kdT k = Wd × kdT + (1 − Wd) × ks
0% 10% 6% 15% 0 × 6 + (1− 0) × 15 =
20 10 6 15 15.00%
40 10 6 15 0.2 × 6 + (1− 0.2) × 15 =
60 13 7.8 20 13.20
80 18 10.8 25 0.4 × 6 + (1− 0.4) × 15 =
11.20
0.6 × 7.8 + (1− 0.6) × 20
= 12.68
0.8 × 10.8 + (1− 0.8) × 25
= 13.64
 INTRODUCTION • Chapter 1 4

Figure 1.2 shows the changing behavior of cost of capital at each alternative capital
structure.

Figure 1.2 Cost of

Debt Ratio and Cost
Capital
of Capital Cost of equity
(ks)

Cost of capital (k)

15%
After-tax cost of debt
(kdT )

6%
Optimal capital
Structure
Debt ratio
20 40 6 80

Table 1.4 and Figure 1.2 show that the weighted average cost of capital declines as the
amount of debt capital increases. It happens because the cost of debt capital is
comparatively lower than the cost of equity. However, increasing debt capital beyond 40
percent does not reduce the weighted average cost of capital. Instead, using debt beyond
this limit has increased the cost of both debt and equity capital. It happens because the
financial risk of the firm increases and the suppliers of debt and equity capital demand
higher rate to compensate higher risk. In other words, use of high debt increases the level
of risk perceived by shareholders. It increases the required rate of return on equity.
Similarly, the use of high debt capital threatens the position of existing bondholders. It too
increases the cost of debt capital. The optimum capital structure is one that minimizes
weighted average cost of capital. At this capital structure, the market price of share, and
the value of the firm is maximized. In our example, as shown in Table 1.4 and Figure 1.2
the optimal capital structure is at 40 percent debt ratio where the weighted average cost of
capital is minimum.
The optimal capital structure should balance between risk and return to equity
shareholders. It helps to maximize return on equity capital without increasing risk
significantly optimal capital structure helps to increase in flexibility and maintain existing
shareholders control power. Optimal capital structure should have following features:
1. Minimum cost of capital: As discussed above, optimal capital structure minimizes the
cost of capital of the firm. As a result shareholder’s return and value is maximized at
optimal capital structure.
2. Risk: Optimal capital structure should be less risky. The use of excessive debt threatens
the solvency of the company. Company should use debt to that extent up to which debt
does not add significant risk, otherwise its use should be avoided.
3. Flexibility: The capital structure should be flexible. Flexibility in capital structure helps to
grab market opportunity as company can raise required funds whenever it is needed for
profitable investment opportunities. It also helps to reduce costs (Cost of debt and
preferred stock) when funds raised from debt and preferred stock are no more required in
the business.
4. Capacity: The capital structure should be determined within the debt capacity of the
company, and this capacity should not be exceeded. The debt capacity of a company
depends on its ability to generate future cash flows. It should have enough cash to pay
creditors' fixed charges and principal sum.
5. Control: Control power is the one of the most concerned part for the management.
Management always wants to maintain control over the firm. The capital structure should
involve minimum risk of loss of control of the company. Issue of excess equity shares to
new investors may bring threats to the control by existing manager.
 INTRODUCTION • Chapter 1 5

E F F E C T S  O F  C A P I T A L  S T R U C T U R E  O N  
S T O C K H O L D E R S ' R E T U R N  A N D  R I S K
Firms employ debt in its capital structure to increase the return to common stockholders.
These increased returns are achieved at the expense of increased risk. Thus, capital
structure affects stockholders' return and risk. When company uses larger amount of debt,
stockholders' return and risk increases. In other words, capital structure (debt ratio) and
stockholder's return and risk are directly related.
To illustrate the effect of capital structure on stockholders' returns and risk, consider the
following information related to Delta Company. The company has total assets of Rs.
1,000,000. Interest rate on debt is 10 percent. Company's marginal tax rate is 40 percent.
Suppose company expects operating income (EBIT) to be 20 percent of total assets. The
company has three alternatives of debt (debt ratio) in its capital structure (i) 0 percent (ii)
50 percent (iii) 80 percent.
Table 1.5 Debt ratio........................................... 0% 50% 80%
Effect of Capital Total assets....................................... Rs Rs Rs
Structure on
1,000,000 1,000,000 1,000,000
Stockholder's Return
and Risk Debt (@ 10% interest) ........................ Rs 0 Rs Rs
Equity................................................. 1,000,000 500,000 800,000
500,000 200,000
Total liabilities and equity
.................. Rs Rs Rs
1,000,000 1,000,000 1,000,000
EBIT (20% of total assets) ................... Rs Rs Rs
Less Interest @ 10% . .......................... 200,000 200,000 200,000
0 50,000 80,000
EBT..................................................... Rs Rs Rs
Less: Tax @ 40% . ............................... 200,000 150,000 120,000
80,000 60,000 48,000
EAT or NI............................................ Rs Rs 90,000 Rs 72,000
120,000
ROE = NI÷ Equity ............................... 12% 18% 36%

