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Concept of Capital Structure:


The relative proportion of various sources of funds used in a business is termed as
financial structure. Capital structure is a part of the financial structure and refers to
the proportion of the various long-term sources of financing. It is concerned with
making the array of the sources of the funds in a proper manner, which is in
relative magnitude and proportion.

The capital structure of a company is made up of debt and equity securities that
comprise a firms financing of its assets. It is the permanent financing of a firm
represented by long-term debt, preferred stock and net worth. So it relates to the
arrangement of capital and excludes short-term borrowings. It denotes some degree
of permanency as it excludes short-term sources of financing.

Capital is the major part of all kinds of business activities, which are decided by
the size,and nature of the business concern. Capital may be raised with the help of
various sources.If the company maintains proper and adequate level of capital, it
will earn high profit and they can provide more dividends to its shareholders.

Meaning of Capital Structure


Capital structure refers to the kinds of securities and the proportionate amounts that
make up capitalization. It is the mix of different sources of long-term sources such
as equity shares, preference shares, debentures, long-term loans and retained
earnings. The term capital structure refers to the relationship between the various
long-term source financing such as equity capital, preference share capital and debt
capital. Deciding the suitable capital structure is the important decision of the
financial management because it is closely related to the value of the firm.Capital
structure is the permanent financing of the company represented primarily by longterm debt and equity.

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Definition of Capital Structure


According to the definition of James C. Van Horne, The mix of a firms
permanent long-term financing represented by debt, preferred stock, and common
stock equity.

According to the definition of Presana Chandra, The composition of a firms


financing consists of equity, preference, and debt.

According to the definition of R.H. Wessel, The long term sources of fund
employed in a business enterprise.

Objectives of Capital Structure


Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.

Forms of Capital Structure


Capital structure pattern varies from company to company and the availability of
finance.Normally the following forms of capital structure are popular in practice.
Equity shares only.
Equity and preference shares only.
Equity and Debentures only.
Equity shares, preference shares and debentures.

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FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial
structure shows the pattern total financing. It measures the extent to which total
funds are available to finance the total assets of the business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
The following points indicate the difference between the financial structure and
capital structure.
Financial Structures

Capital Structures

1. It includes both long-term and shortterm sources of funds

1. It includes only the long-term sources


of funds.

2. It means the entire liabilities side of the 2. It means only the long-term liabilities
balance sheet.
of the company.

3. Financial structures consist of all


sources of capital.

3. It consist of equity, preference and

4. It will not be more important while


determining the value of the firm.

4. It is one of the major determinations of

retained earning capital.

the value of the firm.

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Components of Capital Structure


Capital structure involves different sources from which the required long-term
capital is collected by the company. It differs from financial structure.

Shareholder's Funds (owned capital)


Equity Capital
Preference Capital
Retained Earnings

Borrowed Funds
Debentures
Term Loans
Deposits

Shareholder's Funds (Owned Capital)


In components of capital structure, shareholder's funds (owned capital) means
funds provided or contributed by the owners. It is also known as owned capital or
ownership capital. Various constituents of owned capital are:

1. Equity Capital
In components of Capital structure, equity share capital represents the ownership
capital of the company. It is the permanent capital and cannot be withdrawn during
the lifetime of the company. They are the real risk bearers, but they also enjoy
rewards. Their liability is restricted to their capital contributed. Equity shares are
popular among the investing class. Equity Capital is also known as 'Owned
Capital' or 'Risk Capital' or 'Venture Capital.'

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2. Preference Capital
In components of capital structure, preference shareholders are also owners of the
firm, and they get preference regarding payment of dividends and repayment of
Capital. They are cautious investors. Preference Shares carry a stipulated dividend.
Preference Shares are of different types such as:
Redeemable and Non-Redeemable,
Convertible and Non-Convertible,
Cumulative and Non-Cumulative preference shares.

3. Retained Earnings
In components of capital structure, instead of distributing all the profits to
shareholders by way of a dividend, the firm retains / keeps / saves a part of the
profit for self-financing. Retained earnings constitute the sum total of those profits
which have been realized over the years and have been reinvested in the business.
Thus, it is also known as self-financing or ploughing back of profits. Thus, it is
also known as self-financing or working back of profits.

