CAPITAL STRUCTURE DECISION

Dr [Link] Murthy, Coordnator-PGDM-BIF

This module discusses the concept of Capital Structure, Capital structure planning and Capital
structure decisions and public Enterprises. Part I deals with the concept of financial leverage and
measure of financial leverage. Second part deals with various theories of Capital Structure. Third
part deals with Factors affecting Capital Structure Fourth part deals with Capital Structure
planning. Fifth part deals with Capital Structure decisions and Public Enterprise

Key words: Capital Structure, Financial leverage Debt- Equity Ratio, Net Income Approach
NOI Approach, MM Hypothesis, Trade off Theory, Pecking order Theory, Capital Structure
Planning, Cost of Capital etc
INTRODUCTION:
Capital structure decision is one of the important decisions taken by a finance manager. Given
the capital budgeting decision of a firm, he has to decide the way in which the capital projects
should be financed. For example, a decision to launch a new project or to build a new plant to
buy a new machine implies specific way of financing that project. The issue to be considered
include, the Debt and Equity Mix to be employed and its implications and the appropriate mix
of debt and equity to be considered by the firm
MEANING OF CAPITAL STRUCTURE:
The term capital structure is used to represent the proportionate relationship between debt and
equity. The assets of a company can be financed either by increasing the owners claims or the
creditors claims. The owners claims increase when the firm mobilises funds by issuing equity
shares or by retaining the earnings, while the creditors claims increase by borrowing. The
different sources of financing represent the financial structure of a film. The left hand side of the
balance sheet (liabilities cum equity) represents the financial structure of a firm. Usually, shortterm borrowings are not included in the list of methods of financing the firms Long- term assets
and hence, the long-term claims namely liabilities and equity are said to form the capital
structure of a firm.
WHAT IS FINANCIAL LEVERAGE?
The use of the fixed-charge sources of funds, such as debt and preference capital along with
owners equity in the capital structure, is referred to as Financial Leverage or gearing or Trading

on Equity. The use of the term trading on equity is justified based on the fact that it is the
owners equity that is used as a basis to raise debt; alternatively. It is the equity that is traded
upon. The main objective of a firm is using financial leverage is to magnify the shareholders
return under the assumption that the fixed charge funds (debt or preference capital) can be
obtained at a cost lower than the firms rate of return on net assets (RONA) or Return on
Investment (ROI)
MEASURES OF FINANCIAL LEVERAGE:
The following are the most widely used measures of financial leverage
1. Debt Ratio: The ratio of debt to total Capital i.e., (D/D+E) or D/V Where D is value of
Debt, E is value of share holders equity, V is the value of total Capital (i.e., D+E). D and
E may be measured in terms of book value
2. Debt-Equity Ratio: The ratio of debt to Equity i.e. D/E
3. Interest Coverage: The ratio of net operating income (or EBIT) to interest charges i.e.,
EBIT/Interest

THEORIES OF CAPITAL STRUCTURE:

There exist conflicting theories on the relationship between capital structure and the value
of a firm. According to traditionalists, the capital structure affects the firms value while
Modigliani and Miller (MM), under the assumptions of perfect Capital markets and no taxes,
argue that capital structure is irrelevant
Relevance of capital structure: the net income and the traditional views:
Traditional theories argue that the capital structure is relevent. Net income approach is
one earlier version of the traditional view.
i) Net income approach:
Under NI approach, cost of equity (Ke) and cost of debt (Kd) are constant. As the cheaper
or less expensive debt is replaced for equity in the capital structure, weighted average cost of
capital (Ko), decreases. The optimum capital structure occurs at the point of minimum WACC.
Under this approach, the firm will have the maximum value and minimum WACC when it is
100% debt financed. (See figure 1). The value of the firm is the sum of values of both debt (d)
and equity (E).

