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  • Topic: Finance, Capital structure, Modigliani-Miller theorem
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MB0045-Financial Management
Unit-7 Capital Structure

Program

: MBA

Semester

:I

Subject Code

: MB0045

Book Id

: B1134

Subject Name

: Financial Management

Unit number

:7

Unit Title

: Capital Structure

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MB0045-Financial Management
Unit-7 Capital Structure

Introduction


The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the financing plan of the company.



The capital structure should add value to the firm.



The value of a firm is dependent on its expected future earnings and the required rate of return.



The objective of any company is to have an ideal mix of permanent sources of funds in a manner that it will maximise the company’s market price.



The proper mix of funds is referred to as optimal capital structure.



The capital structure decisions include debt-equity mix and dividend decisions.
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MB0045-Financial Management
Unit-7 Capital Structure

Objectives
Session Objectives:
To




understand,
Features of an ideal capital structure
Factors affecting the capital structure
Various theories of capital structure

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MB0045-Financial Management
Unit-7 Capital Structure

Features of an Ideal Capital Structure



Profitability - The firm should make maximum use of leverage at a minimum cost.



Flexibility - An ideal capital structure should be flexible enough to adapt to changing conditions.



Control - The structure should have minimum dilution of control.



Solvency - Use of excessive debt threatens the very existence of the company.
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MB0045-Financial Management
Unit-7 Capital Structure

Factors Affecting Capital Structures


Leverage - The use of fixed charges sources of funds such as preference shares, loans from banks and financial institutions and debentures in the capital structure is known as “trading on equity” or “financial leverage”.

Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized companies, while they insist on 3:1 ratio for SSI.



Cost of capital – High cost funds should be avoided.



Cash flow projections of the company – Decisions should be taken in the light of cash flows projected for the next 3-5 years.



Dilution of control – The top management should have the flexibility to take appropriate decisions at the right time. The capital structure planned should be one in this direction.



Floatation costs – A company desiring to increase its capital by way of debt or equity will definitely incur floatation costs.
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MB0045-Financial Management
Unit-7 Capital Structure

Theories of Capital Structure
Formulae derivation


Debt capital being constant, Kd is the cost of debt which is the discount rate at which the discounted future constant interest payments are equal to the market value of debt, that is,
Kd = I/B ,
where, I refers to total interest payments and B is the total market value of debt.
Therefore value of the debt B = I/Kd



Cost of equity capital Ke = (D1/P0) + g
where D1 is dividend after one year, P0 is the current market price and g is the expected growth rate.



Retained earnings being zero, g = br where r is the rate of return on equity shares and b is the retention rate, therefore g is zero. 6
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MB0045-Financial Management
Unit-7 Capital Structure

Theories of Capital Structure
Now we know Ke = E1/P0 + g and g being zero, so Ke = NI/S
where NI is the net income to equity holders and S is market value of equity shares.



The net operating income being constant, overall cost of capital is represented as K0 = W1 K1 + W2 K2.

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