Capital Structure

Notes 11 Pages

Bharathiar University

Financial Management

Contributed by

Selvaraj S N

Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 1

UNIT – III FINANCIAL MANAGEMENT
Capital Structure – Meaning – Definition – Types of Capital Structure – Factors
Influencing Capital Structure – Optimal Capital Structure – Dividend and Dividend
Policy – Meaning – Classification – Sources Available for Dividends – General
Determinants of Dividend Policy.

CAPITAL STRUCTURE
The financing or capital structure decision is a significant managerial decision. It
influences the shareholder‟s return and risk. Consequently, the market value of the
share may be affected by the capital structure decision.

Meaning and Scope of Capital Structure
Capital structure represents the relationship among different kinds of long term
capital. Normally, a firm raises long term capital through the issue of shares,
sometimes accompanied by preference shares.

According to Prasanna Chandra, “Capital structure is the composition of a firm‟s
financing consists of equity, preference and debt”.

Types of Capital Structure
The capital structure of any concern may be simple, compound and complex.
(a) Simple Capital Structure: A single capital structure consists of single security
base as a source of fund to finance the activities of a concern, e.g. equity share
capital issued by a concern.
(b) Compound Capital Structure: In compound capital structure a combination of
two security bases in the form of equity and preference capital or equity share
capital and debentures are used as a source of funds
(c) Complex Capital Structure: A complex capital structure is made up of multi-
security base, consisting of equity share capital, preference share capital,
debentures and loans from financial institutions.

FACTORS INFLUENCING CAPITAL STRUCTURE
Capital structure has to be determined at the time a company is promoted. The initial
capital structure should be designed very carefully. Generally, the factors to be
considered whenever a capital structure decision is taken are as follows:

1) Financial Leverage (or) Trading on Equity: The use of long-term fixed interest
bearing debt and preference share capital along with equity share capital is called
financial leverage or trading on equity.
2) Operating Leverage: This leverage depends on the operating fixed cost of the firm.
If higher percentage of a firm‟s total costs is fixed operating costs, the firm is said
to have a high degree of operating leverage.
3) EBIT/EPS Analysis: This analysis is an important tool of measuring a company‟s
performance. Normally a financial plan that will give maximum value of EPS will
be selected as the most desirable mix.
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Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 2

4) Cost of Capital: It is necessary for the company to determine the cost of various
sources of finance to establish the desirability of one source over the other.
5) Growth and Stability of Sales: The capital structure of a firm is highly influenced by
the growth and stability of its sale.
6) Nature and Size of a Firm: Nature and size of a firm also influence its capital
structure. A public utility concern has different capital structure as compared to
another manufacturing concern.
7) Flexibility: Capital structure of a firm should be flexible. It should be possible to
raise additional fund, whenever the need be, without much of difficulty and delay.
8) Cash Flow Analysis: The companies expecting larger and stable cash inflows in
future can employ a large amount of debt in their capital structure.
9) Control: Ordinary or equity shareholders have the legal right to vote. In fact, they
are the real owners and they can exercise the control over the overall affairs.
10) Marketability: The conditions in capital market are continuously changing. At one
time the capital market favors the debenture issue and at other time it readily
accepts common share issues.
11) Floatation Costs: Floatation costs are incurred only when the funds are raised.
Normally cost of floating a debt is less than the cost of floating an equity issue
12) Legal Constraints: In a regulated economy, a firm has to comply with legal
requirements in this respect.
13) Capital Market Conditions: Marketability means the ability of the firm to sell or
market a particular type of security in a particular period of time.
14) Asset Structure: The liquidity and the composition of assets should be kept in mind
while selecting the capital structure
Factors Affecting Capital Structure
Financial Leverage/Trading on Equity
Operating Leverage
EBIT / EPS Analysis
Growth and Stability of Sales
Flexibility
Control
Floatation Costs
Capital Market Conditions
Purpose of Financing
Cost of Capital
Nature and Size of a Firm
Cash Flow Analysis
Marketability
Legal Constraints
Asset Structure
Period of Finance
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Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 3

15) Purpose of Financing: If funds are required for a productive purpose, debt
financing is suitable and the company should issue debentures as interest can be
paid out of the profits generated from the investment.
16) Period of Finance: The period for which the finances are required is also an
important factor to be kept in the mind while selecting inappropriate capital mix.

OPTIMAL CAPITAL STRUCTURE
Optimal capital structure is “that capital structure or combination of debt and equity
that leads to the maximum value of the firm.” At this point, average composite cost or
weighted average cost is the minimum.

