CAPITAL STRUCTURE

CAPITALISATION, CAPITAL STRUCTURE,

FINANCIAL STRUCTURE
• CAPITALISATION refers to the total amount of securities issued
by company.

• CAPITAL STRUCTURE refers to the kinds of securities and

proportionate amount that make up capitalisation. i.e. Equity
shares, Preference shares and Debentures.

• FINANCIAL STRUCTURE refers to all financial resources

marshalled by the firm, short as well as long-term, and all forms
of debt as well as equity.
Financial Structure
• Financial Structure means the entire liability side of balance sheet.
• It includes long & short term debts and all the forms of debt & share
capital.
Forms of Debt
• Period wise: Long Term & Short Term
• Security wise: Secured, Unsecured & Partly Secured
• Conversion in equity: Convertible & Non Convertible
Forms of Share Capital
• Equity Share Capital
• Preference Share Capital : Redeemable & Irredeemable
Convertible & Non Covertible
IMPORTANCE OF CAPITAL STRUCTURE

• The use of long-term fixed interest bearing

securities and preference share capital
along with equity share capital is called
financial leverage or trading on equity.
THEORIES OF CAPITAL STRUCTURE

1.Net Income Approach

2.Net Operating Income Approach
 1). NET INCOME APPROACH

• According to this approach, a firm can minimize its

weighted average cost of capital and increase the
value of firm as well as market price of equity share by
using debt financing to the maximum possible extent.
The total market value of firm on the basis of Net Income
Approach can be ascertained as below:-

V = Total market value of firm.

S = Market value of equity share = EAESH
Ke
(*Ke = Equity Capitalization Rate = Cost of Equity Capital)
D = Market value of debt.

V = S+ D
Overall cost of capital or Weighted average
cost of capital or Overall capitalization rate
Ko = EBIT
V
V=S+D
V = S + 400000 = 4800001 + 400000 = 880000 = Answer

S = Market value of equity share = EAESH = 600002 = 4800001

Equity Capitalization Rate 0.125

 
EBIT 100000
-I 40000 (400000*10%)
EBT 60000
-T 0
EAT 60000
-Dp 0
EAESH 600002
EBIT
-I
EBT
-T
EAT
-Dp
EAESH
V=S+D
V = S + 200000 = 6400001 + 200000 = 840000 = Answer

S = Market value of equity share = EAESH = 640002 = 6400001

(Ke) Equity Capitalization Rate 0.10

 
EBIT 80000
-I 16000 (200000*8%)
EBT 64000
-T 0
EAT 64000
-Dp 0
EAESH 640002
V=S+D
V = S + 300000 = 5600001 + 300000 = 860000 = Answer

S = Market value of equity share = EAESH = 560002 = 5600001

(Ke) Equity Capitalization Rate 0.10

 
EBIT 80000
-I 24000 (300000*8%)
EBT 56000
-T 0
EAT 56000
-Dp 0
EAESH 560002
Overall cost of capital or Weighted average
cost of capital or Overall capitalization rate
Ko = EBIT
V

Ko = 80000/860000 = 9.30%
80,000
-16,000
64,000
10%
6,40,000
+2,00,000
8,40,000

80,000
Market Capitalisation = Price of the shares
× Quantity of the shares
NET OPERATING INCOME APPROACH
• This theory was suggested by Durand. According to
this approach, change in capital structure of
company does not affect the market value of firm
and the overall cost of capital remains constant
irrespective of the method of financing.
NET OPERATING INCOME APPROACH
The value of firm on the basis of Net Operating
Income Approach can be determined as below:
V = EBIT
Ko
V = Value of firm
EBIT = Earning before interest and tax
Ko = Cost of capital
The market value of equity, according to
this approach:
• It is the residual value which is determined by
deducting the market value of debentures from the
total market value of the firm.
S=V-D
S = Market value of equity shares
V = Total market value of a firm
D = Market value of debt
 The cost of equity or equity capitalisation
rate
• Cost of Equity or
Equity Capitalization Rate (Ke) = EAESH
Market value of firm - Market value of debt
Ke = EAESH
V–D
Ke = EAESH
S
 EAESH

