Contents

0 Meaning & Importance of Capital Structure

0 Factors affecting Capital Structure Capitalization 0 Meaning and Theories of Capitalization 0 Over & Under Capitalization

Capital Structure
0 Is the proportion of debt and preference and equity

shares on a firms balance sheet.

0 Finance Decision by the Finance Manager

0 Should choose optimum capital structure

Optimum Capital Structure

0 Is the capital structure at which the weighted average

cost of capital is minimum and thereby maximizing

value of the firm.

0 Difference in views as to : whether there is a

relationship between leverage and value of the firm!!!

Capital Structure Theories

1.

Net Income Approach

2.

Net Operating Income Approach

3.

Modigliani Miller Approach

4.

Traditional Approach

Assumptions
1.

There are only two sources of funds used by a firm: perpetual riskless

debt and ordinary shares

2.

The dividend pay out ratio is 100. ie, the total earnings are paid out as dividend to the shareholders and there are no retained earnings.

3.
4. 5.

The total assets are given and will be constant

The total financing remains constant The operating profits (EBIT) are not expected to grow.

6.

Business risk is constant and is assumed to be independent of its

capital structure and financial risk Perpetual life of the firm

7.

1. Net Income Approach

0 Suggested by Durand

0 Capital Structure decision is relevant to the valuation of the

firm.

0 Change in financial structure ------- change on overall

cost of capital -------change in total value of the firm.

Assumptions of Net Income Approach

1.

There are no taxes

2.

The cost of debt is less than cost of equity

3.

The use of debt does not change the risk perception of the investors

Net Income Approach

0 Increase in Degree of Leverage - Decrease in weighted

average cost of capital -- Increase in value of the firm

0 Financial leverage is an important variable to the capital

structure of a firm.

0 Judicious mix of debt and equity -- reduce cost

2. Net Operating Income Approach

0 Suggested by Durand

0 Diametrically opposite to the Net Income Approach

0 The essence is Capital Structure is irrelevant.

Net Operating Income Approach

0 According to NOI Approach, the Market Value of the

firm is not affected by the change in Capital Structure, the Weighted Average Cost of Capital is said to be constant.
0 The valuation of the firm and its cost of capital is

independent of its capital structure

Assumptions of NOI
1. The market capitalizes the value of the firm as a whole. Thus

the split between debt and equity is not important.

2. The market uses an overall capitalization rate to capitalize

NOI. If business risk is assumed to remain unchanged, cost of capital is constant.

3. The use of less costly debt funds will increase the risk of

equity shareholders. (offset the cost reduction)

3. Modigliani Miller Approach

0 MM proposition supports NOI Approach

0 DOL will not affect WACC, thereby having no impact

on value of the firm.

Assumptions of MM Model
1.

Perfect Capital Market situation

2.
3. 4.

Free buying and selling of securities

Investors behave rationally No transaction costs

5.
6.

Dividend pay out ratio 100%

Business risk is similar for all firms operating in similar environment There are no taxes

7.

4. Traditional Approach
0 It is a compromise between NI & NOI approach 0 According to this view the cost of capital can be reduced or

value of firm can be maximized by using judicious mix of

debt and equity

0 Implies Cost of Capital decreases with reasonable limits of

debt and then increases with leverage

0 It believes the existence of what may be called Optimum

Capital Structure

Cost of Capital
0 COC is the rate of return that a firm must earn on its project/

investments to maintain its market value and attract funds

0 In operational terms, it refers to the discount rate that is

used in determining the PV of the estimated future cash proceeds and eventually deciding whether the project is worth undertaking or not

Cost of Capital
0 It can also be defined as the rate at which an

organisation must pay to the suppliers of capital for

the use of their funds.

0 Hurdle rate, cut off rate, required rate of return, WACC

Cost of Capital: Two perspectives

1. The cost of raising funds to finance a project. This cost

may be in the form of the interest which the company may be required to pay to the suppliers of funds.

2. The cost of capital may be in the form of opportunity cost

of the funds of company. i.e rate of return which the company would have earned if the funds are not invested.

