Capital Structure

Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital structure means the
arrangement of capital from different sources so that the long-term funds needed for the business
are raised.
Thus, capital structure refers to the proportions or combinations of equity share capital, preference
share capital, debentures, long-term loans, retained earnings and other long-term sources of funds
in the total amount of capital which a firm should raise to run its business.
According to James C. Van Horne, “The mix of a firm’s permanent long-term financing
represented by debt, preferred stock, and common stock equity”
According to Gerstenberg, “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, reserves, shares
and bonds”.

Optimal 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, 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.
Features of an Optimum Capital Structure:
The features of an optimum capital structure:
1. Simplicity: All businessmen are not educated. A complicated capital structure may not be
understood by all; on the contrary it may raise suspicions and create confusion. A capital
structure must be as simple as possible.
2. Profitability: An optimum capital structure is one which maximizes earning per equity share
and minimizes cost of financing.
3. Solvency: In a sound capital structure, content of debt will be a reasonable proportion of the
total capital employed in the business. As a result, it has minimum risk of becoming insolvent.
4. Flexibility: The capital structure of a firm should be such that it can raise funds as when
required.
5. Conservatism: The debt content in the capital structure of a firm should be within its
borrowing limits. It should be free from the risk of insolvency.
6. Control: The capital structure should be designed in such a way that it involves minimum risk
of loss of control of the firm.
7. Optimal debt-equity mix: Optimal debt-equity mix in the capital structure of a company
would be that point where the weighted average cost of capital is minimum. Optimum debt-
equity proportion establishes balance between owned capital and debt capital. The firm should
be cautious about the financial risk associated with the maximum utilization of debt.
8. Maximization of the value of the firm: An optimum capital structure makes the value of the
firm maximum.

Importance of Capital Structure:

1. Increase in value of the firm: A sound capital structure of a company helps to increase the
market price of shares and securities which, in turn, lead to increase in the value of the firm.
2. Utilization of available funds: A good capital structure enables a business enterprise to utilize
the available funds fully. A properly designed capital structure ensures the determination of
the financial requirements of the firm and raise the funds in such proportions from various
sources for their best possible utilization.
3. Maximization of return: A sound capital structure enables management to increase the profits
of a company in the form of higher return to the equity shareholders i.e., increase in earnings
per share. This can be done by the mechanism of trading on equity i.e., it refers to increase in
the proportion of debt capital in the capital structure which is the cheapest source of capital. If
the rate of return on capital employed (i.e., shareholders’ fund + long- term borrowings)
exceeds the fixed rate of interest paid to debt-holders, the company is said to be trading on
equity.
4. Minimization of cost of capital: A sound capital structure of any business enterprise
maximizes shareholders’ wealth through minimization of the overall cost of capital. This can
 also be done by incorporating long-term debt capital in the capital structure as the cost of debt
capital is lower than the cost of equity or preference share capital since the interest on debt is
tax deductible.
5. Solvency or liquidity position: A sound capital structure never allows a business enterprise to
go for too much raising of debt capital because, at the time of poor earning, the solvency
is disturbed for compulsory payment of interest to .the debt- supplier.
6. Flexibility: A sound capital structure provides a room for expansion or reduction of debt
capital so that, according to changing conditions, adjustment of capital can be made.
7. Undisturbed controlling: A good capital structure does not allow the equity shareholders
control on business to be diluted.
Factors Determining Capital Structure:
The following factors influence the capital structure decisions:
1. Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay fixed interest
liabilities. Generally, the higher proportion of debt in capital structure compels the company
to pay higher rate of interest on debt irrespective of the fact that the fund is available or not.
The non-payment of interest charges and principal amount in time call for liquidation of the
company.
2. Risk in variation of earnings: The higher the debt content in the capital structure of a
company, the higher will be the risk of variation in the expected earnings available to equity
shareholders. If return on investment on total capital employed (i.e., shareholders’ fund plus
long-term debt) exceeds the interest rate, the shareholders get a higher return.
3. On the other hand, if interest rate exceeds return on investment, the shareholders may not get
any return at all.
4. Cost of capital: Cost of capital means cost of raising the capital from different sources of
funds. It is the price paid for using the capital. A business enterprise should generate enough
revenue to meet its cost of capital and finance its future growth. The finance manager should
consider the cost of each source of fund while designing the capital structure of a company.
5. Control: The consideration of retaining control of the business is an important factor in capital
structure decisions. If the existing equity shareholders do not like to dilute the control, they
may prefer debt capital to equity capital, as former has no voting rights.
6. Trading on equity: The use of fixed interest bearing securities along with owner’s equity as
 sources of finance is known as trading on equity. It is an arrangement by which the company
aims at increasing the return on equity shares by the use of fixed interest bearing securities
(i.e., debenture, preference shares etc.).
7. Government policies: Capital structure is influenced by Government policies, rules and
regulations of SEBI and lending policies of financial institutions which change the financial
pattern of the company totally. Monetary and fiscal policies of the Government will also affect
the capital structure decisions.
8. Size of the company: Availability of funds is greatly influenced by the size of company. A
small company finds it difficult to raise debt capital. The terms of debentures and long-term
loans are less favorable to such enterprises. Small companies have to depend more on the
equity shares and retained earnings. On the other hand, large companies issue various types of
securities despite the fact that they pay less interest because investors consider large companies
less risky.
9. Needs of the investors: While deciding capital structure the financial conditions and
psychology of different types of investors will have to be kept in mind. For example, a poor or
middle class investor may only be able to invest in equity or preference shares which are
usually of small denominations, only a financially sound investor can afford to invest in
debentures of higher denominations. A cautious investor who wants his capital to grow will
prefer equity shares.
10. Flexibility: The capital structures of a company should be such that it can raise funds as and
when required. Flexibility provides room for expansion, both in terms of lower impact on cost
and with no significant rise in risk profile.
11. Period of finance: The period for which finance is needed also influences the capital structure.
When funds are needed for long-term (say 10 years), it should be raised by issuing debentures
or preference shares. Funds should be raised by the issue of equity shares when it is needed
permanently.
12. Nature of business: It has great influence in the capital structure of the business, companies
having stable and certain earnings prefer debentures or preference shares and companies
having no assured income depends on internal resources.
13. Legal requirements: The finance manager should comply with the legal provisions while
designing the capital structure of a company.
Components of Capital Structure
1) Equity Capital
Equity capital is the money owned by the shareholders or owners. It consists of two different
types
 Retained earnings: Retained earnings are part of the profit that has been kept separately
by the organization and which will help in strengthening the business.
 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.
2) Debt Capital
Debt capital is referred to as the borrowed money that is utilized in business. There are different
forms of debt capital.
 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.
 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

