CAPITAL STRUCTURE

INTRODUCTION:
A firm can make use of different sources of financing
whose costs are different and as well as rate of return of
these sources are different. Some sources will have
fixed and some varies.
The fixed returns on some sources of finance have
implications for variable returns i. e. the payment on
interest on debt will affect the return on equity share
holders. So the organisation should maintain a proper
balance between the sources so that cost & risk should
be minimum.
MEANING:
The term capital structure refers to the composition
or make-up of the amount of a firm’s
capitalisation. It includes all the long-term loans
and reserves.

according to Gerstenberg, “The type of securities

to be issued and the proportionate amounts that
make up the capitalisation is known as capital
structure or financial structure”.
Optimum Capital Structure is defined as the
capital structure or combination of debt and equity
that leads to maximum value of the firm or it is
the capital structure at which WACC is minimum
and thereby maximum value of the firm.
The main objective of capital structure here, is to
maximise the value of firm and minimise the
overall cost of the firm.
PATTERN OF CAPITAL STRUCTURE

In case of new company, the capital structure may be

in any of the following four patterns:
1. Capital structure with equity shares only.
2. Capital structure with both equity shares and
preference shares.
3. Capital structure with equity shares and long term
borrowings.
4. Capital structure with equity shares, preference
shares and long term borrowings.
 The choice of the company to adopt an appropriate capital structure
depends upon a number of factors such as:-
1. Nature and size of the company’s business

2. Regularity in earnings

3. Conditions of the money market

4. Attitudes of the investors

5. Purpose of finance
6. Period of finance

7. Market situation

8. Legal restrictions

9. Cost of floatation

10. Taxation policies

11. Trading on equity

CAPITAL STRUCTURE THEORIES:
 Relevant theories  Irrelevant theories
1. Net Income Approach. 1. Net Operating Income
2. Traditional Approach. Approach.
2. Modigliani and Miller
Approach.
ASSUMPTIONS:
1. There are only two sources of funds used by the firm i.e.
debt and equity.
2. There are no corporate taxes . This assumption is removed
later.
3. The D/P ratio is 100 % .
4. Total assets given do not change.
5. The total financing remains constant.
6. Operating profits are not expected to grow i.e. (EBIT)
7. Business risk is constant over a time
8. Perpetual life of the firm.
 Given the above assumptions, the analysis focuses on the following rates:-
KD = I/D = Annual interest rates
Market value of debt
(Assuming that the debt is perpetual)

Ke = P/E = Equity earnings

Market value of equity
KA = O/V = Operating Income
Market value of the firm

Where, V=D+E(market value of debt and equity ), K A is the overall

capitalisation rate of the firm. Since it is the weighted average cost of
capital, is may be expressed as follows:
KA= Ke(E/D+E) + KD (D/D+E)
NET INCOME (NI) APPROACH

According to NI approach
both the cost of debt and the
cost of equity are independent
of the capital structure; they
remain constant regardless of
how much debt the firm uses.
As a result, the overall cost of
capital declines and the firm
value increases with debt.
This approach has no basis in
reality; the optimum capital
structure would be 100 per
The effect of leverage on the cost of capital
cent debt financing under NI under NI approach
approach.
NET OPERATING INCOME (NOI) APPROACH
Another theory of capital structure,
suggested by David Durand, is the NOI
Cost
approach. The essence of this approach Ke
is that the capital structure decision of
a firm is irrelevant. Any change in
KA
leverage will not lead to any change in
the total value of the firm and the
Kd
market price of shares as well as the
overall cost of capital.
According to this approach the
overall cost of capital and cost of debt Debt
remain constant for all degrees of
leverage.
CONT….
The equity capitalisation rate increases with
the degree of leverage. The increase in the
proportion of debt in the capital structure
relative to equity shares would lead to an
increase in the financial risk to the equity
shareholders. To compensate for the increased
risk, the shareholders would expect a higher
rate of return on their investments. The increase
in the equity capitalisation rate would match the
increase in the debt-equity ratio.
TRADITIONAL APPROACH
The main proposition of traditional approach
are:-
1. The cost of debt capital, remains more or
less constant up to certain degree of leverage Cost
but rises thereafter at an increasing rate.
Ke
2. Cost of equity capital, remains more of less
constant or rises only gradually up to a KA
certain degree of leverage and rises sharply
thereafter.
3. The overall cost of capital, as consequence Kd
of the above behavior of Ke and kd are;
• Decreases up to certain point.
• Remains more or less unchanged for
moderate increases in leverage
thereafter, and optimal capital Debt
structure
• Rises beyond a certain point.
CONT..
The traditional approach is midway between the NI and NOI
approaches. It is also known as the Intermediate Approach.
The principle implication of traditional approach is that the
cost of capital is dependent on the capital structure and there
is an optimal structure which minimises the cost of capital.
At the optimal capital structure the real marginal cost of debt
and equity is the same. Before the optimal point the real
marginal cost of debt is less than the real marginal cost of
equity and beyond the optimal point the real marginal cost of
debt is more than the real marginal cost of equity.
CRITICISM OF THE TRADITIONAL VIEW
 The contention of the traditional theory, that
moderate amount of debt in ‘sound’ firms does not
really add very much to the ‘riskiness’ of the
shares, is not defensible.

