CAPITAL STRUCTURE

CAPITAL STRUCTURE

MEANING:

Capital structure is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long term debt, preference share capital and equity share capital.

DEFINITION:

According to Gerestenbeg, “Capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources”.

Capitalization:

· Total amount of securities issued by a company.

FINACIALIZATION:

· Entire liability side of the balance sheet. It includes all short as well as long term financial resources.

Forms / Patterns of Capital structure:

· Equity Shares only

· Equity shares and Preference shares

· Equity shares and debts

· Equity shares, preference shares and debts

Financial leverage or Trading on Equity:

? The use of long term fixed interest bearing debt and preference share capital along with equity shares is called Financial Leverage or Trading on Equity.

? Capital structure cannot affect the total earnings of the firm but it can affect the share of earnings available for equity shareholders.



Optimal capital Structure:

· Optimal capital structure may be defined as “Combination of debt and equity that leads to the maximum value of the firm.

· Optimal capital structure maximizes the value of the firm and wealth of the shareholders and minimizes the company’s cost of capital.

Theories of Capital structure:

1. Net Income Approach:

2. Net Operating income approach

3. Traditional approach

4. Modigiliani and Miller Approach

Net Income Approach:

According to this approach, a firm can minimize the cost of capital and increase the value of the firm as well as market rice of the securities.

Total market value of the firm:

V = S + D

Where

V = Value of the firm

S = Market value of equity shares

=

D = Value of Debt

Overall cost of capital:

=

Net Operating Income approach:

· This theory suggested by Durand

· Opposite to the Net Income Approach

· According to this approach Capital structure of the company does not affect eh market value of the firm and the overall cost of capital remains the same.

· Every capital structure is the optimum capital structure.

Total market value of the firm:

=

Where

V = Value of the firm

EBIT = Earnings Before Interest and Tax

Ko = Cost of capital

Market Value of Equity Shares:

S = V – D

Where

S = Value of Equity Shares

V = Value of the firm

D = Value of Debt

TRADITIONAL APPROACH:

· Also known as Intermediately approach

· Compromise between the Net Income approach and Net Operating Income approach

· According to this approach, the value of the firm can be increased and cost of capital can be decreased initially. Beyond a particular point, the cost of capital increases and value of the firm decreases.

MODIGILINI AND MILLER APPRAOCH:

· According to this approach, there are two types of theories are propagated.

· Theory of Irrelevance and Theory of relevance

THEORY OF IRRELEVANCE:

· Theory of irrelevance means in the absence of taxes.

· It is identical with Net Operating Income approach

· According to this approach Capital structure of the company does not affect the market value of the firm and the overall cost of capital remains the same.

THEORY OF RELEVANCE:

· Theory of relevance means taxes are exist.

· It is identical with Net Income approach

· According to this approach, a firm can minimize the cost of capital and increase the value of the firm as well as market rice of the securities.

· If the company having debt in its capital structure the firm will called as Levered firm

· If the company does not have debt in its capital structure the firm will called as Unlevered firm.

Value of Unlevered Firm (

):

=

(1 - t)

Where,

EBIT = Earnings Before Interest and Tax

Ko = Overall cost of capital

T = Tax rate

Value of Levered firm:

VL = Vu + tD

Where,

VL = Value of Levered firm

Vu = Value of Unlevered firm

T = Tax rate

D = Amount of Debt

FACTORS DETERMINING THE CAPITAL STRUCTURE:

1. Financial leverage or Trading on equity

2. Growth and stability of sales

3. Cost of capital

4. Cash flow ability to service debt

5. Nature and size of the firm

6. Control

7. Flexibility

8. Requirements of investors

9. Capital market conditions

10. Asset structure

11. Purpose of financing

12. Period of finance

13. Cost of flotation

14. Personal considerations

15. Corporate tax rate

16. Legal requirements.

 

[Dhruv Bindhani]

CAPITAL STRUCTURE

MEANING:

Capital structure is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long term debt, preference share capital and equity share capital.

DEFINITION:

According to Gerestenbeg, “Capital structure of a company refers to the composition or make up of its capitalization and it includes all long term capital resources”.

Capitalization:

· Total amount of securities issued by a company.

FINACIALIZATION:

· Entire liability side of the balance sheet. It includes all short as well as long term financial resources.

Forms / Patterns of Capital structure:

· Equity Shares only

· Equity shares and Preference shares

· Equity shares and debts

· Equity shares, preference shares and debts

Financial leverage or Trading on Equity:

? The use of long term fixed interest bearing debt and preference share capital along with equity shares is called Financial Leverage or Trading on Equity.

? Capital structure cannot affect the total earnings of the firm but it can affect the share of earnings available for equity shareholders.



Optimal capital Structure:

· Optimal capital structure may be defined as “Combination of debt and equity that leads to the maximum value of the firm.

· Optimal capital structure maximizes the value of the firm and wealth of the shareholders and minimizes the company’s cost of capital.

Theories of Capital structure:

1. Net Income Approach:

2. Net Operating income approach

3. Traditional approach

4. Modigiliani and Miller Approach

Net Income Approach:

According to this approach, a firm can minimize the cost of capital and increase the value of the firm as well as market rice of the securities.

Total market value of the firm:

V = S + D

Where

V = Value of the firm

S = Market value of equity shares

=

D = Value of Debt

Overall cost of capital:

=

Net Operating Income approach:

· This theory suggested by Durand

· Opposite to the Net Income Approach

· According to this approach Capital structure of the company does not affect eh market value of the firm and the overall cost of capital remains the same.

· Every capital structure is the optimum capital structure.

Total market value of the firm:

=

Where

V = Value of the firm

EBIT = Earnings Before Interest and Tax

Ko = Cost of capital

Market Value of Equity Shares:

S = V – D

Where

S = Value of Equity Shares

V = Value of the firm

D = Value of Debt

TRADITIONAL APPROACH:

· Also known as Intermediately approach

· Compromise between the Net Income approach and Net Operating Income approach

· According to this approach, the value of the firm can be increased and cost of capital can be decreased initially. Beyond a particular point, the cost of capital increases and value of the firm decreases.

MODIGILINI AND MILLER APPRAOCH:

· According to this approach, there are two types of theories are propagated.

· Theory of Irrelevance and Theory of relevance

THEORY OF IRRELEVANCE:

· Theory of irrelevance means in the absence of taxes.

· It is identical with Net Operating Income approach

· According to this approach Capital structure of the company does not affect the market value of the firm and the overall cost of capital remains the same.

THEORY OF RELEVANCE:

· Theory of relevance means taxes are exist.

· It is identical with Net Income approach

· According to this approach, a firm can minimize the cost of capital and increase the value of the firm as well as market rice of the securities.

· If the company having debt in its capital structure the firm will called as Levered firm

· If the company does not have debt in its capital structure the firm will called as Unlevered firm.

Value of Unlevered Firm (

):

=

(1 - t)

Where,

EBIT = Earnings Before Interest and Tax

Ko = Overall cost of capital

T = Tax rate

Value of Levered firm:

VL = Vu + tD

Where,

VL = Value of Levered firm

Vu = Value of Unlevered firm

T = Tax rate

D = Amount of Debt

FACTORS DETERMINING THE CAPITAL STRUCTURE:

1. Financial leverage or Trading on equity

2. Growth and stability of sales

3. Cost of capital

4. Cash flow ability to service debt

5. Nature and size of the firm

6. Control

7. Flexibility

8. Requirements of investors

9. Capital market conditions

10. Asset structure

11. Purpose of financing

12. Period of finance

13. Cost of flotation

14. Personal considerations

15. Corporate tax rate

16. Legal requirements.

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