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Borrowed Capital
Borrowed capital is the amount raised by way of loans or credit. Various parts of
borrowed capital are:

1. Debentures
In components of capital structure, debenture capital is a part of borrowed capital.
The creditors of the company are the debenture holders. Different types of
debentures are issued for the convenience of investors.

2. Term Loan
In components of capital structure, organizations can obtain long-term and medium
term loans from banks and financial institutions. Further, banks advance loans in
US dollar. Term loans are repayable by installments. For obtaining term loans,
collateral security has to be offered by the organization.

3. Public Deposits
Public deposit means any money received by a non-banking company by way of
deposit or loan from the public, including employees, customers and shareholders
of the company other than in the form of shares and debentures. Companies prefer
this method as such deposits are unsecured. A company can accept public deposits
for a period of up to 3 years.

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ADVANTAGES AND DISADVANTAGES OF


FINANCING OPTIONS
Both debt and equity financing offer small businesses a number of advantages and
disadvantages. The key for small business owners is to evaluate their company's
particular situation and determine its optimal capital structure. An optimal capital
structure is one that strikes a balance between risk and return and maximizes the
price of the stock while simultaneously minimizing the cost of capital.

Advantages of Debt Financing


The primary advantage of debt financing is that it allows the founders to retain
ownership and control of the company. In contrast to equity financing, debt
financing allows an entrepreneur to make key strategic decisions and also to keep
and reinvest more company profits. Another advantage of debt financing is that it
provides small business owners with a greater degree of financial freedom than
equity financing. Debt obligations are limited to the loan repayment period, after
which the lender has no further claim on the business, whereas an equity investor's
claim does not end until his or her stock is sold. Debt financing is also easy to
administer, as it generally lacks the complex reporting requirements that
accompany some forms of equity financing. Finally, debt financing tends to be less
expensive for small businesses over the long term than equity financing. Over the
short term, however, debt financing is far more expensive.

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Disadvantages of Debt Financing


The main disadvantage of debt financing is that it requires a small business to
make regular monthly payments of principal and interest. Very young companies
often experience shortages in cash flow that may make such regular payments
difficult, and most lenders provide severe penalties for late or missed payments.
Another disadvantage associated with debt financing is that its availability is often
limited to established businesses. Since lenders primarily seek security for their
funds, it can be difficult for unproven businesses to obtain loans without a personal
guarantee from one of the principals in the business.

Advantages of Equity Financing


The main advantage of equity financing for small businesses, which are likely to
struggle with cash flow initially, is that there is no obligation to repay the money.
Equity financing is also easier to acquire than debt financing for early-stage or
start-up businesses. Equity investors seek growth opportunities, so they are often
willing to take a chance on a good idea. But debt financiers seek security, so they
usually require the business to have some sort of track record before they will
consider making a loan. Another advantage of equity financing is that investors
often prove to be good sources of advice and contacts for small business owners.

Disadvantages of Equity Financing


The main disadvantage of equity financing is that the founders must give up some
control of the business. If investors have different ideas about the company's
strategic direction or day-today operations, they can pose problems for the
entrepreneur. In addition, some sales of equity, such as initial public offerings, can
be very complex and expensive to administer. Such equity financing may require
complicated legal filings and a great deal of paperwork to comply with various
regulations. For many small businesses, therefore, equity financing may necessitate
enlisting the help of attorneys and accountants.

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Features Of Capital Structure


A sound capital structure should possess the following features:

(i) Maximum Return:


The financial structure of a company should be guided by clear- cut objective. Its
objective can be maximization of the wealth of the shareholders or maximization
of return to the shareholders.

(ii) Less Risky:


The capital structure should represent a balance between different types of
ownership and debt securities. This is essential to reduce risk on the use of debt
capital.

(iii) Safety:
A sound capital structure should ensure safety of investment. It should be so
determined that fluctuations in the earnings of the company do not have heavy
strain on its financial structure.

(iv) Flexibility:
A sound capital structure should facilitate expansion and contraction of funds. The
company should be able to procure more capital in times of need and should be
able to pay all its debts when it does not require funds.

