Capital Structure CS

CAPITAL STRUCTURE
CS
23-04-2020
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CAPITAL STRUCTURE::CS
• The term ‘structure’ means the arrangement of the
various parts.
• So capital structure means the arrangement of capital
from different sources so that the long-term funds
needed for the business are raised.
• Thus, capital structure refers to the proportions or
combinations of equity share capital, preference share
capital, debentures, long-term loans, retained
earnings and other long-term sources of funds in the
total amount of capital which a firm should raise to run
its business.
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CS…2
“Capital structure refers to the mix of

long-term sources of funds, such as,
debentures, long-term debts,
preference share capital and equity
share capital including reserves and
surplus.”—I. M. Pandey.
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CS…3
capital structure is the careful balance between equity
and debt that a business uses to finance its assets,
day-to-day operations, and future growth.
Capital Structure is the mix between owner’s funds
and borrowed funds.
• FUNDS = Owner’s funds + Borrowed funds.
• Owner’s funds = Equity share capital +
Preference share capital + reserves and
surpluses + retained earnings = EQUITY
• Borrowed funds = Loans + Debentures + Public
deposits = DEBT
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CS::
Finance-Structure Vs Asset Structure
• Financial Structure consists of short-term
debt, long-term debt and share holders’ fund
i.e., the entire left hand side of the company’s
Balance Sheet. But Capital Structure consists
of long-term debt and shareholders’ fund.
• Asset Structure* = Fixed assets + Current
Assets.
* Asset side of B/s that indicate application of
funds.
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CS:: IMPORTANCE
• Increases the Value of the Firm
• Utilization of available Funds
• Maximization of Returns
• Minimizing the cost of Capital
• Liquidity Position
• Flexibility and Control
• Minimize Financial Risk
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CS:: THEORIES
NET INCOME (NI) APPROACH:: D. Durand
• According to NI approach a firm may increase the total
value of the firm by lowering its cost of capital.
• When cost of capital is lowest and the value of the firm is
greatest, we call it the optimum capital structure for the
firm and, at this point, the market price per share is
maximised.
The same is possible by lowering cost of capital,
by employing more of Debt capital, which in
return increases the value of the firm.
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NI APPROACH
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Net Operating Income (NOI) APPROACH:: D. Durand
• It is opposite of the Net Income Approach if

there are no taxes.
• The overall capitalisation rate of the firm Kw is
constant for all degree of leverages;
• Net operating income is capitalised at an overall
capitalisation rate in order to have the total
market value of the firm, i.e: V = EBIT/ Kw
• The market value of the debt is then subtracted
from the total market value in order to get the
market value of equity.
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NOI APPROACH
Under this approach, the most
significant assumption is that the Kw
(Overall capitalization) is constant
irrespective of the degree of
leverage.
The segregation of debt and equity
is not important here and the
market capitalises the value of the
firm as a whole.
Thus, an increase in the use of
apparently cheaper debt funds is
offset exactly by the
corresponding increase in the
equity- capitalisation rate. 10
Traditional Theory Approach
• It is accepted by all that the judicious use of debt

will increase the value of the firm and reduce
the cost of capital.
• So, the optimum capital structure is the point at
which the value of the firm is highest and the
cost of capital is at its lowest point.
• Practically, this approach encompasses all the
ground between the Net Income Approach and
the Net Operating Income Approach, i.e., it may
be called Intermediate Approach.
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Traditional Theory Approach...2
• The traditional approach explains that up to a
certain point, debt-equity mix will cause the
market value of the firm to rise and the cost of
capital to decline.
• But after attaining the optimum level, any
additional debt will cause to decrease the
market value and to increase the cost of
capital.
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Traditional Theory Approach...3
(a) The cost of debt capital, Kd,
remains constant more or less
up to a certain level and
thereafter rises.
(b) The cost of equity capital Ke,
remains constant more or less or
rises gradually up to a certain
level and thereafter increases
rapidly.
(c) The average cost of capital,
Kw, decreases up to a certain
level remains unchanged more
or less and thereafter rises after
attaining a certain level.
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Modigliani-Miller (M-M) Approach
• MM (Franco Modigliani and Merton Miller)

