Group three (3)

Presentation on

Capital Structure
Names of group members
 Objectives
By the end of the Presentation, students will be able to;
Define Capital Structure

Explain theories of capital structure

Apply components the of capital structures

Examine the Advantages & Disadvantages of

using Capital Structure financing

Importance of capital structure

 Case study

Case study
FIRM X FIRM Y
Earnings Earnings
10,000,000 10,000,000
Return on Assets Return on Assets
100,000,000 100,000,000
Debt value Debt value
0 50,000,000
Interest on debt Interest on debt
0 5%
Expenses on debt Expenses on debt
0 250,000
 Case study
Case study
10,000,000
5,000,000
Price per share Price per share
10 10
Market value of equity Market value of equity
100,000,000 50,000,000
From the above table the market value of;
Firm x will be firm y will be
10,000,000*10 = 100,000,000 (5,000,000*10) + 50,000,000
Because this firm uses only shares sales. =100,000,000
 Case study
Now Firm Y uses Debt and Equity
The Debt is 50,000,000
Equity is 50,000,000
On addition it is 100,000,000
But Firm Y is required to pay an interest of 5% on its debt which is;
50,000,000*5/100
=2,500,000
Therefore the returns on equity will be the earnings minus the interest on debts
100,000,000 – 5,500,000 = 95,500,000
The return per shares =
95,500,000/100,000,000
= 9.55
Therefore the returns on equity is
9.55/10
9.55%
However if this firm had sold its stocks at a premium which is referred to as the leverage, the firm could generate
arbitrage profit
What Does Capital Structure Mean?
Overview

The term capital structure is made up of two words grammatically. In view of this I would like to

explain the words used on the layman’s view.

According to Longman dictionary the word capital is an event or situation which helps to get a result or

an advantage.

Structure on the other hand as a word is the arrangement of different parts of something into a pattern or

system in which parts is connected to each other.

From the above the layman simply defines capital structure as the arrangement of events or situation

which helps to get a result or an advantage.

If the above explanation is in the layman’s view then what is capital structure based on area of study.

Capital structure is the combination of debt, equity and other sources of finance that is used to fund the

long-term financing of an organization.

 Definition
Capital structure is how a company finances its operations. The three
most basic ways of finance are through debt, equity (or the issue of
stock) and, for a small business, personal savings.

Capital structure usually refers to how much of each type of financing

a company holds as a percentage of all its financing. Generally
speaking, a company with a high level of debt compared to equity is
thought to carry a higher risk, though some analysts do not believe that
capital structure matters to risk or profitability
 Theories of Capital Structure
There are several theories that form the framework of capital structure. These
include;
 Modigliani miller theory:
This states that the value of a company in a perfect market is unaffected by the way the company is
financed by through the capital structure it employs. Therefore according to this theory the value of a
firm is determined by the level of debts and equity, this aids the firm to determine the capital structure to
adopt in other to achieve high profitability.

 The trade-off theory:

This theory recognizes that capital raised by firms is constituted by both debt and equity, however the
theory states that there is an advantage of financing through debts due to tax benefit of the debts,
however some costs arise as a result of debt cost and bankrupt costs and non-bankrupt costs.
However this theory has faced a lot of critics whereby Miller (1977) whereby he states that the theory
only seems to be an equivalent to a balance between a rabbit and a horse where the theory only
considers debt and equity in financing in the absence of other factors that influence capital structure in
an organization.
Other critics’ states that there are other factors such as the changes in the price of assets will result into
the variations in the market structure of a firm.
 Theories of Capital Structure
 The agency cost theory:
This theory gives the clear indication of the importance of capital structure; it gives the
importance of management to adopt the most optimal form of capital structure
Pecking order theory:
This theory was developed by Stewart Myers (1984), this theory states that firms will
adhere to the hierarchy of financing whereby the firm will prefer to finance itself
internally and when all internal fiancés are depleted, it will opt for equity , therefore this
theory supports the fact that debt are preferred by firms than equity.
However the Modigliani miller theory provides the basis of which a modern company
should determine its capital structure.
 Components of Capital Structure
From the definitions and explanations above, there are two main components of capital
structure.
We are going to look at them in detail.:

 DEBT
What is debt finance?

 When a firm raises money for working capital or capital expenditures by selling bonds, bills or

notes to individual and/or institutional investors. In return for lending money, the individual or

institution become creditors and receive a promise that the principal and interest on the debt is paid.

A bond is a debt investment in which an investor loans money to an entity (corporate or governmental)

that borrows the fund for a defined period of time at a fix interest rate.

