1. CAPITAL STRUCTURE

2. What is “Capital Structure”?
Current
Assets
Balance Sheet
Current
Liabilities
Debt
Fixed
Preference
Ordinary
shares
Financial
Structure

3. What is “Capital Structure”?
Balance Sheet
Current
Assets
Fixed
shares
Assets
Current
Liabilities
Debt
Preference
Ordinary shares
Capital
Structure

4. Definition

The term capital structure is used to
represent the proportionate relationship
between debt, preference and equity
shares on a firm’s balance sheet.
OPTIMUM CAPITAL STRUCTURE:

Optimum capital structure is the capital
structure at which the market value per
share is maximum and the cost of
capital is minimum.

5. Why is it important?


Enables one to “optimize” the value of a firm or
its WACC by finding the “best mix” for the
amounts of debt and equity on the balance
sheet
Provides a signal that the firm is following
proper rules of corporate finance to “improve”
its balance sheet. This signal is central to
valuations provided by market investors and
analysts

6. Factors affecting capital structure
INTERNAL
 Financial leverage
 Risk
 Growth and stability
 Retaining control
 Cost of capital
 Cash flows
 Flexibility
 Purpose of finance
 Asset structure
EXTERNAL












Size of the company
Nature of the industry
Investors
Cost of inflation
Legal requirements
Period of finance
Level of interest rate
Level of business activity
Availability of funds
Taxation policy
Level of stock prices
Conditions of the capital
market

7. Assumptions Of Capital Structure

There are only two sources of funds i.e.: debt and equity.

The total assets of the company are given and do not change. Investment
decisions will be constant.

The total financing remains constant. The firm can change the degree of
leverage either by selling the shares and retiring debt or by issuing debt and
redeeming equity.

Operating profits (EBIT) are not expected to grow.

All the investors are assumed to have the same expectation about the future
profits.

Business risk is constant over time and assumed to be independent of its
capital structure and financial risk.

Corporate tax does not exit. (removed Later)

The company has infinite life.

Dividend payout ratio = 100%.(No Retained Earnings)

8. Theories



Net Income (NI) Approach
Net Operating Income (NOI) Approach
MM Approach Without Tax: Proposition I,II,III

9. Net Income (NI) Approach


This theory was propounded by “ David Durand” and is also
known as “Fixed ‘Ke’ Theory”.
According to NI approach both the cost of debt and the cost
of equity are independent of the capital structure; they
remain constant regardless of how much debt the firm uses.
As a result, the overall cost of capital declines and the firm
value increases with debt.

This approach has no basis in reality; the optimum capital
structure would be 100 per cent debt financing under NI
approach

10. Assumptions of NI Theory



The ‘Kd’ is cheaper than the ‘Ke’.
Income tax has been ignored.
The ‘Kd’ and ‘Ke’ remain constant

11. Net Operating Income (NOI) Approach

This theory was propounded by “David Durand”
and is also known as “Irrelevant Theory ”.
According to NOI approach the value of the firm
and the weighted average cost of capital are
independent of the firm’s capital structure. Overall
cost of capital is independent of degree of
leverage.

In the absence of taxes, an individual holding all
the debt and equity securities will receive the same
cash flows regardless of the capital structure and
therefore, value of the company is the same.

12. Assumptions of NOI Theory




The split of total capitalization between debt
and equity is not essential or relevant.
The equity shareholders and other investors
i.e. the market capitalizes the value of the firm
as a whole.
The business risk at each level of debt-equity
mix remains constant. Therefore, overall cost
of capital also remains constant.
The corporate income tax does not exist

13. MM Approach Without Tax: Proposition I

MM’s Proposition I, states that the firm’s
value is independent of its capital structure
.The Total value of firm must be constant
irrespective
of
the
equity Ratio).
shareholders
Degree
With
can
receive
of
leverage(debt
personal leverage,
exactly
the
same
return, with the same risk, from a levered firm
and an unlevered firm. Thus, they will sell
shares of the over-priced firm and buy shares of
the under-priced firm. This will continue till the
market
prices
of
identical
firms
identical. This is called arbitrage.
become

14. MM Approach Without Tax: Proposition II

The cost of equity for a levered firm equals the
constant overall cost of capital plus a risk
premium that equals the spread between the
overall cost of capital and the cost of debt
multiplied by the firm’s debt-equity ratio. For
financial leverage to be irrelevant, the overall
cost of capital must remain constant, regardless
of the amount of debt employed. This implies that
the cost of equity
must rise as financial risk
increases.

15. MM Hypothesis With Corporate Tax


Under current laws in most countries, debt has an important
advantage over equity: interest payments on debt are tax
deductible, whereas dividend payments and retained earnings
are not. Investors in a levered firm receive in the aggregate
the unlevered cash flow plus an amount equal to the tax
deduction on interest. Capitalising the first component of
cash flow at the all-equity rate and the second at the cost of
debt shows that the value of the levered firm is equal to the
value of the unlevered firm plus the interest tax shield which
is tax rate times the debt (if the shield is fully usable).
It is assumed that the firm will borrow the same amount of
debt in perpetuity and will always be able to use the tax
shield. Also, it ignores bankruptcy and agency costs.

16. Assumptions of M-M
Approach

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Perfect Capital Market
No Transaction Cost
Homogeneous Risk Class: Expected EBIT of all
the firms have identical risk characteristics.
Risk in terms of expected EBIT should also be
identical for determination of market value of the
shares
Cent-Percent Distribution of earnings to the
shareholders
No Corporate Taxes: But later on in 1969 they
removed this assumption.

17. Traditional Theory
This theory was propounded by Ezra Solomon.
It’s a Midway Between Two Extreme (NI & NOI
Approach)
According to this theory, a firm can reduce the
overall cost of capital or increase the total
value of the firm by increasing the debt
proportion in its capital structure to a certain
limit. Because debt is a cheap source of
raising funds as compared to equity capital.

18. Features of an Appropriate Capital
Structure

Profitability

Solvency

Return

Risk

Flexibility

Capacity

Control

Conservatism