Problem: For varying levels of debt-equity mix, the estimates of the cost of debt and
equity capital (after tax) are given below:
Debt as percentage of
Total Capital Employed
Cost of Debt (%)
Cost of Equity (%)
0
10
20
30
40
50
60
7.0
7.0
7.0
8.0
9.0
10.0
11.0
15.0
15.0
16.0
17.0
18.0
21.0
24.0
You are required to decide on the optimal debt-equity mix for the Company by
calculating the composite cost of capital.

Solution: The estimated costs of debt and equity capital (after tax) at different levels of
debt-equity mix are detailed below. Optimal debt-equity mix will be that combination
which has the minimum composite cost of capital.
The composite cost can be arrived by the following formula:
(k
d
×w
d
) + (k
e
×w
e
)
Where, k
d
= Cost of debt, k
e
= Cost of equity
w
d
= Proportion of debt, w
e
= Proportion of equity
Cost of Debt
(%)
Cost of Equity
(%)
Proportion of
Debt
Proportion of
Equity
Composite Cost
(%)
k
d

k
e

w
d

w
e

(k
d
×w
d
) + k
e
×w
e
)
7.0
7.0
7.0
8.0
9.0
10.0
11.0
15.0
15.0
16.0
17.0
18.0
21.0
24.0
0.0
0.1
0.2
0.3
0.4
0.5
0.6
1.0
0.9
0.8
0.7
0.6
0.5
0.4
15.00
14.20
14.20
14.30
14.40
15.50
16.20

There are two options of debt-equity mix that are optimal:
1) 10% debt and 90% equity (or)
2) 20% debt and 80 % equity.
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Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 4

CAPITAL STRUCTURE THEORY
Capital Structure Theories /Approaches
There are four major approach/theories explaining the relationship between capital
structure, cost of capital and value of the firm.

NET INCOME (NI) APPROACH
This approach has been suggested by Durand. According to this approach, capital
structure decision is relevant to the valuation of the firm. In other words, a change in
the capital structure causes a corresponding change in the overall cost of capital as
well as the total value of the firm.

Assumptions of Net Income Approach
NI approach is based on the following three assumptions:
1) There are no corporate taxes
2) The cost of debt is less than cost of equity or equity capitalization rate
3) The debt content does not change the risk perception of the investors.

The value of the firm on the basis of NI approach can be ascertained as follows:
V = E+D
Where, V = Value of Firm,
E = Market Value of Equity
D = Market Value of Debt.

Market value of Equity can be ascertained as follows:
E = NI/K
e

Where, E = Market Value of Equity,
NI = Earnings available for equity shareholders,
K
e
= Equity Capitalization Rate.

Problem
X Ltd. is expecting an annual EBIT of Rs.1 lakh. The company has Rs.4.00 lakhs in
10% debentures. The cost of equity capital or capitalization rate is 12.5%. You are
required to calculate the total value of the firm. Also state the overall cost of capital.

Net Income (NI) Approach
Traditional Approach
Net Operating Income (NOI)
Approach
Modigliani Miller Approach
Capital Structure Approaches
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Solution
Statement Showing Value of the Firm

Rs.
Earnings Before Interest and Tax (EBIT)
Less: Interest at 10% on Rs.4.00 lakhs
Earnings available for equity share holders (NI)
Equity Capital Rate (K
e
)

Market Value of Equity (E): NI = 60,000 × 100
K
e
12.5
Market Value of Debt (D)
Total Value of the Firm (E+D)

Overall Cost of Capital: K = EBIT = 1,00,000 × 100
V 8,80,000
1,00,000
40,000
60,000
12.5%

4,80,000

4,00,000
8,80,000

11.36%

TRADITIONAL APPROACH
In considering the most desirable capital structure for Matrix Company, the following
estimates of the cost of debt and equity capital (after tax) has been made at various
levels of debt-equity mix.

