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INSTITUTE OF ACCOUNTANCY ARUSHA (IAA)

(BAF II 2024/2025)

CORPORATE FINANCE (CF)

TOPIC: CAPITAL STRUCTURE
Meaning of Capital Structure
Capital structure refers to the combination of a company's long-term sources of financing, which
may include a mix of debt (such as loans or bonds) and equity (such as common stock, preferred
stock, or retained earnings). It represents how a firm finances its overall operations and growth by
using different funding options.
The capital structure is often expressed as a debt-to-equity ratio, which shows the proportion of
debt versus equity used by the company to finance its assets. Companies aim to optimize their
capital structure to balance risk and return, ensuring that they can support growth while minimizing
the cost of capital and financial risk.
Optimum Capital Structure
Optimum capital structure may be defined as a combination of sources of finance at which the
overall cost of capital is minimized and at the same time it leads to the maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.

Financial Structure
The term financial structure is different from the capital structure. Financial structure shows the
pattern of total financing. It measures the extent to which total funds are available to finance the
total assets of the business.
Financial Structure = Capital Structure + Current liabilities.
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Forms of Capital Structure

Capital structure pattern varies from company to company and the availability of finance.
Normally the following forms of capital structure are popular in practice.
✓ Equity shares only.
✓ Equity and preference share only.
✓ Equity and Debt only.
✓ Equity shares, preference shares and debt.

Factors Affecting Capital Structure

Business Risk
Business risk refers to the volatility in a company's earnings due to the nature of its operations.
Companies with higher business risks, like those in highly competitive or uncertain industries,
tend to avoid excessive debt, as leveraging increases the chances of financial distress.
Tax Considerations
Interest payments on debt are tax-deductible, creating a tax shield that can lower a company’s
taxable income. Firms in higher tax brackets often prefer debt financing to take advantage of this
benefit and reduce their overall cost of capital.
Cost of Debt vs. Equity
The cost of debt is typically lower than equity due to fixed interest payments and tax benefits, but
it increases financial risk. Companies balance these costs to decide whether to raise funds through
debt or equity, often opting for the cheaper option while considering long-term financial health.
Control Considerations
Issuing equity dilutes existing shareholders' ownership and control. Companies that want to
maintain control, particularly those with family or closely held ownership, may favor debt over
equity, as borrowing does not affect ownership stakes.
Financial Flexibility
Firms need financial flexibility to respond to opportunities or challenges, such as expansions or
downturns. To preserve this flexibility, companies may limit their use of debt, keeping their
borrowing capacity available for future needs.
Company Growth Stage
Young and fast-growing companies may prefer equity to avoid the burden of fixed debt
repayments. Mature firms, with stable cash flows and lower growth prospects, often rely more on
debt, as they can comfortably service interest payments.
Industry Characteristics
Industry norms influence capital structure decisions. For instance, capital-intensive industries with
stable cash flows, like utilities or real estate, tend to use more debt, whereas industries with more
volatile cash flows, such as tech, often rely more on equity.
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Credit Rating
A company’s credit rating affects its ability to borrow and the cost of borrowing. Firms with higher
credit ratings can access debt at lower interest rates, making debt a more attractive option.
Conversely, companies with lower credit ratings may find debt too expensive and rely more on
equity.
Asset Structure
Companies with more tangible, fixed assets, like real estate or machinery, can use those assets as
collateral to secure debt. Firms with intangible assets, such as patents or intellectual property, may
find it harder to raise debt and instead seek equity financing.
Profitability
Highly profitable companies tend to use retained earnings to finance their operations, reducing the
need for external debt. Less profitable firms may depend more on external financing, either
through debt or equity, to fund their operations or growth.
Regulatory Environment
Government regulations, such as capital requirements and borrowing limits, influence capital
structure decisions, particularly in regulated industries like banking or insurance. Firms must
comply with these rules when planning their mix of debt and equity.

