THE CVM UNIVERSITY

Faculty of Commerce, Management and Law

S. G. M. English Medium College of Commerce and Management (SEMCOM)
A Constituent College of CVM University

M.COM Semester –II Paper Code: PPFM Paper Title: Principles and Practices of
Financial Management

Module Title/Topic Content

No. Session
2  Capital structure : meaning and feature
 Concept of optimum capital structure 12
 Factors affecting capital structure decision
 Capital structure theories – Net Income Approach , Net
Operating Approach , Miller –Modigliani Approach-
Traditional Approach

Capital Structure: meaning and features

Introduction

A firm needs funds for long - term requirements and working capital. These funds are raised
through different sources both short - term and long - terms. The long - term funds required by a
firm are mobilized through owners' funds (equity share, preference shares and retained earnings)
and long – term debt (debentures and bonds). A mix of various long - term sources of funds
employed by a firm is called capital structure.

Capital structure refers to the long - term sources of funds employed by firm, viz, equity shares,
preference shares, reserves and debt capital.

According to Gerestenberg, "Capital structure of a company refers to the composition or make –

up of its capitalization and it includes all long - .term capital resources, viz, loans, bonds, shares
and reserves" Thus capital structure is made - up of debt and equity securities and refers to
permanent financing of a firm !

For example, the capital structure of a company might be 40% long-term debt (bonds), 10%
preferred stock, and 50% common stock.

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Component of Capital Structure

The meaning of Capital structure can be described as the arrangement of capital by using
different sources of long term funds which consists of two broad types, equity and debt. The
different types of funds that are raised by a firm include preference shares, equity shares,
retained earnings, long-term loans etc. These funds are raised for running the business.

Equity Capital: Equity capital is the money owned by the shareholders or owners. It consists of
two different types

a) Retained earnings: Retained earnings are part of the profit that has been kept separately by
the organisation and which will help in strengthening the business.

b) Contributed Capital: Contributed capital is the amount of money which the company owners
have invested at the time of opening the company or received from shareholders as a price for
ownership of the company.

Debt Capital: Debt capital is referred to as the borrowed money that is utilized in business.
There are different forms of debt capital.

a) Long Term Bonds: These types of bonds are considered the safest of the debts as they have
an extended repayment period, and only interest needs to be repaid while the principal needs
to be paid at maturity.
b) Short Term Commercial Paper: This is a type of short term debt instrument that is used by
companies to raise capital for a short period of time

From a technical perspective, the capital structure is the careful balance between equity and debt
that a business uses to finance its assets, day-to-day operations, and future growth. Capital
Structure is the mix between owner’s funds and borrowed funds.

 FUNDS = Owner’s funds + Borrowed funds.

 Owner’s funds = Equity share capital + Preference share capital + reserves and surpluses +
retained earnings = EQUITY

 Borrowed funds = Loans + Debentures + Public deposits = DEBT

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 Features of capital structure

 Capital structure decision is concerned with the sources of long term funds such as debt and
equity capital.
 Capital structure is defined as the mix of various long term sources of funds broadly
classified as debt and equity. Hence capital structure is also referred to as ‘Debt Equity Mix’
of a company.
 Capital structure represents the proportionate relationship between debt and equity in the
total capitalization of the company. Equity capital includes paid up share capital, share
premium, reserves and surplus (retained earnings) while debt capital includes bonds, loans,
debentures etc.
 For the purpose of capital structure, preference shares are also classified in the category of
debt capital. This is because preference shares also bear a fixed rate of dividend and they are
generally redeemable.
 From the viewpoint of the company raising funds, debt is considered to be a cheaper source
than equity capital. However debt also increases the financial risk of the company and may
be responsible for increase in cost of equity.
 Capital structure decision, in turn, affects overall cost of capital of a company.
 The capital structure decision should be examined from the view point of its impact on firm’s
value. If capital structure affects a firm’s value then the firm should try to have an optimal
capital structure at which overall cost of capital is minimum and value of the firm is
maximum

Concept of Optimum Capital structure

Optimal capital structure is a financial measurement that firms use to determine the best mix of
debt and equity financing to use for operations and expansions. This structure seeks to lower the
cost of capital so that a firm is less dependent on creditors and more able to finance its core
operations through equity.

