Capital structure

 Capital structure refers to the

combination or mix of debt and equity
which a company uses to finance its
long term operations.
 The capital structure is how a firm
finances its overall operations and
growth by using different sources of
funds.
 Meaning:

 Raising of capital from different

sources and their use in different
assets by a company is make on the
basis of certain principles that
provide a system of capital so that
the maximum rate of return can be
earned at a minimum cost.

 This sort of system of capital is

known as capital structure
Optimal Capital Structure
 The optimal or the best Capital
structure implies the most economical
and safe ratio between various types of
securities.
 It is that mix of debt and equity which
maximizes the value of the company
and minimizes the cost of capital.
 Essentials of optimal capital structure
minimum cost of capital, minimum risk,
maximum return, maximum control.
Total Required Capital
 From Shares.

= Equity Shares.
= Preference share capital

 From Debentures.
 Theories of capital
structure

 Net Income theory (NI ).

 Net Operating Income theory (NOI).
 Traditional theory.
 Modigliani – Miller (M-M) theory.
 Net Income Theory (NI)

Net Income Approach: which argues that

debt will influence the value of the firm.

This theory was propounded by “David

Durand” and is also known as “ Fixed Ke
theory”.

A Firm can increase the value of the firm

and reduce the overall cost of capital by
increase the proportion of debt in its capital
structure to the maximum possible extent.
  It is due to the fact that debt is
generally a cheaper source of funds
because.

*Interest rates are lower than

dividend rates due to element of risk.
**The benefit of tax as the interest is
deductible expense for income tax
purpose.
For ex:

 Two firms X and Y one with zero leverage and the other with 50%
leverage. Means half of the total assets have been financed by debt
Balance sheet
x y x y
_______________________________________________________
Equity 2,000 1,000 Assets 2,000 2,000
Debt 10% -- 1,000
______________ ______________
2,000 2,000 2,000 2,000
 Operating profit for both firms 300.Rs. Tax at 50% the
earnings to share holders in each firm is.

x y
___________________________________________________
EBIT 300 300
- Interest 10% --- 100
EAIBT 300 200
- Tax 50% 150 100
EAIT 150 100

EPS= 150/200 100/100

0 .75 1.00
Computation of the Total
Value of the Firm

 Total value of the firm (V) = S+D

S= Market value of Shares
D= Market value of
Debentures.
 Over cost of capital (Ko) = NOI/V
 B Co Net operating income 7,000. It has 30000 8%
Debentures. The equity capitalization rate of the Co. is
10% find the value of the firm according to NI Approach.

 Value of the firm

_______________________________________________________
 Net operating income 7,000
 (-) Interest 8% 2,400
 Income to equity holders 4,600

 Market value of equity= 4,600/.10 = 46000

 D 30000
 S 46000
 Market value = 76000

Cost of capital = NOI/V 7,000/76,000 = 9.21%

 B Co Net operating income 7,000. It has 60000 8%
Debentures. The equity capitalization rate of the Co. is
10% find the value of the firm according to NI Approach.

 Value of the firm

_______________________________________________________
 Net operating income 7,000
 (-) Interest 8% 4,800
 Income to equity holders 2,200
 Market value of equity= 2,200/.10 = 22,000

 D 60,000
 S 22,000
 Market value = 82,000
 Ko =7,000/82,000=8.54%
Assumptions of NI theory:
 The Kd is Cheaper than the Ke.
 Income tax has been ognored.
 The Kd and Ke remain constant.

 (Ke cost of equity

 Kd cost of debt
 Ko overall cost of capital)
Relationship among the
three variables (Ke,Kd,Ko)
conclusion
 Thus an increase in the proportion of
debt caused the overall cost of capital
to decrease and the value of the
company to increase

 Since Ni approach assumes that cost of

debt and equity are constant Kd and Ke
curves are parallel to horizontal but
weighted average cost of capital Ko
decreases thus Ko is minimum when
proportion of debt is maximum
 THANK YOU

 Presented by

Raavi. Radhika .
M.B.A., M.com, M.Phil,
(P.hd)