5.

Capital Structure
Theories
Professor & Lawyer
P. GURU PRASAD
Chapter – 9. Topic – 5
Business Finance
Financial Management
PLUS 2 /CBSE
VIVA the School by VVIT
 Capitalstructure determine the risk assumed
by the firm

 Capital structure determine the cost of capital

of the firm

 It affect the flexibility and liquidity of the firm

 It affect the control of the owner of the firm

CAPITAL SOURCE Sources of
long term
finance

Proprietor’s Borrowed
funds funds

Equity Preference Reserve Long term

capital capital and surplus debts
Top Debt Free Companies in India 2020: 1. Hindustan Unilever
2. HDFC Life Insurance: 3. SBI Life Insurance
4. ICICI Prudential Life Insurance: 5. HDFC AMC
6. Bajaj Holdings & Investment Limited (BHIL)
7. SKF India: 8. Maharashtra Scooters
9. CDSL: Central Depository Services 10. Lakshmi Machine Works Limited
Jio Platforms is no ordinary company. First, it's a part of RIL, the largest company in
India. Second, Jio is the market leader and making profits. It makes abundant business
sense to invest in Jio and make profits before the company gets listed on the stock market a
few years from now.13 investors have picked up a strategic stake in Reliance Jio platforms.
At present, Mukesh Ambani is the chairman and managing director of Reliance Jio. And after the
investment of the companies in the reliance Jio, now Mukesh is Asia’s richest and 7th richest
person in the world. JIO is going to be total
     Investor                                               Stake (%)  
DEBT FREE Company.
•Facebook                                                  9.90  
•Silver lake                                                 2.1
Now as a Business
•VISTA                                                        2.30  
Management Student
•General Atlantic                                        1.30  
•KKR                                                            2.30
imagine your self about
•Mubadala                                                   1.85
•Abu Dhabi Investment Authority              1.16
advantage of DEBT FREE
•TPG                                                            0.93
•L. Catterton                                                0.39
So the Capital
•Public Investment Fund                            2.3 EQUITY.
•Qualcomm                                                 0.15
Structure of JIO is going
•Google                                                        7.73
to be pure Equity Capital
•Intel                                                            0.39
Now, everyone wants to invest in Jio reliance as it is largest company in India. Secondly, Jio has
no stocks in the stock exchange so there is a high chance to get maximum profit. At present Jio
has almost $58 billions market value.
What Is Debt Financing?
Debt financing occurs when a firm raises money for working capital or
capital expenditures by selling debt instruments to individuals and/or
institutional investors. In return for lending the money, the
individuals or institutions become creditors and receive a promise
that the principal and interest on the debt will be repaid.
The other way to raise capital in the debt markets is to issue shares of
stock in a public offering; this is called equity financing.
KEY TAKEAWAYS
 Debt financing happens when a company raises money
by selling debt instruments to investors.
 Debt financing is the opposite of equity financing, which
includes issuing stock to raise money.
 Debt financing occurs when a firm sells fixed income
products, such as bonds, bills, or notes.
 Debt financing must be paid back, while equity financing
does not.
 Capital Structure refers to the combination
or mix of debt and equity which a company
uses to finance its long term operations.

 Raising of capital from different sources and

their use in different assets by a company is
made on the basis of certain principles that
provide a system of capital so that the maximum
rate of return can be earned at a minimum cost.

 This sort of system of capital is known as capital

structure.
 optimal Capital Structure

 The optimal or the best capital structure

implies the most economical and safe
ratio between various types of
securities.

 Itis that mix of debt and equity which

maximizes the value of the company
and minimizes the cost of capital.
Essentials of a sound or optimal Capital
structure
 Minimum Cost of Capital
 Minimum Risk
 Maximum Return
 Maximum Control
 Safety
 Simplicity
 Flexibility
 Attractive Rules
 Commensurate to Legal Requirements
 theories of Capital structure

1 . Net Income (NI) Theory- “David Durand”

2 . N e t Operating Income (NOI) Theory-

“David Durand”
3. TraditionalTheory- “Ezra Solomon.”
4. Modigliani-Miller (M-M) Theory- by

“Franco Modigliani and Merton Miller».