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(v) Economy:
The capital structure should ensure the minimum costs of capital which in turn
would increase its ability to generate more wealth for the company.

(vi) Capacity:
The financial structure of a company should be d3mamic. It should be revised
periodically depending upon the changes in the business conditions. If it has
surplus funds, the company should have the capacity to repay its debt and reduce
interest obligations.

(vii) Control:
The capital structure of a company should not dilute the control of equity
shareholders of the company. That is why, convertible debentures should be issued
with great caution.

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Importance of Capital Structure:


The importance of designing a proper capital structure is explained below:

Value Maximization:
Capital structure maximizes the market value of a firm, i.e. in a firm having a
properly designed capital structure the aggregate value of the claims and ownership
interests of the shareholders are maximized.

Cost Minimization:
Capital structure minimizes the firms cost of capital or cost of financing. By
determining a proper mix of fund sources, a firm can keep the overall cost of
capital to the lowest.

Increase in Share Price:


Capital structure maximizes the companys market price of share by increasing
earnings per share of the ordinary shareholders. It also increases dividend receipt
of the shareholders.

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Investment Opportunity:
Capital structure increases the ability of the company to find new wealth- creating
investment opportunities. With proper capital gearing it also increases the
confidence of suppliers of debt.

Growth of the Country:


Capital structure increases the countrys rate of investment and growth by
increasing the firms opportunity to engage in future wealth-creating investments.

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Concept of Optimal Capital Structure:


Every firm should aim at achieving the optimal capital structure and try to maintain
it. Optimal capital structure refers to the combination of debt and equity in total
capital that maximizes the value of the company. An optimal capital structure is
designated as one at which the average cost of capital is the lowest which produces
an income that leads to maximization of the market value of the securities at that
income.
Kulkarni and Satyaprasad defined optimum capital structure as the one in
which the marginal real cost of each available method of financing is the
same. They included both the explicit and implicit cost under the term real cost.

Features of Optimal Capital Structure:


The salient features of an optimal capital structure are described below:
a) The relationship of debt and equity in an optimal capital structure is made in
such a manner that the market value per equity share becomes maximum.
b) Optimal capital structure maintains the financial stability of the firm.
c) Under optimal capital structure the finance manager determines the proportion
of debt and equity in such a manner that the financial risk remains low.
d) The advantage of the leverage offered by corporate taxes is taken into account in
achieving the optimal capital structure.

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e) Borrowings help in increasing the value of company leading towards optimal


capital structure.
f) The cost of capital reaches at its minimum and market price of share becomes
maximum at optimal capital structure.

The main constraints in designing the optimum capital


structure are:

1. The optimum debt-equity mix is difficult to ascertain in true sense.


2. The concept of appropriate capital structure is more realistic than the concept of
optimum capital structure.
3. It is difficult to find an optimum capital structure as the extent to which the
market value of an equity share will fall due to increase in risk of high debt content
in capital structure, is very difficult to measure.
4. The market price of equity share rarely changes due to changes in debt-equity
mix, so there cannot be any optimum capital structure.
5. It is impossible to predict exactly the amount of decrease in the market value of
an equity share because market factors that influence market value of equity share
are highly complex.

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Capital structure theories:


Basic assumptions:
There are only two kinds of funds used by a firm i.e. debt and equity.
Taxes are not considered.
The payout ratio is 100%
The firms total financing remains constant
Business risk is constant over time
The firm has perpetual life.

Net Income Approach (NI)


According to this approach, the cost of debt and the cost of equity do not change
with a change in the leverage ratio. As a result the average cost of capital declines
as the leverage ratio increases. This is because when the leverage ratio increases,
the cost of debt, which is lower than the cost of equity, gets a higher weightage in
the calculation of the cost of capital.
The formula to calculate the average cost of capital is as follows:
Ko = Kd (B/ (B+S)) + Ke (S/(B+S))
Where:
Ko is the average cost of capital
Kd is the cost of debt
B is the market value of debt
S is the market value of equity
Ke is the cost of equity

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Net Operating income Approach (NOI)