Theories of Capital Structure

Introduction
The manner in which a business organization finances its assets through various means like Equity,
Debt, Hybrid Securities, combination of some securities, or all of them, is termed as 'Capital
Structure'. In other words, capital structure of an organization refers to the various components of
its liabilities. A company's decision to have various components of its liabilities in an appropriate
ratio is of vital importance, as it is the key determinant of the financial risk, the company would
be exposed to, which in turn decides its market value. The relationship between a company's capital
structure and its market value can be best understood with the help of various theories and
approaches of capital structure.
Assumptions of Capital Structure Theories
In order to understand the theories of Capital Structure, certain presumptions have been made,
which are as follows:
1) That the funds can be raised only through two basic sources of funds:
i) Shareholders equity, and
ii) Debt with fixed rate of interest.
2) That the total assets of a company are pre-decided and no changes are possible in the investment
decisions of the company.
3) That the companies have a uniform policy to distribute the total profits among their shareholders
without setting aside any retained earnings.
4) That the operating profits of a company are specified without any expectation of further growth.
5) That the business risks of a company are specific, certain, stable and remain uninfluenced by
the financial mix.
6) That any form of taxes, either personal or corporate, are non-existent.
7) That the investors in the company have similar subjective probability distribution of expected
operating profits.
The relationship between capital structures, cost of capital and value of a company may be
explained through four major theories/approaches, which are depicted graphically as under,
followed by their description in detail.

