1

CAPITAL STRUCTURE DEFINED

The term capital structure is used to represent the proportionate relationship between
debt and equity.

The various means of financing represent the financial structure of an enterprise. The
left-hand side of the balance sheet (liabilities plus equity) represents the financial
structure of a company. Traditionally, short-term borrowings are excluded from the list
of methods of financing the firms capital expenditure.

CAPITAL
STRUCTURE

DEBT EQUITY
CAPITAL CAPITAL
Patterns / Forms of Capital Structure.
Following are the forms of capital structure:

1) Complete equity share capital.

2) Different proportions of equity and preference share capital.

3) Different proportions of equity and debenture (debt) capital.

4) Different proportions of equity, preference and debenture (debt) capital.

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CAPITAL MIX INVOLVES TWO TYPES OF RISKS:

1. Financial Risk

2. Non-Employment of Debt Capital Risk (NEDC)

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NON-EMPLOYMENT OF DEBT CAPITAL (NEDC) RISK

1) No advantage of financial leverage.

2) Loss of control by issue of more and more Equity.

3) Higher Floatation Cost.

Strike a balance (trade off) between the financial risk and Risk of non-employment of debt
capital to increase Firms Market Value.

FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE

1) Capital structure is that capital structure at that level of debt equity proportion where
the market value per share is maximum and the cost of capital is minimum.

Appropriate capital structure should have the following features

1) Profitability / Return

2) Solvency / Risk

3) Flexibility

4) Conservation / Capacity

5) Control

IMPORTANCE OF CAPITAL STRUCTURE

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OPTIMAL CAPITAL STRUCTURE.

1) Capital structure or combination of debt and equity that leads to maximum value of
firm.

2) Maximizes value of company and wealth of owners.

3) Minimizes the companys cost of capital

Considerations to be kept in mind while maximizing value of firm:

1) Company should make maximum possible use of leverage to increase EPS and market
value of firm.

2) Company should take advantage of tax leverage.

3) Firm should avoid undue financial risk attached with use of increased debt financing.

4) Capital structure should be flexible.

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THEORIES OF
CAPITAL
STRUCTURE

Net Operating
Net Income The Traditional Modigliani and
Income
Approach Approachch Miller Approach
Approach

THEORIES OF CAPITAL STRUCTURE

1.Net Income Approach

2. Net Operating Income Approach

3. The Traditional Approach

4. Total value principle Approach/ Modigliani and Miller Approach

ASSUMPTION OF CAPITAL STRUCTURE THEORIES

There are only two sources of funds i.e.: debt and equity.

1) The total assets of the company are given and do no change.

2) The total financing remains constant. The firm can change the degree of leverage either
by selling the shares and retiring debt or by issuing debt and redeeming equity.

3) Operating profits (EBIT) are not expected to grow.

4) All the investors are assumed to have the same expectation about the future profits.

5) Business risk is constant over time and assumed to be independent of its capital
structure and financial risk.

6) Corporate tax does not exist.

7) The company has infinite life.

8) Dividend payout ratio = 100%.

1. NET INCOME APPROACH

ASSUMPTIONS:
1. Cost of debt < cost of equity
2. No taxes.
3. Risk not influenced by debts usage.
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IMPLICATIONS
1) Increase in firms value.

2) Proportion of cheap source of funds increase.

3) Proportion of debt increases.

4) Decrease in firm's value.

5) Financial leverage is reduced.

6) Proportion of debt financing decreases.

2. NET OPERATING INCOME APPROACH

ASSUMPTIONS:
1) Market capitalizes value of firm as a whole.
2) Business risk remains constant at every level of debt equity mix.
3) No corporate taxes.
IMPLICATIONS
1) Increased use of debt increases financial risk of the equity shareholders.
2) Cost of equity increases.
3) Advantage of using cheap source of fund i.e., debt is exactly offset by increased cost of
equity.
4) Overall cost of capital remains the same.
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3. TRADITIONAL APPROACH
IMPLICATIONS:
1) Use of debt initially.
2) Value of firm increases.
3) Cost of capital decreases.