If EBIT decreases to 10% of total assets

EBIT..................................................... Rs Rs Rs
Less: Interest @ 10% .......................... 100,000 100,000 100,000
0 50,000 80,000
EBT...................................................... Rs Rs 50,000 Rs 20,000
Less: Tax @ 40% . ................................ 100,000 20,000 8,000
40,000
EAT or NI............................................. Rs 60,000 Rs 30,000 Rs 12,000
ROE..................................................... 6% 6% 6%

If EBIT decreases to 5% of total assets

EBIT.....................................................Rs 50,000 Rs 50,000 Rs 50,000
Less: Interest @ 10% ........................... 0 50,000 80,000
EBT......................................................Rs 50,000 Rs 0 (Rs
Less: Tax @ 40% . ................................ 20,000 0 30,000)
12,000
EAT or NI............................................. Rs 30,000 Rs 0 Rs 18,000
ROE..................................................... 3% 0% −9%

Table 1.5 shows the effect of capital structure (debt-ratio) on stockholders' return. When all
equity is financed in capital structure, the return on equity is 12 percent. At a debt ratio of
50 percent, the return on equity is 18 percent, and at a debt ratio of 80 percent, the return
on equity is 36 percent. Recall that Delta Company is earning 20 percent on its assets. The
cost of debt is 10 percent pre tax. Thus, when Delta Company uses debt in its capital
structure, the difference between the return on its assets and the cost of debt occurs to the
benefit of equity holders. But when EBIT decreases to 10 percent of assets, the return on
equity for the all three alternatives becomes 6 percent. Note that the rate of decline in
return on equity is the highest at higher level of debt. Similarly, when EBIT decreases to 5
 INTRODUCTION • Chapter 1 6

percent of assets, the return on equity, changes dramatically. At all equity finance, it
declines from 12 percent to 3 percent whereas at 80 percent debt it declines from 36
percent to minus 9 percent. The change is 45 percent. Thus, it can be seen that the use of
debt in capital structure both increase the potential returns to common stockholder and
risk, or variability, of those return.

F A C T O R S  A F F E C T I N G  C A P IT A L /F IN A N C I A L  S T R U C T U R E
Capital structure of a firm is affected by various internal and external factors. These factors
are also known as the determinants of capital structure. The macro-economic variables of a
country like tax policy, inflation rate, capital market condition are major external factors
that affect the capital structure of a firm. The characteristics of an individual firm, which
are firm specific, also affect the capital structure of the firm. Hence, financial manager
should consider following factors while designing the capital structure of the firm.
1. Component cost of capital: Capital structure is the composition of long-term sources of
financing viz. long-term debt, preferred stock and common equity. There is cost associated
with each source of financing. The component cost of capital comprises using cost of
issuing costs. We know that optimal capital structure should be less costly. Therefore,
financial manager prefers to use larger amount of less costly component. Generally, cost
of debt is less than the cost of other sources of long-term financing. Hence, financial
managers use significant size of debt capital in capital structure.
2. Nature and size of the firm: Nature and size of a firm also influences its capital
structure. A public utility concern may employ relatively larger amount of debt as
compared to other manufacturing and trading companies. Because a public utility company
generally have stable and regular earnings. Similarly, small companies have to depend
mainly upon ownership capital because they cannot arrange debt capital easily. But large
scale and credit worthy firm can raise debt capital at reasonable rate and terms and use
significant amount of debt in their capital structure.
3. Growth and stability of sales: Firms whose sales are relatively stable can use higher
amount of debt and take higher risk. Stability of sales ensures that the firm will not face
any difficulty in meeting its fixed commitments of interest payment. As far as growth is
concerned, other things remaining the same, faster growing firms must rely heavily on
external capital. Future growth rate of sales is a measure of the extent to which the EPS of
a firm likely to be magnified by leverage. The firm is likely to use debt financing with
limited fixed charge only when the return on equity is to be magnified. Thus, we can
conclude that rapidly growing firms tend to use somewhat more debt than slower growing
companies.
4. Flexibility: Capital structure of a firm should be flexible i.e., it should be such that it is
capable of being adjusted according to the needs of the changing conditions. It should be
possible to raise additional funds without much of difficulty and delay whenever it is
needed. A firm should arrange its capital structure in such a manner that it can substitute
one form of financing by another. Generally, use of debt and preferred stock increases the
flexibility in the capital structure of a firm. Because these sources of financing may have
call features, conversion feature and maturity period. Hence, company should use
sufficient amount of debt and preferred stock to increases flexibility in its capital structure.
5. Management attitudes: The management attitudes that most directly influence the
choice of financing. Aggressive management prefers higher debt ratio to earn higher profit.
But some management tends to be more conservative than others and use less debt than
the average firm in their industry.
6. Corporate tax rate: Companies whose marginal tax rate is high prefer debt financing.
Since interest is a tax deductible expense, companies with higher tax are benefited from
higher tax shield.
7. Legal requirements: A company should also fulfill the legal requirements. The
government has also issued certain guidelines for the issue of shares and debentures.
Being a legal person, company should design its capital structure within the legal
framework.
8. Control: If present management wants to maintain existing control power, it should go for
debt financing. Issue of new shares in the market may dilute existing shareholders' control
power. But large companies whose stock is widely owned may choose additional sales of
common stocks because such sales will have little influence on the control of the company.
 INTRODUCTION • Chapter 1 7