You are required to determine the optimal debt-equity mix for the company by
calculating composite cost of capital.
Debt as percentage of
Total Capital Employed
Cost of Debt (%)
Cost of Equity (%)
0
10
20
30
40
50
60
5.0
5.0
5.0
5.5
6.0
6.5
7.0
12.0
12.0
12.5
13.0
14.0
16.0
20.0

Solution
Statement Showing Composite Cost of Capital (After-tax)
Debt as
percentage of
Total Capital
Employed
Cost of
Debt (%)
Cost of
Equity
(%)
Composite Cost of Capital
(%)
0
10
20
30
40
50
60
5.0
5.0
5.0
5.5
6.0
6.5
7.0
12.0
12.0
12.5
13.0
14.0
16.0
20.0
(5.0 × 0) + (12 × 1.00) = 12.00
(5.0 × 0.10) + (12 × 0.90) = 11.30
(5.0 × 0.20) + (12.5 × 0.80) = 11.00
(5.5 × 0.30) + (13 × 0.70) = 10.75
(6.0 × 0.40) + (14 × 0.60) = 10.80
(6.5 × 0.50) + (16 × 0.50) = 11.25
(7.0 × 0.60) + (20 × 0.40) = 12.20
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Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 6

Optimal debt-equity mix is 30% debt and 70% equity, where the composite cost of
capital is the least.

NET OPERATING INCOME (NOI) APPROACH
This approach has also been suggested by Durand. This is just opposite of Net Income
Approach. According to this approach, the market value of the firm is not at all
affected by the capital structure changes.

Assumptions of Net Operating Income (NOI) Approach
1) The overall cost of capital (K) remains constant for all degrees of debt-equity
mix or leverage.
2) The market capitalizes the value of the firm as a whole and, therefore, the split
between debt and equity is not relevant.
3) The use of debt having how cost increases the risk of equity shareholders, this
result in increase in equity capitalization rate. Thus, the advantage of debt is set
off exactly by increase in the equity capitalization rate.
4) There are no corporate taxes.

Value of the Firm: According to the NOI approach, the value of a firm can be
determined by the following equation.
V = EBIT / K [V = Value of firm, K = Overall cost of capital, EBIT =
Earnings before interest and tax]

Value of Equity: The value of equity (E) is a residual value, which is determined by
deducting the total value of debt (D) from the total value of the firm (V). Thus, the
value of equity (E) can be determined by the following equation:
E = V – D [E = Value of equity, V = Value of firm, D = Value of debt]

Equity capitalization rate = K
e
= EBIT−I
V−D

Problem
XY Ltd has an EBIT of Rs.1 lakh. The cost of debt is 10% and the outstanding debt
amount to Rs.4 lakh. Presuming the overall capitalization rate as 12.5%, calculate the
total value of the firm and the equity capitalization rate.

Solution
Statement Showing the Value of the Firm
Earnings before interest and tax (EBIT)
Overall Capitalization Rate (K)

Market Value of the Firm (V)
= 1,00,000 × 100
12.5
Total Value of Debt (D)
Rs.1,00,000
12.5%

8,00,000

4,00,000
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Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 7

Market Value of Equity (E)
= V−D = 800,000−400,000

Equity Capitalization Rate (K
e
)
K
e
= EBIT−I ×100 = 100,000−40,000 ×100
V−D 800,000−400,000

4,00,000

15%

MODIGLIANI AND MILLER (MM) APPROACH
Modigliani and Miller (M-M) developed a hypothesis, which fundamentally affects
the understanding of effects of gearing. They argue that in the absence of corporate
tax, cost of capital and the market value of the firm remain invariant to the changes in
capital structure or degree of leverage. M&M hypothesis is identical with Net
Operating Income approach if taxes are ignored. However, when corporate taxes are
assumed to exists, their hypothesis is similar to the Net Income Approach.

Assumptions of MM Theory
The MM theory has the following assumptions:
1) The capital market is assumed to be perfect.
2) All securities are infinitely divisible.
3) There are no transaction costs. There is no brokerage or other transaction
charges.
4) There is no benefit to debt financing other than reduction in corporate income
taxes due to tax shield of interest payment of debt.
5) Interest rates are equal between borrowing and lending, firms and individuals.
6) The capital markets are efficient.
7) There are no personal taxes and corporate income taxes.
8) All investors are only price-takers.
9) The firm‟s investment schedule and cash flows are assumed to be constant.

MM Theory:
The Proposition III of MM theory asserts that „the cut-off rate for new investment will
in all cases be average cost of capital and will be unaffected by the type of security
used to finance the investment. The cut-off rate for investment purposes is completely
independent of the way in which an investment is financed. This implies a complete
separation of investment and financing decisions of the firm.

Problem: XYZ Ltd. Intends to set-up a project with capital cost of Rs.50,00,000. It is
considering the three alternative proposals of financing.
Alternative 1 = 100% equity financing
Alternative 2 = Debt-equity 1:1
Alternative 3 = Debt-equity 3:1

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Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 8

The estimated annual net cash inflow is @ 24%, i.e. Rs.12,00,000 on the project. The
rate of interest on debt is 15%. Calculate the weighted average cost of capital for three
different alternatives and analyze the capital structure decision.

