5.

CAPITAL STRUCTURE
5.1. INTRODUCTION

Capital structure is the particular combination of debt and equity used by a company to finance its
overall operations and growth. Equity capital arises from ownership shares in a company and claims
Net Income
to its future cash flows and profits.

It is calculated by dividing total liabilities by total equity. Capital structures can be divided into 4
structures like-

Equity only Equity and Equity and Equity, debenture

Equity only
debentures preferences and preferences

OPTIMAL CAPITAL STRUCTURE

An optimal capital structure is the best mix of debt and equity financing that maximizes a company's
market value while minimizing its cost of capital. Minimizing the weighted average cost of capital
(WACC) is one way to optimize for the lowest cost mix of financing. We do maximum earning of
share – EBIT-EPS analysis Objective of optimum capital structure is –

 Max value of firm

 Max equity shareholder wealth

 Max earning per share (EPS) Then choosing capital structure which ever is max and also mini cost
of capital.

FACTORS AFFECTING THE CAPITAL STRUCTURE:

 Cost of debt

 Cost of equity

 Interest coverage ratio

 COST OF DEBT: The cost of debt is the effective interest rate that a company pays on its debts,
such as bonds and loans.

 COST OF EQUITY: Cost of equity is the return that a company requires for an investment or
project, or the return that an individual requires for an equity investment.

 INTEREST COVERAGE RATIO: The interest coverage ratio is a debt and profitability ratio used to
determine how easily a company can pay interest on its outstanding debt.

Capital Structure
CAPITAL STRUCTURE THEORIES:
Theories

Net Operating Traditional Miller And Modigliani

Income Approaches
NET INCOME APPROACH :The Net Income Approach was presented by Durand. The theory suggests
increasing the value of the firm by decreasing the overall cost of capital which is measured in terms
of the Weighted Average Cost of Capital. This can be done by having a higher proportion of debt,
which is a cheaper source of finance compared to equity finance. Weighted Average Cost of Capital
(WACC) is the weighted average costs of equity and debts where the weights are the amount of
capital raised from each source. WACC = Required Rate of Return x Amount of Equity + Cost of debt
x Amount of Debt Total Amount of Capital (Debt + Equity) .

NET OPERATING INCOME APPROACH: Net Operating Income Approach to capital structure believes
that the value of a firm is not affected by the change of debt component in the capital structure. It
assumes that the benefit that a firm derives by infusion of debt is negated by the simultaneous
increase in the required rate of return by the equity shareholders. With an increase in debt, the risk
associated with the firm, mainly bankruptcy risk, also increases and such a risk perception increases
the expectations of the equity shareholders. This theory is just opposite to NI approach. NI approach
is relevant to capital structure decision. It means decision of debt equity mix does affect the WACC
and value of the firm. As per NOI approach the capital structure decision is irrelevant and the degree
of financial leverage does not affect the WACC and market value of the firm. NOI approach evaluates
the cost of capital and therefore the optimal Capital Structure on the basis of operating leverage by
means of NOI approach.

TRADITIONAL APPROACH :This approach does not define hard and fast facts, and it says that the
cost of capital is a function of the capital structure. The unique thing about this approach is that it
believes in an optimal capital structure. Optimal capital structure implies that the cost of capital is
minimum at a particular ratio of debt and equity, and the firm’s value is maximum for a more –
Traditional Approach.

MODIGLIANI AND MILLER APPROACH (MM APPROACH) It is a capital structure theory named after
Franco Modigliani and Merton Miller. MM theory proposed two propositions. Proposition I: It says
that the capital structure is irrelevant to the value of a firm. The value of two identical firms would
remain the same, and value would not affect the choice of finance adopted to finance the assets.
The value of a firm is dependent on the expected future earnings. It is when there are no taxes.
Proposition II: It says that the financial leverage boosts the value of a firm and reduces WACC. It is
when tax information is available.

DEBT EQUITY RATIO OF DEEPAK SPINNERS LIMITED:

Debt percentage=debt/debt+equity
Equity percentage=equity/debt+equity

year 2021 2020 2019 2018

debt percentage 22% 34% 41% 48%
year 2021 2020 2019 2018
equity
percentage 78% 66% 59% 52%

debt percentage
60%

50%

40%

30%

20%

10%

0%
2021 2020 2019 2018

equity percentage
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2021 2020 2019 2018