What is meant by capital structure? Explain the salient features of an appropriate capital structure.

Capital Structure

Capital structure refers to the way a company finances its operations through a mix of debt, equity, and
retained earnings. It represents the proportion of different sources of funds used by a firm to finance its
overall operations and growth. A company’s capital structure plays a crucial role in determining its
financial health, risk profile, cost of capital, and ultimately its valuation.

Salient Features of an Appropriate Capital Structure:

1. Optimal Mix of Debt and Equity:

An appropriate capital structure strikes a balance between debt and equity financing based on the
company’s risk tolerance, growth prospects, and cost of capital. It aims to minimize the overall cost of
capital while maintaining financial flexibility.

2. Risk Management:

A well-designed capital structure considers the risk associated with different types of financing. By
diversifying sources of funds, a company can mitigate risks related to interest rate fluctuations,
repayment obligations, and financial distress.

3. Cost of Capital:

The optimal capital structure minimizes the weighted average cost of capital (WACC) by determining the
right mix of debt and equity that maximizes shareholder value. Debt is usually cheaper than equity due
to tax deductibility of interest payments but comes with higher financial risk.

4. Flexibility:

An appropriate capital structure provides flexibility to adapt to changing market conditions, business
opportunities, and unexpected challenges. It allows a company to raise additional funds when needed
without compromising its financial stability.

5. Alignment with Business Strategy:

The capital structure should align with the company’s long-term strategic goals, growth plans, and
industry dynamics. It should support investments in new projects, acquisitions, research and
development activities while maintaining sustainable financial leverage.

6. Liquidity Management:

Maintaining an optimal mix of short-term and long-term financing helps in managing liquidity
effectively. A balanced capital structure ensures that the company has access to sufficient funds for day-
to-day operations as well as long-term investments.

7. Stakeholder Interests:

The capital structure should consider the interests of various stakeholders such as shareholders,
creditors, employees, and regulators. It should strike a fair balance between maximizing shareholder
wealth and meeting obligations towards other stakeholders.
In conclusion, an appropriate capital structure is essential for a company’s long-term success as it
influences its ability to generate returns for shareholders, manage risks effectively, and seize growth
opportunities while maintaining financial stability.

Explain the major determinants of capital structure planning.

Capital structure is how a company has arranged the two sources, debt and equity, for operation and
growth. Debt is money borrowed which should be repaid with interest, while equity means ownership
stakes in the company. Debt-to-equity (D/E) ratio is often calculated to give a picture of how a company
is structured in terms of capital. It indicates how much risk a company might actually face from different
quarters. A company might be perceived as risky for an investor if it has a high proportion of debt in its
capital structure, but the same company may possess a high growth potential at the same time.

The optimal capital structure is that mix of debt and equity which not only increases the value of the
firm but also decreases its cost of capital. Debt is beneficial to the companies due to the tax advantage,
keeping ownership, and ease of accessing during low rates. Equity allows outside investors to take
partial ownership with no claim to repaying but is more expensive compared to debt.

The decision on the capital structure is dependent on several factors: industry type, stage of
development, and external changes in interest rates and the regulatory environment. Companies strive
to find an ideal blend of debt and equity that, over the long term, maximizes their market price of equity
shares while minimizing their cost of capital.

Factors to consider during planning of capital structure include financial leverage, simplicity, cost of
capital, flexibility, risk management, and maintaining adequate control by owners. A simple capital
structure ensures that the overall cost of capital is minimized and should not exceed a certain limit to
avoid increased financial risk. It should keep the risk levels low, be flexible enough for future
adjustments, and have adequate control by the owners.

Capital structure determinants include trading on equity or financial leverage (the use of long-term
debts carrying a fixed rate of interest to increase the rate of return on equity shares), stability of
earnings (higher stability leads to higher bond-to-stock ratios), sufficient equity cushion for absorbing
business cycle shocks and providing flexibility, market imperfections (decisions not always following
accepted theory), and security markets are not perfect with imperfect knowledge and consequent risks.

