Capital Structure

Topics
What is capital structure?
Why is it important?
What does capital structure consist of ?
What is business risk and financial risk?
What are the theories of capital structure?
What is an optimum capital structure?
Summary

What is Capital
Structure?
Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt
Preference
shares
Ordinary
shares

Financial
Structure

What is Capital
Structure?
Balance Sheet
Current
Current
Assets
Liabilities

Fixed
Assets

Debt
Preference
shares
Ordinary
shares

Capital
Structure
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Definition
Capital structure of a company refers to the
make-up of its capitalization and it includes
all long-term capital resources, viz., shares,
loans, reserves and bonds.
- Gerstenberg

Why is it important?

Capital Structure
consists of:

1. Owned Funds:
It belongs to the proprietors
It includes share capital, free reserves and surplus.
2. Borrowed Funds:
It consists of long-term borrowings from outside
sources.
It consists of debentures,
bonds and long-term
loans provided by banks
and term lending
institutions.

Equity share capital

Risk bearing capital of the company
Shares which do not enjoy special rights in
respect of payment of dividend and repayment
of capital.
Rate of dividend fluctuates depending upon the
availability of profits

Advantages
1. It represents a permanent source of finance
2. It does not carry any fixed burden
3. It enhances the creditworthiness of the firm

Disadvantages
1. Its cost is very high
2. Issue of equity to outsiders causes dilution of
control
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Preference Shares
Shares which enjoy priorities in the payment of
dividend as well as in the repayment of capital
Preference shareholders are entitled to receive a
fixed rate of dividend
Preference shareholder
is paid back the capital
before any payment is
made to the equity
shareholders.
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Types of preference shares

Surplus profit
Fixed Dividend

Can be converted

Dividend
gets
carried
Returnable
into equity share
over
next
year
Non-Returnable
Cannot be converted
Dividend lapses
into ordinary share
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Advantages
Preferential rights
Arrears of Unpaid dividend payable
Gives flexibility to the company Redeemable and Convertible Shares

Disadvantages
Fixed dividend
No control
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Debentures
Money received by the issue of debentures is a loan
Debenture is a security issued by a company against
the debt.
Debenture holders are the creditors of the company
Interest on debentures has to be paid even if the
company makes losses
Debenture holders have no voting rights
No dilution of control
Less risky for shareholders

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Advantages

Regular fixed income

Safety and security of investment
Liquidity- easy sale in stock exchange
Conversion into shares

Disadvantages
No control
Fixed returns
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Term Loans

3 categories based on Pay back period:

Short term Loans
Medium term Loans
Long term Loans

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Advantages
Cost lower than share capital
No dilution of control
Backed by security

Disadvantages
No voting rights
Repayment is obligatory
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Risk and the Income

Statement

Sales
Operating Variable costs
Leverage Fixed costs
EBIT
Interest expense
Financial
Earnings before taxes
Leverage Taxes
Net Income
EPS =
Net Income
No. of Shares

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Business Risk
The basic risk inherent in the operations of
a firm is called business risk
Business risk can be viewed as the
variability of a firms Earnings Before
Interest and Taxes (EBIT)

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Financial risk

Debt causes financial risk because it imposes a

fixed cost in the form of interest payments.
The use of debt financing is referred to as
financial leverage.
Financial leverage increases risk by increasing
the variability of a firms return on equity or the
variability of its earnings per share.

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Financial Risk Vs Business

Risk

There is a trade-off between financial risk and

business risk.
A firm with high financial risk is using a fixed
cost source of financing. This increases the level
of EBIT a firm needs just to break even.
A firm will generally try to avoid financial risk a high level of EBIT to break even - if its EBIT is
very uncertain (due to high business risk).
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Weighted Average Cost of

Capital
USED IN CAPITAL BUDGETING DECISIONS TO CALCULATE NPV
EXPECTED RETURN ON PORTFOLIO OF ALL COMPANYS SECURITIES
rA = (D/D+E)rD + (E/D+E)rE
EXAMPLE: FIRM HAS Rs 2 MILLION DEBT
CURRENT BORROWING RATE, rD= 8%
100,000 SHARES PRICED AT Rs 30 PER SHARE
EXPECTED RATE OF RETURN ON SHARES, rE = 15%
D=Rs 2M, E=100,000 x Rs 30= Rs 3M, V = D+E=2+3 = Rs 5M
WACC = (D/D+E)rD + (E/D+E)rE
= (2/5).08 + (3/5).15
=.122 OR 12.2%

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What are the theories of

capital structure?

Net Income Theory of Capital Structure

Financial leverage is beneficial

Net Operating Income Theory of Capital

Structure
Financial leverage is irrelevant

Traditional Theory of Capital Structure

There exists an optimal capital structure

Modigliani and Miller

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Net Income Theory

rE

Capital
Cost

rA
rD

Financial Leverage

Stock
Price

Po

Financial Leverage
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Net Income Theory of

Capital Structure
No matter how modest or excessive the firms use of debt
financing, both its cost of debt capital, rD, and cost of
equity capital, rE, remain CONSTANT
The weighted average cost of capital, rA, and the firms
share price, Po, ARE affected by the firms use of financial
leverage
Since the cost of debt is lower than the cost of equity,
greater use of debt reduces the weighted average cost of
capital, ie the firms stock value increases with increase in
financial leverage
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Net Operating Income Theory

r
E

rA

Capital
Costs

rD

Financial Leverage

Stock
Price

Po

Financial Leverage

Net Operating Income

(NOI) Theory
The firms market value is unaffected by its capital structure
As financial leverage increases cheaper debt, rD, is substituted
for more expensive equity
However, the firms cost of equity, rE, will gradually rise in line
with the increasing use of debt
The value of the firms equity is therefore unaffected by the
increase in financial leverage
Suggests that capital structure is irrelevant

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Traditional Theory
rE

rA
Capital
Costs

rD

Financial Leverage
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Traditional Theory
Intermediate Position
At moderate levels of financial leverage investors dont notice
the risk of borrowing
This results in a decrease in the weighted average cost of
capital, rA
The probability that the firm will not be able to meet its
financial obligations increases as more and more debt is
employed
Thus investors wake up when debt is excessive and
eventually at some point the expected cost of default
outweighs the advantage of debt
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Modigliani & Millers theory

Modigliani was awarded the 1985 Nobel price in
Economics for this and other contributions.
This approach says that there is not any
relationship between capital structure and cost of
capital
Value of firm and cost of capital is fully affected
from investor's expectations.

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What is an optimum
capital structure?
An optimal capital structure is one that
minimizes the firms cost of capital and thus
maximizes firm value
Essentials of optimum capital structure
Flexibility
Solvency
Efficiency
Simplicity
Control
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Summary

A firms capital structure is the proportion of a firms

long-term funding provided by long-term debt and
equity.

Capital structure influences a firms cost of capital

through the tax advantage to debt financing and the
effect of capital structure on firm risk.

Because of the tradeoff between the tax advantage to

debt financing and risk, each firm has an optimal capital
structure that minimizes the WACC and maximises firm
value.
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Thank

you

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