In general, the optimal capital structure is a mix of debt and equity that seeks to lower the cost of
capital and maximize the value of the firm. To calculate the optimal capital structure of a firm,

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analysts calculate the weighted average cost of capital (WACC) to determine the level of risk that
makes the expected return on capital greater than the cost of capital.

By calculating the cost of debt and the cost of equity, analysts multiply the cost of debt by the
weighted average cost of debt and the cost of equity by the weighted average cost of equity and
add up the results from each security involved in the total capital of the company.

Key Points in Designing an Optimal Capital Structure

 Maximize the company's wealth: An optimal capital structure will maximize the company's
net worth, wealth, and market value. The wealth of the company is calculated in terms of the
present value of future cash flows. This is discounted by the WACC.
 Minimize the cost of capital: The lower the cost of the capital, the lower is the risk of
insolvency. Companies in industries that have uncertain future cash flows should keep their
cost of financing minimal. The lower the cost of capital, the higher will be its present value
of future cash flows.
 Simplicity in structure: It should be simple to structure and understand. A complicated
capital structure will only create confusion.
 Maintain control: An optimal capital structure maintains the owners' rights and control.

Features of an appropriate capital structure

It is the duty of the financial manager to develop an appropriate capital structure which is most
advantageous to the company. The capital structure should be planned carefully keeping in view,
the interests of the equity shareholders' as they are the ultimate owners of the company. The
planning and designing of an appropriate capital structure is not an easy task. However, it must
be seen while designing the capital structure, that a sound or appropriate capital structure should
have the following features:

i) Profitability: The capital structure of the company should be most advantageous. It should
maximize the earnings per share while minimizing cost of financing.

ii) Solvency: Excessive use of debt 'threatens the solvency of the company. Therefore, the debt
capital should be employed up to such a level that the financial risk is within .manageable limits.

iii) Flexibility: The capital structure should be flexible enough to meet the changing conditions.
It must be possible for the company to provide funds whenever needed to finance any profitable
activities.

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iv) Conservatism: The capital structure of the company should be conservative in the sense that
the debt component of the firm should not exceed debt capacity of the firm. The debt capacity of
the firm depends on its ability to generate enough future cash flows for meeting interest
obligation and repayment of principal when it becomes due.

Control: The capital structure should be designed in such a way that it involves a minimum loss
of control of the company by the existing shareholders/directors.

The above mentioned are the general features of an appropriate capital structure. The relative
importance of these features may differ from one company to another. For example, one
company may give more importance to flexibility to conservatism, and another company may go
for solvency rather than profitability. But it may be said that the company's capital structure
should be easily adaptable.

Factors affecting capital structure decision

Several factors affect a company’s capital structure, and it also determines the composition of
debt and equity portions within this structure. Some of these factors are as follows:

 Business Size – The size and scale of a business affect its ability to raise finance. Small-sized
companies face difficulty in raising long-term borrowings. Creditors are hesitant to give them
loans because of the scale of their business operations. Even if they do get these loans, they
have to accept high-interest rates and stringent repayment conditions. It limits their ability to
grow their business.

 Earnings – Firms with relatively stable revenues can afford a more significant amount of
debt in their capital structure. Since debt repayment is periodical with fixed interest rates,
businesses with higher income prospects can bear these fixed financial charges. On the other
hand, companies that face higher fluctuations in their sales, like consumer goods, rely more
on equity shares to finance their operations.

 Competition: If a company operates in a business environment with more competition, it

should have more equity shares in its capital structure. Their earnings are prone to more
fluctuation compared to businesses facing lesser competition.

 Stage of the life cycle: A business in the early stage of its life cycle is more susceptible to
failure. In that case, they should use a more significant proportion of ordinary share capital to
finance their operations. Debt comes with a fixed interest rate, and it is more suitable for
companies with stable growth prospects.

 Creditworthiness: Any company that has a reputation for paying back its loans on time will
be able to raise funds on less stringent terms and at lower interest rates. It allows them to pay

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 back their loans on time. The opposite is true for firms that don’t have a good credit standing
in the market.

 Risk Aptitude of the Management: The attitude of a company’s management also affects
the proportion of debt and equity in the capital structure. Some managers prefer to follow a
low-risk strategy and opt for equity shares to raise finances. Other managers are confident of
the company’s ability to repay big loans, and they prefer to undertake a higher proportion of
long term debt instruments.

