Capital structure

The capital structure is how a firm finances its overall operations and growth by using
different sources of funds.
A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity.
when people refer to capital structure they are most likely to referring to a firm's debt to
equity ratio which provide insight into how risky a company is

Objective are

1.Maximize the value of the firm.

2.Minimize the overall cost of capital.
to understand how a firm can create value through its financial decision

Optimal capital structure

The best debt-to-equity ratio for a firm that maximizes its value.
The optimal capital structure for a company is one which offers a balance between the
ideal debt-to-equity range and minimizes the firm's cost of capital.
In theory, debt financing generally offers the lowest cost of capital. However, it is
rarely the optimal structure since a company's risk generally increases as debt increases.

Essentials of Optimum Capital Structure

Simplicity
Flexibility
Maximum Return
Minimum Cost
Minimum Risks
Maximum Control
Adequate Liquidity
Provision for anticipated Future contingency

Cost of capital
is an important concept in financial management. Every firm needs funds for making
investments. These funds can be procured from different types of investors, that is,
equity shareholders, preference shareholders, debt-holders, etc. These investors while
providing the funds to the firm will have an expectation of receiving a minimum
return from the firm. This minimum returns expected by the investors depends upon
the risk-appetite of the investors and also on the characteristics of the firm. This
minimum return required by the investors is called Cost of Capital of the firm.
Therefore, while making investment decisions, the firm chooses that alternative which
generates at least that much return which is expected by the investors of the firm.
Otherwise, the firm will not take up that alternative.
In order to maximize the value of the firm, the cost of all the different sources of the
funds must be minimized.

TYPES OF COST OF CAPITAL-

1. Specific and Overall cost of capital-
The individual costs of different sources of funds (Long term debts and bonds,
Equity Shares, Preference Shares and Retained earnings) is called Specific
cost of capital. The combined cost of all these sources together is called
Overall cost of capital (Weighted Average Cost of Capital).

2. Explicit and Implicit cost of capital-

The explicit cost of capital can be defined as the interest or dividend that the
firm has to pay to the suppliers of the funds. There is an actual flow of funds
from the firm or there is an actual flow of return payable by the firm to the
suppliers of the funds. These payments are called explicit cost of capital.
However, Retained earnings have an implicit cost of capital. It is because
these does not involve any actual flow of funds to the suppliers of the funds.
The profits earned by the firm but not distributed among the equity
shareholders are ploughed back and reinvested within the firm. Had these
profits been distributed to equity shareholders, they could have invested these
funds (return for the shareholders) elsewhere and would have earned further
returns. These further returns are foregone by the investors when profits are
retained by the firm (called Opportunity cost). Thus, the implicit cost of
retained earnings is the return which could have been earned by the investor,
had the profits been distributed to them.

MEASUREMENT OF COST OF CAPITAL-

The measurement of cost of capital refers to the process of determining the cost of
funds to the firm.

Cost of long term debts and bonds (Long term borrowings)- Cost of long term
borrowings refers to the cost of borrowing funds to the firm. This is the minimum
return which is expected by the investors from the firm who supply long term debts to
the firm.

Cost of preference share capital- Companies can also raise funds through preference
shares. The cost of capital of preference shares refers to the minimum amount of
returns expected by the preference shareholders of the company. The preference share
capital is differentiated from equity share capital on the basis of these two features-
(a) The preference shares are entitled to receive dividends at fixed rate.
(b) In case of liquidation of the company, preference shareholders get
capital repayment in priority over the equity shareholders.

Cost of equity share capital- The minimum rate of return expected by the equity
shareholders of the company is known as cost of equity share capital. It is represented
by ke and has three sub parts-
(a) Zero-growth dividends- It is assumed under this method that
dividends will remain constant at the current level for the assumed
perpetual life of the firm. Ke= D1/Po
Where, D1= Expected dividend at the end of year 1 and Po= Current
market price of the share.
(b) Constant growth rates in dividends perpetually- Under this method,
dividends are assumed to grow at a constant rate, g, per annum.
Ke= (D1/Po)+g
Where, g= Growth rate per annum, D1= Do(1+g) and Do= Current
dividend paid by the firm.

Cost of retained earnings- Earnings generated by a firm are distributed as dividends

among the equity shareholders. However, if the entire earnings are not distributed and
a part is retained by the firm, then these are available for reinvestment within the firm.
The cost of retained earnings is considered as the opportunity cost of foregone
dividends.

WIGHTED AVERAGE COST OF CAPITAL

WACC can be defined as the rate of return that must be earned by a firm in order to
satisfy the requirements of all the different investors of the firm.
Once the specific cost of capital of each of the sources, debt, equity share capital,
preference share capital and retained earnings is found out, the next step is to
calculate the overall value of the firm, represented by ko and also called WACC.

Net Income Approach

According to this approach capital structure decision is relevant to the valuation of the
firm.
This states that the higher debt content in capital structure (i.e. high financial leverage)
will result in decline in the overall or weighted average cost of capital
This will increase in the value of the firm and consequently increase in the value of
equity shares of the company.

Net operating income approach

This is just opposite of Net Income approach.

According to this approach market value of the firm is not affected by the
capital structure changes.
The market value of the firm is ascertained by the capitalizing the net
operating income at the overall cost of capital (constant).
Thus , the advantage of debt is set off exactly by increase in the equity
capitalization rate.
MV of equity =MV of Debt- MV of the firm

Traditional Approach: