Capital structure

Smita.S.Jape
Asst.Professor
Dr. V.N.Bedekar Institute
of Management studies

DR.VN.BRIMS. 1
 Contents
Finance decision making
Meaning of capital structure
Features
Factors affecting the capital
structure
Theories of capital structure

DR.VN.BRIMS. 2
Finance-decision making
Investment Decisions
Capital budgeting Decisions

Financing decisions
Capital structure

Liquidity Decision
Working capital management

Dividend decision
Working capital management
Distribution decision

DR.VN.BRIMS. 3
 Capital structure: Meaning

 Mix of different classes of assets

 Mix of different securities or long term sources of
long term funds to a firms capitalization
 Permanent financing represents primarily by long
term debt and shareholders equity
 Determined at the time of incorporation
 Capital structure have long term implications so
decisions are important
 Choice of capital structure: pure equity or equity and
preference, Equity and debenture or all three
DR.VN.BRIMS. 4
 Factors affecting capital
structure
 Leverage: Ability to use fixed cost assets to
maximize returns
 Operating leverage /financial
 Trading on equity: owned v/s borrowed
capital
 Interest coverage ratio: Ratio of operating
profit and interest
 Cash flow: EBIT/EPS good tool to determine
cs
DR.VN.BRIMS. 5
 Features

 Flexibility:
 Profitability
 Solvency
 Control
 Conservative: Debt equity ratio 2:1

DR.VN.BRIMS. 6
 Top 10 Sectors (Capital
structure policies of business
firms )
 Electrical:We try to maintain a debt equity
ratio

DR.VN.BRIMS. 7
Top 10 Companies (Capital Market)
s.no Name of company Debt Equity Ratio EPS

1 ONGC 0.02 27.81

2 TCS 1.74 51.89

3 Reliance Industries 0.44 60.01

4 Coal India Ltd 0.38 12.77

5 ITC Ltd 0.01 7.15
6 Infosys Ltd ---- 139.93
7 NTPC Ltd 0.66 10.55
8 HUL Ltd ----- 11.23
9 Wipro Ltd 0.22 18.08
10 L& T Ltd 0.36 71.11
DR.VN.BRIMS. 8
 Theories of capital Structure

 Net income approach --- cost of capital

decreases as and when the debt content
increases in CS. Optimal structure exists
when firm borrows maximum.
 When Valuation of firm (maximum ) cost of
capital is (minimum )
 Financial leverage increased –cost of capital
decrease –valuation of firm increase
 As Ko= Ke+ Kd(Ko=EBIT/V)
DR.VN.BRIMS. 9
 Net Income Approach(NI)
Assumptions:
Cost of debt is
less than cost of
equity
Corporate tax
does not exist
Use of of debt
does not add risk

DR.VN.BRIMS. 10
Net Operating
Income
Approach(NOI)
Assumptions:
Market capitalizes the Ke
Ko, Kd, Ke%
value of firm as a whole
Use of debt increases the
risk of shareholders So Ke
Ko
increases with leverage and
neutralises the advantage
Kd
of low cost debt
Ko remais same regardless 0.5 1.0
of levage
0 Degree of Leverage
Corporate tax does not
exist
Cost of debt remains same
regardless of leverage
DR.VN.BRIMS. 11
Assumptions: Traditional Approach
Cost of equity
remains constant or
rises slightly with the
debt
Cost of debt remains
Ke
same or
rises slightly with the
Kd Ko
leverage Optimum
Ke
Benefits of low cost capital
Ko
debt are offset by Kd structure
increase in cost of
%
equity
Advantges of low
cost debt are less than Degree of leverage
disadvantages of
higher cost of equity
DR.VN.BRIMS. 12
 Cost of capital
 Discount rate is the “minimum rate of return which
company must earn on its investments so as to keep the
prices of its share at the same level”

 If company earns a return which is more than a cost of

capital ,the market price per share is expected to increase

 If co earns a RR<DR,the market price is expected to fall

 If co earns a RR ==DR, price of share does not fall

DR.VN.BRIMS. 13
 Financial leverage

 measures the fluctuation of earnings available to the common

shareholders, relative to the fluctuation of operating earnings
[measured as earnings before interest and taxes (EBIT)]:

 Degree of Financial Leverage (DFL)

 Percentage Change in EPS
 Percentage Change in EBIT

DR.VN.BRIMS. 14
 Significance of debt in capital
structure by level
of financial risk

 long-term debt, short-term debt and total

debt relative to total assets as well as
 long-term debt relative to book value of
assets and market value of assets
 across firm groups with low, medium and
high financial leverage for the Cement sector.

DR.VN.BRIMS. 15
 Traditional approach of CS

 Ko decreases with the leverage in the

beginning ,reaches the maximum point and
rises thereafter
 Ko is function of leverage
 Valuation of firm can be increased or cost of
capital can be reduced by judicious mix of
Debt and equity

DR.VN.BRIMS. 16
 Modigliani and Miller -MM
Approach
 Valuation of firm is independent of CS and depends
on risk .Three basic propositions
 1)V= Capitalizing the EBIT at discount rate
 2)Ke is equal to capitalization rate of pure equity
stream plus a premium for financial risk
 Financial risk increases with leverage Ke increases
in a manner to offset the benefit from the use of low
debt
 Ko remains same regardless of leverage (investment
and financing decisions are independent
 Discount Rate” DR.VN.BRIMS. 17
 Capital structure research has gone through three phases in
the nearly half-century since Modigliani and Miller’s (1958)
 assumptions regarding the “perfect market” assumptions
about taxes, bankruptcy costs, and
 starting in the late 1970s, asymmetric information.

 Theoretical developments in the 1980s were

 affected by the increasing use of game theory in corporate
finance. In this golden age of
 asymmetric information models in finance, the assumptions
of exogenous operating decisions and semi-strong form
market efficiency (that is, securities prices correctly reflect
the value of all publicly available information) continued to
prevail.

DR.VN.BRIMS. 18
 Comparison of Debt Level across Low, Medium and High
Financial Risk Firms under Cement Sector---Table 1

Debt Low Financial Medium Financial High Financial All F Value

Measures Risk Firms Risk Firms Risk Firms Firms

LTDTA 0.5257 0.6421 0.4657 0.5543 4 "79***

(0.2108 (0.2670) (0.1356) (0.2281)

STDTA 0.1302 0.1105 0.1315 0.1227 0.37

(0.1129 (0.0870) (0.1141) (0.1028)

TDTA 0.7526 0.5972 0.6770 3.57**

0.6912 (0.2844) (0.1089) (0.2275)
(0.2684
LEVB 0.6558 0.7936 0.6154 0.7094 3.91**
(0.2046 (0.2327) (0.2153) (0,2477)

LEVM 0.6575 0.7441 0.6261 0.6827 1.62

(0.2879 (0.2369) (0.2484) (0.2585)

2, 77 is the degrees of freedom for all values of standard deviation.

'F' values; ** Significant at 5% level. ***Significant at 1% level; Figures in parenthesis are was
significant difference in the level of long-term debt among firm groups with different level of
financial risk F value = 4.79, p < 0.01 DR.VN.BRIMS.
. It is found that proportion of debt fund
provided by the long-term debt as well as by
short-term debt is significantly related to the
level of financial risk of the firms under
Cement, Food, Pharmaceutical, Information
technology Steel.

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DR.VN.BRIMS. 21