Capital Structure

INTRODUCTION
Capital is the major part of all kinds of business activities, which are
decided by the size, and nature of the business concern. Capital may be
raised with the help of various sources. If the company maintains proper
and adequate level of capital, it will earn high profit and they can provide
more dividends to its shareholders.
Meaning of Capital Structure
Capital structure refers to the kinds of securities & the proportionate
amounts that make up capitalization. It 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 source 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 &
equity.
Definitions
Capital Structure of a company refers to the composition or
make up of its capitalization and it includes all long-term capital
resources.
~ Gerestenbeg
The mix of a firms permanent long-term financing represented
by debt, preferred stock, and common stock equity.
~James C. Van Horne
The composition of a firms financing consists of equity,
preference, and debt.
~Presana Chandra
FINANCIAL STRUCTURE
The term financial structure is different from the capital structure.
Financial structure shows the pattern of total financing. It measures the
extent to which total funds are available to finance the total assets of the
business.
Financial Structure = Capital Structure + Current liabilities.

OPTIMUM CAPITAL STRUCTURE
Optimum capital structure is the capital structure at
which the weighted average cost of capital is
minimum and thereby the value of the firm is
maximum.
Optimum capital structure may be defined as the
capital structure or combination of debt and equity,
that leads to the maximum value of the firm.
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) Leverage : It is the basic and important factor, which affect the capital
structure. It uses the fixed cost financing such as debt, equity and
preference share capital. It is closely related to the overall cost of
capital.
2) Cost of Capital : Cost of capital constitutes the major part for deciding
the capital structure of a firm.
a) Nature of the business: Use of fixed interest/dividend bearing finance
depends upon the nature of the business. If the business consists of
long period of operation, it will apply for equity than debt, and it will
reduce the cost of capital.
b) Size of the company: It also affects the capital structure of a firm. If
the firm belongs to large scale, it can manage the financial
requirements with the help of internal sources. But if it is small size,
they will go for external finance. It consists of high cost of capital.
Continue..
c) Legal requirements: Legal requirements are also one of the
considerations while dividing the capital structure of a firm. For
example, banking companies are restricted to raise funds from some
sources.
d) Requirement of investors: In order to collect funds from different type
of investors, it will be appropriate for the companies to issue different
sources of securities.
3) Government policy : The Company Act restricts to mobilize large,
long term funds from external sources. Hence the company must
consider government policy regarding the capital structure.
CAPITAL STRUCTURE THEORIES
Capital structure is the major part of the firms financial decision which
affects the value of the firm and it leads to change EBIT and market
value of the shares. There is a relationship among the capital structure,
cost of capital and value of the firm. The aim of effective capital
structure is to maximize the value of the firm and to reduce the cost of
capital.
There are two major theories explaining the relationship between capital
structure, cost of capital and value of the firm.

ASSUMPTIONS
Firms use only two sources of funds
equity & debt.
No change in investment decisions of
the firm, i.e. no change in total assets.
100 % dividend payout ratio, i.e. no
retained earnings.
Business risk of firm is not affected by
the financing mix.
No corporate or personal taxation.
Investors expect future profitability of
the firm.
Capital Structure Theories
Capital Structure Theories
A) Net Income Approach (NI)
Net Income approach proposes that there is a definite
relationship between capital structure and value of the firm.
The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
NI approach assumptions
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (K
d
) is less than cost of equity (K
e
) [i.e. K
d
< K
e
]
o Corporate income taxes do not exist.

Capital Structure Theories
A) Net Income Approach (NI)
As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Net Operating Income (EBIT)
Overall Cost of Capital(WACC)
Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
Thus, as per NI approach, a firm will have maximum value
at a point where WACC is minimum, i.e. when the firm is
almost debt-financed.
Capital Structure Theories
A) Net Income Approach (NI)
ke
ko
kd
Debt
Cost
kd
ke, ko
As the proportion of
debt (K
d
) in capital
structure increases,
the WACC (K
o
)
reduces.
Capital Structure Theories
B) Net Operating Income (NOI)
Net Operating Income (NOI) approach is the exact opposite
of the Net Income (NI) approach.
As per NOI approach, value of a firm is not dependent upon
its capital structure.
Assumptions
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (K
d
) is constant.
o Corporate income taxes do not exist.
Capital Structure Theories
B) Net Operating Income (NOI)
NOI propositions (i.e. school of thought)
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 (K
e
)

A higher cost of equity (K
e
) nullifies the advantages gained
due to cheaper cost of debt (K
d
)

In other words, the finance mix is irrelevant and does not
affect the value of the firm.
Capital Structure Theories
B) Net Operating Income (NOI)
Cost of capital (K
o
)
is constant.
As the proportion
of debt increases,
(K
e
) increases.
No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost
Capital Structure Theories
C) Modigliani Miller Model (MM)
MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
Further, the MM model adds a behavioural justification in
favour of the NOI approach (personal leverage)
Assumptions
o Capital markets are perfect and investors are free to buy, sell,
& switch between securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention
Capital Structure Theories
C) Modigliani Miller Model (MM)
MM Model proposition
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC
Capital Structure Theories
C) Modigliani Miller Model (MM)
MM Model proposition
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, arbitrage process will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.
Capital Structure Theories
D) Traditional Approach
The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
Traditional approach (intermediate approach) is a compromise
between these two extreme approaches.
Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.
Capital Structure Theories
D) Traditional Approach
The approach works in 3 stages
1) Value of the firm increases with an increase in borrowings
(since K
d
< K
e
). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders
risk (financial risk) and hence K
e
increases. K
d
also rises due
to higher debt, WACC increases & value of firm decreases.
Capital Structure Theories
D) Traditional Approach
ke
ko
kd
Debt
Cost
Cost of capital (K
o
)
is reduces initially.
At a point, it settles
But after this point,
(K
o
) increases, due
to increase in the
cost of equity. (K
e
)
Pecking Order Theory
The pecking order theory suggests that there is an
order of preference for the firm of capital sources
when funding is needed.

The firm will seek to satisfy funding needs in the
following order:
Internal funds
External funds
Debt
Equity
Pecking Order Theory

There are three factors that the pecking order theory
is based on and that must be considered by firms
when raising capital.
1. Internal funds are cheapest to use (no issuance costs)
and require no private information release.
2. Debt financing is cheaper than equity financing
3. Managers tend to know more about the future
performance of the firm than lenders and investors.
Because of this asymmetric information, investors may
make inferences about the value of the firm based on the
external source of capital the firm chooses to raise.
Equity financing inference firm is currently overvalued
Debt financing inference firm is correctly or undervalued

Trade-off theory
The trade-off theory of capital structure refers to the idea that a
company chooses how much debt finance and how much equity finance
to use by balancing the costs and benefits.
An important purpose of the theory is to explain the fact that
corporations usually are financed partly with debt and partly with equity.
It states that there is an advantage to financing with debt, the tax
benefits of debt and there is a cost of financing with debt, the costs of
financial distress including bankruptcy costs of debt and non-bankruptcy
costs (e.g. staff leaving, suppliers demanding disadvantageous payment
terms, bondholder/stockholder infighting, etc.).
The marginal benefit of further increases in debt declines as debt
increases, while the marginal cost increases, so that a firm that is
optimizing its overall value will focus on this trade-off when choosing
how much debt and equity to use for financing.
Trade-off theory

Capitalization Rate
A rate of return on a real estate investment property based on the
expected income that the property will generate.
Capitalization rate is used to estimate the investor's potential return on
his or her investment. This is done by dividing the income the property
will generate (after fixed costs and variable costs) by the total value of
the property.
Capitalization Rate = Yearly Income
Total Value