CAPITAL

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STRUCTURE
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INTRODUCTION
In order to run and manage a company, funds are needed. If funds are inadequate, the business suffers and if the funds are not properly managed, the entire organization suffers. It is necessary that correct estimate of optimum capital structure which shall help 4/25/12 the organization to run its work

MEANING
The term capital structure refers to the relationship between the various long- term financing such as debentures, preference capital, equity share capital. There should be a proper mix of debt and equity capital in financing the firms assets. The use of long 4/25/12 term debt and preference capital

FINANCIAL BREAK EVEN POINT

It may be defined as that level of EBIT which is just equal to pay total financial charges i.e. interest and preference dividend. EBIT= interest+ preference dividend. At this point earning per share is equal to zero. 4/25/12

FINANCIAL BREAK EVEN POINT

(a) when the capital structure consists of equity share capital and debt only and no preference capital is employed: financial break even point = fixed intrest charges.

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Financial break even point

(b) When the capital structure consists of equity, preference and debt: FBEP = I + Dp/(1-t) Where, I = fixed interest charges Dp = preference dividend
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(1-t) = tax rate

NET INCOME APPROACH

Under net income approach cost of equity and cost of debt are constant as debt is replaced for equity in capital structure, being less expensive , it causes the overall cost of capital decrease that ultimately approaches the cost of debt with 100% debt ratio. 4/25/12 Under net income approach, the

ASSUMPTION
(1)There are no taxes. (2)The risk perception of investor is not changed by use of debt. (3)Debt is replaced for equity (4) Firm uses only two sources of finance i.e. equity and debt.
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formulae
V = S+D S = EBIT- I/ equity capitalization rate Ko = EBIT/ V V= value of firm S= value of equity shares D= value of debt 4/25/12

EXAMPLES
(a) A company expects a net

income of Rs. 80,000. it has Rs. 2,00,000. 8% debentures. The equity capitalization rate of the company is 10% calculate the value of the firm and overall capitalization rate according to the net income approach.
(b) If the debt is increased to Rs.
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NET OPERATING INCOME APPROACH

The change in capital structure of a company does not affect the market value of the firm and overall cost of capital remains same. In other words, the overall cost of capital remains same whether debt or equity mix is 50:50, 20:80, 0: 100. thus, there is 4/25/12 nothing as optimal capital

ASSUMPTION
(1) The overall cost of capital

remains constant.
(2) The risk perception of investor

is changed by use of debt.

(3) increase in Cost of equity

offsets the benefits of using cheaper source of finance.

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NET OPERATING INCOME APPROACH

V = EBIT/ K0 S=VD Ke = EBIT- I/ V- D V= value of firm Ko = overall cost of capital. S= market value of a equity
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EXAMPLE
(a) A company expects a net

operating income of Rs. 1,00,000. it has Rs. 5,00,000. 6% debentures. The overall capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate according to the net 4/25/12 operating income approach.

TRADITIONAL APPROACH

The value of firm can be increased initially or cost of capital can be decreased by using more debt as debt is cheaper source of finance than equity. Like, net income approach this approach implies cost of capital decreases only with in reasonable limit and reaching 4/25/12 the minimum level, it starts

TRADITIONAL APPROACH
V = S+D Ko = EBIT/V Ke = EBIT- I/S S = EBIT- I/ Ke

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EXAMPLE
Net operating income 2,00,000 Total investment 10,00,000 Equity capitalization rate:
(a) If the firm uses no debt

10%
(b) If the firm uses Rs. 4,00,000
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MODIGILANI & MILLER APPROACH

It does not agree with traditional view. As per MM approach value of firm depends upon the earning rather than the way in which the assets have been financed. MM approach is identical with net operating income ,if taxes are ignored. it is identical with net 4/25/12 income approach, if taxes are

ARBITRAGE PROCESS
This process involves purchasing securities whose prices are lower and selling those securities whose prices are higher in the related market.

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THANKS
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