 Control: A management that wants outside interference in its operations may not raise funds
through equity shares. Equity shareholders have the right to appoint directors, and they also
dilute the stake of owners in the company. Some companies may prefer debt instruments to
raise funds. If the creditors get their installments on loans and interest on time, they will not
be able to interfere in the workings of the business. But if the company defaults on their
credit, the creditors can remove the present management and take control of the business.

 State of Capital Market: The tendencies of investors and creditors determine whether a
company uses more debt or equity to finance their operations. Sometimes a company wants
to issue ordinary shares, but no one is willing to invest due to the high-risk nature of their
business. In that case, the management has to raise funds from other sources like debt
markets.

 Taxation Policy: The government’s monetary policies in terms of taxation on debt and
equity instruments are also crucial. If a government levies more tax on gains from investing
in the share market, investors may move out of equities. Similarly, if the interest rate on
bonds and other long-term instruments is affected due to the government’s policy, it will also
influence companies’ decisions.

 Cost of Capital: The cost of raising funds depends on the expected rate of return for the
suppliers. This rate depends on the risk borne by investors. Ordinary shareholders face the
maximum risk as they don’t get a fixed rate of dividend. They get paid after preference
shareholders receive their dividends. The company has to pay interest on debentures under all
circumstances. It attracts more investors to opt for debentures and bonds.

Conclusion

The proportion of debt and equity funds in a company is dependent on both internal and external
forces. Businesses need to keep this in mind while deciding on the ratio of debt and equity
instruments within their capital structure.

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 Capital structure theories – Net Income Approach , Net Operating Approach ,
Miller –Modigliani Approach- Traditional Approach

The capital structure decision should be examined from the view point of its impact on firm’s
value. If capital structure affects a firm’s value then the firm should try to have an optimal capital
structure at which overall cost of capital is minimum and value of the firm is maximum.

There exist two schools of thought on the relationship between capital structure and value of
firm.

One view is that capital structure is relevant i.e. capital structure affects the value of a firm.
Capital structure theories which support this view are – Net Income approach and Traditional
Approach.

The other school of thought (led by Modigliani and Miller) agrees on the irrelevance of capital
structure i.e. capital structure is irrelevant in determining the value of firm. Theories which
support this view include – Net Operating Income and Modigliani Miller Hypothesis.

It must be noted that Modigliani Miller Hypothesis (MM Hypothesis) as originally developed
shows that in the absence of corporate taxes capital structure is irrelevant to the value of a firm.
However when corporate taxes are considered then MM hypothesis states that capital structure is
relevant for the value of a firm.

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 Net Income (NI) Approach

According to this approach, capital structure decision is relevant to the value of the firm. An
increase in financial leverage will lead to decline in the weighted average cost of capital
(WACC), while the value of the firm as well as market price of ordinary share will increase.
Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a
consequent decline in the value as well as market price of equity shares.

From the above diagram, Ke and Kd are assumed not to change with leverage. As debt increases,
it causes weighted average cost of capital (WACC) to decrease

The value of the firm on the basis of Net Income Approach can be ascertained as follows:

Value of Firm (V) = S + D

Where,

V = Value of the firm

S = Market value of equity

D = Market value of debt

Market value of equity (S) =NI/ Ke

Where,
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NI= Earnings available for equity shareholders
Ke = Equity Capitalization rate
Under, NI approach, the value of the firm will be maximum at a point where weighted average
cost of capital (WACC) is minimum. Thus, the theory suggests total or maximum possible debt
financing for minimizing the cost of capital. The overall cost of capital under this approach is

Overall cost of capital = EBIT / Value of the firm

Thus according to this approach, the firm can increase its total value by decreasing its overall
cost of capital through increasing the degree of leverage. The significant conclusion of this
approach is that it pleads for the firm to employ as much debt as possible to maximize its value.

ILLUSTRATION 1

Rupa Ltd.’s EBIT is Rs. 5,00,000. The company has 10%, Rs. 20 lakh debentures. The equity
capitalization rate i.e. Ke is 16%.

You are required to CALCULATE:

(i) Market value of equity and value of firm

(ii) Overall cost of capital.

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 Net Operating Income Approach (NOI)

NOI means earnings before interest and tax (EBIT). According to this approach, capital structure
decisions of the firm are irrelevant.