 5. CAPITAL STRUCTURE
 One
THEORIES
of the important decisions under financial management
relates to the financing pattern or the proportion of the use of
different sources in raising funds. On the basis of ownership, the
sources of business finance can be broadly classified into two
categories viz., ‘owners funds’ and ‘borrowed funds’.
 Owner’s funds consist of equity share capital, preference share
capital and reserves and surpluses or retained earnings. Borrowed
funds can be in the form of loans, debentures, public deposits etc.
These may be borrowed from banks, other financial institutions,
debenture holders and public.
 Capital structure refers to the mix between owners and borrowed
funds. These shall be referred as equity and debt in the subsequent
text. It can be calculated as debt-equity ratio (DEBT/EQUITY) or as
the proportion of debt out of total capital (DEBT/DEBT+EQUITY)
Debt and equity differ significantly in their cost and riskiness for the
firm.
 5. CAPITAL STRUCTURE
THEORIES
Cost of debt is lower than cost of equity for a firm
because lender’s risk is lower than equity
shareholder’s risk, since lenders earn on assured
return and repayment of capital and, therefore, they
should require a lower rate of return.
Additionally, interest paid on debt is a deductible
expense for computation of tax liability whereas
dividends are paid out of after-tax profits.
Increased use of debt, therefore, is likely to lower the
overall cost of capital of the firm provided that cost of
equity remains unaffected. Impact of a change in the
debt-equity ratio upon the earning per share is dealt
with in greater details later in this chapter.
 5. CAPITAL STRUCTURE THEORIES
 Debt is cheaper but is more risky for a business
because payment of interest and the return of
principal is obligatory for the business. Any
default in meeting these commitments may force
the business to go into liquidation. There is no
such compulsion in case of equity, which is
therefore, considered riskless for the business.
 Higher use of debt increases the fixed financial
charges of a business. As a result, increased use
of debt increases the financial risk of a business.
Financial risk is the chance that a firm would fail
to meet its payment obligations.
 5. CAPITAL STRUCTURE THEORIES
 Capital structure of a business thus, affects both the
profitability and the financial risk.
 A capital structure will be said to be optimal when
the proportion of debt and equity is such that it
results in an increase in the value of the equity share.
In other words, all decisions relating to capital
structure should emphasis on increasing the
shareholders wealth.
 The proportion of debt in the overall capital is also
called financial leverage. Financial leverage is
computed as D/E or D/D+E, when D is the Debt and E
is the Equity.
 5. CAPITAL STRUCTURE THEORIES

As the financial leverage increases, the

cost of funds declines because of
increased use of cheaper debt but the
financial risk increases.
The impact of financial leverage on the
profitability of a business can be seen
through EBITEPS (Earning before Interest
and Taxes- Earning per Share) analysis as
in the following example.
EPS = (EBIT-I)(I-t)-PD
n
Where :
EPS = earning per share
EBIT = earning before int. and tax
I = int. charged per annum
t= tax rate
PD = preference dividend
n = no. of equity shares
Example 1 Company X Ltd
Total Funds used( Equity + Debt Capital) Total Investment Rs. 30 Lakh
Interest rate ( 10% = 0.83 Paisa, less than one rupee interest) Bank Interest @10% p.a.
Tax rate (Income tax payable to the Govt) Income Tax @ 30% on Profits
EBIT (Profit before Interest and Tax) Profit earned Rs. 4 Lakh
Debt (Barrowed Funds) APPLY the 3 Situations
Situation I - 100% Own Funds(30 Lakhs)(3lakh shares 10 each) Own Capital 30 Lakhs(3Lakh shares)
Situation II- 33% Barrowed funds and 67% own funds LOAN-Rs. 10 Lakh/ Own 20 Lakhs
Situation III- 67% Barrowed funds and 33% own funds LOAN-Rs. 20 Lakh/ Own 10 Lakhs

EBIT-EPS Analysis Situation I (own Capital) Situation II (Loan 10L) Situation III (Loan 20L)

EBIT 4,00,000 (Profit) 4,00,000 (Profit) 4,00,000 (Profit)

Interest 10% NIL 1,00,000 (Interest) 2,00,000 (Interest)

EBT(Earnings before taxes) 4,00,000 3,00,000 (After Interest) 2,00,000 (After Interest)

Corporate Tax 30% 1,20,000 90,000 60,000

EAT (Earnings after 2,80,000 2,10,000 1,40,000

taxes)
No. of shares of Rs.10 3,00,000 (0:1)D/E 2,00,000 (1:2) D/E 1,00,000 (2:1) D/E

