CAPITAL STRUCTURE

Capital Structure
Also known as Financial Structure. Capital Structure refers to the proportion of debt & equity

used to finance the operations of the firm.

In other words, long term claims form the capital structure of the company.

Optimum Capital Structure

The capital structure (debt-equity mix), which maximises the value of the company, is known as optimum capital structure.

Criteria of Determining the Pattern of Capital Structure/Framework for Capital Structure

Cost (Return) Risk

Control
Time Flexibility

(FRICT Analysis)

Factors Influencing the Pattern of Capital Structure

Factors Related to Economy
- Status of economy - Pace of business activities

- Condition of capital market

- Tax laws - State regulation - Status of financial institutions

Factors Influencing the Pattern of Capital Structure

Factors Related to Industry

- Stage of life cycle

- Degree of Competition - Cyclic Variations

Factors Influencing the Pattern of Capital Structure

Factors Related to the Company
- Size & nature of business - Asset structure of the company

- Age of the company

- Credit standing - Goodwill - Attitude of management

Factors Influencing the Pattern of Capital Structure

International Factors

- Current trends
- Access to internal financial markets

Financial Leverage
Also known as Trading on Equity or Gearing on Equity.
The use of fixed cost source of funds in the capital structure (for the benefit of shareholders) is known as financial leverage. It is a double edged weapon.

Measures of Financial Leverage

Debt-Equity Ratio Debt to Capital Employed Ratio Interest Coverage Ratio

Degree of Financial Leverage

DFL indicates the relationship between change in EPS and change in EBIT.

DFL = % Change in EPS / % Change in EBIT

Q(S-V) - F DFL =

Q(S-V) - F - Interest

Theories of Capital Structure

Net Income Approach

This theory suggests that there is a relationship between the capital structure and the value of the firm and therefore the value of the firm can be affected by increasing or decreasing the proportion of debt in the overall capital of the company.

Net Income Approach- Assumptions

The total capital requirement of the firm is given and it remains constant. The cost of debt (Kd) and cost of equity (Ke) are constant

and Kd < Ke.

Use of more debt doesnt affect the risk perception of investors. There are no taxes.

Net Income Approach- Description

This approach states that a change in capital structure leads to change in cost of capital (WACC), which ultimately results in the change in the value of the firm. As Kd < Ke , the increasing use of debt in the capital structure will reduce the Ko and magnify the returns available to shareholders.

This will increase the total value of equity which will ultimately result in the increased value of the firm.

Traditional Approach
This approach suggests that a firm should make judicious

use of both debt and equity to achieve the capital structure at which the overall cost of capital will be minimum and the value of the firm will be maximum. This capital structure is called as optimum capital structure.
The value of the firm increases with the increase in financial leverage up to a certain limit only. Beyond this

limit, the increase in financial leverage increases its WACC and thus the value of the firm declines.

Traditional Approach- Contd.

In case of a 100% equity firm, Ko = Ke . When debt (Kd < Ke ) is introduced in the capital, Ko decreases. As we increase the degree of leverage, Ko decreases and value of the firm increases.

But, beyond a limit, increase in leverage increases the risk of equity investors. As a result, Ke starts rising.
If the firm further increases the leverage, the risk of debt investors also starts rising and consequently Kd also starts increasing. The increasing Ke and Kd make the Ko to increase and the value of the firm starts declining.

Net Operating Income (NOI) Approach

This theory suggests that capital structure doesnt affect the value of the firm i.e. the value of a firm remains same for all types of debt-equity mix.

NOI Approach- Assumptions

Investors view the firm as a whole and capitalise the total earnings of the firm to find its value.
Cost of debt (Kd) is constant. Ko depends on business risk, which is assumed to be constant.

There are no taxes.

NOI Approach- Description

This approach is based on the argument that investors value a firm as a whole for a given risk. Therefore, for a given EBIT, the value of a firm remains

same irrespective of the capital structure and instead depends on overall cost of capital (Ko), which depends on the business risk.
V=

EBIT
Ko

NOI Approach- Description

E=V-D

EBIT Int.
Ke=

V-D

As financial leverage (proportion of debt) increases, the risk of shareholders increases and thus Ke also increases.
The increase in Ke is such that the Ko remains constant

because the increase in Ke is just sufficient to offset the benefits of cheaper debt.

Modigliani-Miller (M-M) ApproachAssumptions

Capital markets are perfect. It means that investors can borrow or lend any amount of funds at the same rate and switch from one security to another without any transaction cost.

Investors are rational and well-informed about the risk-return pattern of all securities.
Securities are infinitely divisible.

Corporate leverage and personal leverage are perfect substitutes.

There are no taxes.

M-M Approach- Description

This model suggests that:

The value of a firm is equal to the capitalised value of the

earnings of the firm. The capitalisation rate depends on the risk class of the firm.

As the cut-off rate depends on the risk class of the firm, it is not
affected by the capital structure and therefore the value of a firm is independent of the financing-mix.

Thus, all capital structures are equally good and there is nothing
like optimum capital structure.

M-M Approach- Description

This approach suggests that if two firms are same in all aspects except their financing patterns and market values, investors will develop the tendency to sell the shares of the over valued company and purchase the shares of the under valued company.

This arbitrage process will result in both the companies having

same market value. As per this model,
KO = (D / D+E) * KD + (E / D+E) * KE

KE = KO + (KE - KD) * D/E

M-M Model When The Assumption Regarding Taxes Is Relaxed

This approach suggests that in the presence of corporate tax, the value of a firm increases with the leverage as the interest paid on debt provides Interest Tax-Shield. Higher is the degree of leverage, larger will be the cash available for equity investors and higher will be the value of firm.

In other words we can say that capital structure becomes relevant in the presence of corporate tax.

M-M Model When The Assumption Regarding Taxes Is Relaxed- Contd.

EBIT (1 t)
VU = Ko

VL = VU + PV (Interest Tax Shield) KO = (D / D+E) * KD (1-t) + (E / D+E) * KE

KE = KO + (KE - KD) * (D/E) * (1-t)