FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE

Capital structure is a combination of capitals from different sources of finance - say equity, preference
and debentures etc. The source and quantum of capital is decided on the basis of need of the company
and the cost of capital.

Capital structure decision refers to deciding the forms of financing (source), their actual requirements
(amount) and the relative proportion (mix) in total capitalization. In other words, maximization of value
of the firm and minimization of overall cost of capital.

Theories of capital structure are of two types, Capital structure relevance theory and capital structure
irrelevance theory.

Capital structure relevance theory - Net Income Approach

Capital structure is relevant to the value of the firm. An increase in financial leverage leads to decrease
in weighted average cost of capital, while the value of the firm and market price of equity share
increases.

On the other hand, the decrease in financial leverage leads to increase in WACC and consequently
reduction in the value of the firm and market price of equity share

Value of the firm = S + D

Market value of equity (S) = NI / Ke

Overall cost of capital = Operating profit or EBIT

Value of the firm

V – value of the firm , S – Market value of equity

D – Market value of debt, Ke – Cost of equity capital
EBIT – Operating profit, NI – Earnings available to equity share holders
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE

Capital structure relevance theory – Traditional approach

As a result of financial leverage upto certain point, cost of capital comes down and value of firm
increases. However beyond that point, reverse trend emerge. i.e. cost of capital increases and value of
firm decreases.

In other words there is an optimal capital structure which minimizes cost of capital.

Capital structure irrelevance theory – Net operating income approach

Net operating income means earnings before interest and tax. According to this approach, capital
structure decisions of the firm are irrelevant.

 Change in leverage will not change the total value of the firm and the market price of shares
 Increase of debt or leverage will increase the cost of equity as investors seek high return
because of the risk of debt.
 Cheap debt fund is offset by increase in the cost of equity.

In other words, cost of capital is independent of the degree of leverage. As a result the division of debt
or equity is irrelevant.

Value of the firm = Earnings before interest and tax (EBIT)

Overall cost of capital (Ko)

Capital Structure irrelevance theory – Modigliani Miller Approach without tax

 In a perfect capital market

 where there is no transaction cost and tax,
 the value and the cost of capital of the company is constant
 irrespective of the change in capital structure

The assumptions of this approach are:

 Capital markets are perfect.

 All information are freely available
 No transaction costs
 Investors are rational
 Non-existence of corporate taxes
 Firms can be grouped on the basis of their business risk
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE

The prepositions of the approach are:

1. Total market value of a firm = Earnings before interest and tax

Ko (discount rate for the business class decided by the market)

2. Cost of equity will be more in the case of levered firm than an unlevered firm. Cost of equity
includes a risk premium for the financial risk. Cost of equity is determined as follows
Ke = Ko + (Ko - Kd) X (Debt)/Equity
3. Capital structure (financial leverage) does not affect the overall cost of capital.

Operational justification of MM approach is explained as follows:

 Arbitrage process ( buying of asset or security at low price in market and selling at high price in
another market)
 Substitution of corporate leverage by personal leverage.
 Investors of firm whose value is higher will sell their shares and instead buy the shares of the
firm whose value is low. Thus they earn the same return at a lower outlay
 Total value of the firm depends on the the underlying profitability and risk of the business class

Shortcomings of the approach are

 The arbitrage process will fail to work as the capital markets are imperfect, existence of
transaction cost and presence of corporate income taxes.

Capital Structure irrelevance theory – Modigliani Miller Approach without tax

 The value of the firm will increase or cost of capital will decrease based on corporate taxes.
 Earnings of the equity and debt holders will differ between levered and unlevered firm
 Value of levered firm will be greater than unlevered firm

Value of levered firm (Vg) = Value of unlevered firm (Vu) + tax benefit (TB)

Cost of equity in levered firm (Keg) = Keu + (Keu – Kd) X ( Debt /[ Debt + Equity])

WACC in levered firm (Kog) = Keu * ( 1 – tL)

Keu – Cost of equity in unlevered firm, Kd – Cost of debt , Kog – WACC of the levered firm

L - Debt /[ Debt + Equity]

FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE

Trade off Theory of capital structure

The purpose of the theory is to explain the fact that the firms are generally financed partly with equity
and partly with debt.
The theory talks about the necessity of offsetting the cost of debt against the benefits of debt.
In other words,

 There is an advantage to financing with debt, the tax benefits and

 There is a cost of financing with debt, the cost of financial distress including bankruptcy
cost of debt and non-bankruptcy cost.

The theory defines two concepts – Cost of financial distress and agency costs.

Cost of financial distress is classified into direct cost and indirect cost. Direct cost is cost of insolvency of
the company. Indirect cost is the non-bankruptcy cost like staff attrition, suppliers adverse payment
terms, debt-equity holders infighting, staff cost, cost of customers/investors/suppliers etc

Agency cost: The firms often experience a dispute of interest amount the management of firm, debt
holders and shareholders. These issues give rise agency problems which in turn results in agency costs.

In nut shell, as the debt equity ratio increases (ie leverage increases), there is a trade-off between the
interest tax shield and bank ruptcy, causing an optimum capital structure.

Pecking order theory of capital structure

The theory developed by Myers and Majluf was given the name Pecking order, as there is no well-
defined target of debt equity mix and there are two kinds of equity viz internal and external.

Pecking order theory says

 that the capital structure is affected

 by managers choice of a source of capital
 that gives high priority to sources which reveal least information to the outsiders.