EPS (Earnings per share) 0.93 1.05 1.40

 5. CAPITAL STRUCTURE THEORIES
• Three situations are considered. There is no
debt in situation-I i.e. (unlevered business).
• Debt of Rs. 10 lakh and 20 lakh are assumed in
situations-II and III, respectively. All debt is at
10% p.a.
• The company earns Rs. 0.93 per share if it is
unlevered. The cost of Debt is 10%
• With debt of Rs. 10 lakh its EPS is Rs. 1.05.
• With a still higher debt of Rs. 20 lakh, its, EPS
rises to Rs. 1.40.
 5. CAPITAL STRUCTURE THEORIES
• Why is the EPS rising with higher debt?
• It is because the cost of debt is lower
than the return (PROFITS) that company
is earning on funds employed.
• The company is earning a return on
investment (ROI) of 13.33% (EBIT/TOTAL
INVESTMENT*100)= (4LAKHS/30LAKHS*100)
•This is higher than the 10%
interest it is paying on debt funds.
 5. CAPITAL STRUCTURE THEORIES
• With higher use of debt, this
difference between ROI and Cost of
debt increases the EPS.
• This is a situation of favorable
financial leverage.
• In such cases, companies often
employ more of cheaper debt to
enhance the EPS.
• Such practice is called Trading on
Equity.
5. CAPITAL STRUCTURE THEORIES –
TRADING ON EQUITY
• Trading on Equity refers to the increase in profit
earned by the equity shareholders due to the
presence of fixed financial charges like interest.
Now consider the following Case of
Company Y.
• All details are the same except that the
company is earning a profit before interest and
taxes of Rs. 2 lakh.
• In the following example, the EPS of the
company is falling with increased use of debt.
 5. CAPITAL STRUCTURE THEORIES – TRADING ON
Example II-Company Y
EQUITY
Situation I (Own Capital) Situation II (Loan 10L) Situation III (Loan 20L)

EBIT (PROFIT) 2,00,000 2,00,000 2,00,000

Interest-10% NIL 1,00,000 2,00,000
EBT 2,00,000 1,00,000 NIL
TAX- 30% 60,000 30,000 NIL
EAT 1,40,000 70,000 NIL
No. of shares of Rs.10 3,00,000 (0:1)D/E Ratio 2,00,000 (1:2) D/E Ratio 1,00,000 (2:1) D/E Ratio
EPS 0.47 0.35 NIL

It is because the Company’s rate of return on investment (ROI) is less

than the cost of debt. Because in the above case, the profits are only 2
lakhs, and ROI is 0.47 paisa per share. But where as the company is
paying 0.83 paisa as the interest to the barrowed funds. So Trading on
Equity by the company results in less rate of return. In this type of
situations the management should not depend on the barrowed funds.
According to Capital Structure Theories it is always advisable that,
Trading on Equity can be possible only when the Cost of Debt is less
than the ROI.
 5. CAPITAL STRUCTURE THEORIES
The ROI of the company Y is 2 Lakhs/30 Lakhs*100 i.e. 6.67%.
whereas the interest rate on debt is 10%. In such cases, use of debt
reduces the EPS.
This is a situation of unfavorable financial leverage.
Trading on Equity is clearly unadvisable in such a situation.
Even in case of Company X, reckless use of Trading on
Equity is not recommended. An increase in debt may
enhance the EPS but as pointed out earlier, it also raises
the financial risk.
Ideally, a company must choose that risk-return
combination which maximizes shareholders wealth. The
debt-equity mix that achieves it, is the optimum
capital structure
Factors affecting the Choice of Capital Structure
Deciding about the capital structure of a firm
involves determining the relative proportion of
various types of funds. This depends on various
factors.
For example, debt requires regular servicing.
Interest payment and repayment of principal are
obligatory on a business.
In addition a company planning to raise debt must
have sufficient cash to meet the increased outflows
because of higher debt.
Similarly, important factors which determine the
choice of capital structure are as follows:
 14 Factors
Affecting the
Choice of Capital
Structure in the
Business
 Factors affecting the Choice of Capital
Structure
1.Cash Flow Position: Size of projected cash flows
must be considered before issuing debt. Cash flows
must not only cover fixed cash payment obligations
but there must be sufficient buffer also.
It must be kept in mind that a company has cash
payment obligations for
(I) normal business operations;
(ii) for investment in fixed assets; and
(iii) for meeting the debt service commitments
i.e., payment of interest and repayment of
principal.
Factors affecting the Choice of Capital Structure
2. Interest Coverage Ratio (ICR): The interest coverage
ratio refers to the number of times earnings before
interest and taxes of a company covers the interest
obligation.

This may be calculated as follows: ICR = EBIT/ Interest.

