CAPITAL STRUCTURE

Meaning of Capital Structure

• Capital structure refers to the composition of capital, i.e. the mix of sources from which the long-term funds required by a business are to be collected or are raised.

Kinds of Capital Structure

• Capital structure can be of various kinds as described below:

– Horizontal Capital Structure

– Vertical Capital Structure

– Pyramid shaped capital structure

– Inverted Pyramid Capital Structure

Goals/Principles or Determinants Of Capital Structure Management

• Cost Principle

• Risk Principle

• Control Principle

• Flexibility Principle

• Timing Principle

Significance Of Capital Structure

• Capital structure is significant for a firm because the long term profitability and solvency of the firm is sustained by an optimal capital structure consisting of an appropriate mix of debt and equity.

• Reflects the firm’s strategy

• Indicator of the risk profile of the firm

• Acts as a tax management tool

• Helps to brighten the image of the firm

Characteristics Of An Ideal Capital Structure

• Simplicity

• Liquidity

• Flexibility

• Balance

• Economical

• Provision against contingencies

• Business soundness

• Consistent with objectives

Factors Affecting Capital Structure

• Internal Factors

– Cost of Capital

– Risk Factors

– Control Factor

• External Factors

– General Economic Conditions

– Level of Interest Rates

– Policy of Lending Institutions

– Taxation Policy

– Statutory Restrictions

• General Factors

– Constitution of the Company

– Characteristics of the Company

– Stability of Earnings

– Attitude of the Management

Optimum Capital Structure

• The capital structure is said to be optimum when the real cost of each source of financing is identified.

• With an optimum debt and equity mix, the cost of capital is minimum and market price per share is maximum.

Features of An Appropriate Capital Structure

• Profitability

• Flexibility

• Conservation

• Solvency

• Control

APPROACHES OF CAPITAL STRUCTURE

Capital Structure and Cost of Capital

• It is now an accepted principle that the valuation of a firm and its cost of capital may be affected by the change in the financing mix.

• Approaches of capital structure

– Net Income ( NI ) Approach.

– Net Operating Income ( NOI ) Approach.

– Traditional Approach.

– Modigliani and Miller Approach.

Basic Assumption Of Approaches

• Firms use only two types of capital: long-term debt capital and equity share capital to raise funds

• Corporate income tax dose not exist and there are no bankruptcy costs

• Firms follow policy of paying 100% of its earnings by way dividend.

• Operating earnings of firm is given and expected to grow

• The investment decisions are constant

• There is perpetual life of the unit

• The business risk is independent of capital structure and financial risks

• The variations in capital structure are made immediately and there no transaction costs

Symbols And Definitions

• S = Market value of equity shares B = Market value of debt

• V = Total market value of firm NOI = Net Operating Income, i.e. EBIT

• I = Total Interest Payment NI = Net income available to equity shareholders, i.e. EBIT – I

Symbols And Definitions

• Cost of Debt = I/B

• Cost of Equity = NI/S

• Overall Cost of Capital = EBIT/V

Net Income (NI) Approach

• there exists a direct relationship between the capital structure and valuation of the firm and cost capital.

Net Operating Income ( NOI ) Approach

• the valuation of the firm and its cost of capital are independent of its capital structure.

• the market value of a firm depends upon its Net Operating Income and not on the pattern of financing.

Traditional Approach Or Intermediate Approach

• The traditional approach is also known as the intermediate approach as it is the mean between two extreme approaches of net income approach on one hand and net operating income on the another.

• It believes in the existence of what may be called Optimal Capital Structure.

• by a judicious mix of debt and equity capital, it is possible for the firm to minimize the overall cost of capital and maximize the total value of the firm

Modigliani-Miller (M And M) Approach

• the value of the firm and its cost of capital independent of its capital structure, i.e., the total value of the firm remain unchanged inspite of the debt equity mix or the degree of leverage.

• overall cost of capital is equal to the capitalization rate of pure equity stream of risk class.