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2.4 Capital Structure

The document discusses capital structure, which refers to the combination of debt and equity used to finance a company's assets. It outlines several theories of capital structure, including the net income, net operating income, traditional, and Modigliani-Miller approaches. The last part describes Modigliani-Miller's propositions that a firm's value and cost of capital are independent of its capital structure without taxes.

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14 views

2.4 Capital Structure

The document discusses capital structure, which refers to the combination of debt and equity used to finance a company's assets. It outlines several theories of capital structure, including the net income, net operating income, traditional, and Modigliani-Miller approaches. The last part describes Modigliani-Miller's propositions that a firm's value and cost of capital are independent of its capital structure without taxes.

Uploaded by

jayantk
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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2.

4 CAPITAL STRUCTURE
INTRODUCTION
• Capital structure of a company means the composition of long-term
sources of funds.
• It refers to the kind and proportion of securities for raising long-term
funds.
DEFINITION
• Capital structure refers to the kind of securities that make up the
capitalisation.
- W.Gerstenberg

• Capital Structure is the combination of debt and equity securities that


comprise a firm’s financing of its assets

- John J.Hampton
CHARACTERISTICS OF BALANCED CAPITAL STRUCTURE

• An optimal or balanced capital • Simplicity


structure is the ideal • Economy
combination of debt and equity
that attains the stated • Flexibility
managerial goal in the most • Profitability
relevant manner. • Solvency
• That is maximising of market • Control
value per share or minimisation
of cost of capital • Conservatism
• Balanced Leverage
FACTORS TO BE CONSIDERED IN
DETERMINING CAPITAL STRUCTURE OF A
INTERNAL FACTORS
FIRM
EXTERNAL FACTORS

• Nature of business • Requirement of investors


• Size of the company • Conditions of capital market
• Regularity of income • Cost of Capital
• Purpose of financing • Government policy
• Period of finance • Legal requirements
• Development and expansion Plans
• Attitude of Management
• Trading on Equity
THEORIES OF CAPITAL STRUCTURE
• NET INCOME APPROACH
• NET OPERATING INCOME APPROACH
• TRADITIONAL APPROACH
• MODIGLIANI AND MILLER APPROACH (MM)
NET INCOME (NI) APPROACH
• According to NI approach both the cost
of debt and the cost of equity are
independent of the capital structure.
• They remain constant regardless of how
much debt the firm uses.
• As a result, the overall cost of capital
declines and the firm value increases
with debt.
• This approach has no basis in reality.
• The optimum capital structure would
be 100 per cent debt financing under NI
approach.
NET OPERATING INCOME (NOI) APPROACH
• According to NOI approach the
value of the firm and the weighted
average cost of capital are
independent of the firm’s capital
structure.
• In the absence of taxes, an
individual holding all the debt and
equity securities will receive the
same cashflows regardless of the
capital structure and therefore,
value of the company is the same
TRADITIONAL APPROACH
• The traditional approach argues
that moderate degree of debt can
lower the firm’s overall cost of
capital and thereby, increase the
firm value.
• The initial increase in the cost of
equity is more than offset by the
lower cost of debt.
• But as debt increases,
shareholders perceive higher risk
and the cost of equity rises until a
point is reached at which the
advantage of lower cost of debt is
more than offset by more
expensive equity.
MM APPROACH WITHOUT
TAX:PROPOSITION I
• MM’s Proposition I states that the
firm’s value is independent of its
capital structure.
• With personal leverage,
shareholders can receive exactly
the same return, with the same risk,
from a levered firm and an
unlevered firm.
• Thus, they will sell shares of the
over-priced firm and buy shares of
the underpriced firm until the two
values equate. This is called
arbitrage.
MM APPROACH WITHOUT
TAX:PROPOSITION II
• The cost of equity for a levered firm
equals the constant overall cost of
capital plus a risk premium that
equals the spread between the
overall cost of capital and the cost of
debt multiplied by the firm’s
debt-equity ratio.
• For financial leverage to be
irrelevant, the overall cost of capital
must remain constant, regardless of
the amount of debt employed.
• This implies that the cost of equity
must rise as financial risk increases.

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