Ke
Ko

Cost of
Capital

Kd

Degree of Leverage

Figure 1: The effect of leverage on the cost of capital under NI approach

The value of equity is the discounted value of share holders earnings called (net income) i.e.,
E=Net income (NI)/cost of equity (Ke). The value of debt is the discounted value of debt holders
interest income, i.e., D= Interest (INT)/Cost of debt (Kd). Firms cost of capital (WACC) is net
operating income (NOI) divided by value of the firm (V).
ii) Traditional View:
According to this view, a judicious mix of debt and equity capital can increase the value
of the firm by reducing the WACC up to a certain level debt, beyond which it starts increasing
with financial leverage. Thus, the optimum capital structure for a firm occurs when WACC is
minimum which maximises the value of the firm. The traditional theory can be explained in three
stages.
In stage 1 cost of debt (Kd) and cost of equity (Ke) are constant. As a result, WACC or
Ko decreases with increasing leverage and the value of the firm (V) increases. (See figure 2)

Ke
Ko
Cost of Capital
Kd

Optimum Leverage Range

0 Degree of Leverage
Figure 2: The effect of leverage on the cost of capital under Traditional approach
In stage 2, once the firm has reached a certain degree of leverage, increase in leverage
will not have much impact on WACC and value of the firm (V). This is because the increase in
the cost of equity (Ke) due to added financial risk offsets the advantage of low cost debt (Kd).
In stage 3, beyond the acceptable limit of debt value of the firm decrease with leverage as
WACC increases. This is because investors perceive a high degree of financial risk and demand
a higher equity capitalization rate, which is greater than the low cost of debt (Kd).

IRRELEVENCE OF CAPITAL STRUCTURE: NOI APPROACH AND THE MM

HYPOTHESIS WITHOUT TAXES
i) NOI Approach:
Under net operating income approach, the net operating income and the firms opportunity
cost of capital are assumed to be constant with regard to the level of debt and the value of the
firm is the capitalized value of net operating income. Thus, V=NOI/Ko. The cost of capital (Ko)
of the firm remains constant with increased degree of leverage as the benefit received in the form
of lower cost debt is offset by increased cost of equity on account of the risk perceived by the
equity share holders ( see figure 3)

Ke

Cost of Capital
Ko
Kd
0

Degree of Leverage

Figure 3: The effect of leverage on the cost of capital under NOI approach

ii) MM Hypothesis without Taxes:

Modigliani and Miller argue that in perfect capital markets without taxes, a firms market
value and cost of capital remain invariant to the capital structure changes. The MM Hypothesis is
explained in two propositions.
According to proposition I, for the firms in the same risk class, the total market value is
independent of the debt equity mix, and is given by capitalising the expected net operating
income by the capitalisation rate appropriate to that risk class, where V=Net operating income
(NOI)/ Firms opportunity cost of capital (Ka). The simple logic of proposition I is that two firms
with identical assets, irrespective of their method of financing, can not command different
market values. In this situation, arbitrage will take place to enable investors to engage in the
personal or home made leverage as against the corporate leverage to restore equilibrium in the
market.
Assumptions of proposition I:
1. Perfect capital markets: where investors are free to buy or sell securities
2. Homogeneous risk classes: Firm within same industry constitute a homogeneous risk class.
3. Risk: The operating risk is defined in terms of the variability of the Net Operating Income.
4. No Taxes: there do not exists any corporate taxes
5. Full Payout: The firms follow a 100% payout.

Proposition II:
It provides justification for the levered firms opportunity cost of capital remaining
constant with financial leverage. It implies that the cost of equity (Ke) will increase enough to
offset the advantage of cheaper cost of debt. so that the opportunity cost of capital (Ka) does not
change. A leveraged firm will have higher required return on equity as compensation for
financial risk. The cost of equity (Ke) for a levered firm should be higher than the opportunity
cost of capital, Ka that is the leveraged firms Ke>Ka. It will be equal to constant Ko, plus a
financial risk premium. The levered firms cost of equity is, Ke=Ka+ (Ka-Kd) D/E
The crucial point of proposition II is that the levered firms opportunity cost of capital will not
rise even with excessive financial leverage because in practice cost of debt (Kd) will increase
with high level of financial leverage. MM argue that when Kd increases, Ke will increase at a
decreasing rate and may turn down eventually, because the operating risk of shareholders is
transferred to debt holders.
Criticism of MM Hypothesis:
The arbitrage process is the behavioral foundation for MM Hypothesis. The short
comings of this hypothesis lie in the assumption of perfect capital market in which arbitrage is
expected to work. Due to the imperfections in the capital market, arbitrage may fail to work and
may give rise to discrepancy between the market values of levered and unlevered firms.
Relevance of capital structure: The MM Hypothesis under corporate Taxes:
According to MM Hypothesis, the value of the firm is independent of its debt policy
under the assumption that corporate income taxes do not exist. In reality, corporate income taxes
exist and interest paid to debt holders is treated as a deductible expense. In their 1963 article,
MM shows that the value of the firm will increase with debt due to the deductibility of interest
charges for tax computation and the value of levered firm will be higher than of the unlevered
firm.
HOW DO FIRMS CHOOSE THEIR CAPITAL STRUCTURES?
The choice of debt equity mix is an important finance function of the business
enterprises, and it is observed that firms differ significantly in their capital structure design.
According to Myers (1984), the possible causes for such differences may be one or more of the
following:
1) Trade off theory
Firms have two options viz., owned funds and borrowed funds to finance their capital
expenditure/investment decisions. Both options have relative merits and demerits and firms will
have to trade off costs against benefits and arrive at such combination of debt and equity, which

