CAPITAL

STRUCTURE

SUBJECT: FINANCIAL
MANAGEMENT.
COLLEGE : BHAVAN’S COLLEGE.
CLASS : T.Y. B.M.S. (A).
GROUP NO. : 7
ACADEMIC YEAR : 2010-2011 (SEMESTER-V).
SUBMITTED TO : PROF. RIDDHI SHARMA

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SUBMITTED BY:
Sr.no. Group Roll no.
Members
1. PURNIMA ORASKAR 37

2. MEETA PADAYA 38

3. KIRA PANCHAL 39

4. NAVIN PARGHI 40

5. PARITA PATEL 41

6. POOJA PATIL 42

ACKNOWLEDGEMENT:-
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We the group members are thankful to
Prof. RIDDHI SHARMA of FINANCIAL
MANAGEMENT for giving us the
opportunity to prepare a project on
CAPITAL STRUCTURE.
It was a fruitful experience to work on it;
we learned various dimensions relating
to it. At the same time the project gave
us an exposure to the various
complexities associated with it.
We are thankful to our professor for
constantly supporting us and
encouraging us to work on this project
and helped us in the accomplishment of
exploratory as well as result-oriented
research studies.

INDEX:-
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Sr.n Particulars Page.N
o. o.
1. Introduction TO capital structure 5.

2. Factors Determining Capital 7.

Structure

3. Theories of capital structure 13.

5. Net Income Approach 14.

6. Net Operating Income 18.

Approach

7. Traditional Position 20.

8. Miller & Modigliani 22.

Approach

MEANING OF CAPITAL
STRUCTURE:-
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C apital structure refers to the mix of
sources from where the long term funds
required in a business may be raised, i.e.,
what should be the proportions of equity
share capital, preference share capital,
internal sources, debentures, and other
sources of funds in the total amount of capital
which an undertaking may raise for
establishing its business.
In planning the capital structure, the
following issues must be kept in mind:
1. There is no one definite model which can
be suggested/used as an ideal for all business
undertakings. This is because of the varying
circumstances of various business
undertakings. The capital structure depends
primarily on a number of factors like the
nature of industry, gestation period, certainty
with which the profits will accrue after the
undertakings goes into commercial
production and the likely quantum of return
on investment. It is, therefore, important to
understand that different types of capital
structure would be required for different
types of business undertakings.

2. Government policy is a major factor in

planning capital structure. For example, a
change in the lending policy of financial
institutions may mean a complete change in

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the financial pattern. Similarly, the Rules and
Regulations for Capital market formulated by
SEBI affect the Capital structure decisions.
Similarly, monetary and fiscal policies of the
Government also affect the capital structure
decisions.

The finance managers of business concerns

are therefore required to plan capital
structure within these constraints.

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 1.Factors determining
capital structure:-
1) Trading on Equity: A company earns
the profits on its total capital (borrowed
and owned). On the borrowed capital
(including preference capital company
pays interest or dividend at a fixed rate. If
this fixed rate is lower than the general
rate of earnings of the company, the
equity shareholders will have an
advantage in the form of additional
profits. This may be referred to as trading
on equity.
2) Desire to Control the Business:
Quite often, the promoters want to retain
the control of the affairs of the company.
They raise the capital from the public by
issuing different types of securities in
such a way as to retain the control of
whole of substantially the whole of the
affairs of the company with them. For this
purpose, they raise a large proportion of
funds by the issue debentures and
preference shares.

3) Nature of Business: A manufacturing

company may give a differing capital
structure from Trading, financing,
extractive or public utility concerns.
These, differences enable one type of

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 business to issue securities which are not
profitable to other business. So public
utility concern may enjoy advantages of
fixed interest securities like bonds and
debenture because of their monopoly and
stability of income. But, on the other
hand, manufacturing concerns do not
enjoy such advantages and rely to a
great extent on equity share capital.

4) Purpose of Financing: If funds are

raised for betterment expenditure, it is
quite apparent that it will add nothing to
the earning capacity of the company.
Such expenditure may be incurred either
out of funds raised by issue of shares or
still better out of retained earnings but, in
no case, out of borrowed funds. On the
other hand productive projects may be
financed out of borrowings also.

5) Period of Finance: Normally funds

which are required for a short time say
for 5 to 10 years should be arranged
through borrowing because these can
easily be repaid as soon as company’s
financial position improves. On the other
hand, if funds are required permanently
or for a fairly long time, issue of ordinary
shares should be preferred.

6) Elasticity of capital structure: The

capital structure should be as elastic as
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 possible so as to provide for expansion
for future development or to make it
feasible to reduce the capital when it is
not needed. Too much dependence on
debentures and preference shares from
the very beginning makes the capital
structure of the company rigid because of
payment of fixed interest or dividend.
These sources should be kept in reserve
for emergency or for expansion purposes.

