Capital structure refers to the combination of capital (equity, debt, preference shares) used to finance a company. There are various theories on how capital structure affects a company's value and cost of capital. The net income approach argues that leverage always increases value by lowering the overall cost of capital. The net operating income and MM approaches argue capital structure is irrelevant as the costs of equity and debt offset each other. The traditional approach finds an optimal capital structure that minimizes costs up to a point, after which more debt increases risks.

1. Capital Structure Decisions
What is capital structure?
•Combination of capital is called capital structure. The
firm may use only equity, or only debt, or a
combination of equity +debt, or a combination of
equity + debt + preference shares or may use other
similar combinations.

2. How do you design capital structure?
1) It should minimize cost of capital
2) It should reduce risks
3) It should give required flexibility
4) It should provide required control to the owners
5) It should enable the company to have adequate
finance.

3. What are the risks associated with capital structure
decisions?
Meaning of risk = variability in income is called risk.
•
Business risk = it is the situation, when the EBIT may
vary due to change in capital structure. It is influenced
by the ratio of fixed cost in total cost. If the ratio of fixed
cost is higher, business risk is higher.
•
Financial risk = it is the variability in EPS due to change
in capital structure. It is caused due to leverage. If
leverage is more, variability will be more and thus
financial risk will be more.

4. Degree of financial leverage?
It shows the extend of financial risk. Higher the DFL,
higher is the financial risk.
Formula =% change in EPS / % change in EBIT.
Suppose EBIT changes 10%, due to this EPS changes
20%,
20/10 = 2
DFL is 2.

5. EBIT – EPS Analysis
Generally cost of debt is lower than cost of equity.
Therefore raising debt (trading on equity) increases
EPS and it gives benefit to the shareholders. However,
excess of debt will create more risk and therefore it is
not advisable. A firm can identify an ideal level of
quantum of debt and equity so that it is within
proportion.

6. What is coverage ratio or DSCR
DSCR = debt service coverage ratio
Coverage ratio denotes the extent to which interest is
covered by the EBIT. It denotes whether we have
sufficient earnings to meet our interest obligation. If
DSCR is 1 or less than one, it is dangerous situation.
Formula = EBIT / interest.
Higher the DSCR, less is the risk (because there is higher
coverage).

7. Theory of Optimal Capital Structure?
This theory states that we can have an optimum
capital structure – as we raise the debt, we can raise
the value of the firm to some extent. Thus level of
debt can be increased up to some level. That level is
the ideal capital structure.
Ultimate objective of Finance manager is to raise the
value of the firm and raise the wealth – which is
possible by an ideal capital structure.

8. Theories of Capital Structures
There are 4 theories:
1) NI approach (net income approach)
2) NOI approach (net operating income approach)
3) MM approach (Modigliani Millar Approach)
4) Traditional approach

9. Net Income Approach
When you raise debt, leverage will increase. The
overall value of the firm will increase. Debt will have
lower cost, so overall cost of capital will reduce (it is
better if the cost of capital reduces).
V = S+ D
V = value of the firm, S = equity, D = debt
An increase in leverage will increase the value of the
firm, it will raise EPS, it will raise the market price of
the shares and it will reduce weighted average cost of
capital, thus leverage is always beneficial.

10. Net Operating Income Approach
Capital structure decision is irrelevant. If you raise
debt, the cost of equity will increase. The overall cost
of capital will remain constant in spite of leverage.
Thus there is no advantage of raising debt. As we raise
the debt, the cost of equity increases in the same
proportion. The market discounts the firm, which is
leveraged. Thus capital structure decision has no
relevance.

11. MM approach
It is similar to NOI approach
… with well-functioning markets (and neutral taxes) and rational
investors, who can ‘undo’ the corporate financial structure by holding
positive or negative amounts of debt, the market value of the firm –
debt plus equity – depends only on the income stream generated by its
assets. It follows, in particular, that the value of the firm should not be
affected by the share of debt in its financial structure or by what will be
done with the returns – paid out as dividends or reinvested (profitably).

12. Traditional approach
It says that with the use of debt, the overall cost of
capital comes down up to some extent and thereafter
the overall cost of capital increases. Thus there is an
ideal point, up to which the overall cost of capital will
decrease with the help of increase indebt, beyond
which the use of debt is detrimental to the company.

13. Traditional approach
It says that with the use of debt, the overall cost of
capital comes down up to some extent and thereafter
the overall cost of capital increases. Thus there is an
ideal point, up to which the overall cost of capital will
decrease with the help of increase indebt, beyond
which the use of debt is detrimental to the company.