capital structure

Topics: Finance, Capital structure, Corporate finance Pages: 8 (797 words) Published: April 15, 2014
Financial Management
Unit – 4

Capital Structure

Capital Structure
• It refers to the kinds of securities and the
proportionate amounts that make up
capitalization.
• A decision about the proportion among the
three types of securities viz., Equity shares,
Pref. Shares and Debentures refers to the
Capital Structure of an enterprise.

What is “Capital Structure”?
• Definition
The capital structure of a firm is the mix of different
securities issued by the firm to finance its operations.
Securities
• Debt Sources - Bonds, bank loans
• Ordinary shares (common stock),
• Preference shares (preferred stock)

What is “Financial Structure”?
Balance Sheet
Current

Current

Assets

Liabilities

Fixed
Assets

Debt
Preference
shares

Ordinary
shares

Financial
Structure

What is “Capital Structure”?
Balance Sheet
Current

Current

Assets

Liabilities

Fixed
Assets

Debt
Preference
shares

Ordinary
shares

Capital
Structure

Forms or Patterns of Capital Structure





Equity shares only
Equity shares and Preference Shares
Equity shares and Debentures
Equity shares, Preference shares and
Debentures

Importance's:
• View point that strongly supports the close
relationship between leverage and value of a
firm.
• It help to determine various investment
decisions
• Capital Structure decision can influence the
value of the firm through earnings available to
the share holders.

Features of Appropriate Capital
Structure
A). Profitability/Return
B). Solvency/Risk
C). Flexibility
D). Conservation/Capacity
E). Control

Factors Determining the Capital
Structure
1.
2.
3.
4.
5.
6.
7.
8.

Financial Leverage or
Trading on Equity
Growth and Stability of
sales
Cost of Control
Cash flow ability to
service debt
Nature and Size of the
Firm
Requirement of
Investors.
Capital Market Structure
Assets Structure

9. Purpose of Financing
10.Period of Financing
11.Control
12.Flexibility

13.Costs of Floatation
14.Personal Considerations
15.Corporate Tax Rate

16.Legal requirements

Optimal Capital Structure
• Optimum capital structure may be defined as
“ that capital structure or combination of debt
and equity that leads to the maximum value
of the firm”.
• “at which the weighted average of cost of
capital is minimum and there by maximum
value of the firm”

Goals of Optimal Capital Structure
• Return on investment (EPS) is higher than the
fixed cost of funds. It will increase EPS and
market value of the firm.
• Capital Structure should be flexible.
• Firm should avoid undue financial risk at debt
financing.

Theories of Capital Structure
1.
2.
3.
4.

Net Income Approach
Net Operating Approach
The Traditional Approach
Modigliani Miller Approach

1. Net Income Approach
• Suggested by Durand
• Capital Structure decision is relevant to the
valuation of the firm.
• A change in financial leverage (EPS) will lead
to a corresponding change in the overall cost
of capital as well as the total value of the firm.

Assumptions of Net Income Approach
• No taxes
• Cost of debt is less than the cost of equity
• Use of debt does not change the risk
perception of investors.

2. Net Operating Approach
• Suggested by Durand
• It is diametrically opposite to the NIA
• It is that capital structure decision of a firm is
irrelevant
• Any changes in leverage will not lead to any
change in total value of the firm and the
market price of shares as well as the overall
cost of capital is independent of the degree of
leverage.

Assumptions of NOI
• The market capitalizes the value of the firms
as a whole.
• The business risk remains constant at every
level of debt equity mix.
• There are no corporate taxes.

3. Traditional approach
 It is also known as intermediate approach.
 Optimum capital structure can be reached by a proper debtequity mix.  Beyond a particular point, the...
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