 There does not exist sufficient justification for the

assumption that investors’ perception about risk of
leverage is different at different levels of leverage.
MM APPROACH WITHOUT TAX: PROPOSITION I
The significance of MM
hypothesis lies in the fact
that it provides behavioral
justification for constant
overall cost of capital and V

therefore, the total value of

the firm. In other words, the KA

MM approach maintains
that the WACC does not
change with a change in the Debt
proportion of debt to equity
in the capital structure.
ASSUMPTIONS:
 Perfect capital market
 Rational investors and managers
 Homogeneous expectations
 Equivalent risk classes
 Absence of taxes
PROPOSITION I

The basic premise of MM approach is that ,

given the above assumptions, the total value of a
firm must be constant irrespective of degree of
leverage. Similarly, the cost of capital and market
price of share must be the same.
The operational justification for MM
hypothesis is Arbitrage Process.
ARBITRAGE PROCESS

Arbitrage refers to an act of buying a security in a

market where price is low and selling where it is
high. Arbitrage process is essentially a balancing
operation. It implies that security cannot sell at a
different price.
MM illustrates the arbitrage process with reference
to valuation of two firms which are exactly similar
except their leverage.
 The total value of the firms , which only in
respect of leverage cannot be different because of
arbitrage operation.
The investors of the firm whose value is higher
will sell their shares and buy the shares of the
firm whose value is lower.
The investors will be able to earn the same
return at lower investment with the same
perceived risk or lower risk.
The behaviour of investor will have the effect of:
 Increasing the share price of the firm whose shares are
being purchased.
 Lowering the share price of the firm whose shares are
being sold.
 This will continue till the market price of the two
identical firms become identical.
Thus, the arbitrage drives the total value of two
homogeneous firms in all respects, except the debt
equity ratio, together.
DIVIDEND DECISION

Dividend refers to corporate net profits

distributed among shareholders. Dividend policy
of an organisation refers to amount of earnings to
be distributed as dividend to shareholders and the
amount of earnings to be retained by the firm.
DETERMINANTS OF DIVIDEND POLICY
1. Fund requirement
2. Liquidity
3. Access to capital markets
4. Shareholders preference
5. Tax benefits
6. Diversion of control
7. Difference in cost of external equity and retained earnings
8. Legal restrictions
9. Investment opportunities
10. Inflation
11. State of economy
12. Debt obligations
13. Loan covenants
14. Nature of earnings
15. Past dividend rates
TYPES OF DIVIDEND POLICY

1. Stable or constant dividend payout ratio:

According to this policy, the percentage of
earnings paid out as dividend remains constant.

Earnings Earnings
&
Dividends

Dividends
2. Constant dividend per share or dividend rate:
It is the policy of firm to pay a fixed amount per
share as dividend or a fixed percentage on paid up
capital as dividend every year, irrespective of the
fluctuations in earnings.
This policy does not mean that dividend will always
remain constant and never increase. When the firm
reaches new level of earnings and expects to
maintain it, the annual dividend per share of the
dividend rate may be increased. The above policy is
suggested to those firms whose earnings are stable
and do not fluctuate much.
EPS EPS
&
DPS
DPS
3. Constant dividend per share plus extra dividend:
For companies with fluctuating earnings, the
policy to pay a minimum dividend per share with
an extra dividend based on earnings is desirable.
The small amount or fixed dividend ensures
minimum dividend every year and in years of
prosperity the company pays an additional
dividend over and above the minimum dividend.
EPS EPS
&
DPS
DPS
SIGNIFICANCE OF STABILITY OF DIVIDENDS

1. Confidence among shareholders

2. Investors desire for current income
3. Institutional investor’s attitude
4. Stability in market prices of shares
5. Raising additional finance
6. Large number of investor with small holdings
reduces chances of dilution
FORMS OF DIVIDEND POLICY

1. Cash dividend
2. Stock dividend
3. Script dividend
4. Bond dividend
5. Property dividend
DIVIDEND THEORIES:
 Relevant theories
1. Gordon’s Model.
2. Walter’s Model.
3. Traditional Approach.
 Irrelevant theories
1. Modigliani and Miller
Approach.
TRADITIONAL POSITION
According to the traditional position expounded eloquently
by Graham & Dodd, the stock market places considerably
more weight on dividend than on retained earnings.
According to them
“….. the stock market is overwhelmingly in favour of
liberal dividends as against niggardly dividends,”
Their view is expressed quantitatively in the following
valuation model advanced by them
P= m(D+E/3)
P=MP per share, m=multiplier, E=EPS, D=DPS
 According to this model, in the valuation of
shares the weight attached to dividend is equal to
four times the weight attached to retained
earnings. This is clear from the following
equation in which E is replaced (D+R).
Empirical Evidence:
Price = a+b Dividend + C Retained Earnings
Div b>REC
Price + a+ b div + REC + d risk.
b&c are expected to be positive and d is negative.
MODIGLIANI AND MILLER APPROACH

According to MM approach the value of a firm

depends solely on its earnings power and it is not
influenced by the manner in which its earnings
are split between dividend and retained earnings.
This view, is referred to as the MM “dividend
irrelevance” theorem, is presented in their
celebrated 1961 article. In this article MM
constructed their argument on the following
assumptions.
ASSUMPTIONS
 Perfect capital market
 Floatation costs are nil

 There are no taxes

 Investment dividend decisions are independent

 Investment opportunities and future profits of

firms are known with certainty
The substance of MM argument may be stated as
fallows:
If a company retains earnings instead of giving it out
as dividend, the shareholder enjoys capital
appreciation equal to the amount of earnings retained.
If it distributes earnings by way of dividend instead
of retaining, the share holders enjoys dividend equal
in value to the amount by which his capital would
have appreciated. Hence, the division of earnings
between dividend and retained earnings is irrelevant
from the point of view of the share holders.