But

4) Increased use of debt.

5) Financial risk of equity shareholders increase.
6) Cost of equity increases.
7) Overall cost of capital increases.
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4. MODIGLIANI & MILLER APPROACH

A.(IN THE ABSENCE OF TAXES)ASSUMPTIONS:
1) There are no corporate taxes.
2) There is a perfect market.
3) Investors act rationally.
4) The expected earnings of all the firms have identical risk characteristics.
5) All earnings are distributed to the shareholders.
IMPLICATIONS
1) Cost of capital not influenced by changes in capital structure.
2) Debt-equity mix is irrelevant in determination of market value of firm.
(B) WHEN TAXES ARE ASSUMED TO EXIST:
IMPLICATION:
1) Use of debt.
2) Cost of capital decrease.
3) Achievement of optimal capital structure.

FEATURES OF A OPTIMAL CAPITAL MIX

1) Optimum capital structure is also referred as appropriate capital structure and
sound capital structure

2) Capacity of a FIRM

3) Possible use of LEVERAGE

4) FLEXIBLE

5) Avoid Business RISK

6) MINIMISE the cost of Financing and MAXIMISE earning per share

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REASONS FOR CHANGE IN CAPITAL STRUCTURE :-

1) To restore balance in financial plan

(i) A company can adjust its capital structure as according to needs.

(ii) So as to maintain a balance in financial plan and ease out the tension and
strain

2) To simplify the capital structure

(i) When market conditions are favorable various securities at different

point of time can be consolidated.
(ii) This will lead to simplification of financial plan.

3) To suit investors needs

(i) To make the investment more attractive especially when the shares are
limited.
(ii) Due to wide fluctuations in market.
(iii) The company may change capitalization to suit the needs of investors.

4) To fund current liabilities

(i) There may be need of converting short term obligations into long term
obligations or vice versa.
(ii) When the market conditions are favorable.
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5) To write-off the debts.

(i) A company may need to re-organize its capital by reducing book value of
its liabilities and assets to its real values.
(ii) As when the book value of assets are over-valued.
(iii) Or when there are accumulated losses.
(iv) So as to make company legally payable for dividends to its shareholders.

6) To capitalise retained earnings.

(i) To avoid over-capitalisation.

(ii) Maintain a balance between preference shares and equity shares and
equity shares and debentures.
(iii) Company may capitalise retained earnings by issuing bonus shares out of
it.

7) To clear default on fixed cost structures.

(i) When the company is not in a position to pay interest on debentures or

to repay them on maturity.
(ii) It may offer them certain securities(equity shares, preference shares or
new debentures.
(iii) To clear default.

8) To fund accumulated dividends.

(i) When it is a time to pay fixed dividends to its preference shareholders.

(ii) Or when the preference shares are due for redemption.
(iii) The company may prefer to issue new shares in lieu.
(iv) And the company does not have sufficient funds.

9) To facilitate merger and expansion

10) To meet legal requirements.

(i)It is necessitated to meet the changes in various legal requirements as and

when took place.

FINANCIAL DISTRESS AND CAPITAL STRUCTURE

1) Financial risk increases when firm uses more debt,it may not be able to pay fixed interest
and runs into bankruptcy.

2) Firms using more equity don't face this problem.

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3) Use of debt provides tax benefit but bankruptcy costs work against the advantage.

4) When firm raises debt, suppliers put restrictions in agreement resulting to less freedom of
decision making by management called agency cost.

PECKING ORDER THEORY

1) This theory was suggested by DONALDSON in 1961.

2) It was modified by MYERS in 1984.

According to Donaldson,

3) Firm has well defined order of preference for raising finance.

4) When firm need funds it will rely on internally generated funds.

5) This order of preference is so defined because internally generated funds have no issue
costs.

Theory presumptions
1) Cost of internally generated funds is lowest.
2) Raising of debt is cheaper source of finance.
3) Raising of debt through term loan is cheaper than issuing bonds.
4) Issue of new equity capital involves heavy issue cost.
5) Servicing of debt capital is relatively less as compared to equity.

