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 CAPITAL
STRUCTURE
INTRODUCTION
 The cost of capital for a domestic firm is the
rate that must be earned in order to satisfy
the required rate of return of the firm’s
investors.
 The cost of capital has a major impact on the
firm’s value.
DETERMINING CAPITAL
STRUCTURE COMPONENTS
As company raise a major part of their capital
in the form of long-term debt, preferred
stock, and equity, the cost of these
companies must reflect the weighted
average cost of capital (WACC) for each of
these sources of finance.
The three major components of capital:
 Debt
 Preferred stock
 Common stock
COST OF DEBT
 Company calculate the cost of debt for their
capital structure components
 The basis for estimating cost of debt for a
company is interest rates.
 Cost of debt
Kd = interest charges
market value of debt
 As interest charges are tax deductible, companies
need to adjust the before – tax cost of the debt
by applying the tax factor to calculate the after-
tax cost of debt
 After tax cost of debt = Kd(1-t)
COST OF PREFERRED STOCK
 A company pay dividend on its preferred stock
 So these dividend are not tax deductible
 Cost of preferred stock

Kp = Dp
Po
Where
Dp = cash dividends paid on the preferred stock
Po = current market price of the preferred
stock
COST OF COMMON STOCK
 Is the return that the equity investors of the
company require on their investment.
 Define as the minimum acceptable rate of
return that a company must earn on equity-
financed portion of its investment
 By two methods cost on common equity can
be estimated :-
DIVIDEND GROWTH MODEL
CAPITAL ASSET PRICING MODEL
CAPITAL STRUCTURE OF
MULTINATIONAL FIRMS
 Capital structure for the multinational firm
involves a choice between debt and equity
financing across all its subsidiaries. A MNC
can tap both the source available at home
and also the sources in the foreign currencies
where it operates. A MNC can have more
debt in its capital structure if its cash flows
are more stable and it has a low credit risk.
 In fact the overall capital structure of a
parent company is a combination of the
capital structures of all its subsidiaries………
IMPORTANT FACTORS NEED TO
STUDY
Some important factors that help in its choice
of capital structure decision are discussed
below
 Stability of cash flow
 Risk facing a MNC
 Extent of profitability
 Country characteristics and its influence
 Tax law in host country
DETERMINATES OF SUBSIDIARY’S
CAPITAL STRUCTURE
 Capital structure decision of these affiliates
cannot be considered separately from the
capital structure decision of their parents.
 The affiliates take advantage of opportunities
to minimize the cost of capital.
 Capital structure of the affiliates vary
according to the relative prices of distinct
financing instruments in different location
 Thus a subsidiary with a capital structure
similar ton its parent may miss out on
profitable opportunities to lower its cost of
funds.
VARIOUS CHARACTERISTICS TO ARRIVE AT
THE OPTIMAL CAPITAL STRUCTURE
DECISION
 Target capital structure
 Tax advantages to debt financing
 Country risk in foreign operations
 Impact of corporate characteristics
such as stable cash flow, low credit risk
etc…..
FOUR MAIN CAPITAL
STRUCTURE THEORIES
 Net income approach
 Net operating income approach
 Traditional approach
 Modigliani and miller approach
NET INCOME APPROACH
 The cost of debt is lower than the cost of
equity
 The risk perception of investors is not
changed by the use of debt.
 There are no corporate or personal income
taxes.
NET OPERATING INCOME
APPROACH
 The cost of debt is lower than the cost of
equity
 Risk perception of lenders of debt do not
change with the change in financial leverage
and consequently the cost of debt remain
constant at all levels of financial leverage
 The market capitalizes the value of the firm
as a whole. Thus, the split between debt and
equity is not important.
 These are no corporate or personal income
taxes
TRADITIONAL APPROACH
 First stage:-
increase in financial leverage: the use of
increased debt in the capital structure results
in decrease in the overall cost of capital
 Second stage:-
increase in leverage does not affect the
overall cost of capital and the value of the firm
 Third stage:-
further increase in debt will lead to
increase in overall cost of capital and will
reduce the value of the firm.
MODIGLIANI- MILLER APPROACH
 Feature
1. Capital markets are perfect
2. Homogeneous risk classes of firm
3. Expectations about the net operating
income
4. 100% payout ratio
5. No corporate taxes
6. The rate of investment
THANXXX….