CAPITAL STRUCTURE

• The term capital structure is used to

represent the proportionate relationship
between debt and equity.
• The capital structure of a firm is the mix of
different securities issued by the firm to
finance its operations.
 Securities
• Bonds, bank loans
• Ordinary shares (common stock),
Preference shares (preferred stock)
• Hybrids, eg warrants, convertible bonds
 The Capital Structure Cont…

• The value of a firm is defined to be the sum of the

value of the firm’s debt and the firm’s equity.
• V=B+S
• If the goal of the management of the firm is to
make the firm as valuable as possible, then the
firm should pick the debt-equity ratio that makes
the pie as big as possible.
•

S B Value of the Firm

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Distinguished Between Capitalization
Capital Structure & Financial
Structure


• Capitalization:
– It is a quantitative aspect of the financial
planning of an enterprise.
– It refers to the kinds of securities issued by a
company.
• Capital Structure:
– It is concerned with the qualitative aspect.
– It refers to the kind of securities and
proportionate amounts that make up
capitalization.
• Financial Structure:
– It means the entire liability side of the Balance
Sheet.
– IT refers to all the financial resources, short as
well as long term & all forms of debt as well as
 Balance Sheet
Current

Financial Structure
Current Assets
Liabilities


Debt and Capital

 Fixed Structure
Preferred
 Assets
 The Capital-Structure
Question
 There are really two important questions:
1. Why should the stockholders care about maximizing
firm value? Perhaps they should be interested in
strategies that maximize shareholder value.


 2. What is the ratio of debt-to-equity that maximizes

the shareholder’s value?


 As it turns out, changes in capital structure benefit the

stockholders if and only if the value of the firm
increases.


 Note: When we talk about a change in capital structure, we

usually hold other things constant. Thus, an increase in debt
financing implies that equity will be repurchased (and vice 5
 Why is Capital Structure
Important?
• 1) Leverage higher financial leverage means
higher returns to stockholders, but higher risk
due to interest payments.
• 2) Cost of Capital Each source of financing
has a different cost. Capital structure affects
the cost of capital.
• 3) The Optimal Capital Structure is the
one that minimizes the firm’s cost of
capital and maximizes firm value.

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 Patterns/ Forms of Capital
Structure
• Complete equity share capital;
• Different proportions of equity and
preference share capital;
• Different proportions of equity &
debenture(debt) capital;
• Different proportions of equity,
preference & debenture(debt)
capital.
 Theories of Capital
Structure
1.Net Income Approach.
2.Net Operating Income Approach.
3.The Traditional approach.
4.Modiglani & Miller Approach.
 Features of a
Sound/Optimal Capital Mix
1.Maximum possible use of leverage.
2.The capital Structure should be flexible so
that it can be easily altered.
3.To avoid undue financial/business risk with
the increase of debt.
4.It should involve minimum possible risk of
loss of control.
5.It must avoid undue restrictions in
agreement of debt.
6.It should minimize the cost of financing &
maximize earnings per share.
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