Proposes Of Pecking Order Theory

1) Dividend policy is stickily.

2) There is preference for internally generated funds to external financing.

3) If external financing is needed, debt is preferred to equity.

4) Issue of new equity for raising additional funds is considered as a last resort.

ACCORDING TO MODIFIED PECKING ORDER THEORY,

1) Order of preference for raising funds arises because of asymmetric information between
market and firm.

2) Firm may prefer internal funds and then raising of debt as compared to issue of new
equity share capital.
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CAPITAL STRUCTURE CAN INFLUENCE FIRM VALUE BY:

1) Limiting conflicts of interest that can emerge between shareholders and debt holders
andthe probability that there will be costs related to distress and bankruptcy (Jensen
andMeckling, 1976, Williamson, 1988).
2) Modifying the types of incentives offered to management (Jensen and Meckling, 1976).
3) Limiting management activity (Jensen, 1986).
4) Managing problems having to do with information asymmetries (Ross, 1977).
5) Encouraging shareholders and other financers to check up on managements actions
(Shleifer and Vishny, 1986).
6) Encouraging, above all, firm-specific investments of human capital and promoting
efficiency in how decision making power is distributed in the firm (Zingales, 2000).

CAPITAL STRUCTURE: RELATION WITH CORPORATE VALUE AND MAIN

RESEARCH STREAMS
1) In 1958 Modigliani and Miller asserted that there was no relationship between capital
structure and value.
2) In 1963, , he concluded that a maximum level of debt would mean a maximum level of
firm value, due to the fact that interest is tax deductible.
3) Introduction of the costs (direct and indirect) of financial distress are creating a trade-
off between debt costs and benefits.
4) According to (Myers, 1984, Myers and Majluf, 1984) no optimal level of debt becomes
objectively evident, but this is due to the various situations the manager had to deal
with over time.
5) The level of firm indebtedness will be determined by the tangent between the firm
value function and the curve of manager indifference.

ACCORDIG TO HARRIS AND RAVIV (1991) : THE MAIN SOURCES OF EMPIRICAL

EVIDENCE SHOW THAT LEVERAGE IS HIGH AND GROWING WHEN:
1) According to the trade-off theory: taxable income is high and the costs of financial
distress low.

2) For the agency theory: growth opportunities are low and/or there is a large amount of
cash flow available.

3) For the information asymmetry theory: information asymmetries are low and firm
profit is high (as a sign of success).

4) According to (Chevalier, 1995): debt increases in correspondence with the better the
firms reputation is on the market.
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THE EMPIRICAL COMPARISON BETWEEN THE TRADE-OFF THEORY AND THE

PECKING ORDER THEORY

1) Empirical evidence shows moderate coherence with the trade-off theory, when revenue
and agency problems are taken into consideration contextually.

2) The negative relation between leverage and firm profit does not seem to support the
trade-off theory, as it confirms a hierarchical order in financial decision making.

ACCRDING TO (RAJAN AND ZINGALES, 1995): CAPITAL STRUCTURE IS A HOT

TOPIC IN FINANCE.
By analyzing international literature the main research priorities and new analyticalapproaches
are related to:

1) The important comparison between rational and behavioural finance (Barberis and
Thaler, 2002).
2) A lively comparison made between the pecking order theory and the trade-off theory
(Shyam-Sunder and Myers, 1999);

3) The attempt to apply these theories to small firms (Berger and Udell, 1998, Fluck, 2001).

4) The role of corporate governance on the relation between capital structure and value
(Heinrich, 2000, Bhagat and Jefferis, 2002, Brailsford et al., 2004, Mahrt-Smith, 2005).

According to Baker and Wurgler (2000): decisions regarding capital structure are the
result of the interaction between a rational subject and an irrational one; irrationality
can interest just the manager, or just the investor, or both.

According to Graham and Harvey (2001).how decisions regarding financing seem to

follow more the sentiment of management rather than be geared toward finding an
optimal capital structure.

According to Stewart Myers in 2000.The behavioural approach, that considers the

pecking order of financial resources in terms of irrational preferences, caused an
immediate reaction.

