Capital structure, Capitalisation, Capital Structure Theories.

1. Unit II
Financial Management
Capital Structure Planning :
capitalization Concept,
Basis of capitalization,
consequences and remedies of over and under
capitalization,
Determinants of Capital structure,
Capital structure theories Prepared by:-
Dr. Waqar Ahmad
Asstt. Professor
Allenhouse Business School

2. Capital Structure
is the proportion of debt and preference and equity
shares on a firm’s balance sheet.
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.

3. Capital Structure Planning
The capital structure of a company is made up of debt and
equity securities that comprise a firm’s financing of its assets. It
is the permanent financing of a firm represented by long-term
debt, preferred stock and net worth. So it relates to the
arrangement of capital and excludes short-term borrowings. It
denotes some degree of permanency as it excludes short-term
sources of financing.
“Capital structure is essentially concerned with how the firm
decides to divide its cash flows into two broad components, a
fixed component that is earmarked to meet the obligations
toward debt capital and a residual component that belongs to
equity shareholders”-P. Chandra..

4. Importance of Capital Structure:
The importance or significance of Capital Structure
Value Maximization
Cost Minimization
Increase in Share Price
Investment Opportunity
Growth of the Country
Patterns of Capital Structure

5. Capital Structure Planning cont..
Capital structure is the mix of the long-term
sources of funds used by a firm. It is made up
of debt and equity securities and refers to
permanent financing of a firm. It is composed
of long-term debt, preference share capital
and shareholders’ funds.

6. Factors Determining Capital Structure:
1. Risk of cash insolvency
2. Risk in variation of earnings
3. Cost of capital
4. Control
5. Trading on equity
6. Government policies
7. Size of the company
8. Needs of the investors
9. Flexibility
10.Period of finance
11. Nature of business
12. Legal requirements
13. Purpose of financing
14. Corporate taxation
15. Cash inflows
16. Provision for future
17. EBIT-EPS analysis

7. Capitalization
Capitalization is an important constituent
of financial plan in common parlance, the
phrase ‘capitalization’ refers to total of all
kinds of long term securities at their par
values.

8. Basis of capitalization
One of problems facing the financial
manager is determination of value at
which a firm should be capitalized
because it have to raise funds accordingly
there are two theories that contain
guidelines with which the amount of
capitalization can be surmised

9. 1. Cost Theory of Capitalization
According to this theory capitalization of a firm is regarded as the
sum of cost actually incurred in setting of the business. A film
needs funds to acquire fixed assets, to defray promotional and
organizational expenses and to meet current asset requirements
of the enterprise sum of the costs of the above asset gives the
amount of capitalization of the firm, acquiring fixed assets and to
provide with necessary Working capital and to cover possible
initial losses, it will capitalized Under this method more emphasis
is laid on current investments. They are static in nature and do not
have any direct relationship with the future earning capacity.
This approach givens as the value of capital only at a particular
point of time Which Would not reflect the future changes.

10. 2. Earning Theory of capitalization
According to this theory, firm should be capitalized on
the basis of its expected earning A firm’s profit is
seeking entity and hence its value is determiner
according to what it earns. The probable earning are
forecast and they are capitalized at a normal
representative rate of return.
Capitalization of a company as per the earning theory
can thus be determined with help following formula.
Capitalization = Annual Net Earnings X Capitalization
Rate

11. Consequences (or Effect of Over-Capitalisation)
Consequences of Over-Capitalisation could be
described, in the following Analytical Manner:
(1) Consequences for the Company:
(i) An unsatisfactory rate of return on the equity
leads to a poor market value of the company’s shares.
There is thus, considerable loss of goodwill to the
company.
(ii) Investors’ confidence in the company is lost; as to
them, the future of the company seems to be gloomy
and uncertain.
(iii) There is usually, unhealthy speculation, in the
shares of an over-capitalised company; which, in turn,
brings a bad name to the company.