Any change in the leverage will not lead to any change in the total value of the firm and the
market price of shares, as the overall cost of capital is independent of the degree of leverage. As
a result, the division between debt and equity is irrelevant.

As per this approach, an increase in the use of debt which is apparently cheaper is offset by an
increase in the equity capitalization rate. This happens because equity investors seek higher
compensation as they are opposed to greater risk due to the existence of fixed return securities in
the capital structure.

The above diagram shows that Ko (Overall capitalization rate) and (debt – capitalization rate) are
constant and Ke (Cost of equity) increases with leverage.

ILLUSTRATION

Amita Ltd’s operating income (EBIT) is Rs. 5,00,000. The firm’s cost of debt is 10% and
currently the firm employs Rs. 15,00,000 of debt. The overall cost of capital of the firm is 15%.
You are required to CALCULATE: (1)Total value of the firm (2) Cost of equity.

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 Modigliani-Miller Approach (MM)

The NOI approach is definitional or conceptual and lacks behavioral significance. It does not
provide operational justification for irrelevance of capital structure. However, Modigliani-Miller
approach provide behavioral justification for constant overall cost of capital and therefore, total
value of the firm.

MM Approach – 1958: without tax:

This approach describes, in a perfect capital market where there is no transaction cost and no
taxes, the value and cost of capital of a company remain unchanged irrespective of change in the
capital structure. The approach is based on further additional assumptions like:

 Capital markets are perfect. All information is freely available and there are no transaction
costs.
 All investors are rational.
 Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk.
 Non-existence of corporate taxes.

Based on the above assumptions, Modigliani-Miller derived the following three propositions:

1) Total market value of a firm is equal to its expected net operating income divided by the
discount rate appropriate to its risk class decided by the market.
Value of levered firm (Vg) = Value of unlevered firm (Vu)

2) A firm having debt in capital structure has higher cost of equity than an unlevered firm.
The cost of equity will include risk premium for the financial risk. The cost of equity in a
levered firm is determined as under:

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3) The structure of the capital (financial leverage) does not affect the overall cost of capital.
The cost of capital is only affected by the business risk.

It is evident from the above diagram that the average cost of the capital (Ko) is a constant
and not affected by leverage. The value of the levered firm can neither be greater nor
lower than that of an unlevered firm according this approach. The two must be equal.
There is neither advantage nor disadvantage in using debt in the firm’s capital structure.

The shortcoming of this approach is that the arbitrage process as suggested by

Modigliani-Miller will fail to work because of imperfections in capital market, existence
of transaction cost and presence of corporate income taxes.

MM Approach- 1963: with tax

In 1963, MM model was amended by incorporating tax, they recognized that the value of
the firm will increase, or cost of capital will decrease where corporate taxes exist. As a
result, there will be some difference in the earnings of equity and debt holders in levered
and unlevered firm and value of levered firm will be greater than the value of unlevered
firm by an amount equal to amount of debt multiplied by corporate tax rate.

MM has developed the formulae for computation of cost of capital (Ko), cost of equity
(Ke) for the levered firm.

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 Traditional Approach

This approach favour that as a result of financial leverage up to some point, cost of capital comes
down and value of firm increases. However, beyond that point, reverse trends emerge. The
principle implication of this approach is that the cost of capital is dependent on the capital
structure and there is an optimal capital structure which minimizes cost of capital.

Under this approach:

1. The rate of interest on debt remains constant for a certain period and thereafter with an
increase in leverage, it increases.

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2. The expected rate by equity shareholders remains constant or increase gradually. After that,
the equity shareholders start perceiving a financial risk and then from the optimal point and the
expected rate increases speedily.

3. As a result of the activity of rate of interest and expected rate of return, the WACC first
decreases and then increases. The lowest point on the curve is optimal capital structure.

Optimum capital structure occurs at the point where value of the firm is highest and the
cost of capital is the lowest.

According to net operating income approach, capital structure decisions are totally
irrelevant. Modigliani-Miller supports the net operating income approach but provides
behavioral justification. The traditional approach strikes a balance between these
extremes.

Main Highlight of Traditional Approach

The firm should strive to reach the optimal capital structure and its total valuation
through a judicious use of the both debt and equity in capital structure. At the optimal
capital structure, the overall cost of capital will be minimum and the value of the firm
will be maximum.

*******

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