The higher the ratio, lower is the risk of company failing

to meet its interest payment obligations.
However, this ratio is not an adequate measure. A firm
may have a high EBIT but low cash balance. Apart from
interest, repayment obligations are also relevant.
 Factors affecting the Choice of Capital
Structure
3. Debt Service Coverage Ratio (DSCR): Debt
Service Coverage Ratio takes care of the
deficiencies referred to in the Interest Coverage
Ratio (ICR).
It is calculated as follows: A higher DSCR indicates
better ability to meet cash commitments and
consequently, the company’s potential to increase
debt component in its capital structure.
4. Cost of debt: A firm’s ability to borrow at a lower
rate increases its capacity to employ higher debt.
Thus, more debt can be used if debt can be raised at a
lower rate.
 Factors affecting the Choice of Capital
Structure
5. Return on Investment (ROI): If the ROI of the company
is higher, it can choose to use trading on equity to
increase its EPS, i.e., its ability to use debt is greater.
We have already observed in Example I that a firm can
use more debt to increase its EPS. However, in Example II,
use of higher debt is reducing the EPS.
It is because the firm is earning an ROI of only 6.67%
which lower than its cost of debt. In example I the ROI is
13.33%, and trading on equity is profitable.
It shows that, ROI is an important determinant of the
company’s ability to use Trading on equity and thus the
capital structure.
 Factors affecting the Choice of Capital
Structure
6. Tax Rate: Since interest is a deductible expense,
cost of debt is affected by the tax rate. The firms in
our examples are borrowing @ 10%. Since the tax rate
is 30%, the after tax cost of debt is only 7%. A higher
tax rate, thus, makes debt relatively cheaper and
increases its attraction vis-à-vis equity.
7. Floatation Costs: Process of raising resources also
involves some cost. Public issue of shares and
debentures requires considerable expenditure.
Getting a loan from a financial institution may not cost
so much. These considerations may also affect the
choice between debt and equity and hence the capital
 Factors affecting the Choice of Capital
Structure
8. Cost of Equity: Stock owners expect a rate of return from
the equity which is commensurate with the risk they are
assuming.
When a company increases debt, the financial risk faced by
the equity holders, increases.
Consequently, their desired rate of return may increase. It is
for this reason that a company can not use debt beyond a
point.
If debt is used beyond that point, cost of equity may go up
sharply and share price may decrease in spite of increased
EPS.
Consequently, for maximization of shareholders’ wealth, debt
can be used only up to a level.
 Factors affecting the Choice of Capital Structure
9. Risk Consideration: As discussed earlier, use of debt
increases the financial risk of a business.
 Financial risk refers to a position when a company is
unable to meet its fixed financial charges namely interest
payment, preference dividend and repayment obligations.
 Apart from the financial risk, every business has some
operating risk (also called business risk). Business risk
depends upon fixed operating costs.
 Higher fixed operating costs result in higher business risk
and vice-versa. The total risk depends upon both the
business risk and the financial risk.
 If a firm’s business risk is lower, its capacity to use debt is
higher and vice-versa.
 Factors affecting the Choice of Capital
Structure
10. Flexibility: If a firm uses its debt potential to the
full, it loses flexibility to issue further debt. To
maintain flexibility, it must maintain some borrowing
power to take care of unforeseen circumstances.
11. Control: Debt normally does not cause a dilution
of control. A public issue of equity may reduce the
managements holding in the company and make it
vulnerable to takeover. This factor also influences the
choice between debt and equity especially in
companies in which the current holding of
management is on a lower side.
Factors affecting the Choice of Capital Structure
12. Regulatory Framework: Every company operates within a
regulatory framework provided by the law e.g., public issue of
shares and debentures have to be made under SEBI
guidelines. Raising funds from banks and other financial
institutions require fulfillment of other norms. The relative
ease with which these norms can, be met or the procedures
completed may also have a bearing upon the choice of the
source of finance.
13. Stock Market Conditions: If the stock markets are bullish,
equity shares are more easily sold even at a higher price. Use
of equity is often preferred by companies in such a situation.
However, during a bearish phase, a company, may find raising
of equity capital more difficult and it may opt for debt. Thus,
stock market conditions often affect the choice between the
 Factors affecting the Choice of Capital
Structure
14. Capital Structure of other Companies: A useful
guideline in the capital structure planning is the debt
equity ratios of other companies in the same industry.
There are usually some industry norms which may help.
Care however must be taken that the company does not
follow the industry norms blindly.
For example, if the business risk of a firm is higher, it can
not afford the same financial risk. It should go in for low
debt.
Thus, the management must know what the industry
norms are, whether they are following them or deviating
from them and adequate justification must be there in
both cases.
  COST OF CAPITAL
• Cost of capital is an important business term for both
investors and companies. Cost of capital can best be
described as the ability to cover both asset and liability
expenditures while generating a profit.
• In a nutshell, it’s a rate of return that can help companies
decide to move forward on a project or help an investor
determine the risk of investing in a company.
The Gamut of Financial
Management