12. (2) Consequences for the Members:
(i) Members of the company are losers; as the dividend
payable to them is both reduced an uncertain, and
(ii) There is a capital loss to the members; as a result of the
poor market value of their shares.
(3) Consequences for the Workers:
(i) Because of reduced profitability, workers might be
required to suffer a cut in their wages.
(ii) If an over-capitalised company is liquidated untimely due
to this financial disease; workers lose their employment.

13. (4) Consequences for the Society:
(i) The poor functioning of an over-capitalised
company implies wastage of nation’s precious
economic resources; as the same amount of
resource might be profitably employed
elsewhere, to produce more.
(ii)Closure of an over-capitalised company hits the
society adversely; in terms of loss of
production, generation of unemployment, etc.

14. Remedies for Over-Capitalisation:
The only effective remedy to cure over-
capitalisation lies in implementing a scheme of
a capital reduction.
Under the scheme of capital reduction, there
might be:
(i) A reduction in the rate of interest payable on debentures
(or other types of loans)
(ii) A reduction in rate of preference dividend.
(iii) A reduction in the paid-up value of shares-equity or
preference or both. For example a share of the paid-
up value of Rs.10 might be reduced to a share with a
paid-up value of Rs. 5 or Rs. 3.

15. Remedies for overcapitalization
Restructuring the firm is to be executed avoid the
situation of company becoming sick.
It involves
1. Reduction of debt burden
2. Negotiation with term lending institutions for
reduction in interest obligation.
3. Redemption of preference share through a scheme
of capital reduction.
4. Reducing the face value and paid-up value of equity
shares.
5. Initiating merger with well managed profit making
companies interested in talking over ailing
company.

16. Undercapitalization
Under-capitalization is just the reverse of
over-capitalization.
A company is considered to be under-
capitalized when its actual capitalization is
lower than its proper capitalization as
warranted by its earning capacity.

17. Causes of under- capitalization
1. Under estimation of future earnings of the time of
promotion of the company.
2. Abnormal increase in earnings from new economic and
business environment.
3. Under estimation of total funds requirements.
4. Maintaining very high efficiency through improved
means of production of goods or rendering of services.
5. Companies which are set up during recession start
making higher earning capacity as soon as the recession
is over.
6. Use of low capitalized rate.
7. Companies which follow conservative dividend policy
will achieve a process of gradually rising profits.
8. Purchase of assets at exceptionally low prices during
recession.

18. Remedies of undercapitalization
• Splitting up at the shares – This will reduce the
dividend per share
• Issue of bonus share: this will reduce both the
dividend per share and earning per share.
• Both over-capitalization and under – capitalization
are detrimental to the interests of the society.

19. Determinants of Capital structure
I. Financial Leverage or Trading
on Equity:
II. Growth and Stability of Sales
III. Cost of Capital
IV. Risk
V. Cash Flow
VI. Nature and Size of a Firm
VII. Capital Market
Conditions (Timing)
VIII.Control
IX. Flexibility
X. Requirement of
Investors
XI. Marketability:
XII. Inflation
XIII.Floatation Costs
XIV.Legal Considerations

20. Theories of Capital structure
A number of theories explain the
relationship between cost of capital,
Capital structure and value of the
firm. They are:
1. Net income approach (NIA)
2. Net operating income approach (NOIA)
3. Traditional approach (TA)
4. Modigliani-Miller approach (MMA)

21. Theories of Capital structure
A) Net Income
Approach (NI)

22. Capital Structure Theories –
A) Net Income Approach (NI)
 Net Income approach proposes that there is a definite
relationship between capital structure and value of the firm.
 The capital structure of a firm influences its cost of capital
(WACC), and thus directly affects the value of the firm.
 NI approach assumptions –
o NI approach assumes that a continuous increase in debt does
not affect the risk perception of investors.
o Cost of debt (Kd) is less than cost of equity (Ke) [i.e. Kd < Ke ]
o Corporate income taxes do not exist.

