Capital Structure

Capital Structure
It refers to the kinds of securities and the proportionate amounts that make up capitalization. A decision about the proportion among the three types of securities viz., Equity shares, Pref. Shares and Debentures refers to the Capital Structure of an enterprise.

What is Capital Structure?

Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities Debt Sources - Bonds, bank loans Ordinary shares (common stock), Preference shares (preferred stock)

Forms or Patterns of Capital Structure

Equity shares only Equity shares and Preference Shares Equity shares and Debentures Equity shares, Preference shares and Debentures

Importance's:
View point that strongly supports the close relationship between leverage and value of a firm. It help to determine various investment decisions Capital Structure decision can influence the value of the firm through earnings available to the share holders.

Features of Appropriate Capital Structure

A). Profitability/Return B). Solvency/Risk C). Flexibility D). Conservation/Capacity E). Control

Factors Determining the Capital Structure

1. 2. 3. 4. 5. 6. 7. 8. Financial Leverage or Trading on Equity Growth and Stability of sales Cost of Control Cash flow ability to service debt Nature and Size of the Firm Requirement of Investors. Capital Market Structure Assets Structure 9. Purpose of Financing 10.Period of Financing 11.Control 12.Flexibility

13.Costs of Floatation
14.Personal Considerations 15.Corporate Tax Rate

16.Legal requirements

Optimal Capital Structure

Optimum capital structure may be defined as that capital structure or combination of debt and equity that leads to the maximum value of the firm. at which the weighted average of cost of capital is minimum and there by maximum value of the firm

Goals of Optimal Capital Structure

Return on investment (EPS) is higher than the fixed cost of funds. It will increase EPS and market value of the firm. Capital Structure should be flexible. Firm should avoid undue financial risk at debt financing.

Theories of Capital Structure

1. 2. 3. 4. Net Income Approach Net Operating Approach The Traditional Approach Modigliani Miller Approach

1. Net Income Approach

Suggested by Durand Capital Structure decision is relevant to the valuation of the firm. A change in financial leverage (EPS) will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. A firm can minimize the weighted average cost of capital and increase the value of the firm as well as the market price of equity shares by using debt finance to the maximum possible extent.

Assumptions of Net Income Approach

No taxes Cost of debt is less than the cost of equity Use of debt does not change the risk perception of investors.

2. Net Operating Approach

Suggested by Durand It is diametrically opposite to the NIA It is that capital structure decision of a firm is irrelevant Any changes in leverage will not lead to any change in total value of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of leverage.

Assumptions of NOI
The market capitalizes the value of the firms as a whole. The business risk remains constant at every level of debt equity mix. There are no corporate taxes.

3. Traditional approach
It is also known as intermediate approach. Optimum capital structure can be reached by a proper debtequity mix. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The overall cost of capital decreases up to a certain point, remains unchanged for moderate increase in debt thereafter and increases or rises beyond a certain point. Even the cost of debt may increase at this stage due to increases financial risk.

4. Modigliani and Miller Approach

MM hypothesis is identical to NOI approach if taxes are ignored. In the absence of taxes: The theory proves that the cost of capital is not affected by changes in the capital structure. The debt-equity mix is irrelevant in the determination of the total value of the firm.

MM Approach - Assumptions
There are no corporate taxes There is a prefect market Investors act rationally The expected earnings of all the firms have identical risk characteristics Risk to investors depends upon the random fluctuations of expected earnings and the possibility that the actual value of the variables may turn out to be different from their best estimates. The cut-off point of investment in a firm is capitalization rate. All earnings are distributed to the share holders.

Essential features of a sound capital mix

Maximum possible use of leverage Flexible capital structure Avoid undue financial or business risk with the increase of debt Use of debt should be within the capacity of the firm Involve minimum possible risk of loss of control Avoid undue restrictions in agreement of debt.