will maximize the value of the firms. According to this theory, profitable firms with stable,
tangible assets would have high debt equity ratios than the unprofitable firms with risky tangible
assets.
2) Pecking Order Theory
This theory says that there is a pecking order of financing under which internal financing,
debt financing and equity financing are preferred in that order. According to this theory, there is
no well defined target debt equity ratio. While the internal equity is at the top of the pecking
order, the external equity is at the bottom. This theory explains why highly profitable firms
generally use little debt. They borrow little as they dont need much external finance and not
because they have a low target debt equity ratio. Similarly, less profitable firms borrow more
because their financing needs exceed retained earnings and debt finance comes before external
equity in the pecking order.
FACTORS AFFECTING CAPITAL STRUCTURE
The following factors are significant and require careful considerations in the course of planning
the capital structure:
i. Trading on equity or financial leverage
ii. Control on the company
iii. Cost of financing
iv. Flexibility of financial structure
v. period of financing
vi. Statutory requirements
vii. Capital market environment
Trading of equity means that the company takes the advantage of equity share capital to
borrowed funds on reasonable basis. It is based on the assumption that if the rate of interest on
borrowed capital is lower than the normal rate of companys earnings, the equity shareholders
will get a benefit in the form of extra profit.
The control of a company is vested in the hands of a board of directors elected by the
equity share holders. Unlike equity share holders, the debenture holders have no voting rights
and the preference shareholders have only limited voting rights. If the existing equity
shareholders want to retail control over the company, they should encourage debt financing
rather than issue of further equity shares to public.

Generally debt is a cheaper source of financing as compared to equity capital and

preference share capital. However, capital structure of a company should provide for the
minimum cost of capital. It should be flexible enough to adjust itself according to requirements
of changing business conditions. If the company looks for funds for permanent investment then
equity share capital should be preferred rather than preference share capital and debentures.
While framing the capital structure, a company must ensure compliance with the requirements of
the statue.
The environment and conditions prevailing in the capital market should be considered in
determining the capital structure of a company. For example, at the time of depression the
debentures and preference shares carrying a fixed rate of return may be issued easily in the
market as the investing public would like to avoid the risks. But in the boom period equity shares
may be issued easily as the investors would like to take risk and invest in equity shares.

CAPITAL STRUCTURE PLANNING

A company should plan its capital structure immediately as soon as it gets incorporated to
maximize the utilization of funds. The planning of capital structure implies selection of a desired
mix of debt and equity. For this purpose, various methods with their applications need to be
carefully examined. However, the fact remains that identification of desired mix of debt and
equity is a very difficult task. Once it is identified, the same mix should be continued till there is
a genuine need for change of the mix.

METHODS OF CAPITAL STRUCTURE PLANNING

Three most common methods or approaches to determine a companys capital structure are
mentioned below:
1. EBIT-EPS analysis
2. Cost of Capital
3. Cash flow Analysis
EBIT-EPS Analysis:
The relationship between EBIT and EPS is analysed in order to determine the effect of
leverage. Financial leverage or trading on equity arises when fixed assets are financed by debt
capital and preference share capital. If the assets are financed by the use of debt capital, the
return or yield will be more than the cost of debt. As a result, the earning per share goes up

