Capital structure is the mix of the long term sources of funds used by a firm.

It is made up of debt and equity securities and refers to

permanent financing of a firm.
The Capital structure is the composition of capitals from different sources of finance, primarily consisting of equity share holder’s
fund, preference share capital and long term external debt such as bond, debenture and bank loan.
Financing Decision also known as Capital Structure Decision is a very crucial decision made by the financial manager relating to
the financing-mix of an organization.
Financing Decision involves identification of various available sources of fund. The main sources of funds for a firm are
shareholders’ funds and borrowed funds. The shareholders’ funds refers to the equity capital and the retained earnings. Borrowed
funds refers to the finance raised through debenture, bonds, bank loan or other form of debt. The financing decision or capital
structure decision is concerned about the financing pattern or the proportion of the use of different sources in raising their funds.
The capital structure refers to the mix between owners and borrowed funds.

Capital structure decision is important for a firm because –

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. Utilisation of available funds:

A good capital structure enables a business enterprise to utilise 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 utilisation. A sound capital structure protects the business enterprise from over-capitalisation and under-
capitalisation.
3. Maximisation 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. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth through minimisation 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.

8. Minimization of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e., payment of fixed interest charges and
repayment of principal amount of debt in time) will also increase. A sound capital structure protects a business enterprise from such
financial risk through a judicious mix of debt and equity in the capital structure.

Determinants of capital structure –

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.

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 favourable to such enterprises. Small companies have to depend more on the equity
shares and retained earnings.
Cash inflows:

The selection of capital structure is also affected by the capacity of the business to generate cash inflows. It analyses solvency
position and the ability of the company to meet its charges.

Purpose of financing:

Capital structure of a company is also affected by the purpose of financing. If the funds are required for manufacturing purposes,
the company may procure it from the issue of long- term sources. When the funds are required for non-manufacturing purposes i.e.,
welfare facilities to workers, like school, hospital etc. the company may procure it from internal sources.

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.

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.
Management Style: Management styles range from aggressive to conservative. The more conservative a management may try to
grow the firm quickly, suing significant amount of debt to ramp up the growth of the company’s earning per share (EPS).
Business Risk: Business risk refers to the chance a business’s cash flow are not enough to cover its operating expenses like
cost of goods sold, rent and wages. There is negative relation between the capital structure and business risk. The chance of
business failure is greater if he firm has less stable earnings.

Operating leverage: This leverage depends on the operating fixed cost of the firm. If higher percentage of a firm’s total cost is
fixed operating costs, the firm is said to have a high degree of operating leverage. Higher the operating leverage, the greater the
chance of business failure and greater will be the weight of bankruptcy costs on enterprise financing decisions.

Capital structure theories –

1. Modigliani- Miller Approach (MM Theory)
Modigliani and Miller (MM) concluded that with perfect capital markets the total value of a firm should not depend on its capital structure.

When the firm has not debt, the cash flows paid to equity holders correspond to the free cash flows generated by the firm’s
assets.
When the firm has debt, these cash flows are divided between debt and equity holders.The value of the unlevered firms, Vu, must be
equal to the total value of he levered firm, VL =, which is the combined value of Debt plus Equity (D+E)

Propositions of MM Approach
 Proposition I : Value of Levered Firm is equal to Unlevered Firm

In the first proposition, MM argued that the market value of a firm is independent of its capital structure i.e value of levered firm is
equal to value of unlevered firm.

Proposition II : The cost of equity is a liner function of the firm’s equity ratio.
MM’s proposition II states that, with increasing leverage the cost of equity rises exactly to offset the advantage of reduced cost of
debt to keep the value of the firm constant.

MM Proposition II states that the value of the firm depends on three things:
1) Required rate of return on the firm’s assets (rA).
2) Cost of debt of the firm (rD)
3) Debt/Equity ratio of the firm (D/E)

Modigliani- Miller Theory with Corporate Tax in Proposition I

Cash flows of the levered firm are equal to the sum of the cash flows from the unlevered firm plus the interest tax shield. The total value
of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from debt.
VL= VU +PV (Interest Tax Shield)
In a presence of tax, the value of a levered company is higher than the value of an unlevered company by an amount equal to the
product of absolute amount of debt and tax rate

This can be expressed mathematically as follows:

 V  = V  + t × D
L UL

Where V  is the value of levered company i.e. company with some debt in its capital structure,
L

V  is the value of an un-levered company i.e. with no or lower debt,

UL

t is the tax rate and D is the absolute amount of debt.

Modigliani- Miller Theory with Corporate Tax in Proposition II

Since interest expense is tax-deductible, the equation for the weighted average cost of capital  in MM proposition II with
the corporate tax is expressed as:

WACC = Ke × E/V + Kd × ( 1 – t ) × D/ V

Modigliani- Miller Theory with Corporate Tax and Personal Tax in Proposition II

The presence of taxes on personal income, however, may reduce the advantage associated with debt financing.
If the return to investor from purchasing debt instrument are taxed at a higher rate than the returns on common stock, the overall
advantage of debt financing in the economy is reduced.
Modigliani- Miller Theory with Corporate Tax and Personal Tax in Proposition I
In the MM model with corporate taxes and Personal tax (ignoring the bankruptcy cost and agency cost), the net gain from leverage
is the difference between the value of the levered firm and unlevered firm is the product of debt financing in levered firm and
corporate tax rate.

2. Agency Cost Theory

Firms may experience dispute of interest among the management of the firm, debt holders and shareholders. These disputes
generally give rise to agency problems that in turn give rise to the agency costs.There are two main conflicts between parties in a
company, firstly, between the managers and shareholders, and secondly between the shareholders and the creditors.In the first
case, managers are tempted to pursue the profits of the firms they manage to their own personal gain at the expense of the
shareholders. In later case, debt provides shareholders with the incentive to invest sub-optimally.In order to solve the potential
agency problem, agency cost are incurred.

3. Pecking Order Theory

Pecking order theory suggests that when a company is looking at financing its long term investments, it has a well defined
order of preference with respect to the sources of finance available to it. Myer and Majluf developed Pecking Order Theory
upon the asymmetry of information between internal stakeholders (owners and managers) and external providers of the firm.
According to pecking Order Theory a firm is said to follow a pecking order if it prefers internal to external financing and debt
to equity if external financing is used.
Business leaders adopt a financial policy, which aims at minimizing the costs associated with asymmetric information,
especially adverse selection, and prefer internal financing to external financing.
This theory assumes that a business leader complies with the following hierarchy: self financing, non-risky debt issuance,
risky debt issuance, risky debt issuance and equity issuance as a last resort.
 It implies that when it comes to profitable firms, they would always prefer internal financing rather than taking up new debts
or equity. Even though debt is considered to be cheaper than equity within certain proportions.

4. Asymmetric information Theory

Asymmetric information is the situation in which different parties have different information. In a corporation, managers of
a firm have more information about operations and future prospects than do investors.
According to the asymmetric information theory firms with positive future prospect avoid selling stock or not to finance
through new stock offering but firm with negative would want to sell stock or like to finance with outside equity.