What is the Traditional view on Capital Structure?

Traditional View on Capital Structure

The traditional view on capital structure, also known as the traditional theory of capital structure, posits
that there exists an optimal mix of debt and equity financing for a company that minimizes the weighted
average cost of capital (WACC) and maximizes the market value of assets. This optimal capital structure
is achieved when the marginal cost of debt equals the marginal cost of equity. The theory suggests that
as a firm increases its leverage through debt financing, there is an initial increase in firm value up to a
certain point. Beyond this point, excessive leverage can lead to diminishing returns and a decrease in
firm value due to overleveraging.

Key Points of the Traditional Theory of Capital Structure:

 The optimal capital structure occurs where the marginal cost of debt equals the marginal cost of
equity.
 There is a trade-off between increased leverage and the rising costs associated with debt
financing.
 Wealth creation is not only about positive returns on investments but also about utilizing an
optimal blend of equity and debt.

Understanding the Traditional Theory:

The traditional theory relies on several assumptions such as fixed assets and revenues, rational investor
behavior, no taxes, and fixed financing. It emphasizes that firms should strike a balance between debt
and equity to enhance shareholder value while considering the varying costs associated with different
levels of leverage.

Comparison with Modigliani and Miller (MM) Theory:

The traditional theory contrasts with the Modigliani and Miller theory, which suggests that under
efficient financial markets, debt and equity are interchangeable. MM theory considers external factors
like tax rates and interest deductibility in determining a firm’s optimal capital structure.

Limitations of the Traditional Approach:

 Reliance on simplified assumptions may not capture real-world complexities accurately.

 Subjectivity in assessing bankruptcy costs and agency conflicts can lead to variability in decision
outcomes.
 Overlooking dynamic factors like market changes that can impact the benefits and costs of debt
financing over time.

Applying the Traditional Approach in Practice: Companies can apply the traditional approach by
conducting comprehensive risk analysis, engaging stakeholders, and continuously monitoring market
trends to make informed decisions regarding their capital structure.

What is M&M hypothesis on capital structure? Does is make any difference if corporate taxes exist?

Modigliani-Miller Hypothesis on Capital Structure

The Modigliani-Miller (M&M) hypothesis is a theory on capital structure proposed by economists Franco
Modigliani and Merton Miller in the 1950s. The hypothesis suggests that, under certain assumptions, the
value of a firm is independent of its capital structure. In other words, the way a company finances its
operations through debt or equity should not affect its overall value.

Key Assumptions of the Modigliani-Miller Hypothesis:

1. Perfect capital markets: The M&M hypothesis assumes that capital markets are perfect, meaning
there are no taxes, transaction costs, or information asymmetries. In such ideal conditions, investors can
buy and sell securities at fair prices without any restrictions.

2. No bankruptcy costs: Another assumption is that there are no costs associated with financial distress
or bankruptcy. This implies that companies can easily restructure their debt without incurring any
additional expenses.

3. Investors have the same information: The hypothesis assumes that all investors have access to the
same information about the company and its prospects. This ensures that all investors make rational
decisions based on identical data.

Impact of Corporate Taxes on the Modigliani-Miller Hypothesis:

 When corporate taxes are introduced into the analysis, the M&M proposition changes slightly. In
the presence of corporate taxes, the value of a leveraged firm (one with debt) can be higher than
that of an unleveraged firm (one without debt). This is because interest payments on debt are tax-
deductible expenses, which reduces the overall tax liability of a leveraged firm.
 Incorporating corporate taxes into the analysis leads to what is known as the “trade-off theory” of
capital structure. This theory suggests that firms must balance the benefits of debt (tax shields) with
the costs (financial distress and agency costs) to determine an optimal capital structure.
 However, it’s important to note that even with corporate taxes considered, in a world where
markets are efficient and information is freely available, the overall value of a firm should still be
independent of its capital structure according to the original M&M hypothesis.