Importance of Cost of Capital

1. The concept of cost of capital is used as a tool for screening

the investment proposals

2. The cost of capital is used as the capitalisation rate to decide

the amount of capitalisation in case of new concern

3. The cost of capital provides useful guidelines for determining

the optimal capital structure

Weighted Average Cost of Capital

0 The cost of capital is composed of different elements

0 These elements are the cost of each component of capital

0 Component means the different sources from which funds are

raised by a firm
0 The cost associated with each source is called its specific cost 0 When these specific costs are multiplied with the respective

weights (proportion) and summed up, we get the WACC

0 Composite Cost of Capital, Combined Cost of Capital

Calculating WACC
Source of Capital Equity Preference Share Proportion 0.6 0.05 Specific Cost 16% 14% 9.6% 0.7% WC

Debt

0.35

8.4%

2.94% WACC 13.24%

CAPITAL STRUCTURE CAPITALIZATION

Capitalisation
0 In the context of financial planning, capitalisation

refers to the process of determining the amount of

capital required by a company.

Capitalisation Theories
1. Cost Theory

2. Earning Theory

Cost Theory
0 According to the cost theory of capitalisation, the amount of

capital required by the company is calculated by adding up the cost of its fixed assets, the amount of working capital, and the cost of establishing the business.
0 Simple Approach 0 Used in new companies

Earning Theory
0 According to earning theory, the capital requirement of a

company is calculated on the basis of the capitalised value of

its earning.
0 For a new company the amount of capitalisation is calculated

on the basis of its estimated earning.

Examples
1. If the average annual earning of a company is Rs. 5 lakh and

the normal rate of return on the capital employed in case of companies in the same industry is 10%, then the amount of capitalisation is Rs. 50 lakh.
2. If a new company expects to earn an average annual income of

Rs. 3 lakh and the normal rate of return of the industry is 5%,

then the amount of capitalisation or the quantum of fund it

would require to run the business is Rs. 60 lakh.

Earning Theory
0 More a rational approach

0 It helps in evaluating as to how far the actual capital

employed is justified by the earning of the company.

0 If the actual rate of return is same as the normal rate of

return then it is said to be proper capitalised.

Over Capitalisation
0 A company is said to be over-capitalised if its capital

employed is more than its proper capitalisation.

0 For example, if a companys average annual earnings is

Rs.2,00,000 and the normal rate of return is 10%.

0 Then its proper capitalisation is Rs.20,00,000. 0 Now, if the actual capital employed (total long term funds) is

Rs.25,00,000 it will be treated as over-capitalised.

Over Capitalisation
0 In other words, if a companys actual rate of earnings is less

than the normal rate of return, it is treated as a case of overcapitalisation.

Reasons for Over Capitalisation

0 Excessively high price paid for the purchase of goodwill and

other fixed assets.

0 Under-utilisation of production capacity. 0 Raising more capital in the form of shares and debentures than

required.
0 Liberal dividend policy. 0 Underestimation of capitalisation rate or overestimation of

earnings while deciding on the amount of capital to be raised.

Effects of Over Capitalisation

0 Lower rate of dividend

0 Reduction in market value of share

0 Difficulty in raising additional funds

Remedies of Over Capitalisation

0 Debts may be redeemed

0 Efficient utilisation of resources

0 Conservative dividend policy

Under Capitalisation
0 Under-capitalisation is just the reverse of over-capitalisation. 0 Here, capital employed is less than its proper capitalisation 0 i.e., the amount of capital invested is not justified by its annual earnings. 0 Alternatively, if a companys actual rate of earnings is more than the

normal rate of return, it is treated as a case of under-capitalisation.

0 This does not imply that the company suffers from inadequacy of capital.

Under Capitalisation
0 Under-capitalisation is indicative of a sound financial

position and may lead to increase in the market value of companys shares.
0 However, it can encourage competition as high rate of

return may attract new entrants in the field.

Effects of Under Capitalisation

0 Market value of shares goes up since earning are high

0 Workers may demand higher wages

0 The high rate of earnings may encourage outsiders to

start similar earnings and thus competition is

increased.

Remedies of Under Capitalisation

0 Issue of bonus shares
0 Splitting up of shares 0 Market forces will automatically correct the situation