Traditional Approach
According to the traditional approach, mix of debt and equity capital can increase the value of the
firm by reducing overall cost of capital up to certain level of debt.
Traditional approach states that the Ko decreases only within the responsible limit of financial
leverage and when reaching the minimum level, it starts increasing with financial leverage.
Assumptions
Capital structure theories are based on certain assumptions:
• There are only two sources of funds used by a firm; debt and equities.
• The firm pays 100% of its earning as dividend.
• The total assets are given and do not change.
• The total finance remains constant.
• The operating profits (EBIT) are not expected to grow.
• The business risk remains constant.
• The firm has a perpetual life.
• The investors behave rationally.
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Exercise 1
ABC Ltd., needs shs3,000,000 for the installation of a new factory. The new factory expects to
yield annual earnings before interest and tax (EBIT) of shs500,000. In choosing a financial plan,
ABC Ltd., has an objective of maximizing earnings per share (EPS). The company proposes to
issuing ordinary shares and raising debt of shs300,000 or shs1,000,000 or 1,500,000. The current
market price per share is shs250 and is expected to drop to shs200 if the funds are borrowed in
excess of shs1,200,000. Funds can be raised at the following rates.
• Up to shs300,000 at 8%
• Over shs300,000 up to shs1,400,000 at 10%
• Over shs1,400,000 at 15%
Required: Assuming a tax rate of 50% advice the company on the best financial plan.

Modern Approach
Net Income (NI) Approach
Net income approach was suggested by the economics and finance theorist David Durand.
According to this approach, the capital structure decision is relevant to the valuation of the firm.
In other words, a change in the capital structure leads to a corresponding change in the overall cost
of capital as well as the total value of the firm. According to this approach, use more debt finance
to reduce the overall cost of capital and increase the value of firm.
Net income approach is based on the following three important assumptions:
1. There are no corporate taxes.
2. The cost of debt is less than the cost of equity.
3. The use of debt does not change the risk perception of the investor.

To calculate value of the firm we can use this formula: V = S+B

Whereby;
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following formula:
𝑁𝐼
S=
𝐾𝑒
Whereby;
NI = Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate
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Format for calculating value of the firm on the basis of NI approach.

Particulars Amount
Net operating income (EBIT) XXX
Less: interest on debenture (r) XXX
Earnings available to equity holder (NI) XXX
Equity capitalization rate (Ke) X
Market value of equity (S) XXX
Market value of debt (B) XXX
Total value of the firm (S+B) XXX
Overall cost of capital = Ko = EBIT = X%
V
Exercise 2
a) A Company expects a net income of Tshs100,000. It has Tshs250,000, 8% debentures. The
equity capitalization rate of the company is 10%. Calculate the value of the firm and overall
capitalization rate according to the net income approach (ignoring income tax).
b) If the debenture debts are increased to Tshs400,000. What shall be the value of the firm and
the overall capitalization rate?

Net Operating Income (NOI) Approach

The NOI approach, developed by David Durand in the 1950s, suggests that a firm's value is
influenced by its capital structure due to the risk and return associated with debt financing. This is
just the opposite of the Net Income approach.
The NOI approach emphasizes that the WACC increases with increased debt due to higher
financial risk, which can ultimately affect the firm's value.

NOI approach is based on the following important assumptions;

• The overall cost of capital remains constant
• There are no corporate taxes
• The market capitalizes the value of the firm as a whole
Value of the firm (V) can be calculated with the help of the following formula
V = EBIT
Ko
Whereby;
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
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Exercise 3
a) XYZ expects a net operating income of Tshs200,000. It has Tshs800,000, 6% debentures.
The overall capitalization rate is 10%. Calculate the value of the firm and the equity
capitalization rate (Cost of Equity) according to the net operating income approach.
b) If the debentures debt is increased to Tshs1,000,000. What will be the effect on volume of
the firm and the equity capitalization rate?

Exercise 4
Abya Company Ltd. expresses a net operating income of Shs200,000. It has Shs.800,000
to 7% debentures. The overall capitalization rate is 10%.
a) Calculate the value of the firm and the equity capitalization rate (or) cost of equity
according to the net operating income approach.
b) If the debenture debt is increased to Shs1,200,000. What will be the effect on the
value of the firm, the equity capitalization rate?

Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words, MM approach maintains that
the average cost of capital does not change with change in the debt weighted equity mix or capital
structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
• There is a perfect capital market.
• There are no retained earnings.
• The dividend payout ratio is 100%.
• The investors act rationally.
• The businesses have the same level of business risk.

Value of the firm can be calculated with the help of the following formula:
V = EBIT x (1-t)
Ko
Whereby;
EBIT = Earnings before interest and tax
Ko = Overall cost of capital
t = Tax rate
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Exercise 5
There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any debt in
its financing, while B has kshs.250,000 6% Debentures in its financing. Both the firms have
earnings before interest and tax of kshs75,000 and the equity capitalization rate is 10%. Assuming
that there is no corporation tax.
Required: Assuming a tax rate of 50%, calculate value of the firm two firms.