7) Nature of Investors: Some investors

who prefer security of investment and
stability of income usually go in for
debentures. Preference shares will be
preferred by those who want a higher and
stable income with enough safety of
investment. Equity shares will be taken
up by those who are ready to take risks
for higher income and capital
appreciation. Those who want to acquire
control over the affairs of the company
like equity shares.

8) Market Conditions: Conditions of

capital market have an important bearing
on the capital structure of the company
because investor is very often influenced
by the general mood or sentiment of the
capital market although his own mood or
sentiments guide him to invest his funds.
For example, in times of depression,
investor will look more for safety than to
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 income and will be willing to invest in
debenture and not in equity shares.
During boom period, when people have
plethora of funds, any type of security
can be sold easily hence equities can
have a better market. The management
while designing the capital structure of
the company must watch the mood or
sentiments of the capital market.

9) Legal restrictions: every company

has to comply the law of the country
regarding the issues of different types of
securities therefore, hands of the
management are tied by these legal
restrictions. For example in India, banking
companies are not allowed to issue any
type of securities except equity shares
under the Indian banking companies act.
within this overall frame work ,the
management should strive towards
capital structure.

10)Policy of term financing

institutions: If financial institutions
offer credit to the industry on strictly
restrictive terms and adopt harsh policy
of lending .they allow raising of fresh
capital by specific manner.

11)stability of earning or
possibilities or regular and fixed

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 income: The stability of capital
structure of a company very much
depends upon the possibilities of regular
and fixed income.
a) if company expects sufficient regular
income in future ,debenture should be
issued .
b) preference share may be issued if
company does not expect regular income
but it is hopefull that its average earnings
for a few years may be equal to or in
excess of the amount of dividend to be
paid on such preference shares.
c)if company does not expect any regular
income in future, it should never issue
any type of securities other then equity
shares .
12) Trends in capital market: Capital
markets conditions determine not only
the types of securities to be issued but
also the rate of interest on debenture
,fixed rates on dividends on preference
shares and the prices of equity shares .

13)Cost of capital and availability of

funds:

14)Tax benefit.

15) Assets structure: Assets structure

also influences one sources of financing

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 in different ways .firms with long lived
fixed assets,especially when demand foe
the output is relatively assured can use
long term debts.firm whose assets are
mostly receivable and inventory whose
vale is dependent on the continued
profitability of the individual firm can rely
less long term debt financing and more
on short term funds.

16)Attitude and temperament of

management.

17)leaders attitude: Sometimes the

leaders attitude is also an important
determinant of capital structure.in the
majority of cases,the firms management
discussies its capital structure with
leaders and gives much weight to their
advice.but where management is the
confident of future,it may use leverage
beyond norms for the industry.

18)Fiscal incentives and tax

concessions : incentives and tax
concessions being provided by the
government to various types of industrial
units like relaxation of security
margin,15% subsidy by the
government,of repayment period
extension beyond 10 years,gestation
period 2 years,reduction in application to

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 the extent of 50% in application is made
for the promotion in backward areas also
affect the capital structure.

19)Advance given by financing

agencies:Such agencies are
specialised in tendering expert financial
advice concerning the capital structure of
firms .their advice should be given due
weight and consideration in financial plan
of the concern.
Thus we see the determination of a
thorough consideration of a large number
of factors .there can be no ideal patern of
capital structure for all companies ebven
in the same industry .so each company
has to be studied as an individual case.

THEORIES OF CAPITAL
STRUCTURE:

1. NET INCOME APPROACH.

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2. NET OPERATING INCOME
APPROACH

3. TRADITIONAL APPROACH.

4. MILLER AND MODGLIANI

APPROACH.

NET INCOME APROACH:-

Net income approach stats that a firm can
minimize the weighted average cost of capital and
increased the value of the firm as well as the
market price of equity shares by using debt
financing to the maximum possible extend. This
theory states that a firm can increase its value and
reduces the overall cost of capital by increasing the
proportion of debt in its capital structure. Net
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income approach is based on the following
assumption.
1. The cost of debt is less than the cost of
equity.
2. There are no taxes.
3. The risk perception of the investors is not
charged by this use of debt.
The increase in the debt financing in the capital
structures decreases the proportion of equity
capital and this results in decreases in the
weighted average cost of capital resulting in an
increase in the value of the firm. The cost of debt is
less than the cost of equity because of two
reasons:
• Debt involves less risk then equity.
• Interest being – deductible expenses.