23. Capital Structure Theories –
A) Net Income Approach (NI)
 As per NI approach, higher use of debt capital will result in
reduction of WACC. As a consequence, value of firm will be
increased.
Value of firm = Earnings
WACC
 Earnings (EBIT) being constant and WACC is reduced, the
value of a firm will always increase.
 Thus, as per NI approach, a firm will have maximum value at
a point where WACC is minimum, i.e. when the firm is
almost debt-financed.

24. Capital Structure Theories –
A) Net Income Approach (NI)
ke
ko
kd
Debt
Cost
kd
ke, ko
As the proportion of
debt (Kd) in capital
structure increases,
the WACC (Ko)
reduces.

25. Calculate the value of Firm and WACC for the following capital structures
EBIT of a firm Rs. 200,000. Ke = 10%
Debt capital Rs. 500,000 Debt = Rs. 700,000 Debt = Rs. 200,000
Kd = 6%
Particulars case 1 case 2 case 3
EBIT 200,000 200,000 200,000
(-) Interest 30,000 42,000 12,000
EBT 170,000 158,000 188,000
Ke 10% 10% 10%
Value of Equity 1,700,000 1,580,000 1,880,000
(EBT / Ke)
Value of Debt 500,000 700,000 200,000
Total Value of Firm 2,200,000 2,280,000 2,080,000
WACC 9.09% 8.77% 9.62%
(EBIT / Value) * 100
Capital Structure Theories –
A) Net Income Approach (NI)

26. Theories of Capital structure
B) Net Income
Operating Approach
(NI)

27. Capital Structure Theories –
B) Net Operating Income (NOI)
 Net Operating Income (NOI) approach is the exact opposite
of the Net Income (NI) approach.
 As per NOI approach, value of a firm is not dependent upon
its capital structure.
 Assumptions –
o WACC is always constant, and it depends on the business risk.
o Value of the firm is calculated using the overall cost of capital
i.e. the WACC only.
o The cost of debt (Kd) is constant.
o Corporate income taxes do not exist.

28. Capital Structure Theories –
B) Net Operating Income (NOI)
 NOI propositions (i.e. school of thought) –
The use of higher debt component (borrowing) in the capital
structure increases the risk of shareholders.
Increase in shareholders’ risk causes the equity capitalization
rate to increase, i.e. higher cost of equity (Ke)
A higher cost of equity (Ke) nullifies the advantages gained due
to cheaper cost of debt (Kd )
In other words, the finance mix is irrelevant and does not
affect the value of the firm.

29. Capital Structure Theories –
B) Net Operating Income (NOI)
 Cost of capital (Ko)
is constant.
 As the proportion
of debt increases,
(Ke) increases.
 No effect on total
cost of capital (WACC)
ke
ko
kd
Debt
Cost

30. Calculate the value of firm and cost of equity for the following capital structure -
EBIT = Rs. 200,000. WACC (Ko) = 10% Kd = 6%
Debt = Rs. 300,000, Rs. 400,000, Rs. 500,000 (under 3 options)
Particulars Option I Option II Option III
EBIT 200,000 200,000 200,000
WACC (Ko) 10% 10% 10%
Value of the firm 2,000,000 2,000,000 2,000,000
Value of Debt @ 6 % 300,000 400,000 500,000
Value of Equity (bal. fig) 1,700,000 1,600,000 1,500,000
Interest @ 6 % 18,000 24,000 30,000
EBT (EBIT - interest) 182,000 176,000 170,000
Hence, Cost of Equity (Ke) 10.71% 11.00% 11.33%
Capital Structure Theories –
B) Net Operating Income (NOI)

31. Theories of Capital structure
C) Modigliani –
Miller Model (MM)

32. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
 MM approach supports the NOI approach, i.e. the capital
structure (debt-equity mix) has no effect on value of a firm.
 Further, the MM model adds a behavioural justification in favour
of the NOI approach (personal leverage)
 Assumptions –
o Capital markets are perfect and investors are free to buy, sell, &
switch between securities. Securities are infinitely divisible.
o Investors can borrow without restrictions at par with the firms.
o Investors are rational & informed of risk-return of all securities
o No corporate income tax, and no transaction costs.
o 100 % dividend payout ratio, i.e. no profits retention

33. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
MM Model proposition –
o Value of a firm is independent of the capital structure.
o Value of firm is equal to the capitalized value of operating
income (i.e. EBIT) by the appropriate rate (i.e. WACC).
o Value of Firm = Mkt. Value of Equity + Mkt. Value of Debt
= Expected EBIT
Expected WACC

34. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
MM Model proposition –
o As per MM, identical firms (except capital structure) will
have the same level of earnings.
o As per MM approach, if market values of identical firms
are different, ‘arbitrage process’ will take place.
o In this process, investors will switch their securities
between identical firms (from levered firms to un-levered
firms) and receive the same returns from both firms.

35. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
Levered Firm
• Value of levered firm = Rs. 110,000
• Equity Rs. 60,000 + Debt Rs. 50,000
• Kd = 6 % , EBIT = Rs. 10,000,
• Investor holds 10 % share capital
Un-Levered Firm
• Value of un-levered firm = Rs. 100,000 (all equity)
• EBIT = Rs. 10,000 and investor holds 10 % share capital

36. Capital Structure Theories –
C) Modigliani – Miller Model (MM)
   
 
Return from Levered Firm:
10 110,000 50 000 10% 60,000 6 000
10% 10,000 6% 50,000 1,000 300 700
Alternate Strategy:
1. Sell shares in : 10% 60,000 6,000
2. Borrow (personal leverage):
Investment % , ,
Return
L
   
       
 
10% 50,000 5,000
3. Buy shares in : 10% 100,000 10,000
Return from Alternate Strategy:
10,000
10% 10,000 1,000
: Interest on personal borrowing 6% 5,000 300
Net return 1,000 300 700
Ca
U
Investment
Return
Less
 
 

  
  
  
sh available 11,000 10,000 1,000  

37. Theories of Capital structure
D) Traditional Approach

38. Capital Structure Theories –
D) Traditional Approach
 The NI approach and NOI approach hold extreme views on
the relationship between capital structure, cost of capital and
the value of a firm.
 Traditional approach (‘intermediate approach’) is a compromise
between these two extreme approaches.
 Traditional approach confirms the existence of an optimal
capital structure; where WACC is minimum and value is the
firm is maximum.
 As per this approach, a best possible mix of debt and equity
will maximize the value of the firm.

39. Capital Structure Theories –
D) Traditional Approach
The approach works in 3 stages –
1) Value of the firm increases with an increase in borrowings
(since Kd < Ke). As a result, the WACC reduces gradually.
This phenomenon is up to a certain point.
2) At the end of this phenomenon, reduction in WACC ceases
and it tends to stabilize. Further increase in borrowings will
not affect WACC and the value of firm will also stagnate.
3) Increase in debt beyond this point increases shareholders’
risk (financial risk) and hence Ke increases. Kd also rises due
to higher debt, WACC increases & value of firm decreases.

40. Capital Structure Theories –
D) Traditional Approach
ke
ko
kd
Debt
Cost
 Cost of capital (Ko)
is reduces initially.
 At a point, it settles
 But after this point,
(Ko) increases, due
to increase in the
cost of equity. (Ke)

41. EBIT = Rs. 150,000, presently 100% equity finance with Ke = 16%. Introduction of debt to
the extent of Rs. 300,000 @ 10% interest rate or Rs. 500,000 @ 12%.
For case I, Ke = 17% and for case II, Ke = 20%. Find the value of firm and the WACC
Particulars Presently case I case II
Debt component - 300,000 500,000
Rate of interest 0% 10% 12%
EBIT 150,000 150,000 150,000
(-) Interest - 30,000 60,000
EBT 150,000 120,000 90,000
Cost of equity (Ke) 16% 17% 20%
Value of Equity (EBT / Ke) 937,500 705,882 450,000
Total Value of Firm (Db + Eq) 937,500 1,005,882 950,000
WACC (EBIT / Value) * 100 16.00% 14.91% 15.79%
Capital Structure Theories –
D) Traditional Approach

42. Thank You