EAESH
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Assumptions:
1. There are no Corporate Taxes.
2. There is a perfect market.
3. Investors act rationally.
4. The expected earnings of all the firms have identical risks.
5. The cut off point of investment in a firm is capitalization rate.
6. All earnings are distributed to the shareholders.
7. Risk to investors depends upon the random fluctuations.
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
EBIT
1. Total Market Value (V) = --------
Ke

2. Market Value of Equity : S = V – D

(where D is market value of debentures)

3. Leverage Cost of Equity:

= Cost of Equity + (Cost of Equity - Cost of Debt)
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 1 : No Corporate Tax
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists
• Value of the firm will increase (or the cost of capital will decrease)
with the use of debt, because interest is a deductible expense for tax
purposes.

EBIT
• Value of UNLEVERED firm (Vu)= ----------------------------------- x (1 – t)
Overall cost of Capital (Ko)
where t is the rate of tax.

• Value of LEVERED firm (VL) = Vu + t D

where Vu is value of UNLEVERED firm & D is value of Debentures.
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists

There are two firms X and Y which are exactly identical

except that X does not use any debt in its financing,
while Y has Rs. 1,00,000 5% Debentures in its
financing. Both the firms have earnings before interest
and tax of Rs 25,000 and the equity capitalization rate
is 10%. Assuming the corporation tax of 50%, calculate
the value of the firm using M & M approach.
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists
Modigliani & Miller Approach :
Theory 2 : Corporate Tax Exists
Modigliani & Miller Approach: Summary

• It is identical to Net Operating Income Approach if taxes are ignored.

• It taxes are not to be ignored, it is identical to Net Income Approach.

Modigliani & Miller Approach: Arbitrage

• In case of unlevered firms, the equity shareholders try to increase

personal debt for investing in levered firm. They will sell their equity
shares of unlevered firm, borrow some more money and buy shares
of levered firm, till the market value of both the firms becomes equal.
Factors determining the Capital Structure
1. Financial Leverage or 9. Capital Market Conditions
Trading on equity
2. Growth & Stablility of Sales 10.Assets Structure
3. Cost of Capital 11.Purpose of Financing
4. Cash Flow Ability to Service Debt 12.Period of Finance
5. Nature & Size of Firm 13.Costs of Floatation
6. Control 14.Personal Consideration
7. Flexibility 15.Corporate Tax Rate
8. Requirement of Investors 16.Legal Requirements
 FINANCIAL BREAK EVEN POINT

Financial break even point = I + Dp

(1+t)
I = Fixed interest charged
Dp = Dividend on Preference shares
t = tax rate in decimal
 Financial Break Even Point or Indifference
Point
• At this level of EBIT, the rate of return on capital employed is equal to the cost
of debt.

• In other words, EPS remains the same irrespective of capital structure.

• This level is also called Equivalency Point or Point of Indifference

Point of Indifference Or Range of Earnings
• Where EBIT remains the same irrespective of different debt equity
mix.
(X – I1 ) (1-t) – Dp = (X – I2 ) (1-t) – Dp
S1 S2
X = Point of Indifference or Equilancy Point
I1 = Rate of Interest in Plan 1
I2 = Rate of Interest in Plan 2
t = Tax Rate
Dp = Preference Dividend
S1 = Amount or Number of Equity Shares in Alternative 1

S2 = Amount or Number of Equity Shares in Alternative 2

Capital Gearing
• Relationship between Equity (Equity Share Capital + Reserves) and
Long Term Debt.
Reasons for Changing in Capitalization
1. Restoring Balances in Financial Plan
2. Simplifying the Capital Structure
3. Addressing Investors Needs
4. Funding the current liabilities
5. Writing off the deficit
6. Capitalizing the retained earnings
7. Clearing the default on Fixed Cost Securities
8. Funding the Accumulated of Dividend
9. Facilitating Merger & Expansion
10. Meeting Legal Requirements