According to this approach net income i.e.

expected profit after tax (profit to shareholders) is
estimable, based on expectation of shareholders.
Hence, Ke can be estimated. Based on this value of
Ke, we can calculate Ko. This Ke is independent
variable and Ko is a dependent variable.
The equation for this approach is same as:

Ko = WeKe +
WdKd

We know that equity is costlier sources of capital.

Debt is relatively cheaper. This is because lenders
take less risk. They get their interest payment
irrespective of quantum of profit or loss.

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Hence equity, being a costlier sources; should be
used less. Debt being a cheaper source; should be
used more in proportion. Average cost will be less
when we use more proportion of debt.
We can summarize this approach as fallows:
As per net income approach:
Ko = WdKd + WeKe

a. Expected return on equity is estimable

using appropriate estimation of
shareholders, which is Ke.
b. Cost of debt is estimable using rate of
interest and tax rate, which is Kd.
c. Overall cost Ko is calculated based on
weighted average of Ke and Kd.
d. Thus, Ko is dependent variable and Ke
and Kd are independent variables.
e. In this case, cost and proportion of equity
as well as debt is estimated. This is used to
calculate overall cost of capital i.e.
weighted average cost of capital Ko.
In this case, cost and proportion of equity as well
as debt is estimated. This is used to calculate
overall cost of capital i.e. weighted average cost of
capital Ko.

This approach is called as net income approach.

This is because Ke depends upon net income
available to shareholders i.e. PAT is estimable.

According to this approach Ko declines as debts:

equity ratio Dm/Em increases. This is because as
Dm/Em increases, the proportion of the cheaper
capital i.e. debt (Kd) increases. It is graphically
represented as fallows:

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 From this graph it is clear that as leverage i.e.
Dm/Em increases, Ko decreases. This is because
cheaper capital viz. Debt, in proportion, increases.

Net Operating Income

Approach:-
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Cost of equity is estimatedsbn based on
expectations of shareholders. Such estimation is
always debatable. Another argument is that the net
operating income i.e. PBIT is better estimable for a
proposed new venture. So total return on
investment is known i.e. Ko is estimable and wil
remain constant irrespective of debt: equity
proportion or capital structure. Using Ko, we can
estimate the return available to equity
shareholders and check whether it is in the
acceptable range.This approach is called as Net
Operating Income Approach.
This approach assumes overall cost of capital i.e.
Ko and cost of debt Kd to be constant. Ke is
variable. Hence the equation:
Ko= Wd Kd + We
Ke

This is now rearranged as :

Ke= Ko + (Ko -Kd) × (Dm/Em)
We can summarise this approach as follows:
As per net operating income approach:
Ke = Ko + (Ko - Kd) × (Dm/De)
Expected return on total investment is estimable
which is Ko
Cost of debt is estimable using rate of interest and
tax rate, which is Kd
Return available to shareholders Ke is calculated
based on Ko and Kd
Thus, Ke is a dependent variable and Ko and Kd
are independent variables.
In this case cost and proportion of equity as well as
debt is estimated. This is used to calculate return
on equity i.e. Ke

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This approach is called as Net Operating Income
approach. This is because Ko depends upon net
income on total investment i.e. PBIT is estimable.
In this approach, as overall cost Ko is treated as
constant. So return on equity increases as leverage
Dm/Em increases. The implied meaning of this is
that the market discounts the leverage risk in
price of equity and expectations (the opportunity
cost) of equity increases. This may be graphically
represented as follows:

(Leverage level)

It may be observed from the graph that Ke

increases as the degree of leverage increases.

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Traditional Approach Theory:-

This approach is similar to Net Income Approach..

According to this, the value of firm can be
increased initially or the cost of capital can be
decreased by using more debt as the debt is a
cheaper source of funds then equity. Thus optimum
capital structure can be reached by a proper debt-
equity mix.

Optimal Capital Structure -- The capital structure

that minimizes the firm’s cost of capital and
thereby maximizes the value of the firm.

Thus as per the traditional approach the cost of

capital is a function of financial leverage and the
value of firm can be affected by the judicious mix
of debt and equity in capital structure. The increase
of financial leverage upto a point favorably affects
the value of firm. At this point the capital structure
is optimal & the overall cost of capital will be the
least.

There are two type of risks-

Business risk – Business risk includes factors such

as market fluctuations, availability of materials etc.
and it will always be there more or less of risks.

Financial risks- Financial risk keeps on increasing

after a certain stage as more and more debt
commitments are undertaken.

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This theory states that there is a correlation
between the weighted average cost of the debt and
equity ratio. The relation between the two when
presented graphically takes the form of a U-shaped
curve. Cost of capital will be very high if the debt-
equity ratio is zero. When debt is injected into the
capital structure step- by- step the weighted
average cost of capital will progressively come
down only up to the lowest (optimum) point and
then the cost of capital will go up with the further
introduction of debt , since the debenture holders
have to be offered a higher rate of interest.