Theories of Capital Structure

Relevance Theory of Irrelevance Theory of

Capital Structure Capital Structure

Net Operating
Net Income (NI)
Income (NOI)
Approach
Approach

Traditional Modigliani-Miller
Approach (MM) Approach
I. Relevance Theory of Capital Structure
1. Net Income Approach
Net Income Approach was presented by Durand. The theory suggests increasing value of the
firm by decreasing the overall cost of capital which is measured in terms of Weighted Average
Cost of Capital. This can be done by having a higher proportion of debt, which is a cheaper
source of finance compared to equity finance.
Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts
where the weights are the amount of capital raised from each source.
According to Net Income Approach, change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of
the company. The Net Income Approach suggests that with the increase in leverage (proportion
of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a
decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.
 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no sources of finance
like Preference Share Capital and Retained Earnings.
 All companies have uniform dividend payout ratio; it is 1.
 There is no flotation cost, no transaction cost and corporate dividend tax.
 Capital market is perfect, it means information about all companies are available to all
investors and there are no chances of over pricing or underpricing of security. Further it
means that all investors are rational. So, all investors want to maximize their return with
minimization of risk.
 All sources of finance are for infinity. There are no redeemable sources of finance.
Valuation of a Company,
V= S + D
Where,
V= Total Value of the Firm,
S= Market Value of Equity,
D= Market Value of Debt.
Market value of Equity may be calculated with the help of the following formula:
S= NI/Ke
Where,
NI= Earnings available for equity shareholders
Ke= Cost of Equity
The overall cost of capital can be ascertained as follows:
Overall Cost of Capital (Ko) = EBIT/V
Where,
EBIT= Earnings before Interest and tax,
V= Total Value of the Firm,
2. Traditional Approach
The traditional approach to capital structure stresses the fact that there is a right mix of equity and
debt in the capital structure, at which the market value of a company is maximum.
 This approach tells that in the capital structure of a company, debt should exist in the capital
structure only up to a specific point. Beyond this point, any increase in leverage would
result in a reduction in the value of the firm.
 In other words, it means that there is an optimum value of debt-to-equity ratio at which the
Weighted Average Cost of Capital (WACC) is the lowest, while the market value of the
firm is the highest.
 After the specific debt-to-equity ratio, the cost of equity goes up to offer a detrimental
effect to the WACC. When the debt-to-equity ratio goes above the threshold, the WACC
goes up and the market value of the firm starts to go down.

Assumptions under the Traditional Approach

Following are the assumptions under the Traditional Approach −
 The rate of interest on the debt stays constant for a certain period and after that, with an
increase in leverage, it goes up.
 The expected rate of interest in investment by equity shareholders remains constant or
increases gradually. After reaching the threshold, the equity shareholders start perceiving
a financial risk, and then from the optimal point, the expected rate of interest increases
quickly.
 As a result of the rate of interest and expected rate of return working together, the WACC
first starts to decrease, and then it increases. In the capital structure graph, the lowest point
refers to the optimal ratio.

Valuation of a Company,
V= S + D
Where,
V= Total Value of the Firm,
S= Market Value of Equity,
D= Market Value of Debt.
Market value of Equity may be calculated with the help of the following formula:
S= NI/Ke
Where,
NI= Earnings available for equity shareholders
Ke= Cost of Equity
The overall cost of capital can be ascertained as follows:
Overall Cost of Capital (Ko) = EBIT/V
Where,
EBIT= Earnings before Interest and tax,
V= Total Value of the Firm,

II. Irrelevance Theory of Capital Structure

Those who believe in perfect market conditions are of the view that the issue of capital structure
is irrelevant; implying that any change in capital structure has no influence on the value of
corporate wealth.
The reasons they argue are two-fold:
1) The shareholders opt for the arbitrage process, which results in any financial leverage having
no influence on total cash flow, and ultimately the value of corporate wealth remains unchanged.
2) Financial leverage does not bring about changes in the cost of capital, and, as a result, the value
of the firm remains unchanged.
These views are explained at great length by Durand and Modigliani and Miller. Therefore, the
reader must be acquainted here with the Net Operating Income (NOI) Approach and Modigliani-
Miller (M-M) hypothesis.
There are two theories which are of the view that capital structure is irrelevant:
1) Net Operating Income (NOI) Approach, and
2) Modigliani-Miller (MM) Approach.

1. Net Operating Income (NOI) Approach

Net Operating Income (NOI) Approach presumes that the cost of equity increases linearly with
leverage of an organization. However, change in leverage does not impact either the weighted
average cost of capital (WACC) or total value of the company, both of which remain constant,
despite the change in the degree of leverage.
Net operating income (NOI) Approach advocates that any change in the level of debt of a company
does not influence the total value of the company. According to this approach, neither the WACC
of a company nor its total value depends upon the capital structure decision or financial leverage.
Market value of a company depends upon its operating income and business risk associated with
its operations, both of which remain unaffected by the financial leverage or capital structure.
Financial leverage is capable of impacting only that part of the income, which is earned by debt
holders/equity holders but not the operating income of a company.
That is the precise reason why a change in debt-equity ratio of a company would not make any
difference in its market value.