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and

when the loan funds (bond principal) are to be returned (maturity date).
DEBT

A loan is what we typically think of when Debt financing is mentioned. 

 Debt financing is when a creditor decides to loan funds in exchange for reimbursement in the
future with accumulated interest.
The creditor does not acquire an ownership privilege in the debtor's venture.
 Debt financing is generally considered smart because debtors do not surrender any ownership
interests in their business.
Other reasons debt financing is considered smart are because the financing cost is more or less a fixed
expense and interest on the loan is deductible.

Cost of debt
 Cost of debt is the effective rate that a company pays on its current debt. This is calculated
either before-or-after tax returns; however because interest expenses are deductible, the after-tax is
mostly used.
A company would use various bonds, loans and other forms of debt so this measure is useful for
giving an idea as to the overall rate being paid by the company to use debt financing.
Cost of debt

The measure can also give investors an idea as to the riskiness of the company as compared to

others because riskier companies generally have a higher cost of debt.

Advantages of using debt financing

•Experts indicate that debt financing can be a useful strategy, particularly for companies with

good credit and a stable history of revenues, earnings, and cash flow. But small business

owners should think carefully before committing to debt financing in order to avoid cash flow

problems and reduced flexibility.

•It allows the founders to retain ownership and control of the company.

•It provides small business owners with a greater degree of financial freedom.

•Debt obligations are limited to the loan repayment period, after which the lender has no further

claim on the business.

Disadvantages of using debt financing
 The main disadvantage of debt financing is that it requires a small business to make regular
monthly payments of principal and interest. Very young companies often experience shortages
in cash flow that may make such regular payments difficult.

 Most lenders provide severe penalties for late or missed payments, which may include
charging late fees, taking possession of collateral, or calling the loan due early.

 Failure to make payments on a loan, even temporarily, can adversely affect a small
business's credit rating and its ability to obtain future financing.

 Another disadvantage associated with debt financing is that its availability is often limited
to established businesses. Since lenders primarily seek security for their funds, it can be difficult
for unproven businesses to obtain loans.

 Finally, the amount of money small businesses may be able to obtain via debt financing is
likely to be limited, so they may need to use other sources of financing as well
 EQUITY
What is Equity financing?
 The act of raising money for companies activities by selling common or preferred stocks to
individual or institutional investors. In return for the money paid, shareholders receive ownership
interest in the corporation. This is also known as share capital.
This is where a company raises money by issuing shares.

 Cost of equity
In financial theory, the cost of equity is the return that stockholders require for a company.
A firm's cost of equity represents the compensation that the market demands in exchange for owning
the asset and bearing the risk of ownership.

Advantages of Equity financing

The main advantage of equity financing is that it is easy and fast to raise and using this means can
raise a lot of capital for a company.
Disadvantage of equity financing
Unlike debt financing, claims does not end until stockholders stock are sold
out.
 CONCLUSION
 Capital structure is very crucial to firm’s value; the capital structure will
determine the final value of the company whereby the value of the company will
be determined by the level of equity and debts, the Modigliani miller theory
states that the value of firm is determined by the debts and equity, where the
value of the firm is derived from adding up the debts and equity. They considered
two firms where one is financed using debt and equity while the other is financed
by equity only, however the value of the two firms in the market are the same in
both cases.
Finally it is clear that the Modigliani miller theory is the only theory that gives a
clear guidance to the form of capital structure that firms should adopt.

It is the only model that gives guidelines to modern firms regarding the capital
structure these firms and organizations should adopt, this theory however is
based on some drastic assumption but like all theories there has to be assumption
made to derive the required relationship between variables so as to state the
theory.

Well in any organization there needs to be a mix of financing sources, so

even though you will choose debt over equity, in some instances to
satisfy some interest parties’ equity must be used. So there lies your
answer. There is no text book answer. It is more practical.
 The major reasons are:
 Though debt is cheaper it is more risky. Because there is an obligation to pay back the interest on
debt and debt amount irrespective of making profit or loss. But dividends to the equity shareholders
will be distributed only if company makes profit.
 Raising huge capital is not possible only by going for debt.
 By going to equity not only firms raise huge amount of capital in a short period but also they can
spread the risk of doing business.
 Equities are expensive because the expectation of shareholders is more as they are taking more
risk.
 The market value of the equity rises if the business does well and has a robust future outlook.
This leads to the promoter holding also multiplying in value though it is notional to a great extent. In
times of need the promoter can sell part stake in the business by offloading 5-10% equity to raise
cash. The same can’t be said about debt.