Conclusion:

In conclusion, while the Modigliani-Miller hypothesis initially posits that capital structure does not
impact firm value under certain ideal conditions, introducing corporate taxes alters this perspective by
highlighting potential advantages of leverage due to tax shields. Nonetheless, in practice, firms must
carefully consider various factors beyond just tax implications when determining their optimal capital
structure.

Critically examine the Modigliani Miller Hypothesis on Capital Structure.

Overview of the Modigliani-Miller Theorem

The Modigliani-Miller theorem (M&M) is a fundamental concept in corporate finance that posits that
the capital structure of a company, whether it is financed through debt, equity, or a combination of
both, does not impact its overall value. Developed by Franco Modigliani and Merton Miller in 1958, the
theorem has two main versions: one based on the assumption of perfectly efficient markets and another
that considers real-world conditions.

Modigliani-Miller Theorem in Perfectly Efficient Markets:

In the first version of the M&M theorem, which assumes perfectly efficient markets, several key
propositions are made:
Value Irrelevance: The capital structure of a firm does not affect its total value. This is because in an
ideal world without taxes or transaction costs, the value of a company is determined solely by its cash
flows.

Cost of Equity: The cost of equity increases with leverage as higher debt levels raise the risk profile of
the company, leading investors to demand higher returns to compensate for this increased risk.

Modigliani-Miller Theorem in Real-World Conditions:

The second version of the M&M theorem incorporates real-world factors such as taxes, transaction
costs, bankruptcy costs, and asymmetric information:

Tax Shields: In the presence of taxes, leveraged firms benefit from tax shields due to interest payments
being tax-deductible. This can make leveraged firms more valuable than unleveraged ones.

Cost of Equity in Real World: While leverage still increases default risk and thus the cost of equity, the
tax shields provided by debt can mitigate this effect. As a result, the cost of equity becomes less
sensitive to changes in leverage.

Critique and Examination:

While the Modigliani-Miller theorem provides valuable insights into how capital structure affects a firm’s
value under different assumptions, there are criticisms and limitations to consider:

 Market Imperfections: In reality, markets are not perfectly efficient, and factors like taxes,
bankruptcy costs, and agency issues can influence a company’s optimal capital structure.
 Empirical Evidence: Some empirical studies have shown deviations from the M&M theorem’s
predictions in practice, suggesting that other factors beyond those considered by M&M may impact
capital structure decisions.
 Dynamic Nature: The static nature of the theorem may not fully capture changing market conditions
or strategic considerations that could influence a firm’s choice of capital structure over time.

In conclusion, while the Modigliani-Miller theorem provides a foundational understanding of capital

structure irrelevance under certain assumptions, its applicability to real-world scenarios is subject to
debate due to market imperfections and evolving financial landscapes.

What Is Arbitrage and How Does It Work?

Arbitrage is the practice of simultaneously buying and selling the same or similar assets in different
markets to profit from small differences in their prices. This strategy takes advantage of temporary
inefficiencies in the market where identical or similar financial instruments are priced differently across
various platforms. By exploiting these pricing differences, arbitrageurs aim to make risk-free profits
while also helping to bring markets closer to efficiency.

How Arbitrage Works

Arbitrage involves identifying opportunities where an asset can be purchased at a lower price in one
market and sold at a higher price in another market simultaneously. The process typically requires quick
execution to capitalize on these pricing discrepancies before they are corrected by market forces.
Traders often use advanced technology and automated systems to monitor price differentials and act
swiftly when profitable opportunities arise.

Example of Arbitrage

For instance, if Company X’s stock is trading at Rs 200 on the Nepal Stock Exchange (NPSE) but is priced
at Rs 250 on the Indian Stock Exchange (ISE) at the same time, a trader can buy shares on the NPSE and
sell them on the ISE for a profit of Rs 50 per share. This process can be repeated until the pricing gap
closes due to market adjustments.

In summary, arbitrage is a trading technique that leverages price differences in assets across multiple
markets to secure risk-free profits quickly through simultaneous buying and selling transactions.