Stewart Myers is the founder of the pecking order theory.

According to Myers and Fama, there should be a rational explanation to the

phenomenon observed by Stein, Baker, Wrugler, Barberis and Thaler.

Berger and Udell (1998) asserted that firm financial behaviour depends on what phase
of their life cycle they are in.
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How corporate governance directly or indirectly influences the relation between capital
structure and value (Fluck, 1998, Zhang, 1998, Myers, 2000, De Jong, 2002, Berger and
Patti, 2003, Brailsford et al., 2004, Mahrt-Smith, 2005).

The analysis of capital structure and corporate governance is necessary when describing
and interpreting the firms ability to create value (Zingales, 2000, Heinrich, 2000, Bhagat
and Jefferis, 2002).

ROLE OF CORPORATE GOVERNANCE WITH RESPECT TO THE RELATION BETWEEN

CAPITAL STRUCTURE AND VALUE

1) The aim of corporate governance is to insure that opportunistic behavior does not
occur, by mitigating and moderating agency problems that could involve an agent
(manager) and various principals (shareholders, debt holders, employees, suppliers,
clients etc.) or else a principal (the main entrepreneur) and various agents (managers,
employees, investors etc.).

2) It facilitates the creation of special skill required in strategic decisions (incentive to firm-
specific investment) and limit problems of asymmetric information.

The expression corporate governance can take on two meanings:

a. A system of how decision making power is distributed within the firm, so to overcome
problems of contract incompleteness between different stakeholders (managerial or
internal corporate governance).

b. A set of rules, institutions and practices developed to protect investors from

entrepreneurial and managerial opportunistic behavior (institutional or external
corporate governance)

A literature review of those mechanisms that have been traditionally used is offered by
Shleifer and Vishny (1997) and by Denis (2001).

1. Conflicts of interest and the risk of opportunistic behavior increase the firms cost of
capital.

2. Efficient governance that increases the firms trustworthiness generates market

appreciation and investor trust.

LEVERS OF BOTH MANAGERIAL AND INSTITUTIONAL CORPORATE GOVERNANCE

1) Management participation in the equity of the firm.
2) The presence of external and independent members in the Board of Directors.
3) The presence of institutional investors.
4) The efficiency of the financial system.
5) The legal system and enforcement.
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INFLUENCE OF CORPORATE GOVERNANCE ON THE RELATION BETWEEN CAPITAL

STRUCTURE AND VALUE

1) Equity and debt, therefore, must be considered as both financial instruments and
corporate governance instruments (Williamson, 1988):

2) Debt subordinates governance activities to stricter management, while equity allows for
greater flexibility and decision making power.

3) When capital structure becomes an instrument of corporate governance, than the mix
between debt and equity and their well-known consequences must be taken into
consideration.

4) How the right to make decisions and manage the firm (voting rights) is dealt with must
also be examined.

5) Coase (1991), in a sort of critique on his own work done in 1937, points out that it is
important to pay more attention to the role of capital structure as an instrument that
can mediate and moderate economical transactions within the firm and, consequently,
between entrepreneurs and other stakeholders (corporate governance relations).

How corporate governance can potentially have a relevant influence on the

relation between capital structure and value, with an effect of mediation and/or
moderation.
The five relations identified in Figure 2 describe:

1) The relation between capital structure and firm value (relation A) through a role of
corporate governance mediation (relation B-C).

2) The relation between capital structure and firm value (relation A) through the role of
capital governance moderation (relation D).

3) The role of corporate governance as a determining factor in choices regarding capital

structure (relation E).

All five relations shown in Figure 2 are particularly interesting and show two threads of
research that focus on the relations between:
1. Capital structure and value, mediated (indirect relation through the intervention of another
variable relation B-C-A in Figure 2) and/or mitigated (direct relation but conditioned by
another variable relation A-D in Figure 2) by the corporate governance variable; and

2. Corporate governance and capital structure, where the dimensions of the corporate
governance determine firm financing choices, causing a possible relation of co-causation
(relation E-B in Figure 2). Re
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1) A change in how debt and equity are dealt with influences firm governance activities by
modifying the structure of incentives and managerial control.