without any investment from the owners. The same also applies in case of preference share
capital.
Cost of Capital
The cost of capital is meant by the minimum rate of return expected by investors. The return
depends on the degree of risk assumed by the investors. Generally, the debt holders assume less
risk than ordinary shareholders because:
1. The rate of interest is fixed
2. Interest charges are tax deductable
3. The rate of return on debt capital and interest payments is assumed.
Debt is a cheaper source of finance than equity. Therefore, a company would always like to
utilize debt as a source of finance if the cost of capital is considered as a criterion for financing
decision.
Cash flow analysis
Cash flow analysis is very important in order to understand the capability of a company
to meet its various commitments including serving of fixed charges, i.e. payment of interest,
preference dividend, and principal repayment, etc. If a company uses a large sum of debt with
short-term maturity, the fixed charges amount will naturally be high. Thus, a company which
expects a large and stable cash inflow in the future period should utilize a large amount of debt in
its capital structure. Therefore, expected future cash flows should be carefully examined by the
company before utilizing any further debt capital.
The expected cash flows can be analysed under the following groups, viz:
(a) Operating cash flows--- relating to the operations of the company
(b) Non- Operating cash flowsconsisting of capital expenditure and changes in working
capital, and
(c) Financial flowscomprising interest, dividends, repayment of debts, etc.
Such analysis as mentioned above provides a clear picture of the companys ability to service
debt obligations even under adverse situation.

CAPITAL STRUCTURE DECISIONS AND PUBLIC ENTERPRISES

The practical significance of the debt-equity ratio is limited in the case of public
enterprises in many countries because major portion of the loans is derived from the Government
itself or from public sector financial institutions. The Government as the owner as well as the
lender has access to all the information it needs about the financial soundness of the enterprise
and does not need to refer to any favourable ratio to derive confidence before sending. Even
when the public enterprises are allowed to borrow from private banks or from foreign financial
institutions, there is a government guarantee that supports the logic that the loans will not be
repudiated and that the enterprises financial embarrassments, if any, taken care by adoption of
an appropriate policy measure. Because of those institutional arrangements for sharing risk and
reducing the disadvantages of debt, it is possible to justify higher debt-equity ratios for public
enterprises.
However, in reality, all of the public enterprises are not wholly owned and financed
(through loans) by government and there are many joint ventures. Since the institutional
arrangements for diluting risks are not always available public enterprises have to face the irk of
the lending agencies (local or foreign) towards this aspects of strength of their capital structure.
In many a case, the parent ministries would like-to proceed with a particular investment, for
political or other reasons, and they have to approach other ministries e.g. planning and finance,
for a critical scrutiny and appraisal of their proposals. In any case, the government owned
financial institutions are expected to raise points about the risk of further lending to an enterprise,
the debt-equity ratio of whose capital structure is not in line with the standards or which does
not appear to be healthy in the context of its financial products. Most of the plans of investment
in public enterprises, whether for replacement and rehabilitation of existing assets or for
expansion and diversification, require significant amounts of foreign exchange. In cases where
this resource is arranged from foreign lending agencies like the World-Bank/IDA, the creditors
make it a point to specify adherence to a range of healthy debt-equity ratios (and also to a
conservative dividend disbursement policy) till their loans are repaid. A high proportion of
equity in its capital structure is desired to be is maintained because it should enable it have
freedom of action in the matter of retaining its earnings for its self-financed projects or for
financing a part of its working capital provided, of course, that it is in the profit making
scenario. For enterprises which operate at a loss (because of government imposed pricing
policies or their inefficiencies, there is usually a demand for converting at least a part of their
loan capital into equity capital. When such proposals are examined, the question of a reasonable
or proper debt-equity ratio for the type of enterprises under consideration is raised at any time.
Another issue to be considered is that with a high debt-equity ratio, the initial cost of a
project/manufacturing facility put up by a public enterprise has the effect of increasing the fixed,
costs of operation through the capitalisation of interest during construction period. This may
drag the enterprise to a difficult situation when compared to its competitors and can lead to a
vicious cycle of accumulated losses, under utilisation of capacity, low morale of workers