Solution
Evaluation of Three Different Alternatives of Financing a Project (Rs)

Alternative
1
Alternative
2
Alternative
3
Equity
Debt
Total Project Cost

Net cash inflow from project @24% p.a.
Less: Interest on debt@ 15%

1) Return on Equity
Dividend payments × 100
Total equity
2) Return on Debt
3) WACC
(cost of equity × % equity) +
(cost of debt × % debt)
50,00,0000
--
50,00,000

12,00,0000
--
12,00,000

24%

0

24%

25,00,000
25,00,000
50,00,000

12,00,000
3,75,000
8,25,000

33%

15%

24%
12,50,000
37,50,000
50,00,000

12,00,000
5,62,500
6,37,500

51%

15%

24%
Total Value of Company
50,00,000
50,00,000
50,00,000

WACC = (cost of equity × % equity) + (cost of debt × % debt)
Alternative 1 = (0.24×100) + (0 × 0) = 24%
Alternative 2 = (0.33×50) + (0.15 × 50) = 24%
Alternative 3 = (0.51×25) + (0.15 × 75) = 24%

It can be observed from the problem given above that at different levels of leverage,
the WACC is same and the value of firm will also be same.

DIVIDEND AND DIVIDEND POLICY
Dividend is that portion of profits of a company which is distributed among its
shareholder according to the decision taken and resolution passed in the meeting of
Board of Directors.

According to Weston and Brigham, “Dividend policy determines the division of
earnings between payments to shareholders and retained earnings”.

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Financial Management

Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 9

CLASSIFICATION OF DIVIDEND
Dividends can be classified in various forms. Dividends paid in the ordinary course of
business are known as Profit Dividends, while dividends paid out of capital are known
as Liquidation Dividends. Dividends may also be classified on the basis of medium in
which they are paid:

On the basis of On the basis of On the basis of
Types of Shares Mode of Payment Time of Payment

Equity Preference Interim Regular Special
Dividend Dividend Dividend Dividend Dividend

Cash Stock Bond Property Composite
Dividend Dividend Dividend Dividend Dividend

TYPES OF DIVIDEND POLICY
The dividends are to be distributed according to the nature of the company based on
several factors. The company needs to frame a policy in respect of dividend
distribution. The classification (or) types of dividend policy is as follows:

Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The investors
such as retired persons, widows and other economically weaker person prefer to get
regular dividends.

Stable Dividend Policy
The term „stability of dividend‟ means the consistency or lack of variability in the
stream of dividend payments.

Irregular Dividend Policy
Some companies follow irregular dividend payment on account the following:
Dividend
Types of Dividend Policy
Regular Dividend Policy
Stable Dividend Policy
Irregular Dividend Policy
No Dividend Policy
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Dr.S.N.Selvaraj, M.B.A., M.Phil., Ph.D., Associate Professor, Dr.N.G.P. Arts and Science College Page 10

(i) Uncertainty of earnings
(ii) Unsuccessful business operations
(iii) Lack of liquid resources

No Dividend Policy
A company may follow a policy of paying no dividend presently because of its
unfavorable working capital position or on account of requirements of funds for
further expansion and growth.

SOURCES AVAILABLE FOR DIVIDENDS
The following are the sources generally available for the payment of dividends:
 Earnings from regular operations.
 Earnings accumulated from previous year.
 Income from subsidiaries.
 Profit from the sale of appreciated property.
 Conversion of redundant reserves.
 Surplus from mergers and purchase of subsidiaries.
 Revaluation of assets.
 Surplus earned by reduction in capital stock.
 Donated surplus.
 Sale of securities at a premium.

GENERAL DETERMINANTS OF DIVIDEND POLICY

1) Legal Restrictions: It provides a framework within which the dividend policy is
formulated.
2) Size of the Earnings: Practically and truly speaking, the upper ceiling on dividend
is dedicated by the earnings of the business.
Determinants of Dividend Policy
Legal Restrictions
Investment Opportunities and
Shareholder‟s Preferences
Size of Earnings
Retained Earnings
Management‟s Attitude
towards Control
Contractual Restrictions
Control
State of Capital Market and
Access to it
Profit Rate and Stability of
Earnings
Inflation
Page 10

Capital Structure

Capital Structure

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