Unit- 3 capital structure.pdf

UNIT- 3
CAPITAL STRUCTURE
BY DEEPALI GUPTA

CAPITAL STRUCTURE
• The composition of Long term sources of funds such as debentures, long term
debts, preference & share capital & retained earning (reserves & surpluses).
• To decide the proportion of ownership funds & borrowed funds.
• Ownership funds include ordinary, preference share capital & retained earning.
• Borrowed funds include the amt. raised (i.e) issue of debentures & loan taken from
institution.

OPTIMUM CAPITAL STRUCTURE
• The capital structure or composition of debt & equity that leads to maximum
value of firm, max. wealth of share holders & minimizing the cost of capital.
• Following consideration:
 If the ROI is higher than F.C : Co. should prefer to raise funds having F.C (i.e.) debt, loans, pref.
share capital Increase earning per share & mkt value of firm

OPTIMUM CAPITAL STRUCTURE
When debt is used as a sources of finance: the firm saves amt of tax as int.
allowed is deductible exp.
 Advantage of tax leverage & cost of debt is reduced.
• Firm should avoid Undue financial risk : Increased debt – equity
increase risk & reduce mkt price of share.
• Capital structure should be flexible.

THEORIES OF CAPITAL STRUCTURE: DURANT
DAVID
• Net Income Approach
• Changes in financial structure causes corresponding changes in overall cost of capital & also
in total value in firm
• A firm can minimize avg. cost of capital & increase the value of firm as well as mkt price of
equity share by using debt financing
• Following assumption:
• The cost of debt < cost of equity
• There are no tax.
• The risk perception of investor is not changed by the use of debt.

NET INCOME APPROACH
Ke ( Cost of equity)
Kd ( Cost of debt)
Cost
of
Capital
Degree of Leverage
Effect of Leverage on cost of capital

NET INCOME APPROACH
• The total mkt value of a firm on the basis of Net Income Approach of can be ascertain by:
• V= S+D where,
• V = total mkt value of firm;
• S= Mkt value of equity share
• D= Mkt value of debt
• = earnings available to equity shareholders (NI)
equity capitalization rate
• Weighted cost of capital
K0 = EBIT
V

NET OPERATING INCOME APPROACH
• Suggested by Durand 1976 : Another extreme of effect of leverage on the value of firm.
• Opposite of N.I approach
• Change in the capital structure does not effect the market value of firm & overall cost of capital remains
constant whether debt – equity mix is 50:50 or 20:80 or 0:100.
• Increase in proportion of debt in capital structure would increase the financial risk of the shareholders.
• No optimal capital structure
• Assumption:
• The mkt capitalize the value of firm as a whole.
• Business risk remain constant at every level of debt- equity mix.
• There are no corporate tax.

NOI
Ke (cost of equity)
Ko (over all cost of
capital)
Kd ( cost of debt)
Degree of Leverage
Cost
of
capital

NOI
• Can be determined as below :
• V = EBIT
Ko
Ko = overall cost of capital
Mkt value of the equity share (S) = V – D where;
V = total mkt value of firm
D = Mkt value of debt.
Cost of equity or equity capitalization rate
Ke = EBIT – I
V - D

THE TRADITIONAL APPROACH
• Also k/n as Intermediate approach.
• Compromise b/w two extremes of N.I & N.O. Approach.
• The value of the firm can be increased initially or cost of capital can be decreased by using
proper debt- equity mix but beyond a particular point, the cost of equity increases with the
increase of debt or F.L
• Thus, overall cost of capital decrease upto certain point, remains more or less unchanged for
moderate & increases risk after a certain point.
• Increase Kd Increases Financial Risk

TRADITIONAL APPROACH
•Effect of
Leverage on
cost of
capital
Ke
Ko
Kd
A B
O X
Cost
of
Capital
Degree of Leverage
Range of optimal
Capital structure

MODIGLIANI & MILLER APPROACH (THEORY OF
IRRELEVANCE)
• M&M hypothesis is identical with N.O.I, if
taxes are ignored.
• Debt-equity is irrelevant in determining
the total value of firm.
• Though debt is the cheaper source but
with the increase use, financial risk
increase & affect cost of equity, overall
cost of capital remain constant.
• Two identical firms cannot have diff. mkt
value or cost of capital b’coz of
arbitrage process.
Assumptions
•There are no Corporate tax.
•There is a perfect market.
•Investor act rationally.
•The expected earnings of all the firms
have identical risk characteristic.
•The cut-off point of investment in a
firm is a capitalization rate.
•All the earnings is distributed to the
shareholders.
•Risk to investors depend upon random
fluctuation of expected earning & the
possibilities that actual value may turn
out to be diff. from best estimates

ESSENTIAL FEATURES OF A SOUND
CAPITAL MIX
• Max. possible use of leverage.
• Capital Structure should be flexible.
• To avoid undue financial/business risk with the increase of debt.
• Use of debt should be within the capacity of a firm.
• Should involve min. possible risk of loss of control.
• Must avoid undue restriction in agreement of debt

Unit- 3 capital structure.pdf

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