management inefficiencies, short-term unrealistic solutions and further losses. Once an enterprise
is trapped in this situation, it is difficult to come out and rehabilitate its capital structure, as the
Government departments ministries are not that prompt in analysing the causes of these
problems and providing the needed reliefs at appropriate time.
It is also to be remembered that, the equity component of a public enterprise must not be
considered as a tool of cash convenience and as a zero cost input, because it certainly has an
opportunity cost for the economy at large. Since, public enterprises need to operate under pricing
and operating policies dictated by their owner governments socio-economic and political
objectives debt-equity ratio is one mode by which the enterprise has been compensated for its
expenses/losses on meeting these socio economic and other obligations. If a certain range of
debt-equity ratios is adopted for enterprises in a particular sector of the economy, it may result in
fixing a concessional rate of interest/return on the capital mix in the form of loan at market rate
and equity at zero per cent cost.
It should be understood that the view that the practical significance of the debt equity
ratio is limited in the case of public enterprises is not based on a complete appreciation of all the
factors in which these enterprises have to operate in many developing countries, while
comparing the private sector in this respect may have to be modified suitably when applied to the
public enterprise situation in a particular country, it will remain a useful indicator, both with the
administrative ministers and with the enterprise managements, to assess the strength of their
capital structures
CONCLUSION:
Capital Structure Planning is one of the important decisions taken by the finance Manager in the
current corporate world. It is also one of the most widely discussed issues in finance theory as
well as in practice. The theories on capital structure gained importance especially after the
publication of the classic paper by Modigliani and Miller (MM) in 1958. It is a curtain raiser to
the most controversial issue in finance literature i.e. whether the proportion of debt and equity in
firms capital structure affects its value. The Practical significance of Capital Structure Decision
i.e., debt-equity ratio is limited in the case of public Enterprises in many countries because major
portion of loans are derived from Government itself or from public sector financial institutions.
The Government owned financial institutions are expected to raise points about the risk of
lending to Enterprises, for who the capital structure is not in line with the standards. The equity
component in public Enterprises should not be considered as a zero cost input, as it has got an
opportunity cost to the economy.

References:
1. Barges, A, The Effect of Capital Structure on the Cost of Capital, Prentice- Hall, Inc,
1963
2. Modigliani, H, and R H. Miller, The Cost of Capital, Corporation Finance and the Theory
of Investment, American Economic Review ,48 (June 1958), pp 26-9
3. Modigliani and M.H Miller, Corporate Income Taxes and the Cost of Capital: A
correction, American Economic review,53, June 1966,pp 433-43
4. Myer, S.C, The Capital Structure Puzzle, Journal of Finance,3 (July 1984), p 581
5. Pandey, I.M, Financial Management, vikas Publishing House Pvt. Ltd.2010
6. Pandey, I.M Capital Structure and Cost of Capital Vikas publishing house Pvt ltd, reprint
1996
7. Van Horne, James C , Financial management and Policy, PHI, 2011
8. Solomon, Ezra, The Theory of Financial Management University press, 1963
9. Subhash Chandra Das, Business Accounting and Financial Management, PHI learning
private ltd, Delhi, 2013.
10. Indira Gandhi National Open University, New Delhi, Financial Management, 2007.

Short Answer Type Questions

1. What do you mean by Capital Structure?
2. What is Financial Leverage?
3. Difference between Net Income Approach and Net operating Income Approach
4. Briefly discuss the Traditional Theory on Capital Structure
5. Briefly explain the MM Hypotheses
6. What are the factors that influence the Capital Structure decision of a firm?
7. Briefly discuss the methods of Capital Structure Planning,
8. Briefly discuss the significance of Capital Structure decision in Public Enterprise

True or False Questions:

1. Net income Approach States that Capital Structure is Irrelevant

(False)

2. Financial Leverage is also Called on Trading or Equity

(True)

3. Net Operating Income Approach indication that Capital Structure is relevant (False)
4. Interest coverage is Calculated as the ratio of net operating income to interest charges
(True)
5. MM Theory without the corporate income taxes a assumption, states that the capital
Structure is irrelevant.

(True)

6. According to pecking order theory managers always prefer to use debtors the first
option

(False)

7. The Capital Structure decision of the firm can be characterized as a choice of that
combination of debt and equity, which maximizes the market value of the firm.
(True)
8. Capital Structure is not affected by the agency costs

(False)

9. Earnings per share is total earnings divided by no-of equity shares.

(True)

10. The Market value of the levered firm will be equal to the market value of an
unlevered firm plans the present value of interest tax shield

(True)