The manager’s choice of finance is

1. Internal financing
2. Debt finance
3. Equity finance
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE
Factors affecting capital structure

1. Financial leverage of trading on equity: The use of long term fixed interest bearing capital increases
the earnings per share and the value of firm. However the debt can adversely affect the firm if the
cost of debt is more than that of the expected rate of return of the firm
2. Growth and stability of sales: affects the capital structure decision. Greater the stability and growth
of sales, greater is the use of debt. On the other hand, if the growth is fluctuating, debt finance be
employed.
3. Cost principle: Ideal capital structure is the one that minimizes the cost of capital and maximizes the
earnings per share.
4. Risk principle: According to this principle, equity finance is tapped for capital requirements than
debt finance. Because use of more debt erodes the shareholders wealth in unfavorable business
conditions. There are two risks called business risks and financial risk.
a. Business risk is unavoidable because of the environment in which the business has to
operate like market demand, price variations, proportion of fixed cost in total cost etc.
b. Financial risk is the additional risk borne by the shareholders when a firm uses debt in
addition to equity financing.
5. Control principle: While designing the capital structure, the existing management control and
ownership are not to be disturbed. Issue of new equity will dilute the control pattern. Issue of more
debt will cause higher degree of financial risk to owners.
6. Flexibility Principle: If the costly debt can be interchanged with a cheaper cost of debt it is called
flexibility principle. The said flexibility option is not available with equity investment.
7. Other considerations: are factors like nature of industry, competition, etc. Industries facing
competition resort to more equity than debt.

Key concepts for designing optimal structure

1. Leverages associated with capital structure are operating and financial leverage. Determination
of optimal level of debt involves equalizing between risk and return. EBIT – EPS analysis is a
widely used tool to determine level of debt in a firm.
2. Coverage ratio The ability of the firm to use the debt is decided by the coverage ratios namely
debt service coverage ratio and interest coverage ratio.
3. Cash flow analysis- To determine the debt capacity, cash flow under favourable and adverse
conditions are to be examined. A high debt equity ratio is not risk if the company has ability to
generate cash flows. Thus it is possible to increase the debt until the cash flows equal the risk
set out by debt.
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE

EBIT –EPS analysis

EBIT and EPS analysis is a vital tool for designing the optimal capital structure of a company

 Financial leverage affects the pattern of distribution of operating profit among various types of
investors and increases the variability of EPS
 Effect of leverage on EPS emerges because of the existence of fixed financial charge (interest
and pref dividend)
 Effect of fixed financial charge on EPS depends on the relationship between the rate of return
on assets and the rate of fixed charge
 If the rate of return on assets is higher than cost of finance, then the increasing use of fixed
charge finance, will increase EPS. This is called Trading on Equity
 If the rate of return on assets is lower than cost of finance, then the effect may be negative and
will decrease EPS

Fixed financial charge may be analysed by a choice of debt finance or preference shares. Debt finance is
preferred because of the following reasons

 Rate of interest payable on debt is less than that of pref dividend, in general
 Interest on debt finance is tax deductible

Financial Breakeven and Indifference analysis

 Financial BEP is the minimum level of EBIT needed to satisfy all the fixed financial charges (
interest and dividend)
 Denotes the level of EBIT at which EPS is zero
 EBIT – EPS break even analysis helps to determine the appropriate amount of debt a company
might carry.Algebraic equation is as follows

(EBIT - I1)(1-t) (EBIT - I2)(1-t)

=
E1 E2

 Where I1 is interest charge in alternative 1, and I2 is interest charge in alternative 2

 EBIT is indifference point
 E1 is the no of equity shares in alternative 1, E2 is the no of equity shares in alternative 2
 t – tax rate
 alternative 1 is equity finance and alternative 2 is debt – equity mix

Limitations of EBIT EPS analysis

 Ignores the risk dimension ie the effect of leverage on all the overall risk of the firm
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE
 It is more of a performance measure. EPS depends upon operating profit which in turn depends
upon the efficiency of the firm.

Cost of capital, capital structure and market price of share

An appropriate capital structure ( debt-equity mix) reduces the cost of capital and increases the market
price of share and thereby the firm.

Over Capitalisation

A situation where a firm has more capital than its requirement. Ie assets are worth less than its issued
share capital and earnings are insufficient to pay dividend and interest.

Under capitalisation
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE

Various approaches of capital structure in a nut shell

Particulars Net income Traditional Net operating MM approach MM approach with

approach approach income without tax tax
approach
Capital Relevant Relevant Irrelevant Irrelevant Irrelevant
structure
Increases with Increases with No change on No change on
Value of increase in increase in account of account of Increase when
firm financial financial leverage increase or increase or corporate tax exist
leverage till optimal point decrease of decrease of
leverage leverage
Increases with Increases with Remains Changes with Changes with
Market increase in increase in constant change in change in leverage
value of financial financial leverage leverage
shares leverage till optimal point
Remains Equal to cost of Increase if Increase if Increase if leverage
constant debt at optimal leverage leverage increases.
point. increases. increases. Cost of equity
Cost of More than cost of Cost of equity includes a risk
equity debt before includes a risk premium because of
optimal point. premium financial risk
Less than cost of because of
debt beyond financial risk
optimal point
Remains Equal to cost of Remains Remains Remains constant
constant debt at optimal constant constant Always less than
Cost of point. Always less Always less than that of cost of
debt Less than cost of than that of that of cost of equity
equity optimal cost of equity equity
point.
More than cost of
equity beyond
optimal point
WACC Decreases with Decreases with No change on No change on Decrease when
increase in increase in account of account of corporate tax exist
financial financial leverage increase or increase or
leverage upto certain point decrease of decrease of
leverage leverage
Transaction Not applicable Not applicable Not applicable No cost Not applicable
cost
FINANCIAL MANAGEMENT – MODULE - 1 FOR INTERMEIDATE COURSE

CAPITAL STRUCTURE
Corporate Not applicable Not applicable Not applicable No taxes Existence of
taxes corporate taxes
Capital Not applicable Not applicable Not applicable Perfect capital
market market