9. Period of finance: The period during which the finances are required is also an important
factor to be kept in the mind while selecting an appropriate capital mix. If the finances are
required for a limited period say seven years, debentures should be preferred to shares. In
case funds are needed on permanent basis, equity share capital is more appropriate.
10. Asset structure: Firms whose assets are suitable as security for loans tend to use
more debt. General-purpose assets, which can be used by many businesses, make good
collateral, whereas special purpose assets do not. Thus, real estate companies are usually
highly leveraged, whereas companies involved in technological research employ less debt.
11. Debt covenants: Debt covenants (terms of debt contract) may restrict the company
to use excess of amount of debt. Indenture mentions such terms and conditions which may
affect capital structure decision.
12. Operating leverage: There is negative relationship between operating leverage and
debt level in capital structure. When company employs higher operating leverage, it should
try to reduce financial leverage by reducing level of debt in its capital structure. Otherwise,
total risk which is measured by degree of combined leverage will be extremely high.
13. Cash flow stability: Cash flow stability and debt ratio are directly related. If
company's cash flow is stable and regular, it can use larger amount of debt. With a regular
cash flow stream, a company can meet its fixed payments of interest and principal on time
without any difficulties. In other words, if firm's cash flow is stable, its debt servicing
capacity increases. As a result company can take advantage of leverage using significant
amount of debt.

T H E FI N A N C I A L PL A N
Theplan
Financial financial plan refers to the projection of future financial course of action to be carried out
for efficient execution of operating plans and effective accomplishment of corporate objectives.
A plane that
spells It
outbegins
the with the preparation of strategic plans that in turn guides the formulation of operating
future plans and budgets. Financial plan provides road map for guiding, coordinating and controlling
financial
course the firm's
of financial action in order to achieve its objectives. Most corporate organizations spend
action, budgets,
and significant
capital time and labor in preparing the financial plan as it enables a firm:
expenditures
• To identify significant actions to be taken in various aspects of a firm's finance functions.
required for
execution
• To of develop various options in the field of finance functions, which can be exercised as
operating plans.
condition changes.
• To systematize the interaction required between investment and financing decision.
• To state clearly the relation between present and future financial decision.
• To ensure that strategic plan of the firm is financially viable.
• To provide standard against which future financial performance is compared.

Process of Financial Planning

A firm's financial plan largely involves the forecast and use of various types of budgets. These
budgets are prepared for every key area of a firm's activities such as production, marketing,
research and development, purchase and so on. The major steps involved in financial planning
process of a firm are as follows:
• Project financial statements and use these projections to analyze the effects of the operating
plan on projected profits and various financial ratios. The projections can also be used to
monitor operations after the plan has been finalized and put into effect.
• Determine the funds needed to support periodic plan (e.g., the five-year plan), which
includes funds for plant and equipment, inventories, receivables, new product development,
research and developments and for other major activities.
• Forecast availability of funds over the planning horizon. This involves estimating the funds to
generate internally as well as those to be obtained from external sources.
• Establish and maintain a system of controls to govern the allocation and use of funds within
the firm.
 INTRODUCTION • Chapter 1 8

• Develop procedures for adjusting the basic plan, if the economic forecasts upon which the
plan was based do not materialize.
• Establish a performance based management compensation system.