Assumptions of Net Operating Income (NOI) Approach

There are following presumptions, which form the basis of net operating income (NOI) Approach:
1) Corporate taxes do not exist;
2) The overall cost of capital is not affected by the debt-equity ratio;
3) An increase in debt proportion in the capital structure changes the risk perception of the
shareholders.
4) Overall cost of capital of a business entity depends upon its business risk. Both the factors, viz.,
Overall cost of capital and business risk are stable.
5) Cost of debt is unvarying.
The total value of the firm on the basis of NOI Approach can be ascertained as follows:
Total Value of Firm (V) = EBIT/Ko Or NOI/Ko
Where,
V = Total value of the firm,
EBIT = Eaming before Interest and Tax
NOI = Net operating income,
K. = Overall cost of capital.
The total value of the equity on the basis of NOI
Approach can be ascertained as follows:
Total Value of Equity (E or S) = V - D
Where,
V = Total Value of the Firm,
D. = Total Value of Debt

2. Modigliani and Miller (MM) Approach

Modigliani and Miller’s Approach
Modigliani and Miller devised this approach during the 1950s. The fundamentals of the Modigliani
and Miller Approach resemble that of the Net Operating Income Approach. Modigliani and Miller
advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is
irrelevant to a company’s capital structure. Whether a firm is high on leverage or has a lower debt
component in the financing mix has no bearing on the value of a firm.
The Modigliani and Miller Approach further state that the operating income affects the firm’s
market value, apart from the risk involved in the investment. The theory states that the firm’s value
is not dependent on the choice of capital structure or financing decisions of the firm.
Assumptions of Modigliani and Miller Approach
 There are no taxes.
 Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
 There is a symmetry of information. This means that an investor will have access to the
same information that a corporation would, and investors will thus behave rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
 There is no corporate dividend tax.
The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a
mix of debt and equity) is the same as the value of an unleveraged firm (a firm wholly financed by
equity). Suppose the operating profits and future prospects are the same. If an investor purchases
shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.
Modigliani and Miller Approach: Two Propositions without Taxes
Proposition 1
With the above assumptions of “no taxes,” the capital structure does not influence the valuation of
a firm. In other words, leveraging the company does not increase the company’s market value. It
also suggests that debt holders in the company and equity shareholders have the same priority, i.e.,
earnings are equally split amongst them.
Proposition 2
It says that financial leverage is directly proportional to the cost of equity. With an increase in the
debt component, the equity shareholders perceive a higher risk to the company. Hence, in return,
the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction
here is that Proposition 2 assumes that debt shareholders have the upper hand as far as the claim
on earnings is concerned. Thus, the cost of debt reduces.
Formulas
Amongst the two companies, one of which is geared and the other one is un-geared, the market
value of the 'leveraged' company will exceed than that of the un-geared one by an amount equal to
the leveraged company's debt multiplied by the tax rate, as shown in the following equation:
Vg = Vu + DT
Where,
Vg= Market value of leveraged company
Vu= Market Value of Un-leveraged company
The market value of an un-leveraged company will be equal to the market value of its share, as
shown in the following formula:
Vu= S
Where,
S= Market Value of Equity
The cost of equity of a leveraged company is calculated by applying following formula:
Ke = Ko+[(Ko – Kd) * D/E]
Where,
Ke= Cost of Equity
Ko= Overall Cost of Capital of Un-leveraged firm
Kd= Cost of Debt
D/E= Debt to Equity Ratio
The WACC will be calculated by the following formula
WACC= (Cost of Equity * % equity) + (Cost of debt * % debt)
Modigliani and Miller Approach: Propositions with Taxes
The Modigliani and Miller Approach assumes that there are no taxes, but in the real world, this is
far from the truth. Most countries, if not all, tax companies. This theory recognizes the tax benefits
accrued by interest payments. The interest paid on borrowed funds is tax-deductible. However, the
same is not the case with dividends paid on equity. In other words, the actual cost of debt is less
than the nominal cost of debt due to tax benefits. The trade-off theory advocates that a company
can capitalize on its requirements with debts as long as the cost of distress, i.e., the cost of
bankruptcy, exceeds the value of the tax benefits. Thus, until a given threshold value, the increased
debts will add value to a company.
This approach with corporate taxes does acknowledge tax savings and thus infers that a change in
the debt-equity ratio affects the WACC (Weighted Average Cost of Capital). This means that the
higher the debt, the lower the WACC. The Modigliani and Miller approach is one of the modern
approaches of Capital Structure Theory.
The cost of equity of a leveraged company after tax is calculated by applying following formula:
Ke = Ko+[(1 – T) (Ko – Kd) * D/E]
Where,
Ke= Cost of Equity
Ko= Overall Cost of Capital of Un-leveraged firm
Kd= Cost of Debt
D/E= Debt to Equity Ratio
T= Tax Rate
The WACC after tax will be calculated by the following formula
WACC= (Cost of Equity * % equity) + (1 – T) (Cost of debt * % debt)