2) Corporate governance influences choices regarding capital structure (relation E). Myers
(1984) and Myers and Majluf (1984) show how firm financing choices are made by
management following an order of preference.
IMPORTANT POINTS
1. Internal resource financing allows management to prevent other subjects from
intervening in their decision making processes.

2. Managers dont voluntarily accept the discipline of debt; other governance

mechanisms impose that debt is issued.

3. Firm financing decisions can be strictly deliberated by managers-entrepreneurs or else

can be induced by specific situations that go beyond the will of the management.

4. The causal model represents a complex phenomenon that nevertheless could stimulate
a promising thread of future research. Corporate governance, in fact, could become
crucial in explaining the relation between capital structure and value in its function as a
variable that intervenes in the abovementioned relation.

5. In the relation between capital structure and value. The corporate governance create a
bridge by mediating between leverage and value, thus showing a connection that
otherwise would not be visible.

6. In reality capital structure influences firm governance that is connected to firm value.

7. Recalling some of the methodological considerations made by Corbetta (1992)

Capital structure corporate governance value (relation B C);

Even in a direct relation: capital structure value (relation A), previously hidden:

8. How capital structure influences firm value through the interaction of many dimensions
of corporate governance (relation A-D)?

9. The corporate governance variable plays the role of moderating the relation between
capital structure and value, that can have either an amplifying effect () or one of
reduction (2) of the basic relation (relation A); as debt increases firm value could
increase or diminish depending on the role of other corporate governance instruments.

10. The relation between capital structure and corporate governance becomes extremely
important when considering its fundamental role in value generation and distribution
(Bhagat and Jefferis, 2002).
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11. Through its interaction with other instruments of corporate governance, firm capital
structure becomes capable of protecting an efficient value creation process, by
establishing the ways in which the generated value is later distributed (Zingales, 1998).

12. The relation between capital structure and value could be set up differently if it were
mediated or moderated by corporate governance.

13. Debt could have a marginal role of disciplining management when there is a shareholder
participating in ownership or when there is state participation.

14. When other forms of discipline are lacking in the governance structure, capital structure
could be exactly the mechanism capable of protecting efficient corporate governance,
while preserving firm value.
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Theories of Capital Structure (explained with examples) |

Financial Management

The capital structure decision can affect the value of the firm either by
changing the expected earnings or the cost of capital or both.

capital or both.

The objective of the firm should be directed towards the maximization of

the value of the firm the capital structure, or average, decision should be
examined from the point of view of its impact on the value of the firm.

If the value of the firm can be affected by capital structure or financing

decision a firm would like to have a capital structure which maximizes the
market value of the firm. The capital structure decision can affect the value
of the firm either by changing the expected earnings or the cost of capital or
both.

If average affects the cost of capital and the value of the firm, an optimum
capital structure would be obtained at that combination of debt and equity
that maximizes the total value of the firm (value of shares plus value of
debt) or minimizes the weighted average cost of capital. For a better
understanding of the relationship between financial average and the value
of the firm, assumptions, features and implications of the capital structure
theories are given below.

Assumptions and Definitions:

In order to grasp the capital structure and the cost of capital
controversy property, the following assumptions are made:
Firms employ only two types of capital: debt and equity.

The total assets of the firm are given. The degree of average can be changed
by selling debt to purchase shares or selling shares to retire debt.
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The firm has a policy of paying 100 per cent dividends.

The operating earnings of the firm are not expected to grow.

The business risk is assumed to be constant and independent of capital

structure and financial risk. The corporate income taxes do not exist. This
assumption is relaxed later on.