advocated that the relationship between the cost of
capital, capital structure and the valuation of the
firm should be explained by NOI by making an
attack on the Traditional Approach.
• Net Operating Income Approach, supplies proper
justification for the irrelevance of the capital
structure.
• MM support the NOI approach on the principle that
the cost of capital is not dependent on the degree
of leverage irrespective of the debt-equity mix.
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M-M Approach...2
• In the words, the total market value of the firm
and the cost of capital are independent of the
capital structure.
• Proposition I: It says that the capital structure is
irrelevant to the value of a firm. The value of
two identical firms would remain the same and
value would not affect by the choice of finance
adopted to finance the assets. The value of a
firm is dependent on the expected future
earnings. It is when there are no taxes.
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M-M Approach...3
• Proposition II: It says that the financial
leverage boosts the value of a firm and
reduces WACC. It is when tax information is
available.
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Leverage
• Leverage “is the employment of funds or assets
for which firm pays a fixed cost or fixed return”.
• In short it’s the usage of FIXED COST to maximize
the potential returns for shareholders.
• Various variable which have impact on the returns
of the Shareholders are:: COST & REVENUE,
PROFITS, INTEREST , TAX RATE, EBIT and OUTPUT.
• Therefore Leverage is the % of returns on SH-
equity to % return on capitalization.
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Types of Leverages
• FINANCIAL LEVERAGES
• OPERATIONAL LEVERAGES
• COMBINED LEVERAGES
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LEVERAGES & INCOME STATEMENT
SALES /REVENUES
Less: COST OF GOODS SOLD (CGS)
OL
GROSS PROFITS (GP)
Less: OPERATING EXPENSES
EARNINGS BEFORE INTEREST & TAXES (EBIT)
Less: INTEREST
TL
NET PROFIT BEFORE TAXES
Less: TAXES
FL NET PROFIT AFTER TAXES
Less: PREFERRED STOCK DIVIDENDS
EARNINGS AVAILABLE FOR COMMON STOCK HOLDERS
EARNINGS PER SHARE (EPS)
OL: OPERATING LEVERAGE

FL: FINANCIAL LEVERAGA
TL: TOTAL LEVERAGE/ COMBINED LEVERAGE
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FINANCIAL LEVERAGE
• Financial leverage deals with the profit magnification in

general. It is also well known as gearing or ‘trading on equity’.
• Measures of Financial Leverage
There are various measures of Financial Leverage
Debt Ratio: It is the ratio of debt to total assets of the firm
which means what percentage of total assets is financed by
debt.
Debt Equity Ratio: It is the ratio of debt to equity which
signifies how many INR of debt is taken per INR of equity.
Interest Coverage Ratio: It is the ratio of profits to interest.
This ratio is also represented in times. It represents how many
times of the interest is the available profit to pay it off. Higher
such ratio, higher is the interest paying capacity. The reciprocal
of it is income gearing.
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DEGREE of FINANCIAL LEVERAGE (DFL)
• A degree of financial leverage measures

magnification that happens due to debt capital
in the structure.
• The degree of financial leverage is the
proportion of a percentage change in EPS due to
a certain percentage change in EBIT.
OR
FL = Operating Profit/PBT
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Uses of Financial Leverage
• Financial leverage helps to examine the

relationship between EBIT and EPS.
• Financial leverage measures the percentage of
change in taxable income to the percentage
change in EBIT.
• Financial leverage pinpoints the correct
profitable financial decision regarding capital
structure of the company.
• FL is used to measure the fixed cost proportion
with the total capital of the company.
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OPERATING LEVERAGE (OL)
• Operating leverage refers to the use of fixed operating
costs such as depreciation, insurance of assets, repairs
and maintenance, property taxes etc. in the operations
of a firm.
• It is associated with the investment activity of the firm.
OL = Contribution /Operating Profit
• Operating leverage consists of two important costs viz.,
fixed cost and variable cost. When the company is said
to have a high degree of operating leverage if it
employs a great amount of fixed cost and smaller
amount of variable cost.
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Uses of Operating Leverage
Operating leverage is one of the techniques to
measure the impact of changes in sales which
lead for change in the profits of the company.
• If any change in the sales, it will lead to
corresponding changes in profit.
• Operating leverage helps to identify the position
of fixed cost and variable cost.
• It measures the relationship between the sales
and revenue of the company.
• Operating leverage describes the over all position
of the fixed operating cost. 24
COMBINED LEVERAGE (CL)
• When the company utilizes both financial and
operating leverage to amplification of any
change in sales into a larger relative changes in
earning per share.
• Combined leverage is also known as composite
leverage or total leverage. Combined leverage
shows the relationship between the revenue in
the account of sales and the taxable income.
• CL = FL x OL
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OL & FL
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CAPITAL STRUCTURE

“Capital structure refers to the mix of

• It is opposite of the Net Income Approach if

• It is accepted by all that the judicious use of debt

• MM (Franco Modigliani and Merton Miller)

OL: OPERATING LEVERAGE

• Financial leverage deals with the profit magnification in

• A degree of financial leverage measures

• Financial leverage helps to examine the

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