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 MILLER AND MODIGLIANI
POSITION:-
According to this approach the total cost of
capital of particular firm is independent of its
methods and level of financing. Modigliani and
Miller argued that the weighted average cost of
capital of a firm is completely independent of its
capital structure. In other words, a change in the
debt equity mix does not affect the cost of capital.
They gave a simple argument in support of their
approach. They argued that according to the
traditional approach, cost of capital is the weighted
average of cost of debt and cost of equity, etc. The
cost of equity, they argued, is determined from the
level of shareholder’s expectations. Now, if
shareholders expect 16% from a particular
company, they do take into account the debt
equity ratio and they expect 16^ merely because
they find that 16% covers the particular risk which
this company entails. Suppose, further that the
debt content in the capital structure of this
company increases; this means that in the eyes of
shareholders, the risk of the company increases,
since debt is a more risky mode of finance. Hence,
shareholders will now start expecting a higher rate
of return from the shares of the company. Hence,
each change in the debt equity mix is automatically
offset by a change in the expectations of the
shareholders from the equity share capital. This is
because a change in the debt equity ratio changes
the risk element of the company, which in turn
changes the expectations of the shareholders from
the particular shares of the company. Modigliani
and Miller, therefore, argued that financial leverage
has nothing to do with the overall cost of capital

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and the overall cost of capital of a company is
equal to the capitalization rate of pure equity
stream of its class of risk. Hence, financial leverage
has no impact on share market prices nor on the
cost of capital.

Modigliani and Miller make the

following propositions:-

1. The total market value of a firm and its cost of

capital are independent of its capital structure. The
total market value of the firm is given by
capitalizing the expected stream of operating
earnings at a discount rate considered appropriate
for its risk class.

2. The cost of equity (Ke) is equal to capitalization

rate of pure equity stream plus a premium for
financial risk. The financial risk increases with more
debt content in the capital structure. As a result, Ke
increases in a manner to offset exactly the use of
less expensive source of funds.

3. The cut off rate for investment purpose is

completely independent of the way in which the
investment is financed.

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ASSUMPTIONS OF MODIGLIANI & MILLER
APPROACH:-

1. The capital markets are assumed to be perfect.

This means that investors are free to buy and sell
securities. They are well informed about the risk-
return on all type of securities. These are no
transaction costs. The investors behave rationally.
They can borrow without restrictions on the same
terms as the firms do.

2. The firms can be classified into ‘homogeneous

risk class’. They belongs to this class if their
expected earnings is having identical risk
characteristics.

3. All investors have the same expectations from a

firm’s net operating income (EBIT) which are
necessary to evaluate the value of a firm.

4. The dividend payment ratio is 100%. In other

words, there are no retained earnings.

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5. There are no corporate taxes. However this
assumption has been removed later.

Modigliani and Miller agree that while companies in

different industries face different risks which will
result in their earnings being capitalized at
different rates, it is not

possible for these companies to affect their market

values, and therefore their overall capitalization
rate by use of leverage. That is, for a company in a
particular risk class, the total market value must be
same irrespective of proportion of debt in
company’s capital structure. The support for this
hypothesis lies in the presence of arbitrage in the
capital market. They contend that arbitrage will
substitute personal leverage for corporate
leverage. This is illustrated below:

Suppose there are two companies A & B in the

same risk class. Company A is financed by equity
and company B has a capital structure which
includes debt. If market price of share of company
B is higher than company A, market participants
would take advantage of difference by selling
equity shares of company B, borrowing money to
equate there personal leverage to the degree of
corporate leverage in company B, and use these
funds to invest in company A. The sale of Company
B share will bring down its price until the market
value of company B debt and equity equals the
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market value of the company financed only by
equity capital.

Advantages:
• In practice, it’s fair to say that none of the
assumptions are met in the real world, but
what the theorem teaches is that capital
structure is important because one or more of
the assumptions will be violated. By applying
the theorem’s equations, economists can find
the determinants of optimal capital structure
and see how those factors might affect optimal
capital structure.

Disadvantages:
• Modigliani and Miller’s theorem, which justifies
almost unlimited financial leverage, has been
used to boost economic and financial
activities. However, its use also resulted in
increased complexity, lack of transparency,
and higher risk and uncertainty in those
activities. The global financial crisis of 2008,
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 which saw a number of highly leveraged
investment banks fail, has been in part
attributed to excessive leverage ratios.

CONCLUSION:-
Thus capital structure is the financing mix of the
firm.

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 BIBLIOGRAPHY:-

SITES REFERED :-

1) www.google.com
2) www.referenceforbusiness.com
3) www.wikipedia.org

BOOKS REFERED:-

1)

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THANK YOU!

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