The following are the basic definitions:

The above assumptions and definitions described above are valid under any
of the capital structure theories. David Durand views, Traditional view and
MM Hypothesis are tine important theories on capital structure.
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1. David Durand views:

The existence of an optimum capital structure is not accepted by all. There
exist two extreme views and a middle position. David Durand identified the
two extreme views the Net income and net operating approaches.

a) Net income Approach (Nl):

Under the net income (Nl) approach, the cost of debt and cost of equity are
assumed to be independent of the capital structure. The weighted average
cost of capital declines and the total value of the firm rise with increased
use of average.

b) Net Operating income Approach (NOI):

Under the net operating income (NOI) approach, the cost of equity is
assumed to increase linearly with average. As a result, the weighted average
cost of capital remains constant and the total of the firm also remains
constant as average changed.

Thus, if the Nl approach is valid, average is a significant variable and

financing decisions have an important effect on the value of the firm, on the
other hand, if the NOI approach is correct, then the financing decision
should not be of greater concern to the financial manager, as it does not
matter in the valuation of the firm.

2. Traditional view:
The traditional view is a compromise between the net income approach and
the net operating approach. According to this view, the value of the firm can
be increased or the cost, of capital can be reduced by the judicious mix of
debt and equity capital.

This approach very clearly implies that the cost of capital decreases within
the reasonable limit of debt and then increases with average. Thus an
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optimum capital structure exists and occurs when the cost of capital is
minimum or the value of the firm is maximum.

The cost of capital declines with leverage because debt capital is chipper
than equity capital within reasonable, or acceptable, limit of debt. The
weighted average cost of capital will decrease with the use of debt.
According to the traditional position, the manner in which the overall cost
of capital reacts to changes in capital structure can be divided into three
stages and this can be seen in the following figure.

Criticism:
1. The traditional view is criticised because it implies that totality of risk
incurred by all security-holders of a firm can be altered by changing the way
in which this totality of risk is distributed among the various classes of
securities.

2. Modigliani and Miller also do not agree with the traditional view. They
criticise the assumption that the cost of equity remains unaffected by
leverage up to some reasonable limit.
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3. MM Hypothesis:
The Modigliani Miller Hypothesis is identical with the net operating
income approach, Modigliani and Miller (M.M) argue that, in the absence
of taxes, a firms market value and the cost of capital remain invariant to
the capital structure changes.

Assumptions:
The M.M. hypothesis can be best explained in terms of two propositions.

It should however, be noticed that their propositions are based

on the following assumptions:
1. The securities are traded in the perfect market situation.

2. Firms can be grouped into homogeneous risk classes.

3. The expected NOI is a random variable

4. Firm distribute all net earnings to the shareholders.

5. No corporate income taxes exist.

Proposition I:
Given the above stated assumptions, M-M argue that, for firms in the same
risk class, the total market value is independent of the debt equity
combination and is given by capitalizing the expected net operating income
by the rate appropriate to that risk class.

This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is

not affected by leverage.
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Arbitrary-process:
M-M opinion is that if two identical firms, except for the degree of leverage,
have different market values or the costs of capital, arbitrary will take place
to enable investors to engage in personal leverage as against the corporate
leverage to restore equilibrium in the market.

Proposition II: It defines the cost of equity, follows from their proposition,
and derived a formula as follows:

Ke = Ko + (Ko-Kd) D/S

The above equation states that, for any firm in a given risk class, the cost of
equity (Ke) is equal to the constant average cost of capital (Ko) plus a
premium for the financial, risk, which, is equal to debt-equity ratio times
the spread between the constant average of capita and the cost of debt,
(Ko-Kd) D/S.

The crucial part of the M-M hypothesis is that Ke will not rise even if very
excessive raise of leverage is made. This conclusion could be valid if the cost
of borrowings, Kd remains constant for any degree of leverage. But in
practice Kd increases with leverage beyond a certain acceptable, or
reasonable, level of debt.

However, M-M maintain that even if the cost of debt, Kd, is increasing, the
weighted average cost of capital, Ko, will remain constant. They argue that
when Kd increases, Ke will increase at a decreasing rate and may even turn
down eventually. This is illustrated in the following figure.
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Criticism:
The shortcoming of the M-M hypothesis lies in the assumption of perfect
capital market in which arbitrage is expected to work. Due to the existence
of imperfections in the capital market/arbitrage will fail to work and will
give rise to discrepancy between the market values of levered and unlevered
firms.