According to this approach:
The overall capitalisation rate remains constant for all levels of financial
leverage
The cost of debt also remains constant for all levels of financial leverage
The cost of equity increases linearly with financial leverage
The formula to calculate the cost of capital is Ko=Kd(B/(B+S))+Ke(S/(B+S))
Ko and Kd are constant for all levels of leverage. Given this, the cost of equity can
be expressed as follows:
Ke =Ko+(Ko-Kd)(B/S)

Traditional or Intermediate Approach


This approach is midway between the NI and the NOI approach. The main
propositions of this approach are:
The cost of debt remains almost constant up to a certain degree of leverage but
rises thereafter at an increasing rate.
The cost of equity remains more or less constant or rises gradually up to a
certain degree of leverage and rises sharply thereafter.
The cost of capital due to the behavior of the cost of debt and cost of equity

o Decreases up to a certain point

o Remains more or less constant for moderate increases in leverage


thereafter

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o Rises beyond that level at an increasing rate.

MM Approach
According to this approach, the capital structure decision of a firm is irrelevant.
This approach supports the NOI approach and provides a behavioural justification
for it
Additional assumptions of this approach include:
Capital markets are perfect. All information is freely available and there are
no transaction costs
All investors are rational
Firms can be grouped into Equivalent risk classes on the basis of their
business risk
There are no taxes
This approach indicates that the capital structure is irrelevant because of the
arbitrage process which will correct any imbalance i.e. expectations will change
and a stage will be reached where further arbitrage is not possible.

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Important Factors Affecting the Choice of


Capital Structure
Under the capital structure, decision the proportion of long-term sources of capital
is determined. Most favourable proportion determines the optimum capital
structure. That happens to be the need of the company because EPS happens to be
the maximum on it. Some of the chief factors affecting the choice of the capital
structure are the following:

(1) Cash Flow Position:


While making a choice of the capital structure the future cash flow position should
be kept in mind. Debt capital should be used only if the cash flow position is really
good because a lot of cash is needed in order to make payment of interest and
refund of capital.

(2) Interest Coverage Ratio-ICR:


With the help of this ratio an effort is made to find out how many times the EBIT is
available to the payment of interest. The capacity of the company to use debt
capital will be in direct proportion to this ratio.

It is possible that in spite of better ICR the cash flow position of the company may
be weak. Therefore, this ratio is not a proper or appropriate measure of the capacity
of the company to pay interest. It is equally important to take into consideration the
cash flow position.

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(3) Debt Service Coverage Ratio-DSCR:


This ratio removes the weakness of ICR. This shows the cash flow position of the
company.
This ratio tells us about the cash payments to be made (e.g., preference dividend,
interest and debt capital repayment) and the amount of cash available. Better ratio
means the better capacity of the company for debt payment. Consequently, more
debt can be utilised in the capital structure.

(4) Return on Investment-ROI:


The greater return on investment of a company increases its capacity to utilise
more debt capital.

(5) Cost of Debt:


The capacity of a company to take debt depends on the cost of debt. In case the
rate of interest on the debt capital is less, more debt capital can be utilised and vice
versa.

(6) Floatation Costs:


Floatation costs are those expenses which are incurred while issuing securities
(e.g., equity shares, preference shares, debentures, etc.). These include commission
of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing
debt capital is less than the share capital. This attracts the company towards debt
capital.

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(7) Tax Rate:


The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt
decreases. The reason is the deduction of interest on the debt capital from the
profits considering it a part of expenses and a saving in taxes.

For example, suppose a company takes a loan of 0ppp 100 and the rate of interest
on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a
saving of in tax will take place (If 10 on account of interest are not deducted, a tax
of @ 30% shall have to be paid).

(8) Cost of Equity Capital:


Cost of equity capital (it means the expectations of the equity shareholders from
the company) is affected by the use of debt capital. If the debt capital is utilised
more, it will increase the cost of the equity capital. The simple reason for this is
that the greater use of debt capital increases the risk of the equity shareholders.

Therefore, the use of the debt capital can be made only to a limited level. If even
after this level the debt capital is used further, the cost of equity capital starts
increasing rapidly. It adversely affects the market value of the shares. This is not a
good situation. Efforts should be made to avoid it.